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Will a Strong Dollar Finally Be Good Sign for Stocks?

The weak dollar-strong stocks trade that has dominated markets for the past three years has been breaking down, providing hopes that greenback gains don't have to be a bad thing for equity investors.

Sheet of US one hundred dollar bills
Don Farrall | Digital Vision | Getty Images
Sheet of US one hundred dollar bills

Though the dollar still trades at relatively low levels against the world's currencies, it has been on a steady trajectory higher since hitting its low of July 2011.

The surge has come as fears have intensified over the effect the European sovereign debt crisisis having on the global economy.

But rather than drag U.S. stocks down, as a stronger dollar had done since the depths of the 2008 financial crisis, the move has coincided with a general though volatile levitation of the equity markets.

"The direction of the dollar and the direction of the market seem to be overall in sync at this point, and it's been a process that started just about 12 months ago," says John Stoltzfus, chief market strategist at Oppenheimer in New York. "A lot of this correlation that is occurring is really related in part at least to the fact that the U.S. is being considered by global equity investors as the place to be right now as the more relatively stable economy compared to Europe or the emerging markets."

Indeed, the dollar index, which measures the greenback against a basket of its global competitors, has gained about 10 percent over the past 12 months, while the Standard & Poor's 500 has rallied a shade more in the same period.

That happened even as the Federal Reserve maintained its weak-dollar policy through various monetary easing programs.

"With the dollar strength comes appreciation, pun intended, of this market for the S&P 500 via desire for exposure to U.S.-based asset classes," Stoltzfus says.

The dollar-stocks relationship is, to be sure, a tenuous and complicated one.

It's a hard argument to make — with 1.5 percent gross domestic productgrowth and an 8.3 percent unemployment rate— that the move to the dollar has been inspired by powerful U.S. economic strength.

Rather, the American economy is seen these days as simply a safer place to park money than Europe, with its daunting debt problems, or even China, where growth has pulled back.

The dollar and U.S. stocks, then, are benefiting more from a safe-haven desire than a strong vote of investor confidence.

"If the dollar is rallying out of fear, that is an entirely different animal," says Dave Lutz, managing director of trading at Stifel Nicolaus in Baltimore. "Obviously, that's a risk-aversion trade and that would be negative for the market."

Regardless, Lutz sees the positive correlation between stocks and the dollar as likely to continue.

"Obviously we're not seeing massive growth signs here in the U.S. We are seeing stability in the housing market, which is important, and we are starting to see indicators a touch better," he says. "You compare that to the absolute disaster that the European Union has now, and we're the best boat of a sinking fleet, if you will."

The dollar index is just one barometer, and many traders prefer simply to watch the dollar's move against the euro. In that case, the euro peaked around 1.45 against the dollar last August and has been a steady path lower as well.

That relationship could cause some problems, though.

Analysts have been cutting their earnings outlooksat a steady rate, basing their opinions in part on trade advantages Europe will have with a lower currency.

Jim Paulsen, chief market strategist at Wells Capital Management in Minneapolis, has a 1,500 price target for the S&P 500 this year but is concerned over whether the market gains will hold up if the euro keeps weakening.

Technical analysts say a recent mild strengthening of the euro is running out of steam, with the dollar likely to rise soon.

"I don't know if you can get to where you were in the '80s and '90s where a strong dollar was looked at as a positive overall," Paulsen says. "The thing that's problematic is there's a safe-haven premium in the dollar. If you're going to put the market up, part of that's going to be in rising confidence. If there's rising confidence, I suspect probably for a while some of that dollar premium comes out."

The Federal Reservealso stands at the ready to provide more asset purchases — quantitative easing — should the economic picture worsen. That would pull the dollar down, something Paulsen says will be positive for commodities and metals in particular.

"If the Fed does not supply as many dollars because the economy is doing better, you lose the safe-haven premium," he says. "I suspect that the dollar is more likely to come off a little bit here than go up with the market."

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