Chart Presentation: Capital Flows

Oct. 15 (Bloomberg) — U.S. stocks fell the most in a month after Citigroup Inc. said defaults will plague the financial industry for the rest of the year.

Our recent argument has been that the subprime crisis in 2007 is similar to the Asian crisis in 1998 and that both were caused in part by global capital flows. In response to the 1998 crisis the Fed cut the funds rate from 5.5% to 4.75% which helped initiate the tech and telecom bubble that would eventually peak in March of 2000 as the Fed moved the funds rate back to 5.5%.

In 2007 capital has been flowing away from the U.S. dollar and into commodities, commodity currencies, and the Asian markets. While an excess of capital leads to speculative excess those excesses are then laid bare when capital moves away. The inverse or flip side of strength in the commodity sector this year has been weakness in the U.S. home builders and financials. We show charts of Bear Stearns and Beazer below.

The point is that the tech and telecom bubble post-1998 was preceded by an easing of credit conditions due to a sense of crisis in those markets which were hemorrhaging capital. In 1998 money was moving away from Asia, Russia, and Brazil and today money has been moving towards those markets.

One might argue that this time is different- that the decline in U.S. real estate prices is justified based on fundamentals and that price gains were based on wildly speculative and often fraudulent lending practices. Fair enough… but… how is that different from the Chinese equity markets at present? The only difference is the direction of the flow of capital.

Another way to look at this is to view the Singapore equity market post-crisis in 1998. If capital was flowing out of Singapore based solely on fundamentals then why, we might ask, did the Singapore market subsequently triple in price? In fact we could argue that the level of speculation in the U.S. real estate market pales in comparison to what the forex traders were doing in 1998 and are doing in 2007.

Quickly… capital was exiting Singapore in 1998 and the Singapore stock market was falling. This time around capital has been moving away from Japan which gives the chart of Mitsubishi UFJ a similar appearance.

The early stages of 1998- 2000 tech and telecom rally included a nice ramp upwards by Nokia and then a break out by Intel (below) in late October. Telecoms such as Nippon Tel (NTT) didn’t join the party until early 1999 so if history is repeating we would like to see a positive reaction this week to Intel’s earnings and then a broadening of the telecom rally into 2008.