Is the US Dollar Index bounce back enough to cause a market crash?

As all of us know that the US Dollar Index has been continuously losing in value since March 09, which is the time since when the stock markets globally started to rally. The Dollar Index was a relatively unknown entity to the layman till a few weeks back. However due to the persistent talk about the value of the US Dollar Index in all kind of media and by various financial experts it has now become something that most investors are aware of as all business channels now have a ticker on the USD Index and also talk about it all the time.

Most analysts who are unable to give a fundamental reason for the markets to fall signficantly from the current levels focusing on this Index. Given the fact that the economic story is only improving in India and growth momentum is likely to accelerate going forward it is very difficult to justify fundamentally by any kind of logic a sharp reversal in the direction of the markets. The value of consensus estimates is also very low in my view as these keep on changing after every quarter’s results. Just as an example, at the beginning of the year the consensus estimate for EPS for Maruti was around Rs 60 per share which has now moved unto Rs 80 plus. However as I go through the projections of most analysts they are estimating that next year the company will have just about a 10% earnings growth which is totally out of sync with the growth prospects of the company. My guess (without going into detailed projections) is that the earnings growth will be more like 20-25%. Similar is the case with the projections of most companies’ earnings.

Coming back to the topic under discussion and to put things in the right perspective we need to analyze the historical correlation between the USD Index and the stock markets.

– The USD Index moved up from a level of 90 in late 1998 to a level of around 110 by the first quarter of the year 2000 which was the period of a very strong bull market globally (The internet bubble). Even prior to this the USD was moving up for a few years when there was a bull market on in most Western economies, but not in India.

– The USD Index appreciated by nearly 10% from a level of 118 in March 2002 till October 2002. In this time period the Dow fell by nearly 30%. The Indian markets also fell by around 20% during this time period.

– In the following bull market which started at the end of 2002 till December 2004 the USD Index bell from a level of 108 to 80 levels and the global markets rallied sharply.

-From December 2004 to November 2005 the USD Index rallied by nearly 13% from a level of 81 to 91. In this entire year the Dow remained more or less flat, however in the same time period the NIFTY rallied by over 30%. Most other emerging markets also rallied. (KOSPI by over 30%, Brazil by over 25% etc.)

– Subsequently the USD started falling again and fell to a level of around 75 at the time the global markets peaked out in October 2007-January 2008 period.

– Even as the correction started in global equity markets and the housing crisis broke out in the US and talks of a bigger financial crisis started growing the USD Index kept on falling and bottomed out at 70-71 levels in July 1008. From December 2007 to July 2008 Dow fell from 14000 to 11000 levels and NIFTY fell from 6300 levels to 4000 levels.

– From July 2008 the USD Index rallied to a level of around 90 by March 2009. In this time period the full blown financial crisis was on and there was a flight to safety. All risky assets fell in this time period.

–From March 2009 till date the US Dollar Index has lost around 15% in terms of value and trades at around 76 levels. In this time period most stock markets have doubled and most commodity prices have shot up. This has also been a period where it is finally more or less confirmed that a financial Armageddon has been averted and things will be back to normal.

My submission based on the above is as follows,

– The relationship between USD Index movement and stock market movement is at best unproven and tenuous. There seems to be a greater correlation of a fall in the US Dollar Index and market rallies in the recent past. However a rise in the index does not necessarily cause a market fall.

– The relationship is much stronger with commodities rather than equities. As such there is a greater correlation of gold, copper, crude etc prices with USD movement vis a vis equities

– Even if we are to accept that a US Dollar carry trade is on and that an appreciation in the value of the dollar will result in funds moving out of risky assets, it will again be more so for commodities. It is unlikely that long term investors are putting money into emerging markets just as a part of USD carry trade

– As I wrote in a previous article given the fact that today there are two currencies i.e. the Dollar and Yen where the carry trade can be played out given the fact that short term interest rates are low and expected to remain low in these countries for a prolonged period of time. Also given the fact that the movement in these two currencies is in opposite directions there can be a shift in the currency of the carry trade. In fact in the earlier bull phase of 2003-07 most people used to track the appreciation and depreciation of the Yen and correlate market corrections with a strengthning Yen. Today no one seems to be bothered about it.

A US Dollar bounce back due to a better and sharper than expected US economic recovery might infact be positive for global equity markets.

Lastly, I believe that a big correction in the markets will come only after valuations become far in excess of what is reasonable (which is not the case today) and also when most people are not expecting a correction and a reversal in the value of the USD. Today I believe that there is more or less a consensus on a USD bounce back and a sharp correction in the markets. Normally consensus never comes true, lets see whether is does this time.

“Investing is normally done with a long term perspective. If you buy a stock and it moves up the next day it might just be luck”