Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: With all the talk of the Fed’s rate-tightening timeline, the next logical question for investors was how a stronger dollar would affect the market. There seems to be mixed opinions on this as a variety of fundamental reasons could cause certain sections of the market to move one way or another. In general, however, do stocks show any correlation to the dollar?
Stovall: On average, if we look at a rolling 36-month correlation between the S&P 500 and the U.S. dollar index, we find that there’s really no correlation at all. Therefore, I think what you have to do is look at the dollar and the S&P 500 during periods in which the dollar is actually rising quite strongly.
In that case, we tend to find that large-cap stocks tend to do relatively well because one of the reasons that the dollar is strengthening is due to interest from overseas investors. They know a lot about large-cap U.S. stocks, but know pretty much nothing about small-cap U.S. stocks. Basically, over the long haul, there is no correlation. However, during periods of dollar strength, large-cap stocks tend to do better than small caps.
EQ: In this week’s Sector Watch, you dug deeper into the S&P 500’s sub-industry groups to identify any correlation with a rising dollar. What were some of the groups that stood out?
Stovall: I thought it was interesting that for the groups that had positive correlations to the dollar, the correlation coefficients were actually relatively low. If you recall, 1.0 is perfect positive correlation, so that’s essentially like marching in lockstep.
The S&P 500 sub-industry with the strongest correlation on a rolling 36-month basis since 1989 was airlines at 0.3. Everything else was lower than that. Insurance Brokers and Homebuilding also rounded out the top three in terms of positive correlation.
In terms of negative correlation, it’s a little more pronounced. Gold has a -0.3, while Metals and Glass Containers was -0.34, and the worst was Diversified Metals and Mining at -0.47. So there were more sub-industries with negative correlations to the dollar, and those that had the deepest negative correlations seemed to be more pronounced than those sub-industries with the strongest positive correlations.
EQ: Going back to your point about foreign investors, the strengthening dollar could also serve as a catalyst for overseas capital to come in and push U.S. stocks higher. Considering how interconnected the financial markets have become and how much easier it is to invest globally, would this effect be more pronounced now than ever before?
Stovall: That’s certainly a possibility. We’re not forecasting that this is going to be an unprecedented rotation into U.S. stocks, but I think investors certainly have great reasons to be attracted to the U.S.
On the fixed-income side, the yield on the U.S. 10-year Treasury note is more than twice that of the yield on similar European bonds. When you look at U.S. stocks, because of the uncertainty surrounding the European equity markets, combined with worries about Chinese economic growth, I think investors are basically saying that they’ll go for the surer bet, which would be the U.S. economy and its stock market.
So in general, I would tend to say that we do expect to see a stronger dollar, and it will be a result of investors overseas coming to the U.S. to invest their fixed-income and equity dollars, and because of the ease of transfer of assets, maybe it might end up a very strong relative rotation as compared with what we’ve seen in the past.
EQ: You also found that the negative correlation of commodities to a rising dollar are above their historical averages as well. Would this be a bad time to invest in commodities like gold, oil, etc.?
Stovall: The average rolling correlation with gold is slightly higher than usual with the average being -0.4 and the current level of -0.46. However, oil is more than twice as negative. Normally, the negative correlation is -0.27 but right now it is -0.67. So it’s certainly being hit on the chin more than normal.
My expectation is that as the dollar continues to strengthen, it could become more of a challenge for these commodities. But the more they get hit, the greater the opportunity should you believe in reversion to the mean and that sooner or later, this relationship will turn around.
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