Most Commented On: Dollar Weakness and Stock Market Strength

It has now been five years since Jeff has been writing 'A Dash.' Before he left for vacation, he mentioned several of his regular themes that are of continuing importance for investors. We took a few of these ideas and found some interesting articles that you might have missed the first time, or might enjoy reading again. This first update consists of one of his most commented on articles. Whether remarkably insightful or just plain controversial, this post has garnered some of the most vocal attention from Jeff's readers.

Dollar Weakness and Stock Market Strength — the Data (November 14, 2009)

Anyone who is following the market on a daily basis is paying
attention to the strength of the dollar versus other currencies.  It
can be confusing.  While a strong dollar might seem like a good thing,
there is actually an inverse market relationship with stocks — at
least in recent times.

I described the basics of the dollar debate here:  Understanding the Debate on the Dollar.  There are many opinions — prescriptive, political, and descriptive.  The next step is to consider some data.

Dollar Strength and U.S. Equity Market Returns

my last article I highlighted the inverse relationship between a strong
dollar and the stock market.  This chart provides a dramatic
illustration of the relationship for calendar 2009.

Dollar one
Sometimes a chart tells the story in a glance, but I always like to look at data as well.  I used the Fed's measure of the dollar versus a broad basket of currencies, weighted by trade.  The series started in 1995.

The correlation for this year is an almost perfect negative relationship:   -.96.

A negative relationship sometimes stands out even more if you invert one of the scales.  Here is that chart.

Dollar two

The data are the same, but the tight relationship is especially clear using the inverted scale.

much for what we know.  An obvious question for investors in stocks is
what would happen if the dollar gets stronger.  Perhaps we should look
at more data.

A Longer Perspective

Some believe that
a strong dollar is consistent with economic growth and a strong stock
market.  To examine this concept, we need to consider more data.

Dollar three

we look at the full data series, we see long periods where dollar
strength was consistent with a rising stock market.  In fact, the
correlation between the two series is a positive value:  .35.

For an objective analyst of data, the chart suggests three conclusions:

  1. The relationship changes over time;
  2. The last year is quite atypical;
  3. There are other important variables at work.

The Carry Trade

The prevailing hypothesis about the
dollar/stock relationship is the "carry trade."  Supposedly there are
investors/companies/speculators who are able to borrow in dollars at a
very low interest rate.  This makes the dollar the "funding currency." 
Most outspoken on this subject is Nouriel Roubini, who sees disaster ahead.  [Full disclosure — I am a contributor at Nouriel's valuable site.  I respect and appreciate his encouragement of alternative viewpoints.]

borrowers do not then do the obvious — lend in another currency,
hedging the difference with a forex trade.  Instead they supposedly use
the borrowed funds to engage in a variety of speculative trades —
emerging markets, real estate, and, of course, US stocks.

Following this logic, there is now a speculative bubble of major proportions.  This seems implausible.

skepticism comes partly from the lack of any real data supporting this
viewpoint, and partly from the daily trading.  If you really had this
trade on, would you really take it off if the dollar moved by 0.4%? 
The carry trade hypothesis does not explain the closely calibrated
trade between the dollar and stocks, but we see this every day.

now, let us stick to conclusions supported by data.  There is a strong
inverse relationship.  If you are a trader, you had better pay
attention.  If you are a long-term investor, you need to understand the
long-term relationship.

Meanwhile, I invite reader comments,
citations for new data, and fresh hypotheses.  I will pursue this for
at least one more article, considering various causal models.

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