Dollar moves and the stock market

The dollar has seen a significant decline since the beginning of the year, yet the Dow has reached levels above 13,000. The argument for the currency decline is that slower growth in the United States and the potential for Fed easing is forcing the dollar down. This seems at odds with the stock market increase which suggests good economic conditions.

This divergence in views suggests that traders in each asset class are discounting information differently. Ultimately, one of these stories will prove true. It is clear that the dollar-stock market relationship is fairly complex and needs careful analysis.

On a macro-level, dollars denominated assets are becoming cheaper and more attractive for foreign investors, but the actual returns for foreign investors already investing in the United Sates have been devastating. For European investors, investing in the S&P 500 continues to be a losing proposition. While US investors have made up for all of the loses since the stock market decline in 2000, European investors are still underwater. There have not been any gains for foreign investors in 2007. Certainly investments in the home equity markets has been a better deal. So is it the attractive cheap levels that will invite more flows into the stock markets that is driving stocks, or are we whistling in a graveyard of loses when translated into their home currency?

On a micro-level, the impact on the stock market from a dollar decline will differ substantially across firms. At first brush, the seemingly obvious difference is that those firms that have more export business should gain relative to those who have a high percentage of import business. Firms with more overseas profits should gain relative to those that have domestic business. This should be good for large cap stocks.

But the analysis gets trickier if you ask why the dollar is falling. If the dollar decline is caused by slower growth in the United States, then earnings will decline in the domestic business of firms. A gain in overseas earnings has to be weighed by the loss in earnings from a domestic slowdown. Here, the impact of dollar decline on an industry grouping may be stronger than the global impact on the market as a whole.

Nevertheless, there is a group of stocks which will be clearly hurt by the combination of domestic slowdown and a dollar decline, importers. Importers which have rising costs and sell into the weaker domestic markets will have a consistent negative effect. There is no ambiguity on the impact of a dollar decline in this case.

A combination of selling domestic importers and buying exporters or firms which have the highest percentage of offshore business would be the best portfolio to play a weaker dollar, but this has to be tempered by the hedging practices of the firms and their ability to pass-through currency prices changes.

While there are plays between import and export firms, the key issue is resolving the difference in opinions between equity and currency markets. We have seen this scenario before and it has not looked good for stocks.