Is the dollar about to undermine the stock market?

Thursday, December 07, 2006

It’s been a nervous start to the day as markets shift risk ahead of the ECB rate decision/press conference, a slew of Japanese data tonight, and of course tomorrow’s employment situation report in the United States. Macro Man dodged a bullet in New Zealand, where a hawkish RBNZ caused the kiwi dollar to spike to its highest rate since January against the “big dollar.” Fortunately, the remaining currency bets have thus far proven sufficient to offset the losses from the short equity beta, though those profits are dwindling as Macro Man types....

At this juncture, liquidity (as measured by the ability to trade a given size with a given transaction cost) is beginning to deteriorate across a number or markets. The propensity for outsized or wacky moves grows larger by the day; one need only consider what happened to gold and the yen this time last year for an indication.

The dollar sell-off, while extremely modest in an absolute sense, seems to have garnered an unusual amount of press over the last few weeks. Part of this may be down to the extremely low levels of volatility prevailing over the summer and autumn, so that a 5-6 figure rally in EUR/USD seems like a massive jump. Some of it, however, already appears to be looking for a crisis that doesn’t really exist. To wit, there is an implicit (or even, at times, explicit) assumption amongst many commentators that the distress in the US housing market must necessarily manifest itself in other markets as well. The abject failure of equities to crumble has frustrated both stock market and economy bears, so a weakening of the dollar becomes the preferred vehicle through which to transmit systemic distress. No doubt many folks expect the weakness of the dollar to eventually filter through into lower stock prices, a la October 1987.

Macro Man struggles mightily with this interpretation, even though it would ultimately benefit the P/L quite a bit. For one, the magnitude of the dollar sell-off from 1985 to 1987 was sufficient to prompt a G7 agreement to prop the dollar. The dollar has sold off substantially less on a percentage basis from its high earlier ion the decade.

More significantly, twenty years ago the market had gotten progressively more expensive, as measured by the earnings yield. Since 2002, meanwhile, the earnings yield of the SPX has risen steadily and now exceeds the yield on both US treasuries and many categories of corporate debt. Regardless of what one might think of the future trajectory of corporate earnings in the US, it is difficult to construct an argument that the market has been anything but cheap for the last several years.


That value anchor is one of the major reasons that Macro Man does not expect the stock market correction, when it comes, to be anything but a correction. Moreover, it is not unreasonable to expect the dollar sell-off to peter out early next year, much as it did in 2004 and 2005. At some point, surely, Voldemort will realize what he’s buying; after all, how can one have complete confidence in the euro as a store of value when even the bridges on the notes are fake!





Posted by Macro Man at 11:18 AM  

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