We can talk about earnings and Japan and the Fed and commodities until we are blue in the face, but the primary reason that stocks have been going up over the past eight months is that the dollar is going down. It’s very simple, as you can see in the chart below.
The clock starts running for this chart the day after Federal Reserve chief Ben Bernanke announced his strategy to begin a second round of quantitative easing in a speech in Wyoming. The dollar has crashed by 10% since, allowing big-cap stocks to soar by 27%. Heading into this week, most commodities have done much better than that: Silver was up 140%, cotton was up 121%, corn was up 58%, crude oil was up 53%, and energy-related sectors like oilfield services were up 70% or more.
To believe that stocks are going to keep rising, therefore, you pretty much need to believe that the dollar is going to continue to fall. It’s not a given, but it’s a good bet. So what would lead to the dollar to keep collapsing?
The latest Philadelphia Fed report showed east coast manufacturing plunged in the past month. I won’t got into all the math, but the decline puts in play the possibility that U.S. GDP growth will clock in at 1.5% in the second quarter — miles lower than President Obama and the Bernanke are going to feel good about, and a long way from both the consensus GDP estimates and a growth rate that will generate jobs.
A deceleration in the economy would take pressure off U.S. interest rates as there would be less demand for money. That might occur just as other countries — China, in particular — are raising rates. So you know what happens if there is more demand for Chinese paper and less demand for U.S. paper, right? The demand for yuan rises and demand for dollars falls.
As a result of this very plausible and real scenario, the CNY/USD cross — Chinese Yuan vs. U.S. dollar — is becoming the key one to watch in the world. It kind of makes sense when you consider that foreign exchange markets have been pricing in dollar weakness since last year, but this is the one that could help the U.S. the most and potentially put a dent in China’s armor as a manufacturing haven. To the extent that it becomes marginally more expensive to make stuff in China than in the U.S. manufacturing here would benefit.
The weakness of the Philly Fed might be just what the doctor ordered — Dr. Bernanke, that is — because it will give him cover to keep up quantitative easing after the current $600 billion allotment is done. If you think about it, the Treasury wants the Fed to keep up its liquidity program as much as anyone because it keeps down the interest rate the U.S. needs to pay to fund the deficit.
The bottom line is that underlying U.S. economic weakness could actually help stocks if it leads the dollar to fall and quantitative easing to continue. Putting it more simply, if the red line on the chart above, representing the dollar, continues to go down and to the right, then you can expect the black line in the chart, representing big-cap stocks, to keep moving up and to the right — and the same, but more so, for commodities and commodity-related stocks. Oil, oilfield stocks, silver, gold, gold miners, you get the picture.
The 1,400 to 1,430 level of the S&P 500? Sure, why not. Paper securities would simply be keeping pace with the decline in the dollar’s buying power. It’s kind of a bummer to think of it this way, but it’s reality.