There is a surreal quality to the action in the financial markets this holiday season. After emerging from what seemed to be a societal collapse in the fall of 2008, the government induced liquidity has bathed the markets in gains and seems to be in the process of healing all economic wounds. We've run up so fast in the S&P 500 that we are already above long-term historical averages in valuation.
Nevertheless, it's always the case that the seeds of the next crisis are visible at the conclusion of the previous crisis. The bears in 2003 believed that the U.S. real estate market was overheating and would be the source of the continued recession. Though wrong at the time, their predictions proved prescient. We feel that the source of the next crisis is far more clear today than it was in 2003. No one can predict the future, thus we don't know if the next crisis will take place soon, producing "another leg down" so to speak, or if the next crisis is several years off, with a powerful bull market remaining between now and then. The most likely source of the problem is clear: government liquidity and the secular decline of the U.S. dollar. Eerily, the past 24 hours have seen a disheartening breakdown in the dollar-yen relationship as well as a breakout in the euro-dollar. 
The next crisis won't only be about the dollar. More importantly, it will be about an asset bubble in China. As of now, it appears the Chinese financial markets remain some ways away from breaking point, yet like the housing market in 2003 they are starting to flash early warning indicators. The real estate market in China is red hot: prices in 70 Chinese cities rose 3.9% in October, following a 2.8% increase in September, with the Shanghai and Beijing markets are expanding at an even faster pace. The relatively naive investing public in China has never experienced a serious crisis in their newfound capital markets.
While the Chinese government has the ability to prevent the formation of asset bubbles, it would take a significant dampening of GDP growth, something that could easily backfire on the Communist Party. While the EU Chamber of Commerce report outlines how much overcapacity has built up in China, there has also been significant documentation of the rabid extension of credit mandated by the stimulus program. Do these themes sound familiar? As a point of basic nature, its impossible for any economy to grow at near double digit rates forever (or for any extended period of time). In fact, as macroeconomies tend to do, it's likely that at some point China outgrows itself, greatly surpassing its natural rate of expansion as the government desperately seeks to maintain legitimacy via economic growth.
We'd advise you to duck and cover when that case of mean-reversion strikes. What is far less likely is that China peacefully navigates its transition from massive economic expansion to calmer growth with an authoritarian political system and capital markets. On top of these growing problems, China's foreign exchange reserves are losing value by the hour as the dollar loses more and more ground.
Eventually, the Chinese will have to begin a significant diversification program and this will also have serious ramifications for the funding of the U.S. deficit/debt. The dollar may truly collapse if the federal government is forced to pay substantially higher interest rates on the debt because of the withdrawal of foreign Central Bank demand. We've all learned over the years that bubbles look stupid for a long time before they pop, thus we have no time horizon on when China will face these problems. Yet we look ahead with consternation to the end of government stimulus in the People's Republic.
How do you combine dollar weakness and the collapse of a bubble in China? Stagnate growth in the U.S. and EU will already mean that once artificial government-induced demand falls off, the Chinese will need to find other sources of demand or be prepared to reduce growth. The domestic market in China, while growing, simply can't support the 10% growth we've seen in previous years on its own. The yuan will have to be revalued versus the dollar as we go forward, and this will also weigh on export demand in China.
As the end of the stimulus, potential revaluation, and stagnated Western growth converge, anything could touch off a panic in China. The Shanghai stock market is dominated by small investors, people who will sell quickly and in an undisciplined fashion, something resembling the NYSE in 1929. We hope its merely coincidence that we seem to be reaching important resistance and perhaps the formation of a double-top on the Shanghai Comp just as buying exhaustion seems to be setting in world wide (based on volume numbers). 
Our analysis here is merely speculative, but we do believe that greater attention needs to be paid to the withdrawal of stimulus in China rather than the withdrawal of stimulus in the U.S. An economic setback in China would cause massive damage to global economic confidence. It's likely that China has several, if not many years, until its pace of economic growth will confront the hard realities of gravity. Nevertheless, we find it painful to watch the same mistakes being made in the East as were made here in an attempt to correct some of the global financial imbalances.
Disclosure: The author does not own any immediately relevant positions to this article.
