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The dangerous market bubble Add to ...

Next, the rise in stocks correlated almost perfectly with the decline in the dollar, precisely repeating the perverse pattern of the super-bubble years. As investors regained their appetite for risk, so they took their money out of the United States. The correlation weakened slightly but remained intact, with the dollar rising as stocks fell early in 2010. The parallels with Japan's crash of 1990 are eerie. It kept its banks alive while cutting interest rates to zero, and then the world used its currency to borrow cheap. In 2009, exactly the same thing happened to the dollar. The money flowing out of the United States was executing a kind of dollar carry trade, as investors looked for higher yields elsewhere.

Then there is the issue of correlation. According to MSCI, the correlation of the BRICs and the emerging markets with the developed world reached an all-time high in the summer of 2009. By then, the rolling annual correlation between them was above 0.8-so that a move in one was by far the strongest explanation for a move in the other.

In late 2009, correlations between the stock market and the carry trade were also stronger than at any point in 2007 or 2008-with the significant difference that the weak currency traders borrowed was the dollar, not the Japanese yen. The dollar and U.S. stocks were tightly linked. So, still, were the yen carry trade and the oil market. Calculations by Jamie Lee of pi Economics show that moves in the S&P 500 were by now sufficient to explain 60 percent of moves in the exchange rate of the Australian-dollar against the U.S. dollar. For commodity-backed carry trade currencies as a whole, the S&P explained about half their movements. And the link between the yen and the S&P was stronger than it had been in the weeks after the Shanghai Surprise almost three years earlier, when markets first lapsed into crisis.

Such strong correlations may merely be the result of the correlated crash that preceded them. If all these markets became undervalued together in a panic, then they might well be linked with each other on the way back up. But the pattern of the synchronicity between world markets makes this very hard to believe. Not only did markets take their cues from the falling dollar, but they took fresh orders almost every minute. Over a six-week period, the exchange rates of the dollar against the euro, the Australian dollar, and the price of gold all had a correlation of more than 0.5 with the U.S. stock market, every minute. Even in weeks when neither had a clear overall trend, they moved in the same direction as each other almost three times as often as they moved in opposite directions.

As the historical relationship between these markets is minimal, this suggested that all of them were priced inefficiently-bad news when the world economy was fighting to find equilibrium after a free fall. The relationship is so tight that it may be caused by computer-driven funds that have tracked the relationship in the past and are trading on the assumption that it will continue. If a computer-driven fund sees a gain in the S&P, it automatically buys the Australian dollar, for example.

Another explanation for 2009's resurgence is that markets entered a "rational bubble." On this view, the banks' recovery relied on co-opting, or abusing, the U.S. government's credit rating. In 2009, the United States stood as the ultimate guarantor of U.S. bank debt and issued much more debt to stimulate its economy. It could do this because its credit is rated higher than any other nation on the planet. To use an uncomfortable analogy, it is in the same position as the giant insurer AIG before the crash. AIG's AAA rating, although undeserved, allowed many securities to trade for more than they were worth. Its downgrade was a moment of truth for the market.

It may indeed be "rational" for investors to buy into the great rally of 2009-even if this involves inflating an incipient bubble.

Much the same would happen, although with no guarantor of last resort to step in, if the market were to lose its confidence in the United States and its AAA credit rating. But the U.S. government has tax-raising powers, and the likelihood of default remains remote. Therefore in the medium-term, fund managers who do not want to look stupid and lose assets should rationally stay invested in the market, as the rally will continue until the bond market loses faith in the U.S. government's creditworthiness and forces up interest rates. This is in line with history, as the U.S. bond market allowed the great bull market to start in 1982, when yields fell post-Volcker and later triggered the collapse of 2007 when yields rose.

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