Sunday, October 01, 2006

The U.S. dollar and the equity market

As the third quarter ended the stock market was generally strong despite all of the well known reasons for worry--interest rates, the residential housing market, energy prices, growing credit concerns etc. There are also positives(see recent post of 9/18) but they seem only enough at best to offset the negatives rather than push the market higher.

So what are other variables that have, for the moment, reinforced the positive. A common explanation relates to end of the quarter buying by mutual funds and other institutional investors that must report their results and holdings to shareholders at the quarter end date. In the first instance these investors need to show that they are for the most part fully invested into their stated goals. Secondly, some want to report their strong commitment to stocks that seem to be on the upswing in the eyes of securities analysts, the business media, or by themselves in their letters to shareholders. And third, funds or fund families that have big positions in stocks that they believe in and are willing to hold can add to their positions during the last week or two of the quarter with the hope that the short term impact of supply and demand on valuation will cause the stocks price to rise and improve their quarter end results.

Of course, another reason for the recent performance could simply be that, regardless of all of this quarter end jabber, the markets, especially large capitalization stocks, deserve a higher valuation based on their earnings outlook in this not too hot, not too cold market. That's simple and may be the answer.

The entire reason that I've written all of the above is to set the stage for my next thought. The stock market is strong and is being led by large cap stocks due to the widespread belief among the "lead steer" investors that the dollar is going to lose value against other major currencies over the next 12 to 18 months. They believe that the large budget deficit and the large trade deficit will over time put pressure on dollar valuation, and this pressure will be aggravated by a weakening U.S. economy that will eventually require the Fed to begin to lower interest rates. Each of these pressures will lead large foreign holders of U.S. treasuries to reduce their concentration of dollar holdings(sell dollars).

How can the market as a whole hedge against this risk? There are the foreign exchange futures and derivatives markets but they are generally for capital markets institutions and hedge funds, and they have multiple risk characteristics. For most mutual funds there are limits to what they are allowed to do and limits to their risk appetite. Same for pension funds. And the individual investor is, for the most part, likely to steer clear of the fx markets.

So what investments provide the most insulation to a dollar decline without having an fx bet characteristic--it's large cap equities of firms that already have significant earnings denominated in currencies that could appreciate and that have exports that will become more price competitive as the dollar declines and therefore will have sales increases. Their global profile is not likely to make anyone a bundle but it will smooth out the volatility in a global weighted valuation and on a dollar basis could rise in value.

One might ask, isn't this just a zero sum game. While dollar denominated investors buy the U.S. global firms, won't foreign investors who are just as savvy be selling the U.S. globals to protect against currency declines. Yes, but mostly No. For most large U.S. corporations, foreign holdings represent around 10% of total stock outstanding. So if 10% of your shareholder base may be selling and the rest could be buying, the impact is positive.

In the last six months the small cap U.S. stocks have been down sharply after three years of good performance, mid-caps stocks have declined as well, and large cap stocks and the Dow in particular are threatening a record high. Interest rate increases and energy prices have certainly led to the relative underperformance of the small caps especially but, in my mind, investors going global has been an important factor in the divergent performance.


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