Saturday, November 25, 2006

Is the Dow in a Bull or Bear Market?


Magicians are quite clever: they pull the audience's attention to their right hand and then do the "magic" with the hidden left.

Markets aren't so different. While our attention is drawn to the numerator--the price change of an equity index such as the Dow--the real magic is occurring in the hidden denominator.

That hidden denominator, in the case of the Dow, is the dollar. U.S. stocks and indices are measured in dollars. But the dollar itself is a moving target.

And it's been moving down.

Denominated in dollars, we have the magic of Dow 12,000.

Denominated in British pounds, the Dow has only recovered a tad more than half of its 2000-2003 decline.

Denominated in gold, the original hard currency, the Dow has been in freefall and only recently recovered from multi-year lows.

So how much of the bull market has been Dow strength (vigor in the numerator), and how much has been dollar weakness (a plunge in the denominator)?

At the very least, judging from the red line, at least half of the Dow's strength can be attributed to weakness relative to other currencies. The Dollar Index chart I posted recently makes that point far better than I ever could.

But bullishness in the Investor's Intelligence survey is at an annual high. Watching the right hand, we celebrate Dow 12,000. Meanwhile, no one mourns what's happening in the left hand.

Magic, indeed.

14 comments:

Anonymous said...

hello from germany,

great chart!

this fits also in the topic.

no dow records in sight..... (inflation and goldadjustet)

http://immobilienblasen.blogspot.com/2006/11/dow-vs-inflation-and-gold-no-records-in.html

Brandon Wilhite said...

Dr. Brett,

I don't really trade the stock market...instead I trade spot forex. For months, it has seemed like only a matter of time before this week's USD freefall. I wonder how much this will affect the US stock market...I guess some of the larger institutional investors will be savvy and able to get out...but isn't it true that many of them won't? In fact, don't many of them have in their investment policy to remain invested a certain percentage and only among US equities? I have to admit that the rally in stocks has seemed a bit odd to me... fundamentally it seems like the stock market is in a lose-lose situation for the medium term, when you consider all of the factors beyond earnings.

Brett Steenbarger, Ph.D. said...

Hi JMF,

Excellent! Thanks for that link; I will include with the links on my personal site tonite. I think this is an important topic--

Brett

Brett Steenbarger, Ph.D. said...

Hi BW,

So far, the weak dollar has not forced the Fed's hand to raise interest rates, so at least temporarily, US goods become cheaper overseas and that's seen as good for business. Should, however, the many countries that hold substantial dollar reserves decide to shift some of those assets into other currencies (something I suspect is already under way), then the weak dollar becomes a rout and forces the Fed's hand. The problem is that raising rates when housing and the economy are soft would risk recession. So, yes, there are risks for stocks here, IMO. Thanks for your note--

Brett

Andrei Tratseuski (TopGun) said...

Hello,

I really found your post to be interesting. Just a thought DOW is only about 40 stocks as if the study was done on S&P it would be more influential.
On the other hand we get paid in dollars.
Adjusted for inflation we are still down from 2000, but otherwise it ok.
Question, based on the charts you supposing that DOW will go up, down??? In my view, it is going sort of up for a while. Based on the expectation that FED will lower the rates. It is complete different situatuion when we are talking about the greenback though.

Brett Steenbarger, Ph.D. said...

Hi Andrei,

Thanks for your note. In the past, the link between a falling dollar and a falling stock market has been a falling bond market, reflecting Fed tightening to protect the dollar. So far, we're not seeing that tightening, which could give us higher stock prices in the short run, but might be even more bullish for commodities such as gold.

Brett

NO DooDahs said...

Denominated in Yen, the DJIA has minted a new all-time high. Same in Venezuelan Bolivares. Also in Mexican Pesos. I haven't charted it in Indian Rupees, but it might be close. A chart in Brazilian Reals might be interesting.

Brett Steenbarger, Ph.D. said...

Hi,

With currencies, as with people, misery loves company. It's nice to know that the dollar is not at Dante's lowest rung of the underworld. :-)

Seriously, however, those are great examples of how performance is relative to the yardstick being used. The debasement of currencies is a world wide phenomenon, not one limited to the States. Thanks for the excellent observation--

Brett

Brandon Wilhite said...

Dr. Brett,

Just wanted to throw this out there... one viewpoint is that USD will not de-value too rapidly as this would be detrimental to the central banks that still have heavy USD reserves; so the central banks may be looking to diversify, but they won't do it all at once... one other thing...if a US stock trader were worried enough about the devaluing USD they could always consider hedging that risk away so they were mostly USD neutral. They'd have to make some decision as to how to do that, of course :)

BW

yinTrader said...

Hi Brett

Looking at a Monthly chart for SGDUSD from 1998 till present, the Singdollar was at low of 1.5000, rising near to below 1.9000 in 2001 and falling back progressively to 1.5571 now, ie Nov 25 2006.

Our local economy has been healthy over the years in spite of inflation and world economic fluctuations, but our currency is pegged to the USD, too.

Our STI /Straits Times Index is still resilient in spite of falling USD/SGD.

Your comments, please.

Brett Steenbarger, Ph.D. said...

Hi BW,

I think you're right: that's the hope--to manage the downside. Central banks don't have the best track record when it comes to such management, however. And how well will they hold their discipline once the big hedge funds push the markets to their pain thresholds? This may yet turn out well--with a VIX at multi-year lows, that's certainly what investors are counting on. Not much event risk priced in...

Brett

Brett Steenbarger, Ph.D. said...

Hi Yin,

Thanks for the perspective. My sense, FWIW, is that gold is the current hedge for all major world currencies.

Brett

Brandon Wilhite said...

Dr. Brett,

I think you're right. Even the central banks can get flattened by the market. From a practical standpoint, none of this actually makes a difference to my trading, except to prepare me mentally for what *could* happen with my trading systems :)

BW

Brett Steenbarger, Ph.D. said...

Hi Brandon,

Yes, I think that mental preparation is important. It also highlights the potential for developing new trading systems that exploit the global macro themes--

Brett