Dollar Strength and the Stock Market: Analysis and Potential Risks

The dollar index showed robust performance last week, but weaker-than-expected non-farm payroll data significantly narrowed its gains on Friday. In the first half of the year, the index plummeted nearly 11%, marking its worst first-half performance since its inception in the early 1970s.

Historically, a weaker dollar has been viewed as beneficial for the U.S. stock market. After all, the S&P 500 delivered a total return of 6.2% during a recent period of dollar depreciation. However, the U.S. stock market has also performed remarkably well in years when the dollar was unusually strong. Therefore, dollar fluctuations may not matter as much for investors valuing assets in dollars.

However, if the Federal Reserve were to drastically cut interest rates as the Trump administration desires, leading to a sharp devaluation of the dollar, the stock market rally might face negative reactions. This happened in October 1987.

Historical Analysis of the Dollar-Earnings Relationship

For in-depth analysis, MarketWatch columnist Mark Hulbert first assessed the historical performance of the dollar index as a concurrent and leading indicator of earnings per share (EPS) for the S&P 500.

In studying the dollar's potential as a concurrent indicator, Hulbert found almost nothing. Since 1973, the dollar index's annual fluctuations have been able to explain or predict just 1% of the concurrent fluctuations in the S&P 500's EPS (as measured by R-squared). This near-zero correlation stems from the highly unstable relationship between the dollar's annual fluctuations and EPS: in different five-year cycles since 1973, the correlation between the two has ranged from as high as 0.44 to as low as -0.83.

So how has the dollar performed as a leading indicator? Hulbert further observed whether the dollar's annual change was related to the subsequent growth rate of EPS, but came to similar conclusions. The figure below shows that since the 1970s, the correlation between the dollar's change over the past 12 months and the S&P 500's future 12-month EPS growth rate has been unstable.

Statistically speaking, it is impossible to conclude that a falling dollar is beneficial or detrimental to U.S. stock investors. But there is a non-statistical concern: the similarity between the current financial environment and the weeks leading up to the stock market crash in October 1987. On "Black Monday," the Dow Jones Industrial Average plunged 22.6% in a single day.

Although the 1987 crash was driven by multiple factors, the sharp decline in the dollar was one of the main reasons. Therefore, in extreme cases, the dollar's fall deserves investor attention.

Similarities to the 1987 Crash

Before "Black Monday," the dollar index was down 7% since the beginning of 1987. What was particularly worrying to investors was that the Reagan administration was actively pushing for further dollar devaluation. Then-Treasury Secretary James Baker publicly pressured the Federal Reserve to drastically cut interest rates, claiming that this move would stimulate the economy and lead to further dollar depreciation.

Randall Forsyth, editor of Barron's, wrote in his history of the 1987 stock market crash that Baker's remarks in the week leading up to "Black Monday" "were aimed at pushing the dollar lower against the (German) mark and other currencies. Baker believed that a weak dollar was better than high interest rates - which were seen as a threat to the US economic recovery, especially with the 1988 election approaching. The market reaction was to sell stocks... The prospect of a currency war made risky assets (especially highly priced stocks) too dangerous."

The similarities between the current financial and political environment are worrying. Today, stock market valuations are higher, and the Trump administration is again aggressively pressuring the Federal Reserve to cut interest rates. There is no doubt that cutting interest rates will inevitably lead to further dollar depreciation against foreign currencies.

Hulbert said that the 1987 crash was just an isolated event, and history may not repeat itself, but it rhymes – and this rhyme is chilling.