RISING DOLLAR BENEFITS US STOCKS MORE THAN FOREIGN STOCKS -- EMERGING MARKETS ARE ESPECIALLY VULNERABLE TO STRONGER DOLLAR BECAUSE OF FALLING COMMODITY PRICES -- FIRMER DOLLAR HELPS SMALL CAPS MORE THAN LARGE CAPS -- BOUNCING YEN HURTS JAPANESE STOCKS
RISING DOLLAR BENEFITS US STOCKS... The direction of the U.S. dollar has an important impact on global money flows. For one thing, the direction of the dollar impacts the direction of commodity prices, and countries tied to natural resources (more on that later). For another, dollar direction helps determine the relative attractiveness of U.S. stocks versus foreign stocks. The green area in Chart 1 shows the trend of the U.S. Dollar Index over the last ten years. The blue line is a "ratio" of the S&P 500 divided by EAFE iShares. [EAFE measures the trend of developed stock markets in Europe, Australasia, and the Far East]. The red line is a "ratio" of the S&P 500 divided by Emerging Market iShares (EEM). The chart is designed to show that U.S. stocks usually underperform foreign stocks when the dollar is weak. That was the case between 2003 and 2008 when U.S. stocks underperformed foreign developed and emerging markets (falling ratios). Since the dollar bottomed during 2008, U.S. stocks have outperformed foreign stocks (rising ratios). The SPX/EAFE ratio bottomed during 2008 along with dollar. The SPX/EEM ratio, however, didn't bottom until the end of 2010 before starting to rise durign 2011. Let's see why.
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Chart 1
LINK BETWEEN FALLING EMERGING MARKETS AND COMMODITIES... To understand the movements in emerging markets, we have to look at the direction of commodity markets. That's because the two assets are closely linked. The green line in Chart 2 shows the Dollar Index turning up during 2011 (up arrow). At the exact same time, the CRB Index of commodity prices turned down (down arrow). That's normal since a rising dollar is bearish for commodity prices. Notice, however, that a "ratio" of Emerging Markets divided by the S&P 500 (red area) started to drop sharply right around the same time that commodities peaked (red arrow) That's also normal since some of the largest emerging markets are tied to commodities -- like Brazil and China. Brazil is one of the world's biggest exporters of commodities, and China the world's biggest importer.
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Chart 2
BRAZIL AND CHINA ISHARES FALL WITH COMMODITIES... Chart 3 shows the close correlation between falling commodity prices since 2011 and Brazil and China iShares. During the last two years, the CRB Index has lost -14%. China iShares (red line) have lost -14%, while Brazil iShares (blue line) have lost twice as much at -30%. It could be argued that the drop in China helped cause the commodity slump and relative weakness in commodity exporters like Brazil. The main point, however, is that all are dropping together. The rising dollar during those two years is a big reason why commodities have been so weak -- and emerging markets along with them. Because of their close link with commodities, emerging markets are more vulnerable to a rising dollar than developed markets. Which is why emerging markets have been the weakest stocks in the world. Since the start of 2011, Emerging Market iShares have lost -13% versus a 13% gain for EAFE iShares. The U.S.market was the strongest market in the world with an S&P 500 gain of 34%.
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Chart 3
FIRM DOLLAR GIVES ADDED BOOST TO SMALL CAPS... Small cap stocks in the U.S. get an even bigger boost from a stronger dollar and weaker foreign stocks. Chart 3 compares the trends of the Russell 2000 Small Cap Index (black line), the S&P 500 Large Cap Index (blue line), and the Vanguard World Stocks Index -ex USA (red line) since the start of the year. Notice that small caps have done a lot better than large caps during 2013 (23% versus 18%). Meanwhile foreign stocks (red line) are up only 3%. [The VEU includes developed foreign stocks, with a 25% weight in emerging markets]. While a rising dollar helps U.S. stocks do better than foreign stocks, it helps small caps even more. Large cap multinational stocks get a lot of their profits from overseas markets, while small caps stocks depend more on the health of the U.S. economy. As a result, U.S. small caps get an added edge over large caps when the stronger dollar implies a stronger U.S. economy.
Chart 4
RISING YEN PUSHES JAPANESE STOCKS LOWER... Japanese stocks have given up their position as the world's strongest stock market during 2013. The reason for that is a bouncing yen. Chart 5 shows that the yen and Japanese stocks usually trend in opposite directions. The falling yen since late last year gave a huge boost to Japanese stocks. A yen bottom during May caused a sharp pullback in stocks. Over the last week, the yen climbed to the highest level in a month. That was enough to push the Wisdom Tree Japan Hedged Equity ETF (DXJ) back below its 50-day average. Japanese stocks will need a weaker yen in order to restore their uptrend.
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Chart 5
POWERSHARES QQQ TRUST BOUNCES OFF SUPPORT GAP... The Nasdaq is helping lead the rest of the market higher today. Chart 6 shows the PowerShares QQQ Trust testing its mid-July peak, which would put it at the highest level in thirteen years. [The QQQ is based on the Nasdaq 100, which includes the biggest non-financial stocks in the Nasdaq market]. The QQQ/SPX relative strength line is also rising, which shows Nasdaq leadership. It's also encouraging to see the recent pullback in the QQQ bouncing off chart support formed by the underlying price gap formed earlier in July (see green box). Gaps below the market are supposed to act as support in an ongoing uptrend. The QQQ would have to drop below that gap area to signal a short-term top.
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Chart 6
APPLE IS FINALLY HELPING QQQ... Apple is the biggest stock in the Nasdaq market, and has been the biggest drag on that market over the last year. That may be changing for the better. The daily bars in Chart 7 show Apple (AAPL) climbing to the highest level in two months after bouncing off support formed during April. The stock, however, still needs a decisive close above its May peak and its 200 moving average to turn its major trend higher. The AAPL/QQQ ratio (dashed line) has also started to climb. That's the first time in a long time that Apple is actually helping the QQQ.
