Much has been made in the financial press about how equities are inversely tracking the U.S. dollar - when the dollar falls equities rise, and when the dollar rises equities fall. Some have argued that this relationship makes sense. For example, David Brown at Seeking Alpha argued the following:
Frankly, this inverse relationship between the dollar and the market is not that surprising since a weak dollar means more exports and fewer imports for the U.S. and higher material prices. That also explains the strength of large-caps over small-caps, since as general rule large-cap stocks have much more revenues from exports than small-caps.
Others have explained the inverse relationship between the U.S. dollar and equities by arguing that whenever there is rising risk aversion (including aversion to equities), a rising dollar is the result.
So, can we expect this relationship to hold up in the future? If so, should that information factor in to our investment decisions?
Perhaps, we can gain some insight by looking at how this relationship has held up in the past (hint: it hasn’t!)
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That is not much of a pattern. Sometimes there is an inverse relationship between the dollar and equities and sometimes there is a direct relationship. Given the unstable nature of correlations, it seems to make sense not to depend upon correlations.
Relative strength models evaluate each security in a given investment universe on its own merits, not on any real or perceived relationship that a given security has had with other securities in the past.
There are very few things that can be counted on in the financial markets. Correlations should not be counted on given their unstable nature. One thing that we have found that has occurred with regularity over time is the existence of long-term trends. It is the existence of long-term trends that make it possible to earn excess returns by executing a systematic relative strength model.
“David Brown at Seeking Alpha” suffered an all-to-common serious disconnect, when he argued that the recent “inverse relationship between the dollar and the market is not that surprising since a weak dollar means more exports and fewer imports for the U.S. and higher material prices.”
His disconnect? The U.S. dollar index is a FUTURES CONTRACT. It is NOT trade-weighted. The USDX might actually have been trade-weighted 20 or 30 years ago, but it isn’t no.
For fun - I say for fun, because I know it won’t mean anything for your trading process - you might compare the list of currencies and weights for the trade-weighted index found at the Federal Reserve’s research site to the currencies and weights for the USDX.
I agree totally about the nature of the correlations involved. It should be pointed out that correlation doesn’t imply causality. When a correlation changes over time, reversing, etc., it’s possible that either the correlations observed were spurious, or that a third, “confounding variable,” was actually the causal factor, and both the dollar and the stock market responded to that third variable. Either way, that would imply that paying a great deal of attention to the dollar/stock relationship would be relatively fruitless.