Wednesday, April 08, 2009

Stocks & Dollar: When One Falls, the Other Rallies?

It's safe to say most investors are convinced that trends in one market affect trends in another. When oil rallies, stocks are supposed to decline, goes the conventional wisdom. When stocks rally, bonds are supposed to fall. When bonds rally, gold is supposed to rally with it. And so on.

Forex traders are not immune to thinking this way, either. And who could blame them? How many times have you heard analysts say things like, “Higher oil prices sent the U.S. dollar down today, as rising energy costs are feared to worsen the U.S. economic slump”? Or, “The dollar gained today as a rally in the Dow restored investor confidence in the strength of the U.S. economy”?

That's not to say that correlations between markets don't exist. They do, but they are always temporary at best. Still, at Elliott Wave International's Message Board, readers often ask us to verify them. One question that comes up frequently is this: "When U.S. stock rally, the U.S. dollar falls, and vice versa -- right?"

When trying to answer a question like that, you could go a couple of routes. You could consider the “fundamentals." Why would the USD rally when U.S. stocks decline? Well, it could be because, “as the money flows out of the stock market, it goes into other dollar-denominated assets – i.e., Treasury bonds.”

But a simpler way to answer this question is to compare the trends in the Dollar Index to that of the DJIA, the U.S. benchmark stock index. And as you can see, over time, even a quick comparison proves the presumed negative correlation between U.S. stocks and the USD inconsistent. (Chart copied from EWI's intensive Currency Specialty Service.)

Click the Dollar Index Chart for a Larger View

Dollar Index Chart

In 1995-2000, the DJIA rallied. The USD rallied, too. (Positive correlation.)

In 2000-2002, the DJIA lost big – and so did the USD. (Positive correlation.)

In 2003-2004, the DJIA rallied. The USD lost. (Negative correlation.)

In 2005, the DJIA stayed flat. The USD rallied. (No correlation.)

In 2006, the DJIA gained. The USD lost. (Negative correlation.)

In 2007, the DJIA gained. The USD lost big. (Negative correlation.)

In 2008, the DJIA lost big. The USD first lost, then gained, then lost again. (No correlation.)

Since the start of 2009, the USD gained -- as the DJIA kept falling. (Negative correlation.)

Finally, in March, right before the Dow bottomed, the USD reversed and started falling. (Negative correlation.)

Bottom line: Trying to gauge the long-term trend in the USD based on the trend in U.S. stocks doesn't yield consistent results.

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