Watch the dollar!

The role of the currency markets in the equity markets is highly underappreciated by the greater investment community. I will write more on correlations between specific currencies and asset classes later, but today I want to touch on the dollar's role in the U.S. stock market. A weak dollar is generally bullish for equities and vice versa.

What does it mean to be wealthy? If your answer is to have a lot of dollar bills, then you're wrong. The correct answer is to have a lot of purchasing power. Paper currencies such as U.S. dollars are just a medium used to execute this purchasing power. If paper currency was truly a gauge of your wealth, then Zimbabwe would be the richest country in the world. Everyone in Zimbabwe is a millionaire, but alas, a loaf of bread or a bottle of water can cost several million Zimbabwe dollars there.

The value of your true purchasing power is an important point to keep in mind when investing. A depreciating dollar takes ones purchasing power down with it. So what good is having more dollars in your wallet if the value of those dollars has decreased? The 40% rally in the U.S. markets since early March of 2008 has everyone jumping for joy. But in the meantime, the dollar index (the index measuring the value of the U.S. dollar against a basket of foreign currencies) has gone from 89 to 77- a 14% drop, representing a decrease in our purchasing power. It is no coincidence that the dollar made a recent peak in the first week or March, and the markets made a recent bottom at the same time. See below:

Dow Jones bottomed March 9th. Dollar index peaked March 4th.

Taking a more broad example, those who understand real economics, inflation and sound money (gold) believe that the bull market in U.S. equities ended in 2000. Those in the opposing camp contend that 2003-2007 represented a bull market. But in reality, the dollar lost enough value from 2003-2007 to represent an actual fall in purchasing power, in spite of the Dow Jones moving from 8,000 to 14,000 during this period. Measured in real money such as Gold, or even strong foreign currencies, the Dow is actually down (ie. a loss of purchasing power) during this period. The charts below outlines the rise of the Dow measured in U.S. dollars (paper money), the plummet in the Dow beginning in 2000 measured in real money (gold), , and the corresponding decline in the dollar index.

Dow measured in U.S. dollars since 2000

Dow measured in gold since 1997- note the fall since 2000

Dollar Index since 2000- a decline of 34%