Why Strong Dollar Hurts Stocks, and What You Can Do

The dollar and stock market used to be close comrades, rising and falling together on the strength of the US economy. But those days are over.

Deborah Harrison

In their place has come an inverse relationship in which the greenback's weakness sends investors into risk assets like stocks, based largely on the notion that an export driven economy is the best we can hope for.

With the subsequent grand scale monetary intervention from the Federal Reserve following the financial crisis in 2008 and 2009 still ruling the day, strong-dollar/weak stocks remains the trade of the day today and the dominant force in the market so far this month.

"Until we see the Fed step away from its inflationary policies, you're going to see this relationship," said Brian LaRose, strategist at United-ICAP in Jersey City, NJ. "As long as this dollar rally continues we have a very hard time seeing the bullish commodity-equity trade continue from here."

The bad news for stock investors is that the dollar has been on a rallypredicated in large part on the renewed fears that eurozone nations such as Greece and Portugal are on the cusp of defaults. Investors have sought the greenback as a safe haven against global tumult.

Consequently, many strategists are advising their clients to reposition their risk portfolios as the dollar rally continues.

"The dollar rally is a headwind," analysts at RBC Capital Markets said in a note to clients. "The inverse correlation between it and the equity market is the strongest we've seen since 1971. Meanwhile, the recent rally in the dollar has done very little to encourage the unwinding of record short positions."

Strong volume in short positions—which in this case bet against dollar strength—normally would be seen as contrarian bullish signs and spark a selloff from holders of those options and thus boost the dollar.

But the dollar has risen even without the strength of short-covering. That might suggest that once the shorts do start to bail out, the dollar will gain even further.

For the stock market, that would be bad news if current trends hold up.

As such, RBC has changed its allocation in several sectors, upgrading its positions in defensives such as health care and consumer staples and downgrading energy and materials, areas that will get stung by falling commodity prices.

Bank of America Merrill Lynch has taken similar positions, also boosting its view on health care while cutting exposure to industrials and energy and materials.

Barclays Capital warned its clients to begin shifting their strategy from one that is based on Fed policies that weaken the dollar to a less certain environment in which companies with solid valuations will offer safety.

Considering a dollar that the firm considers "cheap," energy stocks now appear to be expensive.

"We have made the point (within the context of small-caps’ relative performance and sector selection) that until the Fed begins draining liquidity, valuation should take a back seat to the business cycle as a performance driver," Barclays said in a research note. "We believe we are seeing the early signs of a transformation toward the point when valuation will play a much bigger role."

In ideal circumstances, this isn't the way the markets are supposed to work.

Consumer-driven economies help keep dollar demand high and preserve its value. Companies, then, don't need to rely on cut-rate prices for exports, but rather are driven by organic business growth on the home front.

Over the course of the past 45 years or so, bull markets for the dollar have resulted in 80 percent gains for the Standard & Poor's 500 , as opposed to 20 percent rises during bear markets, according to research from Bespoke Investment Group.

But with unemployment at a stubbornly high 9 percent and the housing market showing little or no signs of recovery, there's not much hope that the consumer will help propel the dollar higher.

That's a scary prospect for a market facing the end of direct Fed involvement through its quantitative easing program, and as Washington dithers over ways to fix the country's debt problem.

"Investors are currently embracing risk because of the Federal Reserve’s quantitative easing policy," strategists Daniel Aaronson and Lee Markowitz, of Continental Capital Advisors in New York, said in a recent research note. "However, there is a limit to what the Fed can do in light of the government’s indebtedness. Eventually, markets will recognize the severity of the government’s situation and there will be nothing that the Fed can do."

The dollar-stocks inverse relationship, then, could depend on how the various economic and political scenarios play out.

"That's certainly the way things are going to be for the foreseeable future, though I don't know that's the way things are going to be forever," said Susan Fulton, founder and principal at FBB Capital Partners in Bethesda, Md. "The ups and downs are more geopolitical than they are attached to the dollar."

For strategy, Fulton said her firm has been using exchange-traded funds for South America and Asia and in general focusing on diversification.

It's a strategy that reflects an uncertain environment as investors wait for the markets to return to normal and the dollar and stocks to move together again.

"We'll get back to that point. The problem is you have to get past the pain first," said LaRose, of United-ICAP. "As much as you'd like to say things are going to get better, unfortunately you have to go through the bad to get better."