A Rising Dollar Environment: What Does It Mean to You?
Abstract: Many investors view changes in the US Dollar Index with passing interest, at best; despite the occasional trip abroad they may not see the direct impact that trends in the US Dollar have on their portfolio. Under the surface, however, we have seen many interesting biases across various asset classes when the dollar is generally rising versus generally falling. This is of import, given that we have just moved back into a rising dollar environment.
One of the biggest developments over the course of last week was that the US Dollar [DX/Y] has broken out at 82.50, (as displayed in the image directly below). In doing so, the Dollar gave a double top buy signal and violated its bearish resistance line on its longer term .50 chart. Furthermore, the Dollar can now be considered in a "rising dollar environment". Given this development, we wanted to discuss this concept further, and its implications.
Many investors view changes in the overall direction of the US Dollar with passing interest, at best, as they may not feel directly "invested" in its outcome. But over the years we've produced some research that makes a case for advisors to develop an understanding of the general impacts that trends in the dollar have had in the past. This is not to say that because the dollar is rising we must own XYZ, or that because the dollar is falling we must sell XYZ short, but there are some very distinct historical biases within various markets that correspond with the rise and fall of the domestic Greenback fairly consistently. By understanding these trends, it gives you another advantage with clients, and another means for showing how encompassing your brand of risk management can be when applied to a vast array of financial markets.
The US Dollar has been in the news quite a bit lately, in large part due to the demise of its across-the-pond counterpart, the Euro [FXE]; and given the problems that abound for the Euro Zone, and namely Greece, Portugal, and Spain. As a result, your clients may well be more tuned in than usual to the foreign currencies, and perhaps this has generated some questions from them. With that said, and due to the latest technical developments, we'll start by first explaining what, exactly, the US Dollar Index [DX/Y] is, and thus what causes fluctuations in its valuation. Beyond that we'll broaden the discussion toward a more encompassing view of historical trends in various global asset classes during past significant moves in our domestic currency; of which there have been plenty in the past 25 years. To begin we should first explain that the US Dollar Index [DX/Y] is priced in terms of a weighted basket of major foreign currencies. When we refer to moves in "the dollar," it is this index to which we are referring.
What is the US Dollar Index (DX/Y)?
The US Dollar Index is a geometrically-averaged calculation of six currencies weighted against the US dollar, which has been in existence since 1973. Futures Contracts were listed on the index back in 1985 and only one major reconstitution of the index has taken place since that time, which occurred with the inclusion of the Euro.
Today the US Dollar Index contains six component currencies, which are "trade-weighted": the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. Prior to the formation of the Euro Fx, the US Dollar Index contained ten currencies, including as well the West German Mark, French Franc, Italian Lira, Dutch Guilder and Belgium Franc. Today the currency weights contributing to the pricing of this index are as follows:
Currency Weights
Euro = 57.6%
Canadian Dollar = 9.1%
Japanese Yen = 13.6%
Sweden Krona = 4.2%
British Pound = 11.9%
Swiss Franc = 3.6%
Clearly the majority of the US Dollar Index today is based upon its relationship with the Euro; a full 70% of the Dollar's move is based upon the purchasing power of a dollar versus a combination of Euros and Japanese Yen. Our data on this index goes back to the point in time when a liquid market was created for this calculation of the dollar with the inception of futures contracts on the US Dollar Index (in 1985). Since that time we have seen many significant moves for the Dollar, and our goal with this research was to identify any meaningful correlation between other major asset classes and moves in the underlying currency markets. In other words, do some assets perform habitually better in a rising dollar market, and vice versa? (We bring your attention to this topic again today, because as alluded to above, we have in fact just moved back into what we can label a "rising dollar environment".)
Before we began to study this we had to qualify what, exactly, is a generally "rising dollar market", versus a generally "falling dollar market". Traditional measures of correlation would look at daily or monthly returns of some security, the Dollar for example, and then match up the returns of something else (a bond index perhaps) in the same manner. If bonds were generally up during the same sessions that the Dollar posted gains, they would be considered positively correlated. If bonds were generally down during days (or months) when the Dollar was up, they would be considered inversely correlated. Such data is available elsewhere and didn't truly provide the type of research we wanted to provide to you. So, for our purposes we have gone with a different, yet fairly simplistic definition of rising and falling dollar environments:
Study Parameters
Rising Dollar Market: Any move of at least 10% from a low constituted a new "rising dollar market". The beginning of this trend was then established at the low watermark and the trend remained in force until a correction of at least 10% occurred, at which point the peak of that rally then marked the end of the rising trend in the dollar. This represents a "trough to peak" move in the dollar, and that time period is what we used to qualify a rising dollar market.
Falling Dollar Market: Any decline of at least 10% in the dollar index from a peak began a "falling dollar market". The beginning of this trend was then established at the high watermark and the trend remained in force until a rally of at least 10% occurred off a low, at which point the trough of that decline marked the end of the falling trend in the dollar. This represents a "peak to trough" move in the dollar, and the time period within is what we used to qualify a falling dollar market.
As the chart above shows, there have been many various markets for the US Dollar over the last 24 years; in sum there have been a total of 10 rising dollar markets and 10 falling dollar markets (including the current "rising" stint, which began on November 25th, 2009) based upon our basic criteria. Interestingly, the duration of each (rising or falling) has averaged about 450 days during the study period (458 day average for falling markets vs. 433 day average for rising periods) and resulted in moves of about +/- 20% in each direction (keep in mind that the manner in which these trends were calculated means that no trend could have resulted in a move materially less than 10% in either direction).
So that is the basis for the study -- we identified periods when the dollar was rising and periods when the dollar was falling, going back to 1985. The next step was to then look at various asset classes and their respective performance during rising dollar markets and falling dollar markets. We chose investment vehicles representing Domestic Equity, Foreign Equity, Emerging Markets, Domestic Fixed Income, Foreign Currency & Fixed Income, Various Equity Styles (Large, Mid, Small, Value, and Growth), and Commodities. The results were interesting as many assets did in fact show meaningful performance biases during either rising or falling dollar markets.
The red bars in the graphics below represent average performance during all falling dollar markets, while the green bars represent average performance by that same asset class during all rising dollar markets. For some assets we did not have data going back to 1985, so returns reflect the average since the time at which we had data, those dates are denoted. For example, based on the graphic below we can see that the S&P 500 has performed well in both rising dollar markets and in falling dollar markets, and has averaged positive absolute returns in both during our study period. The SPX was greatly helped in the last "falling dollar market", as it posted huge returns off the March 2009 low. Generally speaking, in a "rising dollar market", Small Cap US stocks, Mid Cap US stocks and Growth stocks (though not always Value) tend to do quite well. Meanwhile, strong asset classes during falling dollar periods include Non-US Equity and Commodity indices, as well as Gold.
We found the results of this initial study interesting enough to add another layer to it, looking specifically within the US equity market, but sub-dividing it based upon the broad Dow Jones sectors. We had to adjust the time frame of the study a bit based upon data availability, but we have sector index data beginning in 1992, affording ample history for a meaningful data sample. Again, our study includes the 10 broad Dow Jones market sectors (Basic Materials, Consumer Cyclicals, Consumer Non-Cyclicals, Energy, Financials, Healthcare, Industrials, Technology, Telecommunications and Utilities). The results of the study are found below, and again the red bars represent average performance during falling dollar markets, while the green bars represent average performance by that sector during rising dollar markets. Interestingly, four of the sectors performed better in rising dollar markets, while five performed better in falling dollar markets, and Telecom was a push. Of note, the Basic Materials sector is the best performing group when the dollar is falling, and also the only to post negative absolute returns during rising dollar environments! Energy is the other big beneficiary during a falling dollar market. Conversely, when the dollar is rising, Technology, Financials, and Healthcare have tended to be the notable winners. One last point on the sector performance is that Energy has historically held up in a rising dollar market, despite its connections to Commodities, having posted returns similar to the market.
What Does All of this Mean to Me?
Our goal with this research was to objectively identify asset classes and sectors that have historically performed well during falling dollar markets; and more timely for today, during rising dollar markets. The last trough in the US Dollar came in late-November, and based on the information shown in this study it is not surprising what areas of the market have moved into leadership roles throughout the investable universe.
As the table above quantifies, since the Dollar bottomed out, Commodities as a whole have struggled, yielding a paltry +0.85% return, as measured by the Continuous Commodity Index [UV/Y]. Even worse has been the performance in Gold, which shows a loss of 1.08%. In keeping with what our historical results show, International Equities have been held back over the past few months as the US Dollar has surged ahead.
Yet as you can also see in the table above, the leadership has come from Small Cap, Growth, and Domestic Equities as a whole. And underneath the surface the index returns have been fueled by the Financial and Technology sectors. The only current divergences from historical results is that Healthcare is lagging, and Basic Materials is holding up (at least for now). But remember, this "rising dollar market" period has not yet finished.
This is not to say that these trends have to hold true, but we think there to be value in the perspective added by this (updated) study. Again, time will tell how this recent shift in the currency markets is received by the market, but at least thus far the rotation we have seen within the leadership roles around the market have been consistent with past rising dollar environments. How you choose to participate in these trends of leadership is up to you, but following them provides a much more disciplined road map to investing than does reacting to everything that comes out of the mouth of newscasters, Euro Zone officials, those from China, or even those within our own domestic administration. Bottom line, stay focused on the guidance that DALI Level One through Seven provides you, as well as the ETF Guided Models. Additionally, it if often beneficial to look underneath the hood of the PowerShares DWA Technical Leaders Index [PDP] in order to see which areas of the market, in general, are exhibiting positive outperformance characteristics. The PDP has undoubtedly had exposure to some of the strongest areas of the market over the past six months (when the US Dollar bottomed) as the PDP is up 17.55% since the end of the November compared to a return of the S&P 500 [SPX] of 6.85%. As a matter of fact, the PDP currently has a 30% allocation to the Technology and Financial sectors (two of the best performing broad sectors since the Dollar bottomed). Also, the Technical Leaders Index is currently skewed towards the Mid Cap (66.8%) and Growth (60%) areas of the market, both of which are generally benefactors of a rising US Dollar. In the end, all of these tools will help steer you to where you need to be, as they endeavor to seek out those areas of the market that deserve a leadership role in your portfolios
