Another sign that US investors are still in a trance came as the Fed Chairman, Alan Greenspan, indicated that he is now more concerned with a softening economy than an overheating economy. This of course indicates that the Fed could soften is stance towards interest rates and it opens the way for interest rate cuts in the future. At least it now appears as if the Fed is highly unlikely to raise interest rates on December 19 and will probably leave them unchanged for the time being.

But the real irony is that the stock market reacted with euphoria to the news, with the NASDAQ up 274 points (more than 10%) and the Dow up 338 points (over 3%) on Tuesday. How is this possible? What are these people thinking? The US stock market, and by implication the investors who buy these shares, is discounting rapidly growing earnings on the back of alleged “productivity gains”. The bulls argued that these productivity gains could keep the economy growing without the threat of inflation and hence we were in a "New Era".

This "New Era", like the emperor’s clothes, has already been debunked - there is no need to delve into all the arguments here. What is much more interesting is to briefly recap where we came from and where we are, and to see if that sheds any light on where we may be going.

The real driving force behind the US economy was not the invention of the internet, or Corporate America’s investment in computers and other technologies, it was just a mundane increase in the money supply, brought about by several converging factors outside the control of the US government. Since about 1992, the world has experienced one economic crisis after another, starting with South America and winding its way through Central America, South East Asia, Russia, Eastern Europe and most recently, Western Europe. These crises went hand in hand with currency devaluations and that, coupled with relatively high real interest rates in the United States and a relatively strong economy, caused an enormous influx of capital into the US, hence an increase in money supply.

This influx of capital reduced US interest rates by boosting bond prices and stimulated consumer spending by means of the wealth effect. It did not take long for a stock market bubble of historical proportions to develop. All that Alan Greenspan had to do was sit back and relax. He no more engineered this economic miracle than what he can prevent its demise. It was foreign capital that created this fiasco and it is the repatriation of the same foreign capital that will expose the US stock market mania for the folly that it really is.

A crucial point in all of this, and I haven’t yet heard anyone mention it, is the convergence of real interest rates in Europe and the US. During the early 1990’s when the currency crises swept across the world, the US economy was growing faster than Europe and real interest rates in the US were higher than in Europe. This is ultimately what drew the capital into the US. But now the US economy is slowing down and approaching that of Europe. Simultaneously, inflation is creeping up and yields are coming down, which means that real interest rates are dropping and are also converging with European real interest rates. If the Fed changes its stance towards lower interest rates, this would further speed up the convergence and the benefit to foreign investors will dissipate.

The bottom line is that while the dollar was going up against most other currencies foreign investors got a double whammy. They could make good returns on the stock and bond markets and capture a profit from the increasing dollar, in many cases yielding well over 20% per year or more in terms of their local currencies. But for now it looks as if the party’s over.

For US investors the situation is just as gloomy. With the US economy slowing down, the whole house of cards falls down. A slowing economy is unlikely to deliver the optimistic earnings forecasts that Wall Street keeps touting and a declining stock market will put the wealth effect in reverse, therefore curtailing the consumer spending that has fueled much of this hysteria.

The US stock market is already looking terrible if you are in technology stocks and downright scary for the rest of the market, which appears analogous to Wiley Coyote who has just run over a cliff but has not looked down yet. Watch out below!

If the Fed raises rates, the market could collapse and consumer spending will grind to a halt possibly causing a recession. If the Fed lowers interest rates, the dollar will become unattractive to foreigners and if they repatriate their capital it could cause a collapse in the dollar, which will in turn increase US inflation due to the trade deficit and cause all sorts of pandemonium. In fact, a decline in the dollar due to foreign repatriation of funds could put upward pressure on US interest rates while the Fed might be trying to lower interest rates.

In short, I don’t see a happy ending to this dilemma. Not that any investment bubble in history has ever had a happy ending. I continue to accumulate gold stocks and biding my time. Patience is a most valuable trait when it comes to investing and speculating. Of all the asset classes I can think of, none would fare better, with less risk, than gold and gold.