Currency level in stock

Nowhere is this more evident than in the Nasdaq and the Nikkei 225, although this has some fundamental justification. The Nasdaq is full of high-tech names that buy products (such as chip-making equipment) from the companies in the Nikkei. Higher sales and earnings by Nasdaq companies mean higher sales and earnings down the road for Nikkei companies.

That may be changing. According to research by ING, global markets tracked the U.S. with a correlation coefficient of 0.93 between 2003 and 2005. In the most recent two years ending in February, though, the correlation has dropped to 0.63. If we assume stock valuations will track growth, and if we also assume the long-term decline in the dollar that started in 2000 is not going to end any time soon, the sensible thing to do is to invest internationally.

And that is exactly what American investors are doing. According to the most recent capital flow report from the Treasury, foreigners bought $13.5 billion in U.S. equities in February, the latest reporting month, down from $22.8 billion in January. At the same time, though, U.S. investors bought a net $15.3 billion in foreign equities, up from $13.2 billion in January. Americans have been steadily increasing the amount of foreign equities bought since 2004.


Stock market indices are not correlated with currencies, at least not consistently, with the one great exception of the yen and the Nikkei. This, too, has some fundamental logic. Most of the Nikkei 225 companies are exporters such as Sony, Canon, the car companies, and the chip-makers. When the yen falls, these companies can sell more goods abroad, and sometimes cut prices. If the yen has just fallen, you can fairly reliably expect the Nikkei to rise the next day, and vice versa.

Usually the correlation (which is an inverse one) is more than 0.95, depending on what period you are looking at. Note that foreigners are an important component of the Japanese stock market, holding upwards of 40 percent of total equities while holding only about 4 percent of Japanese bonds.

However, look at the euro/dollar pair (EUR/USD) and the S&P 500. In this case the currency that is rising alongside the U.S. stock index is the euro, which makes no sense at all. There is no logical universe in which a dollar-based stock index would rise because the dollar is falling. Your statistics professor was right when he said on the first day of class, “Correlation is not causation.” An inverted dollar/euro shows in recent years the S&P is rising despite the dollar falling. We seem to see the two move in tandem from 1999 (when the euro came into existence) to 2003, but since then, they have moved inversely.

Does that mean the U.S. stock market is escaping the investor-repelling effect of the falling dollar? So far, yes. U.S. outflows to other markets and weaker inflows to U.S. markets are still a minor side effect in the grand scheme of things. U.S. investors will probably always have a preference to hold most of their savings at home and in their home currency.

Foreign ownership of U.S. stocks tends to be fairly stable at about 15 percent of the total market — unlike the bond market, of which foreigners own more than half. If foreigners reduce their holdings of U.S. equities, they may still keep the money in dollars, moving it to bonds or direct investment, to keep a share of the world’s biggest economy. You are not a global investor if you own no piece of the U.S.

Note that a movement to the fixed-income side was tending to the very short end in February because of risk aversion. Purchases of longer-term notes and bonds and of Agency paper fell dramatically, in part because of the subprime flap, but also because of the universal expectation the Fed’s next move will be to cut rates, making long-term paper the unwise choice, and making the capital inflow seem “hot.” Hot money is money that can exit on short notice.

So what about the argument that other markets (such as the DAX) are rising more than the U.S. market and their currencies are rising against the dollar, too — and therefore the dollar and U.S. stock markets should fall? This is a fallacy of composition that assumes the size of the pie is fixed. That one is rising doesn’t mean the other must fall when the total amount available is rising. The allocation is dynamic, and in other ways, too. At some point, the one that is rising relatively less will start looking good compared to the one that has just become fully priced.

So far, the yen may be the key to the Japanese stock market, but the U.S. dollar is not the key to U.S. stocks — although the time may come when it will pay to be aware of the long-term trend away from U.S. leadership in global equity markets and the threat of diversification. When you read a press report that U.S. stocks are going to fall because of the dollar, or the dollar is going to fall because of falling U.S. stocks, take it with a grain of salt, or maybe a spoonful. When it comes to intermarket relationships, it pays to be skeptical.