The Dow Jones Industrial Average Index’s recent historic highs have brought great fanfare. We need to ask: Are there deeper intermarket implications in this milestone, particularly for forex traders? Let’s lift this milestone and look what lies underneath.
The first question is: how did this occur while the U.S. dollar declined? A major contributing factor for a dollar decline has been the end of interest rate increases by the Federal Reserve Bank last August after 17 consecutive increases. The Dow closed on this date at 11,173.8 and the U.S. Dollar Index (USDX) closed at 8466. We can see that the pace of decline of the dollar increased as the Dow rallied.
Today, market sentiment consensus is forming that there is little probability for a rate increase, and if a slow-down in U.S. consumer spending occurs, the potential for a decrease in rates will help lower the dollar value further. There is also a global dynamic behind the U.S. dollar decline as the Euro zone’s economic growth increases expectation for an interest rate increase in Europe. So we have the scenario where U.S. rates may go down and European rates may go up. This would put further pressure on the dollar.
Looking at the Dow against the USDX, we can say that generally a declining dollar has been good for the Dow. The benefit of this inverse relationship is the impact on earnings of U.S. based global corporations. A weak dollar lowers the cost of exports. Foreign purchasers of U.S. products have greater buying power.
But there are other underlying impacts. All of the Dow component corporations have significant foreign assets. Those assets are priced in foreign currencies which must be converted into U.S. dollars at key accounting intervals. In times of dollar declines, these assets gain in accounting valuation. For example, Caterpillar Corp. issues loans in a foreign currency to its customers to finance equipment purchasing and leasing. These loans are at a level where they have a material impact on their earnings. Caterpillar states in its 2006 10K report: Because “we make a significant amount of loans in currencies other than the U.S. dollar, fluctuations in foreign currency exchange rates could also reduce our earning and cash flow. During times of dollar declines, collecting loans in foreign currencies is a favorable event.” Conversely, if the dollar went into a period of strengthening, Caterpillar’s earnings would be adversely affected.
Another example is one of the world’s best-known multi-nationals, Coca-Cola. They report that 72% of their net operating revenue comes from outside of the United States. This makes Coca-Cola very sensitive to currency fluctuations. Wal-Mart is another example of the intimate connection between the U.S. dollar and a company’s operating health. They are on a major international acquisition path and have reported that more than 20% of their net sales are now generated by non-U.S. based operations. Wal-Mart also is very sensitive to fluctuations in the value of the Chinese renminbi because China is a significant manufacturing source for Wal-Mart’s products. No Dow component company is exempt from currency impacts.
There are several messages here. The first is globalization. By investing in the components of the Dow, investors are really playing global economic and currency events. Traders can no longer make investment decisions with regard to only U.S. market conditions. Also, the Dow’s historical highs occurred as the global economy has expanded. World economic growth is at 5% and the International Monetary Fund team expects that to continue in 2007 and 2008. And second, currency valuations will continue to affect the current and future operating profits of these multi-nationals. By understanding the currency dynamics behind the Dow move, we can be better prepared for the ultimate retracement.
The final message is that of currency and economic vigilance. Equity traders need to watch for a global growth slowdown, commodity price inflation, a yen strengthening and for the euro’s strength to cut into euro exports. If these scenarios can combine, it could spell the end in the Dow’s run.
It is more important than ever to follow the fundamental and currency forces that move the charts.
Abe Cofnas is president of learn4x.com LLC and author of Understanding Forex: Trading to Win. E-mail: firstname.lastname@example.org.