The Impact of the Dollar on Stock Prices

A falling dollar is supposedly the best thing for your stock portfolio. The U.S. dollar and the stock market have a mostly one-way, inverse relationship. The majority of the impact flows from the dollar -- the cause -- to the stock market -- the effect. When the dollar rises, the stock market falls and vice versa. You can see this by comparing the U.S. Dollar Index and the S&P 500 for the last five years. There are a few logical reasons for this to occur and a few reasons that seem illogical. However, if you understand that the stock market is not an indicator of true economic results, it seems far less illogical.

Profits From Abroad

According to the National Center for Policy Analysis, the United States' share of world GDP was slightly above 25 percent in 2009, which means that there is more economic activity in the rest of the world than there is inside the United States. The U.S. might be the biggest economy, but it still makes up only a significant minority, and not the majority, of the global economy. Companies realize this, which is one reason they operate overseas. For perspective, a report in "U.S. News & World Report" showed Ford getting about 51 percent of its revenue from overseas in 2011, while McDonald's got about 66 percent. Companies doing that much business overseas will be strongly affected by foreign exchange fluctuations against the dollar. If a company makes 1 million euros in profit, and the dollar falls in value, then those euros will translate to more dollars. The market swoons when those extra unearned profits come in. It sounds ridiculous if you look at companies for the strength of their business, but the stock market involves a lot of perception, not just economic realities.

Effect on Exports

Stocks of companies that rely on commodities, like those that grow crops or extract metals, gain a direct positive benefit from a weaker dollar. A weaker dollar usually pushes commodity prices higher, in dollar terms. Since each dollar buys less material, companies that sell commodities pay the same to extract the material but get more dollars when it is sold. This boosts profits. The United States is the world's largest agricultural exporter, according to the USDA, and a weaker dollar increases the competitiveness of these exports abroad. The companies benefit from increased foreign sales, and the share price rises when earnings are reported.

Trade Deficits

Globalization flows both ways, and paying employees abroad or buying supplies abroad costs more when the dollar is weak. The United States has a trade deficit that runs at -$40 billion or less per month, which means the U.S. imports more goods than it exports. When the dollar is weaker, those same goods cost more, as the price is set according to the home currency of the company making the product. Even a company involved in mostly services, like a bank, will find that the foreign LCD screens connected to the computers will cost more. Manufacturers that buy most components abroad will see the cost per good increase as the dollar weakens. That will eat into their margin or force the company to increase prices.

Foreign Capital

The relative increase in foreign currencies from a falling dollar does not just benefit corporations. Wealthy individuals overseas see that they can get more U.S. dollars for their own currency and therefore buy more shares in the U.S. stock market. So they exchange their currency and buy shares in U.S. dollars. As the companies rise, and the dollar gets stronger, they can sell and get their now appreciated U.S. dollars and convert them back into their currency, thus getting a higher return than if they invested in their own currency.

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About the Author

Nihar Patel covers finance and investing for several online publications, including Seeking Alpha. He also runs his own investment analysis website. Patel holds a J.D. from UC Hastings College of Law, as well as a bachelor's degree in political science and history from UC Davis.

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