April 20, 2007

The Weak Dollar Means 13000

I don't know if anyone else has been following the stock market, but the last two days have shown us record highs in the Dow Jones Industrial Average (hence forth referred to as the Dow). At the same time, the dollar exchange rate is at an all time low against a lot of currencies, and inflation has been slightly above normal. I'll spare you the technical aspects, though out of a need to pretend my time as an economics major hasn't been wasted I can if you'd like. The cheerleaders on T.V. seem to be missing the connection. What follows is the practical reasons the three are related.

First some definitions as they apply here. Inflation means prices are rising. What cost $1 last year might cost $1.03 this year. This is not a hard concept. A weak dollar means that $1 is worth less in terms of other currencies. For example $1 is worth about 0.735 Euros. Alternately, 1 Euro is worth $1.36. Not much harder, but it can be a source of confusion.

The recent rise in the Dow, and by association, the rest of the market has been based, in large part, on rising earnings reported by many large companies. Large, international, companies. Part of the reason earnings are higher is because all prices are higher. This applies to the stock market as well. A stock that cost $10 last year would now cost $10.30 because of inflation alone, with all other things being equal.

I mention the companies in the Dow are international because of the weak dollar. Follow: a weak dollar means that American goods are cheaper to foreign consumers. Say $1 = 0.735 Euros. In this case, a product worth $100 would cost 73.50 Euros in Europe. If the dollar gets stronger, to say $1 = 0.8 Euros, than that same product that costs $100 in America now costs 80 Euros in Europe. With American goods costing less abroad, it follows that foreigners will buy more. Hence, higher revenues and earnings for American-based international companies, like those in the Dow.

The market rise has been fueled by better than expected earnings. Those earnings have been fueled by inflation and a weak dollar. The media needs to stop talking about how bad the inflation numbers are and how bad it is for America that the dollar is weak in the same breath that they mention the record high Dow. I'm not saying the markets aren't good, because they have been since the beginning of March. I'm saying that they are good because of the things that some people cite as signals of a coming fall. That fall will only be realized if the government acts rashly to curb inflation and strengthen the dollar.

I'm also not saying that this is a bad time to invest. This only me bucking against the rah-rah cheerleaders on T.V. that say the market is great without giving reasons and shouting down the people (mostly economists mind you) that say the markets might not be as strong as it seems. I don't have a T.V. show, I have a blog (admittedly mostly dormant). C'est la vie.

Posted by chupathingy on April,20, 2007 at 5:38 PM | Comments (8)

Veeeeerrrry interesting comments!! I've been becoming more and more interested in the economy and bizzare things you can do with money that sortof make more of it... And coming from an outsider's perspective (my degree was in computer science and I didn't know a thing about this stuff until about a year ago), it really helps to have somebody clarify how things like the exchange rate work and why it fluctuates...

So what are you saying will happen if the gov't tries to curb inflation? And how would the gov't do that anyway, higher interest rates or something? Very interesting stuff... Keep up on the econ posts if you got any more thoughts!

And also... What's the real difference between the Dow and the S&P 500? They both move rather similarly it seems... And I know that most large cap mutual funds kinda mirror the S&P. So why is teh Dow the important statistic?

Anyway, good post!

Comment by: matt good at 12:30 AM, April, 22, 2007

I'm glad that someone besides me can benefit (dare I say enjoy?) from these little exercises. I mostly write stuff like this to kind of organize my thoughts on things. The beauty and curse of the financial world is its complexities, which is what drew me to it in the first place. And since my first major and sick fascination is economics, I tend to see everything through that lens which is, per economic custom, vague and cloudy.

On that note, in a nutshell, yes, the government primarily controls inflation with interest rates. Higher rates slow the economy down and reduce inflation. That's about all you need to know on a practical level, but I may post sometime about this because the actual mechanism can get complicated (and interesting).

A market index, like the Dow (more precise would be the Dow Jones Industrial Average or DJIA) and S&P 500, is simply a measure of a specific basket of stocks. The DJIA is 30 large companies, which are thought to reflect the overall stock market. The Dow Jones company has many different indexes that they follow, and the DJIA is just the most popular and I think its the oldest, though I may be wrong on that. The S&P 500 is the largest 500 companies, and is considered the main benchmark of the stock market. There are hundreds of different indexes, though these are the two you'll hear the most often. I think this is actually a fairly common source of confusion.

And thank you for convincing me to write more stuff like this. They say the best way to learn is to teach it to someone else, and I'd love nothing more than a validation that I've actually learned something at college. And if you ask a question that I don't know, then I can look it up, especially once this semester ends and I'll have more time on my hands.

Comment by: neil at 1:02 PM, April, 22, 2007

I feel I should also comment that what I say is to the best of my knowledge, but should not be considered unassailably one hundred percent correct. I try my best, but I'm still pretty new at this myself.

Comment by: neil at 1:10 PM, April, 22, 2007

I don't think that just because the dow is rising, everyone should be happy. I have a feeling far more people are affected by inflation than a higher dow, since a lot of the profit earned by these companies are padding the wallets of their executives rather than their employees, being that the income gap between execs and employees on average is far higher than it was in the past. So, yes inflation is bad because prices are rising and salaries aren't rising to compensate.

Another thing is that the inflation isn't all benefiting American international corporations. A lot of goods (probably most goods, actually) Americans buy come from other countries. A weak American dollar works the other way too: when we buy foreign goods, they cost more. that doesn't benefit any American.

So when the weak dollar really just means inflated prices and executive wallets, i really don't see how the average american sees any benefit...

Comment by: mallio at 9:33 AM, April, 23, 2007

You're completely right that the Dow and even the stock market in general is a poor indicator of the well-being of the average person.

All I was talking about was the rise in the market itself. One component of stock prices is that they are subject to inflation like all other prices. My point was simply that I believe that inflation directly and the weak dollar indirectly (via international earnings via increased demand) are responsible for a large part of the current rise in stock prices in the face of some less positive economic trends.

Comment by: neil at 11:39 AM, April, 23, 2007

I'm a big fanatic of checking the market daily etc. . . I'd agree with the general feeling of the post. Most of these "finance gurus" are writing sensationalist articles to get people to read them.

I want interest rates to drop back to the 1% range so I can get a cheap mortgage, so I hope the economy tanks in the coming months. But that is a very short sighted wish. . .

Any views on 401k vs roth 401k would be welcome! I've been mulling it over myself for a while and started a post on boardix about it.

Comment by: Dave at 6:33 PM, April, 23, 2007

I honestly don't know a whole lot about the differences. If I didn't have a term paper ruling my life for the next couple days, I would gladly look up the difference and pass it along. It's definitely being added to the list I've been creating of things to look up and maybe post about in the future (i.e. after the semester ends).

In the meantime, if you have any questions about the intricacies of flexible vs. fixed exchange rates, I could probably answer in my sleep :P

Comment by: neil at 7:11 PM, April, 23, 2007

While I don't understand hardly any actual economics, i am trying to become something of a personal finance guru. Whether or not I know anything yet is debatable, however.

About the 401k vs. the roth 401k... The trick I hear a lot of people talking about that makes sense is a sort of "tax diversification." Since we're pretty young and retirement is rather far off, we can't make really good guesses at what the tax rate will be or what tax bracket we will be in during retirement. So what seems like a pretty good idea is putting about half your retirement in a 401k or similar, and about half in a roth of some sort, IRA or 401k or something. That way, you can select how much you want to withdraw from each and kinda fudge your taxable income to an amount that works well for you. Seems like a pretty good idea to me, anyway.

I've been thinking about starting up a Roth IRA for that reason, or rolling over into one when I switch jobs. I'm trying to figure out which one with grow into more given the relatively long amount of time until people our age will need it... I don't really have the knowledge to figure that one out either. But from the calculators i've messed with and stuff i've read, it seems like even more important than choosing the right one right off the bat is to just regularly contribute and start early. Does anyone else have an opinion on this sorta thing?

Comment by: matt good at 9:32 PM, April, 23, 2007