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In the great debate about the stock market’s uncertain future, a case can be made either for or against continued up moves. Many factors, including valuations, sentiment, momentum, earnings growth, economic growth, dividend yields, and interest rates are all routinely mentioned as reasons for either optimism or pessimism. As you know, we favor fund investor behavior as a predictor, but today we’ll focus on a subject that doesn’t get much ink (or bytes), and explain how it relates to stock market prices: the U.S. dollar.
Since late 2002, investments have gone up, up and away. Stocks, oil, metals, real estate, art, collectibles, classic cars – you name it. Every investment carries a higher price tag than it did then. In the last five years, it's been difficult to lose money. Everything has gone up.
Or has it?
If a stock trades for $100 one week and then trades for $110 a week later, you would say it went up 10%. But say you went shopping in Paris. You buy a pair of pants for $100 U.S. dollars. Yet by the end of your trip a week later, that same pair of pants costs $110 U.S. dollars. Assuming the store didn’t raise its prices, you could blame the falling U.S. dollar for the increase. In other words, the pants didn’t actually go up in price (not in euros anyway). Your favored currency simply became about 10% less valuable.
The U.S. dollar has been falling fairly steadily in recent years. One obvious sign of its decline is the rise in costs for goods purchased overseas. A less obvious sign lies in the fact that it is more expensive to buy a gallon of gas in the U.S. Assets have a global price. When the U.S. dollar falls, nearly everything becomes more expensive to those of us carrying American currency in our wallets.
Let’s say a barrel of oil is priced at US $70. Currently, a dollar buys about seventy cents worth of euros. So buying a barrel of oil would cost about 49 euros. Suddenly, the U.S. dollar falls 50% overnight. The price of that barrel of oil climbs to about $140. Why? Oil didn’t get cheaper in France just because our dollar fell. Post-crash, each dollar buys only 0.35 euros. It’s the same logic behind the price increase of those Parisian pants.
The last time a euro was worth one U.S. dollar was in early December 2002. This chart shows the weakening dollar.

Back in 2002, the Dow was at 8,620, not too far from the bear market bottom. If you had invested $10,000 into the Dow – using the Dow Diamonds exchange traded fund (DIA), you would have about $15,790 today, not including dividends of about 2% or so a year. Not bad.
But if you lived in Paris in 2002, opened an E*TRADE account in the states, bought the same Dow Diamond ETF using U.S. dollars, and then sold today and converted back to euros, you'd be up a paltry 12%, not the near 60% the U.S. investor enjoyed. The trouble is, the $15,790 U.S. dollars only buys 11,159 euros today, yet it took 10,000 euros to make the investment back in 2002.
The following chart shows Dow Diamonds in both U.S. dollars and euros.

So why would the Dow be priced like oil or pants? Since companies like Microsoft and ExxonMobil make some of their money selling stuff to other countries, their value in U.S. dollars should climb as the dollar falls. As these companies make much of their money in the U.S., we wouldn’t expect the relationship to be perfect – basically Microsoft’s windfall abroad (converting back to U.S. dollars) is partially watered down by U.S. dollar earnings at home. Still, Microsoft has some global value – if foreign investors were willing to pay 200 billion euros to buy out Microsoft before the dollar fell in value, certainly the company is worth nearly as much in euros now that the dollar has fallen.
You can really see the effect of the falling dollar by reviewing investments you made abroad before the U.S. dollar fell (the Powerfund Portfolios owned a good share of foreign stock and bond funds in recent years.)
The DJ Euro STOXX 50 ETF (FEZ) is a similar ETF to the Dow Diamonds in that it owns 50 giant European stocks (as opposed to the Dow’s 30 giant U.S. companies). However, while companies like SAP, Nokia, and ING Groep earn money globally, they earn most of it in euros. As our dollar falls, you’d expect their share prices in dollars to climb rapidly – even more rapidly than Dow stocks.
If you parked $10,000 into FEZ back in December 2002, today you’d have a cool $23,500 – an impressive 135% gain. Sure beats the Dow! Much of this big gain would be due to the dollar falling in value to the euro, but a good chunk of the return could be attributed to the popularity of European stocks relative to U.S. stocks, which were overpriced in the late 1990's.
So how much of the increase was real and not exaggerated by currency fluctuations? It’s hard to know exactly, but if back in December 2002 that same Parisian investor had placed US $10,000 (10,000 euros at the time) into FEZ, sold it today and converted back to euros, the “FEZ dispenser” (couldn’t resist…) would deliver 16,610 euros – a nice 66% jump, but hardly the 135% windfall the U.S. investor enjoyed. In euros, European stocks outperformed U.S. stocks by about 55%. In dollars, it was closer to 80%.
The graph below shows FEZ in dollars and euros.

What does all this mean for Powerfund investors?
Stocks are global assets subject to currency fluctuations. Too many of today's investors probably think their foreign funds are better investments, or run by smarter managers. They underestimate the wind at their backs in the form of a falling U.S. dollar. The reality is that anything that can be construed as a global asset – a claim of ownership - will appear to perform well when your local currency is weakening. Bonds and similar income-oriented investments denominated in your currency are the exceptions.
Going forward, we expect U.S. stocks to outperform foreign markets (either through falling less or rising more than their foreign counterparts). Few today hold this belief. But that’s okay. Few thought foreign stocks would beat U.S stocks back in 2000.
If the U.S. dollar keeps falling, we may be proven wrong. But how much further can our dollar fall without major global implications that lower European stock earnings? If and when we see the U.S. dollar come back, many of these global assets will fall, and fall hard. Too many investors are loading up on $130 pants because they used to be $100. They think the pants are increasing in value, when in all actuality, the money in their wallet is declining in value.
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