The fundamentals that normally would boost the valuations of firms listed in the stock market appear to be in a dismal state. Majority of the firms have reported shrinking profits, or no profits at all. The uemployment rate is climbing towards 10 percent - forecasted to reach 12 percent. Property foreclosures are at an all time high, up 37 percent in July 2009, compared to July 2008. What possible scenario then would lead to an upsurge in valuations of publicly listed firms, leading the equity market to enjoy significant gains in the last six months? The Down Jones index (DJIA) is up close to 50 percent in September 2009, compared to March 2009.
Is this a glimpse of what is known as "Irrational Exuberance" as Greenspan once put it (and later became a title of the book written by Yale prof. Shiller)? Is Wall Street simply rushing to glory without any stable foundation to fall back on?
The underlying reason of the surge in the stock market, however, might be found by analyzing the recent foreign exchange performance of the USD. From March 2009 till September 17, 2009, the USD has weakened by more than 17 percent against the other formidable foreign reserve currency EURO. The logical reaction to this news is that this cannot be good. However, there is a silver lining in the weakening dollar. What the weakening dollar does is it boosts the balance sheets of thousands of American firms that claim revenues from sales overseas. Let us think about this for a second. For instance, an American firm makes EURO 10 million in revenues from its European operations. This revenue when translated to USD today, figures to be 17 percent more than it would have been back in March 2009. Aaah. After all, the balance sheets of the American firms are always recorded in USD terms. OK, but, is the forex behavior the only explanation for the upsurge in the stock market in the last six months? Well, it is difficult to see any other signs in the economy right now that would make anyone believe otherwise.
Now to the follow on question. Is the decline of the dollar a calculated move by the federal reserve or is it market driven? Is the fed trying to boost the sentiment of the US consumers by giving them capital gains sooner than they expected (i.e, not backed by fundamentals)? Consumer spending after all is the backbone of the US economy, and that the fed would strategize something like this to reignite consumer spending cannot be ruled out. Someone on CNBC this morning claimed that this is a calculated move by the fed, turning the dollar to what he termed the "Japanese Yen". Why did he say that? It could be because the Japanese Yen has been a weak currency for a long time as Japan has been in a perpetual recession that it never seems to be able to climb out of. The interest rates in Japan have been near historic lows for ever, discouraging Japanese and foreign investors from Yen driven investment schemes, and turning them to investments overseas, backed by other currencies. Japan's population is aging, meaning they are risk averse, and focused on wealth preservation.
But China is still investing in US treasury bonds which in turn should strengthen the dollar. There is news however that China is starting to cut back on its US bond investments because of the weakening of the dollar. The other plausible explanation for the dollar's decline could be our beloved metal - Gold. Gold has been doing very well in recent months and investors might have been lured into its appeal and in return are abandoning the dollar.
Whatever the case may be, the weakening USD appears to be doing wonders to the US stock market, and by the same measure, firms located in other countries that earn heavily in USD would see their balance sheets, in their local currencies, shrink. To verify this, we would need to research the equity market performances in various other countries, a task I hope someone is up for.
-SP
