Onward and Upward? Don’t forget about the Dollar

05/23/2003 - Tom Beilstein, Portfolio Manager

The market’s current rally has been a refreshing change from the bear market of the last three years. The rally has not only produced large gains, but has been extremely broad, rewarding investors in most in equity categories equally. Since the market lows on March 11, large-cap stocks (as measured by the S&P 500) are up 16.4%, mid-cap stocks (S&P 400) 16.7%, small-cap stocks (S&P 600) 16.2% and international stocks (MSCI EAFE) 15.3%. The rally has also been kind to most sectors. The Consumer Discretion sector is up 23.0%, followed by Telecommunications at 22.4% and Financials at 20.0%. Even the sectors that are lagging, Energy and Consumer Staples, are up 6.6% and 9.5%, respectively. The breadth of this advance is a bullish sign and leads to increased confidence that this rally will have more staying power than previous rallies.

The biggest obstacle to this rally is the depreciating dollar. Last week, U.S. Treasury Secretary John Snow made comments indicating that the Treasury would not intervene to stem continued dollar weakness. The U.S. Dollar Index is down 8.1% year-to-date and is down 22.1% since January 28, 2002. Devaluation could lead to inflation as producers experience higher demand for their products and raise prices. As prices rise, the currency buys fewer real goods and services. This forces the government to raise interest rates to make the currency more attractive, which slows the economy. This is a severe example. The dollar is nowhere near this point, but it needs to be noted that there could be major consequences if the dollar’s fall reaches extreme proportions.

With economic conditions sluggish around the world, it is clear that nobody wants their currency to be very strong. A weak currency makes a country’s exports more attractive and can help spark a nation’s growth in the short-term. The U.S. switch from a “strong dollar policy” to a “sound dollar policy” is an indication of this. A “sound dollar” is a currency that can be trusted as a medium of exchange and a store of value. A “strong dollar” is one that is gaining value versus other worldwide currencies. With potential rate cutting in Europe and the Japan’s desire to slow the ascent of the Yen, the dollar’s downside momentum may recede. Thus, as long as the dollar’s descent remains orderly with favorable implications for liquidity and earnings, the markets should continue to do well.

Sources: Baseline and Ned Davis Research