Comparing the US dollar index (USDX), which tracks the value of the US dollar against six other major currencies, and the value of the Dow Jones Industrial Average (DJIA), Nasdaq, and S&P 500 over a 20-year period (from 2011 to 2021), the correlation coefficient is 0.35, 0.39, and 0.38, respectively. Note that all the coefficients are positive, which means that as the value of the US dollar increases, so do the stock indices, but only by a certain amount. It is also notable that each coefficient is below 0.4, which means that only about 35% to 40% of the movements of the stock indices are associated with the movement of the US dollar.
The currency of a country can become more valuable relative to the rest of the world in two ways: when the number of monetary units available in the world market is reduced (that is, when the Fed increases interest rates and causes a reduction in spending), or by an increase in demand for that particular currency. The fact that a rise in the US dollar will affect the value of US stocks seems natural, as US dollars are needed to buy stocks.
The effect of a significant depreciation in the value of the US dollar on the value of a US-based investor’s portfolio depends largely on the content of the portfolio. In other words, if the value of the dollar falls substantially against other currencies, your portfolio may be worth less than before, more than before, or about the same as before; it depends on the types of stocks in your portfolio.
Equity correlation scenarios in US dollars
The following three examples illustrate the different potential effects of a dollar drop on an investor’s portfolio:
1. Worst case scenario. Your portfolio is made up of stocks that rely heavily on imported commodities, energy, or commodities to make money. A substantial part of the manufacturing sector of the US economy relies on imported raw materials to create finished products. If the purchasing power of the US dollar declines, it will cost manufacturers more than before to buy goods, putting pressure on their profit margins and ultimately their bottom line.
Companies in your portfolio that do not adequately hedge against their dependence on the price of imported goods or the effects of the falling dollar can expose you to great currency risk. For example, a company that makes baseball bats from imported wood will have to pay more for the wood if the US dollar goes down. In this case, a lower US dollar will present a problem for the company because it will have to decide whether to make less money per unit sold or to increase prices (and risk losing customers) to offset the higher cost of the wood.
2. Probable scenario. Its portfolio is made up of a diverse collection of companies and is not overweight in any economic sector. He has also diversified internationally and owns shares in companies that operate around the world, selling to many different markets. In this situation, a falling dollar will have both positive and negative effects on your portfolio.
The extent to which the businesses you own depend on a high or low US dollar to make money will be a factor, so diversification is crucial. Many of the companies in a typical portfolio hedge the risk of a depreciation of the US dollar in their business, which should balance the positive and negative effects of the change in the dollar.
3. Best case scenario. Its portfolio is comprised of companies that export American manufactured goods around the world. Businesses that are substantially dependent on foreign income and international exports can do well if the value of the US dollar depreciates because they get more US dollars when converted from other world currencies. These companies sell products around the world, and a low dollar only makes high-quality American products more price competitive in international markets.
The bottom line
The value of US stocks, especially those that are included in market indices, tends to rise along with the demand for US dollars; in other words, they have a positive correlation. One possible explanation for this relationship is foreign investment. As more investors put their money in US stocks, they are required to buy US dollars first to buy US stocks, causing indices to rise in value.