Why Treasuries Are Risky
When PIMCO’s Bill Gross speaks, people listen...especially when the subject is bonds. And well they should. As the co-founder of one of the World’s largest fixed income investment management firms, with over $1 trillion in assets under management, he might just know a little something about that asset class. So it was with tuned ears that we listened to his pronouncement last week that, in his opinion, the almost three-decade rally in fixed-income has run its course. Said Gross in an interview with CNBC last Thursday, “Let’s suggest the economy looks good, that risk assets — whether it’s high-yield bonds or whether it’s stocks — have a decent return relative to the potential of declining bond prices... I’ll go with the stock market.” Gross went on to say that he believes stocks may outperform bonds over the next three months. It was a striking statement from someone who makes his living managing bond portfolios and whose PIMCO Total Return Bond Fund has grown to be the largest mutual fund in history, at $214 billion, thanks to fearful investors fleeing equities to the safety of bonds. He reiterated his statement in a later Bloomberg interview in which he stated that “bonds have seen their best days” and that the prospect of a strengthening U.S. economy and rising interest rates makes an “argument to not own as many bonds.” By the way, he’s a man who puts his money where his mouth is as PIMCO announced in December that it would now begin to offer stock funds.
To many investors, that the investment world’s proclaimed “Bond King” is now touting stocks over bonds should be a wake-up call. Since the 2008 financial crisis, investors have fled stock funds and poured cash into US Government bond and other fixed-income funds in search of safety. That trend continued throughout 2009 causing many investors to miss the US stock market’s nearly 74% rise, the biggest rally since the 1930’s. Even thus far in 2010 bond mutual fund inflows are 5 times greater than they were at this time last year. Part of the reason for the rush to bond funds is that investors are reaching for higher returns with money-market funds yielding close to zero, but there is still a large component of fear to the move—fear over the future of the world economy and its potential ill effects on equities. Despite a slew of positive economic and company-specific data from around the globe, investors are still eschewing risk. What most don’t understand, however, is that there are many types of risk--among them inflation risk, and its corollary interest rate risk, are very real, sizeable, and potentially devastating to the unwary investor.
Investors have been making money in bonds for so long they assume that it will continue forever. It can’t. US Treasuries have rallied for almost three decades, pushing the yield on the 10-year Treasury note from a high of 15.8 percent in September 1981 to a record low of 2.03 percent in December 2008 during the height of the financial crisis. Since their December lows, however, 10-year US treasury yields have been creeping slowly upward and last Thursday the bond market got slammed after a poor Treasury auction brought the yield on the 10-year to 3.89%, its highest level since June. Fears of high US debt levels and pending inflation (from stronger economic growth) are making bonds less attractive, pushing down prices and raising yields. Currently, with inflation near zero, both the real and nominal rates of return on US Treasuries is about equal to their current yield--3.9% in the case of the 10-year--and, of course, someone holding a 10-year note to maturity has a very good chance of earning that 3.9%. However, as inflation rises, the real rate of return on that investment will decline and as US interest rates climb (either due to inflation or sovereign risk fears), Treasury prices will drop, giving bond investors a double-whammy of a declining real long-term yield to maturity plus a potential annual loss in their bond portfolios, something many have never seen. Because so many investors have gone so long without losing money in Treasuries, whether they will stay the course and continue to pour money into fixed-income funds is now in question.
According to Morning Star, bond funds almost never outperform equity funds over a decade, as they did in the 10 years ending in March 2009, and they have never done so in two consecutive 10- year periods. That little statistic is striking. Just as “trees don’t grow to the sky” is a wise stock valuation philosophy in equity investing, so too is it true with bond prices in the fixed-income world. If we go through a period where investors realize that they can, in fact, experience annual losses in Treasuries and other “safe” fixed-income investments, we may see an exodus from bond funds. And with inflation and interest rates on the rise it’s a good bet that all that money will find a home in equities.
Monday, March 29, 2010
Monday, March 22, 2010
Ramblings of a Portfolio Manager
What’s the Next Big Worry?
“The market climbs a wall of worry” is the old saying on Wall Street, meaning stocks rise despite (or perhaps because of) the prevailing level of pessimism about the economy or stock prices themselves. If this old maxim is true then there has been plenty of fuel for the rally we have been having. Between Legislative & Headline Risk: Obamacare, banking reform, Cap & Trade; Liquidity Risk: tax hikes, Bush tax cut expiration, Fed tightening; Global Economic Risk: Chinese and Indian tightening, Greek meltdown, Dubai blowup, the other PIGS, the market has had ample reason to take a long and protracted nose dive. Instead, we are making new 12 month highs daily and the VIX is trading below 17. On the surface one would think investors are either insane or greedily oblivious to the obvious risks. In reality, the Markets are doing what they always do—discounting the noise and focusing on the fundamentals. So far, the fundamentals have been good.
With apologies to FDR, the real fear now is not fear itself but the lack of fear. The VIX (which is NOT a volatility indicator but a fear indicator), while not at ultra historic lows does indicate some complacency on the part of investors. We’ve just made it past Healthcare Reform, which has dominated the headlines for months, and the market is up smartly. If the old adage is to prove correct, then we need another “crisis” for the markets to continue their advance. Alfred E. Newman (of “what, me worry?” Mad Magazine fame) was not a good stock picker. So what should we worry about now? Well, believe or not we still have a lot to fear: We are still looking at potential financial regulatory reform, particularly with a newly emboldened Obama Administration, so we can expect the headlines on that issue to ramp in the coming weeks; we have the November mid-term elections, which though many consider a Republican come-back a positive fait accompli, remain a wild-card; there is the specter of additional weak employment data (this one should be the strongest impetus to new market gains as it will push out further any Fed tightening in investors’ minds); the Obama Administration is now picking a fight over trade policy with one of our largest bankers and trading partners who, arguably, also holds the fate of the Global economic recovery in it’s chop sticks, and, finally, there is the omnipresent threat of another terror attack on US soil. Of course it’s the bullet you don’t hear that is the one that gets you so there are myriad other risks and worries that can crop up, none of which we have yet to contemplate. What other tax and spend plans do the social engineers in Congress have up their sleeves? What other trading partners can we anger with our union-centric protectionist rhetoric? How can Obama’s Green energy policies ramp up to derail the recovery? The list goes on and is as large as your imagination. Heck, around here there is speculation that Elvis will land his Alien spaceship on the Pentagon, accidentally activating NORAD and plunging us into global thermo nuclear war. Could happen. Saw it on YouTube.
The point we want to make is that there are always risks lurking in the headlines but very few of them are truly impactful to corporate earnings and, by extension, long-term stock prices. Most of what we read, hear and see is truly non-impactful noise. But it is this noise that provides us with trading opportunities in a rising market. So the next time you hear the TV talking heads proclaim “this is a game changer” and see the markets react negatively in lock-step, consider the event an opportunity to buy rather than flee. In that situation you truly will have nothing to fear but fear itself.
“The market climbs a wall of worry” is the old saying on Wall Street, meaning stocks rise despite (or perhaps because of) the prevailing level of pessimism about the economy or stock prices themselves. If this old maxim is true then there has been plenty of fuel for the rally we have been having. Between Legislative & Headline Risk: Obamacare, banking reform, Cap & Trade; Liquidity Risk: tax hikes, Bush tax cut expiration, Fed tightening; Global Economic Risk: Chinese and Indian tightening, Greek meltdown, Dubai blowup, the other PIGS, the market has had ample reason to take a long and protracted nose dive. Instead, we are making new 12 month highs daily and the VIX is trading below 17. On the surface one would think investors are either insane or greedily oblivious to the obvious risks. In reality, the Markets are doing what they always do—discounting the noise and focusing on the fundamentals. So far, the fundamentals have been good.
With apologies to FDR, the real fear now is not fear itself but the lack of fear. The VIX (which is NOT a volatility indicator but a fear indicator), while not at ultra historic lows does indicate some complacency on the part of investors. We’ve just made it past Healthcare Reform, which has dominated the headlines for months, and the market is up smartly. If the old adage is to prove correct, then we need another “crisis” for the markets to continue their advance. Alfred E. Newman (of “what, me worry?” Mad Magazine fame) was not a good stock picker. So what should we worry about now? Well, believe or not we still have a lot to fear: We are still looking at potential financial regulatory reform, particularly with a newly emboldened Obama Administration, so we can expect the headlines on that issue to ramp in the coming weeks; we have the November mid-term elections, which though many consider a Republican come-back a positive fait accompli, remain a wild-card; there is the specter of additional weak employment data (this one should be the strongest impetus to new market gains as it will push out further any Fed tightening in investors’ minds); the Obama Administration is now picking a fight over trade policy with one of our largest bankers and trading partners who, arguably, also holds the fate of the Global economic recovery in it’s chop sticks, and, finally, there is the omnipresent threat of another terror attack on US soil. Of course it’s the bullet you don’t hear that is the one that gets you so there are myriad other risks and worries that can crop up, none of which we have yet to contemplate. What other tax and spend plans do the social engineers in Congress have up their sleeves? What other trading partners can we anger with our union-centric protectionist rhetoric? How can Obama’s Green energy policies ramp up to derail the recovery? The list goes on and is as large as your imagination. Heck, around here there is speculation that Elvis will land his Alien spaceship on the Pentagon, accidentally activating NORAD and plunging us into global thermo nuclear war. Could happen. Saw it on YouTube.
The point we want to make is that there are always risks lurking in the headlines but very few of them are truly impactful to corporate earnings and, by extension, long-term stock prices. Most of what we read, hear and see is truly non-impactful noise. But it is this noise that provides us with trading opportunities in a rising market. So the next time you hear the TV talking heads proclaim “this is a game changer” and see the markets react negatively in lock-step, consider the event an opportunity to buy rather than flee. In that situation you truly will have nothing to fear but fear itself.
Monday, March 15, 2010
Ramblings of a Portfolio Manager
The Consumer is Dead. Long Live the Consumer
The consumer is de-leveraging and will never return to his or her prior level of spending. We are going to have an economic new normal because the consumer has been permanently impaired. The US savings rate will approach that of Japan, crimping consumer spending and any economic recovery. These have been some of the catch phrases of economic doomsayers for the last 18 months. The Media, always looking for a good sound bite, has picked up and repeated these mantras, ad nauseum, to the point that many believe them to be truisms. With nearly 70% of our economy dependant upon the US consumer, such dour sentiment naturally has caused investor concern about the strength of any economic recovery.
This morning Capital One Financial announced that credit card delinquencies fell in February, the first time in over 18 months. Last Friday retail sales unexpectedly rose slightly, versus an expected decline, despite heavy snowstorms that hit the Northeast. A week ago the Federal Reserve released its monthly consumer credit data, which showed that, for the first time in almost two years total consumer credit outstanding rose year over year. It was expected to decline. Consumer discretionary stocks, relegated more or less permanently to the hurt locker for the last two years, have been significant outperformers for the month. What should we make of all this?
Last fall, Jim Paulsen of Wells Capital Management told CNBC “never count out the US consumer.” It wasn’t an original statement but a bold one nonetheless in the face of what has become the newsroom culture of negative sentiment regarding the consumer. We agree with him. Americans love their material possessions. One of our favorite movie lines is from The Jerk: “it’s not the money, it’s the stuff.” To us, that says it all. It would take something just short of Armageddon to permanently cripple the US consumer, in our opinion. Recall that after 911 we also heard a host of market watchers decrying the death of the consumer. Back then we were all going to stay inside and “couchette,” that quaint 90s term for huddling at home and emulating the nuclear family home life glorified in the 50’s. Didn’t happen. In fact, that disaster had just the opposite effect with many consumers, feeling that life was too short, running out and buying that boat, sports car or vacation home they had always dreamed of while others sought out shopping as a comfort food to ease the anxiety of a troubled time. Behavior like that is culturally ingrained and it doesn’t shift overnight—or over a couple of months for that matter.
We now have a few data points supporting the notion that the consumer is not dead or at least is rising from the grave. They are nascent signs but important ones nonetheless and if history is any guide, they will strengthen in the months to come, especially if the unemployment rate begins to drop. And a declining unemployment rate should have a double impact as not only will more people be earning money to spend on consumption, but those with jobs already should be further encouraged to spend by the positive sentiment created by the data. Meanwhile, the market has been on a stealth rally since February 9th, with the S&P 500 climbing 8.8% and the Russell 2000 tacking on an incredible 15.4%, yet the Media tells us daily that we are stuck in a range. That signals to us that no one believes in the economic data or the rally that is has engendered. We like that kind of skepticism. As the consumer data continue to improve investors will come to realize that, perhaps, the Emperor does have clothes and that he just bought them in a high-end retailer…and that’s the sentiment we need to continue the Market rally.
The consumer is de-leveraging and will never return to his or her prior level of spending. We are going to have an economic new normal because the consumer has been permanently impaired. The US savings rate will approach that of Japan, crimping consumer spending and any economic recovery. These have been some of the catch phrases of economic doomsayers for the last 18 months. The Media, always looking for a good sound bite, has picked up and repeated these mantras, ad nauseum, to the point that many believe them to be truisms. With nearly 70% of our economy dependant upon the US consumer, such dour sentiment naturally has caused investor concern about the strength of any economic recovery.
This morning Capital One Financial announced that credit card delinquencies fell in February, the first time in over 18 months. Last Friday retail sales unexpectedly rose slightly, versus an expected decline, despite heavy snowstorms that hit the Northeast. A week ago the Federal Reserve released its monthly consumer credit data, which showed that, for the first time in almost two years total consumer credit outstanding rose year over year. It was expected to decline. Consumer discretionary stocks, relegated more or less permanently to the hurt locker for the last two years, have been significant outperformers for the month. What should we make of all this?
Last fall, Jim Paulsen of Wells Capital Management told CNBC “never count out the US consumer.” It wasn’t an original statement but a bold one nonetheless in the face of what has become the newsroom culture of negative sentiment regarding the consumer. We agree with him. Americans love their material possessions. One of our favorite movie lines is from The Jerk: “it’s not the money, it’s the stuff.” To us, that says it all. It would take something just short of Armageddon to permanently cripple the US consumer, in our opinion. Recall that after 911 we also heard a host of market watchers decrying the death of the consumer. Back then we were all going to stay inside and “couchette,” that quaint 90s term for huddling at home and emulating the nuclear family home life glorified in the 50’s. Didn’t happen. In fact, that disaster had just the opposite effect with many consumers, feeling that life was too short, running out and buying that boat, sports car or vacation home they had always dreamed of while others sought out shopping as a comfort food to ease the anxiety of a troubled time. Behavior like that is culturally ingrained and it doesn’t shift overnight—or over a couple of months for that matter.
We now have a few data points supporting the notion that the consumer is not dead or at least is rising from the grave. They are nascent signs but important ones nonetheless and if history is any guide, they will strengthen in the months to come, especially if the unemployment rate begins to drop. And a declining unemployment rate should have a double impact as not only will more people be earning money to spend on consumption, but those with jobs already should be further encouraged to spend by the positive sentiment created by the data. Meanwhile, the market has been on a stealth rally since February 9th, with the S&P 500 climbing 8.8% and the Russell 2000 tacking on an incredible 15.4%, yet the Media tells us daily that we are stuck in a range. That signals to us that no one believes in the economic data or the rally that is has engendered. We like that kind of skepticism. As the consumer data continue to improve investors will come to realize that, perhaps, the Emperor does have clothes and that he just bought them in a high-end retailer…and that’s the sentiment we need to continue the Market rally.
Monday, March 8, 2010
Ramblings of a Portfolio Manager
The Junk Indicator
Earnings season is winding down, economic data releases are being greeted with almost a yawn, the VIX is holding steady under18 and trading volume is easy to confuse with Google’s stock price on our screen. We’ve had a stretch of spring-like weather in the New York City area over the weekend and forecasts are for the more of same the next couple of days. It’s starting to feel like August on Wall Street except that the calendar tells us we haven’t even reached St. Patrick’s Day.
There’s probably a trading opportunity in here somewhere and we think we’ve found it—the Junk Indicator. No, we’re not talking about high yield fixed income securities we’re talking about junk. Good old used and discarded stuff. Wall Street prognosticators constantly scour the data for indicators of where the market and individual stocks might be going, giving us everything from Astrological indicators to Numerology tables as forecasting tools (there are probably still some entrail readers out there too). So it is without shame that we proffer the used auto and parts market as a leading indicator of the direction of the economy and, ultimately, stock prices.
We know a guy. This guy is in the “recycling business.” That’s PC these days for owning a junkyard. Anyhow, it seems his used auto parts business is just now starting to ramp up significantly after nearly 18 months in the doldrums. His used car lot, quiet for almost two years, is also seeing signs of life. This initially confused us as we’ve tried to track his business as a counter-cyclical indicator ever since the economy entered its current downturn—because that’s what common sense and Wall Street analysts (the gaping contradiction here should have been our tip-off) told us to do. We’ve been frustrated, for our sake and his, that business didn’t really pick up as expected during the downturn. That it is now starting ramp made equally little sense until we combined this anecdotal evidence with what we’ve heard from the automakers and the data from the big auto retailers.
The fact is, our friend’s market is people who cannot afford a new car. And despite what we hear on TV about cuts on Wall Street and Corporate America, these are the people who have really borne the brunt of the current economic slump. The stated unemployment rate of 10% probably doesn’t include these individuals—they are part of the additional 7% who have given up looking for work out of frustration. And amid their despair, they have not been buying cars—used or otherwise—and they have been deferring maintenance on their existing modes of transportation. That is until recently. Now, if we can believe this one data point, this strata of the workforce has either found some sort of work—permanent or temporary—or at least feels confident enough in the future to start laying out cash on their ride and its effects are being seen in the used car and parts business. We realize, of course, that there are alternative explanations to this phenomenon and we also understand that the sample size would make a statistician cringe. But we also know quite a bit about our guy and his business, which gives us confidence that what he is seeing is true evidence of the “green shoots” that Larry Kudlow has been talking about for months. The difference between our green shoots and Larry’s is that ours started much, much closer to the ground and, as a result, have deeper and stronger roots. That’s a gardener’s metaphor for our belief that, finally, the job market may indeed be turning and it is getting its start at the very bottom. If that’s true, then the ripple effects will eventually be felt all the way up the tree trunk. If so we may see the unemployment rate, finally and thankfully, head down and the market, ultimately, head higher.
Earnings season is winding down, economic data releases are being greeted with almost a yawn, the VIX is holding steady under18 and trading volume is easy to confuse with Google’s stock price on our screen. We’ve had a stretch of spring-like weather in the New York City area over the weekend and forecasts are for the more of same the next couple of days. It’s starting to feel like August on Wall Street except that the calendar tells us we haven’t even reached St. Patrick’s Day.
There’s probably a trading opportunity in here somewhere and we think we’ve found it—the Junk Indicator. No, we’re not talking about high yield fixed income securities we’re talking about junk. Good old used and discarded stuff. Wall Street prognosticators constantly scour the data for indicators of where the market and individual stocks might be going, giving us everything from Astrological indicators to Numerology tables as forecasting tools (there are probably still some entrail readers out there too). So it is without shame that we proffer the used auto and parts market as a leading indicator of the direction of the economy and, ultimately, stock prices.
We know a guy. This guy is in the “recycling business.” That’s PC these days for owning a junkyard. Anyhow, it seems his used auto parts business is just now starting to ramp up significantly after nearly 18 months in the doldrums. His used car lot, quiet for almost two years, is also seeing signs of life. This initially confused us as we’ve tried to track his business as a counter-cyclical indicator ever since the economy entered its current downturn—because that’s what common sense and Wall Street analysts (the gaping contradiction here should have been our tip-off) told us to do. We’ve been frustrated, for our sake and his, that business didn’t really pick up as expected during the downturn. That it is now starting ramp made equally little sense until we combined this anecdotal evidence with what we’ve heard from the automakers and the data from the big auto retailers.
The fact is, our friend’s market is people who cannot afford a new car. And despite what we hear on TV about cuts on Wall Street and Corporate America, these are the people who have really borne the brunt of the current economic slump. The stated unemployment rate of 10% probably doesn’t include these individuals—they are part of the additional 7% who have given up looking for work out of frustration. And amid their despair, they have not been buying cars—used or otherwise—and they have been deferring maintenance on their existing modes of transportation. That is until recently. Now, if we can believe this one data point, this strata of the workforce has either found some sort of work—permanent or temporary—or at least feels confident enough in the future to start laying out cash on their ride and its effects are being seen in the used car and parts business. We realize, of course, that there are alternative explanations to this phenomenon and we also understand that the sample size would make a statistician cringe. But we also know quite a bit about our guy and his business, which gives us confidence that what he is seeing is true evidence of the “green shoots” that Larry Kudlow has been talking about for months. The difference between our green shoots and Larry’s is that ours started much, much closer to the ground and, as a result, have deeper and stronger roots. That’s a gardener’s metaphor for our belief that, finally, the job market may indeed be turning and it is getting its start at the very bottom. If that’s true, then the ripple effects will eventually be felt all the way up the tree trunk. If so we may see the unemployment rate, finally and thankfully, head down and the market, ultimately, head higher.
Monday, March 1, 2010
Ramblings of a Portfolio Manager
Why must the US Stock Market be a slave to the US Dollar?
Lately, one cannot help but turn on a business news channel and hear, at least a dozen times during the broadcast day, a report on the US Dollar Index (USDX) and its real-time impact on stock prices. More often than not we are presented with an intraday chart of the USDX versus the S&P 500, which explains with near perfect reliability why stocks have strengthened or weakened in the last few moments—always the inverse of the immediate movement of the dollar versus a basket of currencies. We hear and read about this relationship so often now that, in fact, that most newer market participants take it for granted that US equities must always be negatively correlated to the value of the US dollar versus other currencies, a fact that is certain to turn this relationship into a self-fulfilling prophecy for the short run. But does this need to be and has it been so in the past?
The USDX is an index of the value of the US Dollar versus the exchange rates of six major world currencies: the Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc. The index started in 1973 and was revised in 2000 with the creation of the Euro. It began with a base of 100 and all movements of the Dollar versus that basket of currencies is relative to this base, so a value of 125 would mean that the U.S. dollar increased in value by 25% since 1973. The index reached a high of over 120 in 2002 and since that time has been in a more or less steady decline. Over the last year the index has declined from a high around 88 during March 2009, at the height of Market fear when the dollar was sought as a safe haven, to a low of 74 in November of 2009. Since November, however, the index has rebounded to around 80 as hopes of a US interest rate rise, combined with a safe haven move on fears of a Greek default, have bid up the Dollar. Over this recent period the Dollar has indeed shown a nearly perfect negative correlation to US stock prices with a coefficient of -0.81 for 2009 and -1.0 (perfect negative relationship) for the last 12 months, meaning US stocks have moved almost in lock step with the dollar but in the opposite direction.
This correlation is atypical, however, and historically a strong dollar was seen as an indicator of a healthy and strong US stock market. A little history: From 1995 to 2000, both the Dollar and the US markets rallied, a positive correlation. From 2000 to 2002, the US markets suffered a big decline and so did the Dollar, also a positive correlation. From 2003 through 2004, however, the markets rallied while the Dollar lost, a negative correlation. In 2005, the Market was fairly flat and the Dollar rose while in 2006, the Market rallied and the Dollar lost. In 2007, the US Market gained but the Dollar suffered a big decline and in 2008, the Dollar initially lost ground while the Market rose slightly but then spiked late in the year when the financial crisis hit and the dollar became a safe haven while the Market sank. The results of this longer term analysis is that the USDX and US equity markets actually have a weak but positive correlation of about +0.35.
So why has the dollar been a strong negative driver of stock prices over the last 18 months? The answer has to do with the absolute level of interest rates in the US. With the drastic Fed easing cycle US rates are near zero and global investors seeking higher returns have been borrowing in dollars to invest in higher yielding instruments such as stocks and commodities--the so called carry trade--leading to a strong inverse relationship between the S&P 500 and the USDX. We’ve seen this pattern before and perhaps there is a history lesson there. In 2004 we also saw a large inverse relationship between the S&P and the Dollar with a correlation coefficient of -0.71. The Dollar Index fell 7% that year while the S&P gained 9%. Back then, as today, interest rates were extremely low during a Fed easing period that led to a Fed Funds target rate of 1%. At the end of the cycle, as the Fed began to raise rates on a strengthen economy, the relationship weakened and as the economy picked up the strength was enough to keep the stock market rising, even with a rising dollar. The current environment feels a lot like the end of 2003 and we suspect that, with Bernanke at the helm of the Fed, future rate rises will be measured enough to allow continued strong economic expansion in the face of rising rates. If that is the case, then history tells us that further gains for both the Dollar and US markets lie ahead.
Lately, one cannot help but turn on a business news channel and hear, at least a dozen times during the broadcast day, a report on the US Dollar Index (USDX) and its real-time impact on stock prices. More often than not we are presented with an intraday chart of the USDX versus the S&P 500, which explains with near perfect reliability why stocks have strengthened or weakened in the last few moments—always the inverse of the immediate movement of the dollar versus a basket of currencies. We hear and read about this relationship so often now that, in fact, that most newer market participants take it for granted that US equities must always be negatively correlated to the value of the US dollar versus other currencies, a fact that is certain to turn this relationship into a self-fulfilling prophecy for the short run. But does this need to be and has it been so in the past?
The USDX is an index of the value of the US Dollar versus the exchange rates of six major world currencies: the Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc. The index started in 1973 and was revised in 2000 with the creation of the Euro. It began with a base of 100 and all movements of the Dollar versus that basket of currencies is relative to this base, so a value of 125 would mean that the U.S. dollar increased in value by 25% since 1973. The index reached a high of over 120 in 2002 and since that time has been in a more or less steady decline. Over the last year the index has declined from a high around 88 during March 2009, at the height of Market fear when the dollar was sought as a safe haven, to a low of 74 in November of 2009. Since November, however, the index has rebounded to around 80 as hopes of a US interest rate rise, combined with a safe haven move on fears of a Greek default, have bid up the Dollar. Over this recent period the Dollar has indeed shown a nearly perfect negative correlation to US stock prices with a coefficient of -0.81 for 2009 and -1.0 (perfect negative relationship) for the last 12 months, meaning US stocks have moved almost in lock step with the dollar but in the opposite direction.
This correlation is atypical, however, and historically a strong dollar was seen as an indicator of a healthy and strong US stock market. A little history: From 1995 to 2000, both the Dollar and the US markets rallied, a positive correlation. From 2000 to 2002, the US markets suffered a big decline and so did the Dollar, also a positive correlation. From 2003 through 2004, however, the markets rallied while the Dollar lost, a negative correlation. In 2005, the Market was fairly flat and the Dollar rose while in 2006, the Market rallied and the Dollar lost. In 2007, the US Market gained but the Dollar suffered a big decline and in 2008, the Dollar initially lost ground while the Market rose slightly but then spiked late in the year when the financial crisis hit and the dollar became a safe haven while the Market sank. The results of this longer term analysis is that the USDX and US equity markets actually have a weak but positive correlation of about +0.35.
So why has the dollar been a strong negative driver of stock prices over the last 18 months? The answer has to do with the absolute level of interest rates in the US. With the drastic Fed easing cycle US rates are near zero and global investors seeking higher returns have been borrowing in dollars to invest in higher yielding instruments such as stocks and commodities--the so called carry trade--leading to a strong inverse relationship between the S&P 500 and the USDX. We’ve seen this pattern before and perhaps there is a history lesson there. In 2004 we also saw a large inverse relationship between the S&P and the Dollar with a correlation coefficient of -0.71. The Dollar Index fell 7% that year while the S&P gained 9%. Back then, as today, interest rates were extremely low during a Fed easing period that led to a Fed Funds target rate of 1%. At the end of the cycle, as the Fed began to raise rates on a strengthen economy, the relationship weakened and as the economy picked up the strength was enough to keep the stock market rising, even with a rising dollar. The current environment feels a lot like the end of 2003 and we suspect that, with Bernanke at the helm of the Fed, future rate rises will be measured enough to allow continued strong economic expansion in the face of rising rates. If that is the case, then history tells us that further gains for both the Dollar and US markets lie ahead.
Subscribe to:
Posts (Atom)
