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Bounce Isn't a Dollar Story

The Comp slides as other indices enjoy their first gains of '05 for reasons unrelated to currencies.

Stocks kept bouncing along on Thursday but managed to finish in the green for the first time in 2005. Well, major averages finished higher, save for the

Nasdaq Composite

, which spent most of the day above Wednesday's close only to falter in the last few minutes of trading to end with a small loss of less than 0.1% to 2090.

After eight failed upsurges on the

previous day, it was more of the same for the tech-laden benchmark on Thursday. The day's low, 2088.03, was again a lower low than the previous day's low and the high of 2103.90 was lower than the previous day's; according to chart watchers, that combination is bearish (certainly negative), although breadth improved from its recent dominance by losers.

Meanwhile, the

Dow Jones Industrial Average

gained almost 25 points, or 0.2%, to 10,622.80, and the

S&P 500

added 0.4% to 1187.84.

Homebuilders snapped back after several days of losses, while semiconductors and gold shares stayed in the red. The Philadelphia Stock Exchange's Housing Index gained 1.1% as



added 2.6%. The Philadelphia Semiconductor Index lost 0.5%, with

Applied Materials


dropping 0.7%. The Amex Gold Bugs index fell 0.2%, including a 2.5% fall by

Coeur D'Alene



Energy stocks also made a comeback on the back of rising oil prices. Crude futures gained 5% to $45.56 a barrel, the highest closing price in two weeks, amid signs that OPEC might actually follow through with promised production cuts. The Amex Oil Index rose 1.7%, led by



8% jump.

Hopefully, Thursday's results will also knock one of the sillier shibboleths making the rounds to explain why equity markets have been so weak of late. It seems that the stock market's recent slide coincided with the longest dollar rally in the past 12 months (which, by the way, totals all of five days). And, of course, the dollar was falling in the fourth quarter while stocks rallied.

Unfortunately for those seeking simple answers, the correlation has more to do with other causes driving both markets rather than any direct currency effect on equities.

Don't Blame the Buck

For much of last year, the markets were overly optimistic about future interest rate hikes from the

Federal Reserve

and overly pessimistic on U.S. growth prospects. Futures markets in October were projecting that the fed funds rate might be as low as 2.75% by the end of 2005. That surely was part of the pressure pushing the dollar down against the euro, where central bankers were rumored to be considering hiking interest rates. Other factors also were in play, including the record U.S. trade and current account deficits as well as the possibly

waning appetite for U.S. Treasuries among foreign central banks.

If U.S. rates, already so low that they were depressing interest in the dollar, were likely to stay pretty low while European rates were going up, it made sense for the dollar to tumble against the euro. Money, especially short-term money, gravitates to where it can earn the highest after-inflation, or real, return. With the fed funds rate below the inflation rate, that place wasn't in the dollar.

To a great extent, this fundamental factor was being mitigated by Asian central banks buying dollars willy-nilly to keep the values of their own currencies down in an effort to promote exports. So the dollar's fall has been gradual rather than steep despite ultralow U.S. short rates since 2001.

Over the past month, with some bumps along the way, expectations for future Fed rate hikes have increased. Futures markets are now looking for a fed funds rate of about 3.50% by the end of 2005. The release of the minutes of the Federal Open Market Committee's December meeting on Tuesday was particularly critical, in that it indicated that the Fed was planning to raise rates even without signs of growing inflation.

At the same time, virtually all of the data on Europe's economy has been bad. Just on Thursday, reports showed German retail sales were down in November, consumer confidence declined in France and a measure of activity in the U.K.'s services sector for December dropped to the lowest level in three months. That makes it less likely -- in fact, very much less likely -- that the European Central Bank will be hiking rates. Rumors also have waned concerning declining Treasury purchases by foreign banks.

Prospects for higher short-term rates in the U.S. and stable or even lower rates in Europe would naturally draw investors back to the dollar and out of the euro. And that's just what has happened for the past five days. On Thursday, a euro brought $1.3169, down from an all-time record of $1.3666 on Dec. 30.

"Throw in the oversold nature of the dollar at the end of last year and the recent data flow gives you the makings of a decent dollar correction," Wachovia economist Jay Bryson wrote on Thursday. If Friday's payrolls report comes in strong, he expects another leg up for the greenback.

So are stocks falling because of the dollar rise? No -- but they've fallen at least in part for one of the same reasons: More Fed rate hikes are bad for stocks. In fact, the steepest plunge that the indices took over the past four trading sessions was after the 2 p.m. EST release of the Fed's minutes on Tuesday.

Higher rates raise the cost of doing business and make holding stock futures contracts more expensive. Equity valuation models that seek to set a present value on a company's future cash flow also generate lower results when rates are higher. And, ultimately, the hikes are designed to slow the economy, which crimps profits, employment and everything nice.

The Fed's 1999-2000 tightening campaign helped pop the Internet bubble and bring on a recession. The current effort could have similar effects on real estate or other speculative-driven sectors (as some members of the Fed themselves were concerned about in December).

That's not to say the Fed is entirely to blame for the weakness in stocks. Technical indicators have issued numerous warning signals, and any number of sectors, including retail, airlines, steel and semiconductors, have had to cope with poor fundamental news. In addition, some tax-related profit-taking was perhaps to be expected after the fourth quarter's rally.

Just don't go blaming the dollar.

In keeping with TSC's editorial policy, Pressman doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

your feedback.