Theory of Relativity and Stock Markets

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Includes: EEM, EWA, EWG, EWJ, EWU, EWZ, FXI, INP, IVV, RSX, UUP, VGK, VTI, VWO
by: Richard Shaw

Are we up or are we down? Shouldn’t that be a straight forward question? It depends.

In this case, it depends on your currency base. If you are a UK investor, for example, your home market over the last three months is either up 3.81% or down 2.43%. You are up if you measure direction in sterling, but you are down if you measure direction in dollars.

In high school physics, we learned that the same event will be perceived differently by two observers if they are moving relative to each other. For example, if you are in your car going 50 miles per hour and another car passes you at 60 miles per hour, it moves 10 miles per hour relative to you. However, if you are standing by the side of the road and a car goes by at 60 miles per hour, it moves 60 miles per hour relative to you. In both cases it was the same car, but crawling along relative to one observer and zooming along relative to the other.

So too with securities markets. Your position as an investor is your currency base. How your currency base is moving relative to other currency bases, determines how you will perceive the returns, or even direction, of a market compared to another investor with a different currency base.

That’s more than just academic navel link picking. Money flows to where it can benefit the most. Relative returns through the lens of foreign exchange will influence not only where money flows TO, but where it flow FROM. Right now, we expect significant funds are flowing from the eurozone to dollar denominated assets.

This table of country stock market returns expressed three ways — in dollars, in euro and in local currency — shows the substantial differences in perception of return that result from the currency-base frame of reference of the investor.

click image to enlarge

currencyEffect

The dollar has been strong lately, and the euro has been weak. Returns around the world look pretty good to Europeans, whereas they don’t look as good to US investors. Of course, that will swing in both directions over time.

Exchange rates are just one vector, but they are important vectors. This 1-year percentage performance chart of the US dollar index shows the dollar index moving from -15% in December to -8% now. That was a big help to the US stock markets.

usd

For all of its problems, including major creditors calling for a new reserve currency, credit rating agencies threatening to take away the US triple-A rating, and the credit default market pricing US default risk at a multiple of what it was a couple of years ago, the US does not (yet, read that California) have a major sovereign default risk alarm bell ringing, as it has been ringing for Greece and perhaps some other European states, and as it rang for Dubai. So US companies are reporting and projecting improved profits and the dollar is strong. But if the dollar reverses its course, US markets may under-perform and commodities priced in dollars will rise in price.

With the US administration pounding on China to let its currency float and rise relative to the dollar, and with administration commitments to strongly boost exports at the same time that the euro is low relative to the dollar, the implication is that the dollar exchange rate must fall. The exchange rate boost for th US stock market would be removed.

This image contains two price charts for the SPY (proxy for the S&P 500). The upper chart is the SPY price percentage performance expressed in dollars. The lower chart is SPY percentage price performance expressed in dollars, but divided by the price of the US Dollar Index to simulate holding the dollar at constant exchange rate. That lower chart is less impressive, and a little bit toppy. Without the currency boost the excitement about the US markets might be somewhat more subdued.

SPYtwoways

We need to watch the dollar carefully, because it can quickly change our market fortunes. It is up several percent since December 2009, and if that is given back to the market, a comparable hit would probably be realized in the US stock indexes.

Relevant Securities:

Stock ETFs that related closely to table above are: UUP, EWA, EWZ, FXI, VWO, EEM, VGK, EWG, INP, EWJ, RSX, EWU, SPY, IVV, VTI, IWB and IWV.

Holdings Disclosure:
As of March 14, 2010, we hold SPY and EEM in some, but not all managed accounts, We do not have current positions in any other securities discussed in this document in any managed account.

Disclaimer:
Opinions expressed in this material and our disclosed positions are as of March 14, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.