The dollar has been declining steadily against the Euro the past few weeks.  This has received attention as a potential negative for the stock market.  It is nothing of the sort.  In fact, a moderate downtrend in the dollar is bullish for the stock market. 

The Dollar Trend

The dollar hit an all time low against the Euro this past week. 

Egad!  That must mean the US economy is in horrible shape, and that the stock market is about to take a plunge.  Or at least, that is what some analysis would have us believe.

In fact, the weaker dollar is bullish for the US stock market.  A weaker dollar means: 1) US exports are more competitive, and 2) overseas profits of multi-national firms translate into more US dollars. 

Here is the dollar trend against the Euro the past five years.

As can be seen, the dollar has been on a general downtrend against the Euro for five years.  The exchange rate has fallen over 30%. 

During that same time period:

1) The S&P 500 index is up 87% (about a 13.3% annual rate of increase)

2) Real GDP has increased 14.8% (about a 2.8% annual rate)

3) Operating profits for the S&P 500 are up 97% (about a 14.6% annual rate).  Source: S&P from this page.

The next time you hear an analyst suggest that a declining exchange rate value for dollar is a negative factor for the stock market, or is somehow a global negative vote on the US economy, either laugh, or ask for at least a modicum of evidence. 

There simply has not been any negative impact on the US stock market from a weaker dollar in recent years. 

Inflation Trends

A weaker dollar is sometimes noted as a negative factor for stocks because it will push inflation higher.  This argument at least has some technical validity.  The problem is that the impact is so small that there simply is no correlation.  Other inflation factors are far more significant.

Here is a chart of the core CPI rate for the past five years.

Course: Cleveland Fed from this page.

The core CPI rose for a while in 2004 and 2005 due to the stronger economy.  It has weakened the past year in response to slower economic growth.  The trend correlates with GDP growth. There is no correlation to the dollar trend.

Even the direct import price measures don't show any inflationary pressures.  Import prices excluding oil were down 0.2% in September after a 0.1% drop in August.  This measure is up just 2.0% over the past year, and was up just 1.9% the twelve months before that.  That won't add anything to overall inflationary pressures. 

The downtrend in the dollar is not having a statistically significant impact on inflation.

Benefits of a Weaker Dollar

A weaker dollar has direct benefits to the US stock market.  Any CFO at a major international company can quickly confirm this.

McDonald's generates 65% and 40% of their profits overseas.  IBM generates 61% of their business overseas, Cisco 48%, Pfizer 47%, and Caterpillar 53%.  The list could go on and on.  Just about every large cap company in the S&P 500 has major overseas operations.

And, every company with European profits will see those Euros translate into a higher level of US dollars in their third quarter earnings reports due to the weaker dollar. 

Overall third quarter earnings reports will be uninspiring.  Expectations are for operating earnings for the S&P 500 in aggregate to grow by only 2% to 3% over the third quarter of 2006. 

The highlights are likely to be companies that have major overseas operations, due in part to strong economies around the world, but also in part to the weaker dollar.

What it All Means

The hand-wringing over the decline in the US dollar is completely misplaced.

Over the very long term, a significantly weaker dollar can reflect relative weakness in the US economy (but won't cause it).  That is not the situation now, and has not been the past five years.  The US economy has performed well.  The weaker dollar is not reflecting US economic weakness. 

A steady, modest decline in the dollar, on the other hand, has benefits.  It improves the competitiveness of US companies. 

That is why European countries want a stronger dollar, and say so at every international meeting. (If a weaker dollar was so bad for the US, the zero-sum game of foreign exchange would mean a weaker dollar is good for European countries.  It isn't.)

Sometimes, it is also argued that a weaker dollar will lead to expectations of further weakness in the dollar, which in turn will reduce overseas investment in the US stock market.  All we have to refute that is the hard reality of the past five years.  It just doesn't happen that way.

The US stock market will do just fine so long as US interest rates hold steady or decline, and profits keep rising.  The dollar is not some magical indicator of future weakness in the US economy or the stock market.  

The dollar trend just isn't a major influence on US economic or inflation data, and the impact has actually been an increasingly net positive in recent years due to the boost to US corporate profits as major US companies become more globally focused. 

The weakness of the dollar against the Euro is not something investors should worry about.  In fact, it is good news because it boosts US profits.