The Dow Jones Industrial Average has recently broken the all-important 13,000 barrier on relatively little fanfare, quietly setting fresh record-highs on significantly less media attention than the last time around the track. There are many different plausible reasons for the uneventful record-high, but they all seem to point towards the same conclusion: the recent stock market rally is not as nearly broadly-based as in the past.
Likewise significant, these fresh records in the Dow and multi-year highs in the S&P 500 have not forced any worthwhile rallies in the US dollar. As many of us already know, the dollar currently sits at all-time lows against the Euro and multi-decade lows against the British Pound. Thus one of the reasons that the US equity market rally does not feel nearly as broad-based as earlier uptrends is clear: international investors have not bought into the domestic bull market and have otherwise diversified out of the downtrodden greenback.
Where are the International Investors?
Unlike in the past, there have been several key factors that have kept world equity markets from driving currency gains. The most prominent should be fairly obvious to the active currency trader: interest rates have been and will continue to be the primary force behind medium-term currency trends. The reason that the dollar has fallen to multi-year lows is relatively straightforward: falling overall yield differentials leave the Greenback at a clear disadvantage against its major counterparts (see here for more). Likewise significant, international equity indices have kept pace with the US market?reducing the attractiveness of American corporate shares. The very fact that the dollar has been so weak has only further reduced the attractiveness of owning US equities. The chart below shows just how little the S&P has rallied in Euro terms.
As the chart shows, the closely-followed US S&P 500 index is very nearly unchanged year to date when measured in Euros. Given the dollar?s significant declines, the index is just recently above the peaks seen in early 2006. It is therefore little wonder that US equities would seem a relatively unattractive investment to the majority of international investors. Looking at Net Long Term Treasury International Capital Flows (TICS) data, foreigners sold a net $11.6 billion in corporate stocks through December, 2006?the first drop since a minor the -$3.9B reduction in June. The TICS equities index has since rebounded, but the damage has clearly been done. Foreigners and domestic investors alike seem much less enthusiastic about high-growth US stocks.
S&P 500 Continues Higher While Volume Keeps Falling
In fact, one only needs to look at volume data to see that overall trading has been significantly lower through the last year of rallies. Unlike the Q4, 2004 - Q2, 2006 uptrend, trading volumes have been consistently dropping on a monthly basis.
NASDAQ versus the S&P 500: A Sign of the Times?
One of the main reasons that the US equities rally does not feel as broad-based as times past is simple: the largest stock rallies have come from a specific subset of corporations, while the broader market has remained relatively unchanged. One of the clearest indications that bullishness is not as strong as seen at the turn of the decade is the underperforming NASDAQ index. Market technicians cite the NASDAQ / S&P 500 ratio as one of the clearest barometers for optimistic speculative sentiment in the US stock market. The S&P is comprised of a very wide selection of corporations, representing one of the most diversified collections of companies possible. The NASDAQ, on the other hand, consists of predominantly high-growth tech stocks and is viewed as a much more speculative and risky index. Thus more conservative investors are likely to put money into the S&P 500, while the NASDAQ is typically the recipient of risk capital. In times of strong economic growth and overall market optimism, high-growth stocks should clearly outperform the more defensive corporate issues. On the flipside, expectations of economic downturn typically lead to stronger performance in value stocks. Thus the highly diversified S&P 500 / NASDAQ indicator serves as a worthy barometer for overall market sentiment.
Looking at the charts below, we see that the Dow has catapulted to fresh record highs, showing nearly unflappable upward momentum through year-to-date trade. The NASDAQ / S&P 500 index has actually declined through the same period, however, and further hints at waning bullishness in overall corporate growth. Indeed, the more recent trend is quite troubling; the DJIA has posted nearly three weeks of uninterrupted gains, while the NASDAQ / S&P Ratio has remained almost exactly unchanged.
Cross-Market Risk Appetite and Speculative Sentiment at Risk? What Does this Mean for the Currency Market?
To say that the US stock market has had negligible influence over currency markets is slightly misleading; one only needs to look at the late February carry trade unwind to see that overall risk aversion holds considerable sway in the currency market. A precipitous drop in the high-flying Chinese Shanghai index led to sympathetic tumbles across all major equity markets and likewise forced investors to scale back high-risk carry trade positions. At the time, the Japanese Yen seemed to move tick for tick with world equity indices?especially those in the US and the domestic Nikkei 225. Traders have since rebuilt many of the JPY shorts that were initially unwound, selling the Japanese currency against virtually all of its major counterparts. It is therefore little coincidence that the EURJPY currency pair has moved to all-time highs, while the US Dow Jones Industrial Average has likewise reached record levels. These impressive uptrends are now beginning to show kinks in their armor, however, leaving questions as to how long this potential “bubble” may last. A sharp decline in the US stock market serves as a distinct risk to JPY shorts, threatening to derail overwhelmingly JPY-bearish sentiment.
Stay tuned for the next Dow / Currency article in our 2 part series!