Two Key Ways The Dollar Drives US Stock Market Performance

In complex adaptive systems like modern financial markets, a change of price of any one market has a spillover effect into other markets. One of the best understood and most straightforward of these intermarket relationships is the impact of the US dollar on US stocks. In short, a strong dollar tends to boost the performance of domestic stocks at the expense of a foreign rival, as well as the performance of importers at the expense of exporters.

Foreign vs. Domestic

Intuitively, fluctuations in the value of the dollar directly impact the returns that US investors see on the foreign stock investments. To take a trite example, if the UK’s FTSE index rallies 20% in a year in local currency terms, a UK investor would see the value of his holdings (in pound sterling) rise by 20%. However, if the value of the dollar also rose by 10% against the pound over the course of the year, a US investor’s return on his FTSE investment would be closer to 10%.

Of course, corporate executives are well aware of this connection. As an example, FactSet found that two-thirds of the companies in the Dow Jones Industrial Average cited foreign exchange as a headwind for their earnings in Q3 2018, following a sharp 9% surge in the value of the dollar index over the last six months.

This direct, mechanical relationship can help traders determine how aggressively to allocate to foreign stocks. For instance, if the dollar has just experienced a strong year, the sentiment is frothy, and the buck appears overvalued on historically-reliable metrics like purchasing power parity, a US investor may consider increasing his allocation to foreign stocks, reasoning that the greenback is more likely to fall than rise moving forward. The chart below underscores this point, showing the relative performance of the S&P 500 (SPX) against foreign stocks (EFA). As the dollar rose throughout the middle of 2018, US stocks outperformed their foreign rivals:

(Click on image to enlarge)

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