What the Currency Market Could Teach the Stock Market

Market observers frequently assert that a causal link exists between the currency market and the equity market. Hardly a week goes by when The Wall Street Journal or The Financial Times doesn't quote someone explaining the dollar's movement by citing activity in the equity market.

Regular readers of this column know that I am suspicious of such claims. A strong correlation must exist in order to assert a causal relationship. Statistically speaking, there doesn't appear to be a strong or stable relationship between the change in the value of the dollar and the change in a broad measure of U.S. equities. This conclusion applies to the euro and European bourses, as well as to the yen and Japan's Nikkei.

The absence of a strong statistical relationship is perfectly understandable. Investors show a clear preference for domestic equities. In the major equity markets, foreigners tend to hold relatively small stakes. Cross-border portfolio investment tends to be concentrated in fixed-income products.

Consider also the relative size of the two markets. With an estimated $1.5 trillion turnover a day, foreign exchange is the largest financial market in the world. In only half a week, the turnover in the foreign-exchange market is larger than the annual turnover of the New York Stock Exchange.

This doesn't mean there is no relationship between the two markets, just that the relationship is much more complicated than the post hoc explanations would suggest. Consider the relative volatility of currencies and equities. Individual shares tend to be more volatile than currencies. Academic studies have found that the variance in foreign exchange accounts for about a third of the return of a global equity fund.

I want to argue that the experience of the currency market says something important about the equity market, especially the dot-com phenomenon. Among asset classes, foreign exchange is special. When one buys a stock or bond, one is acquiring a claim on a future earnings stream. Based on that expected earnings stream, one can model the present value of the investment.

Since Nixon closed the gold window in the early 1970s, severing the link between the dollar and gold, we've lived in a world of fiat currencies, or paper money. Fiat currencies, in their pure form, do not generate an earnings stream. As such, MBAs and economists have great difficulty modeling a currency's value. Of course, there have been attempts to ascertain the value of particular currencies. Perhaps the best-known theory of value, purchasing power parity, argues that foreign-exchange rates should move to equalize a basket of internationally traded goods. However, if purchasing power parity is valid, it is over a time horizon much longer than that of most investors and speculators and the magnitude of moves in the opposite direction are larger than most market participants are able to tolerate.

Traders as Teachers

The fact that valuation is so elusive in the foreign-exchange market doesn't deter people from trading currencies. Indeed, their experience may help us think about the shares in companies that either don't have an earnings stream or have a P/E ratio so high it leaves observers incredulous.

First, partly because it's difficult to get one's arms around "value" in the currency market, participants' time horizons tend to be truncated. Of that $1.5 trillion in daily currency turnover, the vast majority of positions are held for seven days or less.

Second, psychology often plays a significant role in the foreign-exchange market. Because there appears to be little, if anything, that anchors the price of a currency to value, the market's focus can shift from day to day, making it critical to understand exactly what the focus is. Is it a country's trade balance? Economic growth? Expected interest-rate changes? Or maybe it's an event like Saturday's Group of Seven meeting or the prospect of tax reform or union wage demands.

There seem to be similar types of focus-shifts among many new economy stocks. The herd moves from chips to boxes, search engines to portals, pipelines to backbones, content providers to distributors. And if your stock is not "in play," liquidity and interest dry up. When the focus is elsewhere, equities can rally in the face of higher yields and higher yields can weigh on equity prices.

This also means that expectations and positioning may take on an increasingly important role. As we have seen, stronger-than-expected earnings don't necessarily protect share prices if the stock rallies ahead of a company's earnings release. Buying the rumor and selling the fact is a common pattern.

Third, because many currency market participants compare international statistics, they've come to appreciate that the methodology by which the statistic is derived can be critical to determining its relevance. Two countries may track unemployment in such different ways as to make the two measures incomparable. This is analogous to the different metrics used to quantify the performance of new economy stocks.

Applying the same critical appreciation to the equity market can be revealing. For example, most arguments that the stock market is overvalued are based on an assessment of the likely future earnings stream. Yet there is good reason to suspect that accounting rules, that is, the methodology, unduly depresses earnings. As Federal Reserve Chairman Alan Greenspan has observed, U.S. GDP is roughly 25% lighter than it was a decade ago, and corporate American capital has invested heavily in intangible assets, such as software. For accounting purposes, these purchases count as costs, not as investment.

Not being able to amortize the cost of such investments over a period of years, as you would other investments, dampens earnings. Last year, the government revised its calculation of GDP to allow software to be counted as an investment. In addition, the fact that many businesses, especially those in the technology industries, do not capitalize research and development costs (that is, amortize or spread out those costs over a number of years) tends to pressure earnings.

In a speech toward the end of last year, Greenspan suggested that investors might be seeing beyond the accounting smokescreen. If private sector accounting rules were to be adjusted in the same way as the government's calculation of output, the P/E of the S&P 500 could drop to the mid-to-low 20s, according to some estimates. It's currently at 29.7.

While disagreeing that there is a simplistic causal link between the equity and currency market, my point here is to suggest some interesting parallels between the two markets. The real dollarization story may be that of the stock market. Think of shares as fiat currency.

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