Since the beginning of the year, the US dollar has strengthened against a trade-weighted basket of currencies,i reflecting the growing strength of the dollar against many of its trading partners (though not necessarily all of them). This begs the question, does the relative increase in the strength of the dollar this year bode well for stocks?
It’s a question retirement planning investors may be mulling over as US stocks continue to hit new highs.ii In order to ascertain whether a strengthening dollar should factor into your portfolio, it’s key to understand some of the myths regarding the relationship between the dollar and stocks. Mainly that either a too strong or weak dollar is a drag on stocks. In our view, these are misconceptions largely tied up in beliefs about sentiment and trade.
The first mistake is the assumption a strong dollar implies enthusiasm about the American economy and its prospects, presaging rising stocks. Currency isn’t an appreciating asset, like a stock. It’s a commodity that’s only strong or weak relative to something else. So the dollar is strong because the euro or pound or other currencies are weak. Or vice versa.
Just as irrationally as assuming a strong dollar is a boon for stocks, some inevitably argue the dollar’s strength is a negative.
The stronger the US dollar is, the more expensive it is for consumers in other countries to purchase US goods abroad. The worry is US exports will become uncompetitive, hurting the economy. This was a common refrain throughout the bull market of the 1990s.
There are problems with both of these beliefs as we’ll see, but first let’s examine the other side of the coin.
The alternative to the strong dollar = strong stocks theory is that a weak US dollar signals a lack of faith in the US economy, foreshadowing or symptomatic of weak growth and poor stock returns.
Additionally, when the dollar weakens many begin to fear their personal buying power will diminish as imports become more expensive. There is concern this perceived reduction in buying power could slow consumption and stocks’ growth, not to mention being personally distressing.
Ultimately, there are pros and cons to a weak and strong dollar, but nothing inherently superior about one over the other for stocks’ performance.
To definitively determine if the dollar is affecting stocks, take a look at the behavior of the dollar and stocks over the most relevant time period.
The trade-weighted dollar, or how the dollar stacks up with our trading partners, is the best way to do this. The four-box table below goes back to 1971, when many global currencies (including the US dollar) started floating freely at the end of the Bretton Woods era. Stocks are represented below by the S&P 500, a broad, market-capitalization-weighted index of US stocks. The chart shows the total number of years stocks and the dollar have each been up or down and what percentage of the total they represent.
Stocks are up when the dollar is up 42% of the time and up 37% of the time the dollar is down. That’s quite close. What about when stocks are down?
Stocks are down when the dollar is up 9% of the time and both are down simultaneously 12% of the time, also extremely close.
Stocks are simply up much more often that they’re down. In the 22 years when the dollar was up, stocks rose in 18, or 81% of the time. In the 21 years the dollar fell? Stocks rose 16 times, or 76% of the time. Stocks overall rose 79% of the time, which shows the dollar just isn’t a huge swing factor determining whether stocks rise or fall.
The same holds true if you look at global stocks and the dollar. The chart below swaps out the S&P 500 for the MSCI World.
As the chart shows, the same absence of correlation between the dollar and stocks exists globally. And just like the US, stocks tend to go up more often than down.
Over time, because currencies are inherently zero-sum and irregularly cyclical, currency impacts on a global portfolio net out to close to zero.
While exploring the relationship between the dollar and stocks is interesting, it doesn’t tell you much about the direction of the market or how to optimally position your portfolio. Fisher Investments doesn’t recommend focusing on a single country or indicator when managing your investments. We consider a variety of factors when creating diversified portfolios tailored to our clients’ needs—including their individual investment objectives, investing time horizons and cash flow needs.
i Source: Global Financial Data, Inc., Trade-Weighted Dollar Index from 12/31/2013 to 08/26/2014
ii Source: FactSet as of 8/28/2014