How the value of the Dollar Affects Stock Prices

The relationship between the value of the dollar and stock prices is complex. Stock and shares are what is known as equity in a company. The owner of corporate stock owns a small piece of the company, and is often paid dividends out of profits periodically in addition to having voting rights at shareholders meeting. Issuing shares is a way for companies to raise funds. Dividends are only paid on profits, and there is no legal requirement to pay them unlike with a loan to a bank via deposit. However, the disadvantage is that the company can become vulnerable when share prices fall. 

The stock market is not necessarily a physical entity, but more a worldwide network of buyers and sellers. The growth of technology has massively changed how equities are traded. The New York Stock Exchange still exists as a physical building where buying and selling takes place, however more than half of its trading is now done electronically. Whereas NASDAQ is a virtual exchange, where trading is done by computer. There are a number of stock market indices, that measure the value of a variety of different stocks at any given time, and, in a sense, the value of the stock market. The oldest stock market index is the Dow Jones Industrial Average created by the Wall Street Journal. There is also, in the US the S&P 500, the NYSE composite index, and NASDAQ 100 index which measures the value of stocks traded on its stock market, though it is not exclusively a US index.

There are a number of different reasons why the value of the dollar may affect the stock price of an individual company. One is the direct link between depreciation of the dollar, which raises import prices, and the profitability of a company that relies on the import of components, or raw materials. A company heavily reliant on import prices may find that its shares lose value when the value of the dollar falls. However, for another company that is reliant on exports a depreciating dollar will reduce the price of the good being exported, and may be good for business, and increase share prices.

Conversely an appreciating dollar would reduce the costs of imports, and benefit a company dependent on them, whereas for a company reliant on exports, an appreciating dollar is bad news. Companies that have invested overseas will also be affected by changes in the value of the dollar, as will businesses owned by companies that are based overseas. As changing currency values alter the value of the investments, and the operating costs, for the overseas based owner.

However, as well as changing the stock price of an individual company, changes in the value of the dollar can also infect the value of stock prices generally, and stock market indices. This depend on the reasons for the change in the value of the dollar, a strong economy can cause a currency to appreciate, low inflation can increase demand for a country’s exports, while interest rates play an enormous role in currency value, as high interest rates will increase capital inflows, and cause the dollar to appreciate. 

The value of the dollar may well therefore, impact the behaviour of investors in quite complex ways. Investor behaviour is a complicated subject, there are many theories on it, such as the efficient market hypothesis, which assumes that the market will always behave rationally. This concept also claims prices will always reflect real value, and that issues such as changing margins that affect profits and losses, and the likelihood of dividend payments, will always be reflected in the stock price. Though this theory of rationality is controversial, and widely disputed.

The world equity market has grown rapidly in the last 30 years, and was estimated to have a value of about US$36.6 trillion in 2008. New technology may well have played a significant role in this growth. Stocks and shares are a fairly high risk product, and payment of dividends is not guaranteed, so the return from investment in stocks and shares is also based on the expected rise in value of the shares, as well as dividend payments.

In the stock market rising stock prices are known as a bull market and falling stock prices, as a bear market. Because of the high potential for loss when prices fall, there are a number of psychological factors that affect investor behaviour in the stock market. For example if investors start to sell shares in a company and share prices fall, then the falling share prices may encourage others to sell. Whereas when some investors buy and share prices start to rise then the rising share prices may encourage others to buy. Bad economic news such as a fall in GDP growth may encourage investors to sell shares because they fear that the value of the shares they hold may fall as a result of the bad news. There are therefore, many factors that influence investors that go far beyond the efficient market hypothesis.

As well as the obvious link between the profitability of a business, and the changing value of the dollar, and the psychological impact of bull and bear markets, investors may well change their behaviour when the value of the dollar changes for more complex reasons. They may well be comparing investment opportunities in other markets, such as commodities, foreign exchange markets, and bonds. If the change in dollar value has been caused by a change in interest rates this will also change the behaviour of investors. A falling dollar may increase internal inflation, and reduce the real value of interest rates, while at the same time creating a perception that interest rates may rise to reduce inflation. This may encourage a switch, for example, to bonds from shares. As investors tend to buy bonds when interest rates rise, and sell when they fall. So investors may switch from other markets to the stock market, or in the other direction.

There are also many different types of investors, some will be short-term investors looking for quick profits, and others making longer term investments. Large organisations such as pension funds, that invest in the stock market will usually be looking for longer-term gains rather than short term ones. Hedge funds on the other hand, may take a more short term view and tend to switch markets more frequently.

Another significant factor is how changes in the value of the dollar affect foreign investors. Their behaviour is likely to be significantly affected by variations in exchange rates. The stock market is also seen as a measure of the economic well being of a country, as is the value of the currency. A weak currency has historically been seen as a sign of a weak economy. It is also however, seen as a way to increase exports. However, a foreign investor will be looking both at the health of the economy they invest in, the specific business they buy shares in and also at the changes in the relative value of their investment in relation to the value of the dollar against their own currency. If the value of the dollar rises against their own currency, then the value of their shares, when converted back into their currency falls.

The likely impact of the change in the value of the dollar on stock prices is complex, but also very interesting. A lot will depend on the prevailing conditions within the economy, the reasons for the change in value and also the alternative investment opportunities. As though the value of an investment in a US company may fall if the dollar is devalued it may well be the case that, in a worldwide recession, alternative investments may also become less profitable. It is, after all, probably the unpredictable nature of investor behaviour that makes investment in financial assets such an exciting option for many, and keeps investors investing, despite the potential risks.