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Dollar Dunces

Posted November 23, 2009

Topics: Politics, Finance & Investing

Stock market trend: Possible market top OR Emergent Sideways Pattern

ou know the stock market is in trouble when the only explanation for stock price movements is the direction of the dollar. Market goes up -- must be the dollar going down. Market goes down like last week -- must be the dollar firming up.
Never mind how corporate earnings are doing. Never mind whether or not the global economy is recovering. Never mind anything. It's all about the direction of the dollar.
What I find positively stupid about all this is that the logic doesn't work. Suppose you are a foreign investor holding euros or yen or Australian dollars. If you think that the US dollar is going to decline over time because of rising budget deficits and an ultra-easy money policy of the US Federal Reserve, there is no way that you are going to buy dollar denominated assets in the US stock markets. That's just plain stupid.
Suppose, alternatively, that you are a US citizen holding dollars and seek to earn a reasonable return on some type of investment. Given a choice between holding the US market in the form of an exchange traded fund like SPY or buying exchange traded funds of the countries or regions that are likely to see currency appreciation against the dollar, there is similarly no way that you're going to choose investing in the US market.
Well, then, how about all this carry trade stuff? Shouldn't that cause US stock markets to rise? By definition, absolutely not. The whole idea of the carry trade is to borrow US dollars and invest them in higher yielding assets abroad -- not the US stock market itself.
At least from my perspective, all this adds up to a really bad case of spurious correlation. Yes, the dollar has declined by almost 20% since March of 2009 while the stock market has gone up. But no, the dollar's decline can't be the cause of this.
This as an important implication: The observed co-movement of the dollar and US stock prices is likely unsustainable. To repeat, why the hell would anybody in their right mind invest in the US stock market -- that is, dollar denominated assets -- if they think the dollar is going to continue to go down. It makes absolutely no sense.
On this matter, I would love to hear from any of my readers -- or, for that matter, any of my fellow co-contributors on CNBC . Specifically, I would like to hear a cogent argument as to why the stock market in the United States should go up when the dollar declines. And spare me the "law of one price" argument which would argue that all the stock market is doing is adjusting upwards in nominal value to account for the decline in the dollar. This simply doesn't wash because rational actors out in the world would prefer to chase higher returns elsewhere rather than simply tread nominal value water with the US market.
Anyway, that's my beef for the week. I'm tired of hearing all this dollar nonsense without any logical explanation of the alleged effect other than a few buzzwords about "carry trade." If the carry trade were truly lifting the US stock market, the Japanese stock market, which benefited from the carry trade for almost a decade, would be at 100,000 right now.
To close, a few observations on the market trend. Loyal readers know that I called a market top some weeks ago and have thus far have been either dead wrong or just a little ahead of the curve. The truth may be somewhere in the middle as there is emerging evidence of a possible range bound market and a resumption of a sideways pattern, with the top of the range only slightly extended now.
This is a situation that we must watch very closely now. I continue to be mostly in cash -- although last week I dipped in and out of the market with a nice nibble on TWM -- the exchange traded fund that ultra-shorts the Russell 2000. These are the kind of short-term trades that at least keep me on my toes and attentive to the market trend.
Last take: the Chinese government needs to shut its pie hole on the currency question. Over the last week, as the supplicant Barack Obama embarrassed himself in Beijing, Chinese government officials repeatedly attacked the US for its large budget deficits while denying that it's currency manipulation had anything to do at all with weakness in the US economy or the ability of the US to run those budget deficits.
This is just so much Chinese garbage, and it would be refreshing if the Obama administration had the same kind of "ready response" to these criticisms that it had whenever Hillary Clinton attacked Obama during his campaign. It's the first rule of politics -- you don't let a false charge go unanswered. Yet Obama and his clueless lieutenants keep allowing the Chinese to have the upper hand in this trade reform debate when the Chinese government has the blood of the American economy all over its hands.