Trump’s Dollar Surge Echoes Doomsday Signal of ’87 Stock Market Crash

Summary
The United States dollar has experienced a significant resurgence in value over the past week, its best performance since October 2022, according to the US Dollar Index (DXY). This marks a stark contrast to the first half of this year when the index plummeted by nearly 11%, resulting in the worst first-half return on record. The strengthening dollar has sparked concerns about its potential impact on the stock market.

Main Content: Dollar’s Rise and Stock Market Implications

The recent uptrend in the US dollar is a far cry from the weak-dollar environment seen earlier this year, when the index lost almost 11% of its value. This period saw the worst first-half return on record since the index was created in the early 1970s. However, the relationship between the dollar’s movements and stock market performance is not as clear-cut as one might assume.

At first glance, it may seem that a weak dollar would be beneficial for US stocks, given the S&P 500’s total return of 6.2% during this recent period of dollar decline. Nevertheless, the U.S. stock market has also performed spectacularly in years when the dollar was unusually strong. This raises questions about whether the dollar’s movements truly matter to dollar-based investors.

Investors and analysts are left wondering what the future holds for the dollar and its implications on the stock market. Some are concerned that an aggressive interest rate cut by the Federal Reserve, as desired by President Trump, could lead to a sharp decline in the dollar. This, in turn, might have adverse effects on the stock market.

A look back at history provides some insight into this situation. In 1987, during the Reagan administration, a similar tension arose between interest-rate policy and the dollar’s value. The outcome was disastrous for stocks, with the Dow Jones Industrial Average plummeting by over 22% in a single day – Black Monday.

This period is particularly relevant due to the parallels between then and now. Just prior to the stock-market crash, the dollar index was 7% lower than at the beginning of 1987. What worried investors most was that the Reagan administration was actively pushing for an even lower dollar by aggressively reducing interest rates. This move was intended to boost the economy but ultimately led to a currency war and a sharp decline in stocks.

The current climate shares many similarities with this past scenario, including overvalued stocks and a combative presidential administration pressuring the Fed to reduce interest rates. The potential consequences of such actions are concerning, as lower rates would likely push the dollar down against foreign currencies, potentially leading to adverse effects on the stock market.

The 1987 stock-market crash serves as a cautionary tale for investors. While there is no guarantee that history will repeat itself, it’s essential to consider the potential risks associated with an aggressive interest rate cut and its impact on the dollar’s value.

Main Content: The Dollar as a Coincident Indicator

When examining the relationship between the dollar index and S&P 500 earnings per share (EPS), one might expect to find a strong correlation. However, upon closer inspection, this relationship appears to be more complex than initially assumed. Using data from the early 1970s onwards, it’s clear that the r-squared statistic, which measures how well changes in the dollar index explain contemporaneous changes in EPS, is very low – around 1%.

A possible explanation for this lack of correlation lies in the varying relationship between trailing-year changes in the dollar and EPS across different time periods. Depending on the five-year period considered, the correlation can be as high as 0.44 or as low as -0.83. This suggests that any relationship between the two is not stable and may depend on specific economic conditions.

Main Content: The Dollar as a Leading Indicator

Moving beyond coincident indicators, we also looked at whether changes in the dollar index could predict future growth rates of EPS. Unfortunately, this analysis yielded similar results to our previous findings. Take, for instance, the chart below, which plots the correlation between the dollar’s trailing 12-month change and the subsequent 12-month growth rate of EPS.

The graph shows that while there have been periods with strongly positive correlations (mid-1990s and pre-2008 global financial crisis), there were also times when the relationship was heavily negative (1980s and early aughts). Over the entire period since the early 1970s, DXY’s trailing 12-month changes explained only about 0.4% of the subsequent 12-month growth rates of EPS.

Main Content: Ominous Parallels with 1987

Considering these findings, it appears there is no strong statistical basis for concluding that a falling dollar will either be beneficial or detrimental to dollar-denominated investors in US stocks. Nevertheless, an ominous parallel with the financial environment preceding the October 1987 stock-market crash cannot be ignored.

In both cases, a plunging U.S. dollar was a significant contributing factor to market instability. Given this history, it’s possible that a falling dollar could command investors’ attention in extreme situations. Prior to Black Monday, the dollar index was 7% lower than at the beginning of 1987. Then-Treasury Secretary James Baker’s comments in the week before Black Monday were aimed at pushing for an even lower dollar.

Barron’s editor Randall Forsyth notes that these comments "were intended to push the dollar lower against the [German] mark and other currencies." A weaker dollar was preferred over higher interest rates, which Baker saw as a threat to the US economic recovery. Markets responded by dumping stocks due to concerns about currency war risks.

Conclusion
The recent resurgence of the US dollar has significant implications for the stock market. While there is no clear relationship between the dollar’s movements and EPS, an ominous parallel with the financial environment preceding the 1987 stock-market crash cannot be ignored. The potential consequences of an aggressive interest rate cut by the Federal Reserve, as desired by President Trump, are concerning.

Investors would do well to heed this warning and consider the potential risks associated with a sharp decline in the dollar’s value. While history does not guarantee that it will repeat itself, the 1987 stock-market crash serves as a cautionary tale for investors.