Stock Size and Exchange Rates

Includes: DIS, GE
by: Eddy Elfenbein

Here's a post I'm aiming at new investors:

I'm a big fan of the St. Louis Fed's economic data page. They have gobs of data and yet can customize your graphs.

I made the one below and it shows the S&P 500 divided by the Wilshire 5000 which is the blue line and it follows the left axis. This shows the relative performance of large-cap stocks. When the blue line is rising, large-caps are leading the market. When it's falling, as it has for several years now, that means that small-caps are leading.

The black line is the trade-weighted exchange rate index for the U.S. dollar and it follows the right axis.

(Click to enlarge)

I think this is an interesting graph because at first blush, it's not obvious that these two data sets should be related. But they are.

Let me explain: Large-cap companies, especially the giants in the S&P 500, are heavily weighted toward the massive multinationals. The companies is the Wilshire 4500 (stocks in the Wilshire 5000 but not in the S&P 500) are much smaller, and by extension, have businesses that are more domestically focused. Of course, we're talking about averages, not every stock.

When the U.S. dollar rises against foreign currencies, that makes U.S.-made products less competitive on the world market. American companies that already have a broad global reach — think, Disney (NYSE:DIS) or General Electric (NYSE:GE) — will tend to do well relatively speaking. Domestic manufacturing, however, will suffer. This is reflected in the under-performance of small-cap stocks.

It's really not about size at all but rather something else: currencies. But size encompasses that bias. It's also not a perfect match, but you can see that there's a relationship that's held up for 10 years. While the lines aren't dating, I think we can call them "it's complicated."

The takeaway is that a lot of variables go into the soup that makes up equity prices, and many of these currents you can't easily see. Your stock is an asset just like any other, and it's competing against every investment in the world for capital.

When the market makes a decision, it has its reason. It can be a terrible reason, but it's a reason nevertheless.