As the value of the U.S. dollar rises globally, the U.S. stock indexes tend to rise along with it.
Over the last 20 years, the rise in the value of the U.S. dollar has had a slight positive correlation to the movement of the S&P 500 Index. That is, about 40% of the time, the S&P goes up when the dollar's value rises.
That may be an interesting statistic, but it's more important to determine how and why the investments you choose can be affected by the rise or fall of the U.S. dollar.
Key Takeaways
- Stock indexes tend to rise along with an increase in the value of the U.S. dollar.
- More important to an investor is the impact of the dollar's rise or fall on the individual stocks they own.
- Companies that rely on imports thrive when the U.S. dollar is strong.
- Companies that sell their products globally thrive when the dollar is weak.
How U.S. Dollar Value Moves Stock Prices
The U.S. dollar, or any country's currency, can become more valuable in relation to other currencies in only two ways. It grows in value when there is increased global demand for the currency. And, it grows in value when the nation's central bank reduces the amount of the currency that is available.
It's practically inevitable that an increase in the U.S. dollar's value will raise the value of American stock indexes since U.S. dollars are needed to purchase stocks.
But the effect of a significant appreciation or depreciation in the value of the U.S. dollar on an investor's U.S-based portfolio is very much a function of the portfolio's contents. Your portfolio might be worth less than before, more than before, or about the same as before. It depends on what kinds of stocks are in your portfolio.
U.S. Dollar Stock Correlation Scenarios
The following three examples illustrate the different potential effects of a declining dollar on an investor's portfolio:
The Worst-Case Scenario
Your portfolio is made up of shares that rely heavily on imported raw materials, energy, or commodities to make money.
A substantial portion of the U.S. manufacturing sector depends on imported raw materials to create finished goods. When the U.S. dollar declines in value, the purchasing power of the U.S. dollar declines. It will cost manufacturers more to buy their materials, which puts pressure on their profit margins and, ultimately, their bottom lines.
Companies in your portfolio that don't properly hedge against their reliance on the price of imported goods or the effects of a declining dollar can expose you to foreign exchange risk.
For example, a company that makes baseball bats using imported wood will need to pay more U.S dollars for the wood. The company will have to decide whether it will keep its prices the same and make less money per unit sold or raise its prices and risk losing customers.
The Likely Scenario
Your portfolio is made up of a diverse collection of companies and is not overweight in any one economic sector. You have also diversified internationally and hold stock in companies that operate around the world, selling to many different markets.
In this situation, a declining dollar will have both positive and negative effects on your portfolio.
The extent to which the companies you own depend on a high or low U.S. dollar to make money will be a factor in their stock performance, which is why diversification is crucial. The positive and negative effects of the change in the dollar should balance out.
The Best-Case Scenario
Your portfolio is made up of companies that export U.S. manufactured goods around the world.
Companies that rely substantially on foreign revenue and international exports stand to do very well if the U.S. dollar depreciates in value because they get more U.S. dollars when they convert the foreign cash their products bring in.
These companies sell products around the globe. A low dollar also makes high-quality American goods more competitive in international markets.
The Bottom Line
The values of American stocks, especially those that are included in market indexes, tend to increase along with the demand for U.S. dollars. In other words, they have a positive correlation.
One possible explanation for this relationship is foreign investment. As more investors place their money in U.S. equities, they are required to first buy U.S. dollars to purchase American stocks, causing the indexes to increase in value.
However, the important factor is the makeup of your personal portfolio. If your choices are diversified, your money will be protected from foreign exchange risk, among other risks.
