FDI question for Finster

[friendly_jacek]

Finster,
I assume you behind this: http://users.zoominternet.net/~fwuth...ancialForecast
I noticed that USD index is inversly proportional to US equity. What is the explanation for that? Please pardon my inexperience.

[Finster]

Re: FDI question for Finster

Finster,
I assume you behind this: http://users.zoominternet.net/~fwuth...ancialForecast
I noticed that USD index is inversly proportional to US equity. What is the explanation for that? Please pardon my inexperience.

If you compare carefully, you will see that the inverse correlation is quite loose. For example, in 1997-1998, the US stock market (as measured by, e.g. the S&P 500) was up strongly, but the FDI was up as well. No inverse correlation. In contrast, in 2000-2002, the stock market was down strongly, but the FDI was up. Good inverse correlation. So it comes and goes.

Yet there is a reason to expect at least some general correlation. First recall that virtually every index of the US stock market with which you are familiar uses the USD dollar as the unit in which the value of the stock market is measured. The Dow Jones Industrials, the S&P 500, the Dow Jones Wilshire 5000, the Russell indexes ... virually all of them compare the value of US equities to the value of the US dollar.

Assume for a moment that the real value of the stock market stays constant while the value of the dollar falls. If this happens, we should expect it to take more of those dollars to buy the same value of stocks. As a result, the stock indices rise. This is not purely hypothetical, since this phenomenon is responsible for most of the gains in the stock indices since 2003.

So how do we know whether the stock market really went up or it just appeared to due to the value of the dollar in the general market that we used to measure it with fell? Well, that is one of the main reasons for developing the FDI.

Of course, the FDI is not the only alternative measure. Besides the usual unit of the USD, we could measure the stock market value in euros, yen, ounces of gold, barrels of oil ... all kinds of things. It is an eye-opening exercise to do so, since it reminds us that the USD is not the only unit of measure available. And since it is not constant in value itself, it's not only not the only unit, but it's a really bad unit. Just imagine how topsy turvy your world view would be if every time you tried to measure something in feet, inches, pounds, or quarts, the size of the measuring unit itself changed. You would find, for example, that if you measured the square footage of your house it would change every year, despite making no modifications. It would be like using a rubber ruler that stretched and shrunk.

We don't work that way in the physical world, but we do in the financial world. Even though it doesn't make any more sense there. You can look at the FDI as a unit conversion tool. It allows you to convert, say, 2007 dollars into 1995 dollars, or dollars as of any other date you choose. The raw FDI number converts to the Y2KUSD, i.e. the value of the dollar as of the beginning of the year 2000. So for instance we can take this week's FDI value of 0.7446 and say that today's dollar is worth about 25% less than it was at the turn of the millenium.

[friendly_jacek]

Re: FDI question for Finster

Thanks a lot. This makes a lot od sense. I was aware of the 2003-2007 stocks gains being at least partially explained by falling USD. I was curious about the big spikes of 1932, 1998, 2002-03 (and some others). They correlated with recessions. How would that happen? Flight to dollar denominated safe US bonds?

The thing is that many investors are bearish on both USD and US equities. Yet, your chart shows that you can have either one or the other but not both. Also, COT is very bullish on dollar now. I recently diversified my investments away from USD but now I'm trying to figure out if it was a good thing (at least short term).

[Finster]

Re: FDI question for Finster

Thanks a lot. This makes a lot od sense. I was aware of the 2003-2007 stocks gains being at least partially explained by falling USD.

Yes. Just keep in mind that the FDI and the often-cited "dollar index" are different in an important way. The latter is an index of the value of the dollar in terms of other currencies. Since most currencies undergo chronic loss of value due to inflation, the conventional "dollar index" doesn’t necessarily reflect true losses in the general market value of the USD. Only when the USD loses value faster than other currencies does the conventional "dollar index" register a decline.

I was curious about the big spikes of 1932, 1998, 2002-03 (and some others). They correlated with recessions. How would that happen? Flight to dollar denominated safe US bonds?

The circumstances are not always the same. The rise in the value of the dollar in 1929-1932 was a reaction to the inflation that had taken place between 1914 and 1929. Alan Greenspan explained it well in the essay Gold and Economic Freedom. 2002-2003 was somewhat similar. The 1997-1998 episode was due to the collapse of a number of emerging market currencies, resulting in a global flight to the dollar.

Typically unemployment rises when the dollar rises in general market value, because wages are set in nominal terms and are slow to adjust to changes in the value of the currency. Wages are notoriously sticky, in economist’s parlance, especially in the downward direction. Much of wages are determined by contracts negotiated and effective for years. And although notable exceptions can be found, workers, being habituated to inflation, are very reluctant to accept decreases in nominal wages. So if the dollar rises in value, the real value of wages increases. This leaves wages artificially high, and as we know from Econ 101, when prices are artificially high, surpluses develop. In the case of labor surpluses, we merely call them "unemployment". So in fact unemployment can be a temporary manifestation of an increasing value of the currency.

The thing is that many investors are bearish on both USD and US equities. Yet, your chart shows that you can have either one or the other but not both.

Actually you can have both. Just keep in mind that the real value of stocks and the real value of currency are two separate things. And the stock indices are not in real terms, but in nominal dollars. If they both go down the same, the stock index remains unchanged. If the dollar goes down more than stocks do, the stock indices rise. If stocks go down more than the dollar does, the stock indices fall.

An inverse example of this was cited above - 1997-1998 - where the dollar rose in general market value but stocks rose more. So you had both a rising dollar and a rising stock index.

Also, COT is very bullish on dollar now.

Again, remember this refers to the conventional dollar index. So the COT is not necessarily bullish on the dollar in the general sense, but merely in relation to other major currencies.

I recently diversified my investments away from USD but now I'm trying to figure out if it was a good thing (at least short term).

The important thing to keep in mind here is that just about anything that is not a dollar nor a dollar derivative (such as dollar-denominated bonds) can give you diversification away from the USD. Many investors mistakenly believe for example that they have to buy only foreign stocks to do this. Including foreign stocks can help, but even US stocks can, too. We just cited an example of this - while the USD has been losing value since 2002, we acknowledged that much of the stock gains of 2003-2007 are due to a declining dollar. In so doing, we implicitly assumed that US stocks were at least holding their value. So in fact we have already noted an instance in which US stocks provided refuge from a falling dollar. It isn’t perfect because taxes are levied on nominal, not real, gains, meaning that if you broke even in real terms on your stock investments, you had to fork over some of your original investment to Uncle Sam anyway, as if you had made a profit. But this problem is not unique to US stocks - the IRS takes a cut of your assets any time they register nominal gains.

There is an interesting coda to this point, since the tax law currently allows gains up to a certain level on the sale of a home to be excluded from taxation. This was a key driver of the housing bubble. People were buying homes in a flight from taxation of imaginary gains.

Bottom line is if you’re worried about the dollar losing value, you can hedge simply by holding a broadly diversified portfolio that is low on USD in the form of cash and bonds. That is, you would include both US and foreign stocks, real estate, hard money (gold, etceteras), and commodities (you can now buy ETFs that track broad commodity indices). If you’re also bearish on stocks, you can underweight the stock portion, too. I personally don’t think it’s wise to entirely exclude any major asset class from one’s portfolio (we can never be certain about the future), but someone skeptical of both USD and stocks could reasonably hold up to 50% in hard money and commodities depending on one’s personal financial circumstances and risk tolerance.