Sinking dollar, rising portfolio

Stocks have soared even as the greenback drops like a brick. That may not last. But if history is any guide, the dollar's woes will eventually weigh down U.S. stocks.

When you're traveling abroad, it's easy, if unpleasant, to grasp the impact of a sinking dollar. Now that the euro is at an all-time high against the greenback, dinner for two at a modest Paris café will set you back $200.

Simply put, when the dollar is strong against other currencies, it signifies that our economy is good and the world's faith in the U.S. is high. Conversely, a weak dollar is a sign that something's wrong, says Gordon Fowler, chief investment officer for Glenmede Investment Management.

The dollar has had declines of 25 percent or more twice in the recent past; the current fall is 36 percent since 2002 against a basket of foreign currencies. In the early 1970s, the peculiar combination of rising inflation and low demand known as stagflation was weighing the buck down. In the mid-'80s, the dollar fell amid fears the U.S. was about to be overtaken by Japan Inc. as the world's economic superpower.

This time around, the reasons for the decline are more subtle. The U.S. economy has been expanding, but that growth has not been spread evenly; now the meltdown in the housing market poses a recession threat.

Moreover, we're running a large federal deficit and a trade gap of nearly $60 billion a month. All of that puts downward pressure on the dollar.

So far that pressure has been beneficial: It's made U.S. goods sold overseas more affordable, helping to cut the trade deficit. And it is boosting the bottom lines of U.S. exporters because their foreign sales are in currencies that are appreciating.

This is a healthy, corrective development for our economy, says Eaton Vance chief economist Robert MacIntosh. Certainly the stock market seems comfortable with the trend. The S&P 500 has risen 35 percent in the five-plus years that the dollar has been on the decline.

Dollar up, stocks down?

But the flip side of our stuff being cheaper overseas is that imports are more expensive here. And we do like to import. Eventually that means rising inflation. In both the early '70s and mid-'80s, inflation related to a falling dollar led the Federal Reserve to raise interest rates. That stabilized the buck - and sank the stock market. (See the graphic to the right.)

Whenever the dollar turns, it will probably mark the beginning of the next bear market, says Christopher Orndorff, head of equities for Payden & Rygel, an asset management firm in Los Angeles.

There are scenarios that Orndorff foresees that could allow the market to evade this fate. First, Fed chairman Ben Bernanke could prove more artful than his predecessors at fighting inflation without killing stocks. Or the dollar could strengthen without the Fed's intervention, not necessarily because of good news for the U.S. but because economies in Europe or Asia run into trouble.

There is, however, a longer-term bearish outlook for the dollar too. In this scenario, which Warren Buffett worries about, overseas investors financing our fiscal and trade deficits by buying Treasuries grow impatient with the sinking buck - which, after all, is worth less in their home currencies.

So they sell, and then buy investments in other currencies, further weakening the dollar and forcing up interest rates here. That, in turn, chokes off the U.S. economy, so the overseas investors sell even more, weakening the dollar again. The cycle then repeats. If that's what unfolds, economic superpower really will end up no longer being used near the words United States.

Source - CNN Money