Get Ready For A Stockmarket Roller Coaster As U.S. Dollar Swings
The U.S. dollar has a lot to answer for when it comes to U.S. stock market returns. So a forecast that promises a significant dollar rally followed by a dive should be enough to turn the stomachs of some investors.
“First, the financial markets anticipate the Fed will cut rates in June, but the market has not yet wholly priced in the impact,” according to Saqib Iqbal, an analyst at the financial website Trading.Biz. “This may provide short-term support for the Dollar in the coming weeks.”
Put another way, because not all investors believe that the rate cuts are coming so soon, there is more upside for the greenback currently.
It’s also true that when the economy starts to soften or slowdown, investors from all over the world go to safe haven investments such as 10-year U.S. Treasuries. To make that happen they need to buy dollars, which in turn drives up the price of the dollar relative to other countries.
Why does dollar strength matter to stock buyers?
I wrote about this for the Wall Street Journal a few weeks ago. You can read the story here. In simple terms, when the dollar rises stocks tend to drop. That’s because the foreign earnings of U.S.-based public companies become worth less than they did before the dollar moved. That matters because at least 40% of S&P 500 company earnings come from outside the U.S.
I you doubt that, think about all the huge multinational corporations headquartered in the U.S. that sell their goods or services through subsidiaries based in other countries such as Europe, Japan or South America. They carry much weight.
So if the dollar goes higher we can expect the S&P 500 to drop.
But then Iqbal says: “ If the Fed cuts rate more aggressively than expected, it may significantly weaken the US dollar.”
And guess what happens when the dollar weakens? You guessed it, the stock market tends to rally. Again it comes down to the value of the overseas profits. When the greenback loses value compared to other currencies, the foreign earnings are worth more than they had been.
The outcome is simple — stocks tend to rally in such an environment.
Technical analysts, such as those at AllStarCharts understand the power of the swings in the U.S. dollar.
However, there is another factor going on that might make further rallies hard to swallow. The value of stocks relative to their forecast profits is looking exceptionally high at the moment.
“Elevated valuations make the stock market more ‘accident prone,’” according to a recent report from Leuthold.
The Leuthold paper finds the “Normalized P/E ratio was 22.7x at the 2022 low.” That compares to an average P/E at market lows of 14.6X. Stocks have gone up a lot since then, making them even more pricey.
One way to look at that is if the dollar drops a little due to a weakening U.S. economy investors may decide to dump their positions in the market. Depending on how much stock they sell it could send market prices down in a big way — perhaps to more reasonable price-to-earnings ratios.
In other words, this could be a situation where heads or tails you still lose, at least in the short term.
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