The U.S. dollar has exploded, forcing stock investors to pay attention.
The strength or weakness of the currency can have tremendous influence over stock prices, making it critical for investors to understand the correlation.
Market prices are influenced -- both positively and negatively -- depending on the sector and direction of the U.S. dollar. A strong dollar benefits some industries while hurting others. Right now, the USD is on its way back up.
I have little doubt that the greenback's climb will continue for the rest of 2018 at a minimum. The combined factors of upside technical price momentum, advancing interest rates, and improving economy provide little choice for the U.S. currency to do anything but gain strength.
Now that we have established that the dollar should continue higher, how does dollar strength affect the stock market?
Well, the truth is, studies have shown that strength or weakness in the greenback has a minimal effect on the overall stock market.
Barclay's published a report that compared the S&P 500 performance in both healthy and weak dollar regimes. It discovered that there is little to no correlation between index performance and a climbing or falling greenback. "What?!," I can hear you say, "why this article if there is no greenback effect on stock prices?"
Dollar strength or weakness does have a significant effect on specific market sectors. Here's what every investor needs to know:
1. Commodity Prices Are Correlated
There is a strong correlation between dollar strength and commodity prices.
This means that stocks in the energy and material sectors can suffer from a stronger greenback. Reason being that as the greenback gains strength, it makes commodities more expensive. Costlier commodities result in increased costs for companies leading to decreased earnings.
Investors need to exercise caution to hold energy company shares like Chevron (NYSE: CVX), as well as basic material companies like Dow Chemical (NYSE: DOW) and Alcoa (NYSE: AA). Also, ETFs representing the energy or basic material sectors need to be reevaluated during periods of the U.S. dollar moving higher.
At the same time, these companies and sectors often thrive during weakness in the greenback.
2. Multi-Nationals Suffer From Dollar Strength
Companies that create substantial earnings in foreign currencies suffer when the greenback pushes higher. The reason being is the fact that when the foreign currency is converted into stronger U.S. dollars it losses value. When the U.S. dollar is weak, the opposite occurs, improving the multi-national's bottom line.
Companies sometimes rush to mitigate the damage caused by currency conversion by lowering their earnings expectations in anticipation of a stronger U.S. dollar. The lowering of earnings expectations, in turn, results in bearish pressure on the shares.
However, earnings are expected to continue to grow in 2018, and the S&P 500 has been upward trending since the start of April. In fact, the index just broke above resistance at the 50-day simple moving average (SMA) and the 200-day SMA has served as solid support.
It is important to note that the percentage of S&P 500 earnings arising from foreign sales is in the low 40% range. While still very significant, it marks the lowest rate of foreign-derived sales since the early 2000s.
Despite the lowered foreign sales percentage, should the greenback continue to climb, I expect the overall S&P 500 to feel downward pressure. The bearish weight will be most significant in large multi-nationals who earn substantial profits overseas. Consider lightening your holdings in these stocks.
3. Financials And Consumer Stocks May Benefit
A strong dollar is not sorry for every sector. A strong dollar usually means a healthy economy indicating greater domestic economic activity. Greater activity leads to more consumer spending at home which lifts the earnings of consumer stocks.
Also, a climbing greenback goes hand in hand with higher interest rates, which help a financial firm's bottom line.
Not to mention, history shows that health care and utility shares often outperform during bullish greenback time periods.
Risks To Consider: While things look utterly bullish for the U.S. dollar; no one knows if the greenback will continue higher. All we can do is make an educated guess as to future direction. Always use stops and position size wisely when investing!
Action To Take: Consider the impact of a stronger U.S. dollar when making investment decisions.
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