Most people have enough trouble understanding how stocks work, but when you throw in the effects of changing values in the U.S. dollar, things really get confusing.

To most people, stocks and the stock market do not seem so hard to understand. When we own a stock, we own a piece of the underlying business they think, so how the business goes will determine how our stocks go, or so they think.

It turns out that this is a confused and mistaken view of stocks, in spite of how many people are mistaken and confused. It turns out that actually knowing how they work, what stocks even are, conveys a significant advantage to us, and this is why we speak about these things so often, as this is extremely important.

The vast majority of so-called experts on stocks fundamentally misunderstand them, falling for the mistake of thinking that they are proxies for the business, that they somehow move by way of some invisible hand based upon fundamental criteria such as business performance or macroeconomic change.

Make no mistake, these things can be influential, but stocks have their own market which are entirely separate from the companies that issue them. They are financial instruments, just like Bitcoin is, and while it’s easy to understand why Bitcoin is driven by nothing other than pure supply and demand for it, people miss the fact that stocks work the same way, and are also pure constructs of supply and demand.

These people had a great opportunity in 2020 to see their mistaken views revealed. People can still keep bidding up stock prices all they want, because once again this is just a function of supply and demand, and if demand exceeds supply, the price rises, regardless of anything else that may be going on, even things like a massive recession and a global pandemic.

Many of these people were expecting a very mundane year at best in 2020, at the beginning of the year when no one had any idea what was coming. We scoffed at these prognostications, ideas that stock prices are fundamentally determined by what these people believe that the ratio of a stock’s price to its earnings may be.

Let’s take this very muted view where stocks presumably went up too far last year and too far over the last decade in their eyes and might squeak out a tiny gain this year similar to what people get from bonds. If they were told that we would see such a massive recession, and one that came on so quickly as the country shut down and otherwise limited business activity, and this would cause U.S. GDP to nosedive and end the year significantly down, they would surely be predicting the bear market they have been waiting for so long for, a big bear indeed.

This is not what has happened at all. Instead, 2020 has been a massively successful year for stocks, and both the Nasdaq and the S&P 500 hitting another all-time record Wednesday. The Nasdaq is up a whopping 52% this year so far, one of the best years ever.

How could such a thing happen? How is this even possible? With so many still scratching their heads, the explanation is a simple one, and it’s that people simply chose to pay more for stocks overall and that’s the only thing that influences their price.

Even all of the political risk that we have had this year, well beyond anything we have ever seen, didn’t rattle stock markets very much. We even stood in amazement at their patience with this election with so much on the line, and we underestimated the market’s bravery. This was especially impressive given that the major polls strongly suggested that we would see a Democratic sweep, with a party that is now so anti-capitalist and anti-market.

We only took a rather brief and rather smallish dip in the face of this risk, and once things turned out better than most thought, we were back to the races again. Stock prices are completely subjectively determined, and the market chooses to pay whatever amounts they wish for them. They just chose to pay more and more in the face of such crises and danger, thumbing their nose up at this stuff, which they are well able to do.

We Need to Start by Understanding What Really Moves Stocks

If we’re looking to discuss the relationship between the value of the U.S. dollar and U.S. stocks, it is important to understand how stocks move by themselves before we compare with how they move with the dollar. We especially do not want to think that there are invisible forces that move stocks in the face of this or any other change in fundamentals.

The view of how the value of the dollar affects our economy, in certain ways at least, is much better understood, because this is comparing apples and apples, how a fundamental criterion may affect another fundamental criterion. There is a force that the value of the currency of an economy versus other currencies affect their economies, like imports costing more if the value of your currency declines, but with your exports being worth more as you get paid the same amount in foreign currency but this amount is worth more in your currency.

If you are a net exporter, like China, you want the value of your currency to be low comparatively, because you make more money that way. A net importer like the United States should also prefer this because a country like China putting down the value of their currency means that we can buy the same goods for less money.

Protectionists like Donald Trump get this wrong, at least as far as what would be best for the country. Trump’s tariffs with China and other countries put the cost of things up for Americans, by the amount of the tariff itself, where this money functions as additional taxation, not just tax-like, but a pure consumption tax like a sales tax.

Tariffs are bad for the economy, pure and simple, even though they might benefit domestic exporters to the extent that they work. To the extent that people pay more for inefficiently produced domestic goods that these tariffs are supposed to level the playing field with, this involves a transfer between these producers and consumers, where less value will be derived by way of the inefficiency.

To show how this works, let’s say that it costs $10 to buy an import and $15 to buy it from a domestic producer. If we put a $2 tariff on the import, it’s still preferable to paying $15, so they pay an extra $2. They have to get by with less, and the fact that they do shrinks our economy accordingly.

If we put the tariff up high enough to make our goods preferable based upon price, which no one seems to even consider when they put up these tariffs, then they are now forced to buy the domestic product and pay an extra $5, 50% more. They now need to get by on even less, and once again, this shrinks our economy.

A Declining Dollar is Bad for the Economy but Stocks Follow Their Own Path

The dollar dropping in value as much as it has this year, down over 10 cents since March of this year, is not good for the economy at all given that the U.S. imports more than it exports. All that stuff from China costs this much more, and the costs on this side outweigh the benefits on the export side because the import side is bigger. If you add 10% to the export side and subtract 10% from the import side, you’re going to see the overall number go down.

If you are one of the exporters though, this can be seen as a good thing, as you make more U.S. dollars from your exports. How the stock market reacts to these things could go either way, to the degree that the market chooses to pay attention to these things in the first place, but they tend to like the idea of paying more for stocks that are making more and more money just by watching the dollar fall.

On the other hand, they could choose to pay attention to the economy overall instead, and a falling dollar means that the economy isn’t doing all that well. It isn’t of course, and neither is the dollar. Once again, the market may put whatever weight on this that they choose, but they care more about changes in outlook with their own stocks versus the outlook for the economy in general.

It is not even that the U.S. has continued to underperform other countries as far as economic recovery from shutdowns and restrictions go, and the U.S. has held up very well compared to other areas, especially Europe. The Eurozone led the way in harsh lockdowns and are even at it again to a very significant degree.

Currencies are influenced greatly by fundamentals, and GDP does play a role, but nothing moves currencies like monetary policy, because this determines money supply. It isn’t so much that the Fed completely opened up their vault, it is how much more the door became opened versus places that already had it open pretty wide like the Eurozone.

Stocks moving up and the dollar moving in the other direction since March are primarily driven by the same force, the force of the Fed’s epic monetary escapade that took us to a place we have never gone before. It comes down to what the stock market chooses to follow, and they have chosen to follow the Fed come hell or high water, and we have had plenty of both this year.

There is no particular need to do this, it is just what the stock market has chosen to do this time around. Citibank economists are warning us now that they expect other countries will recover from here faster, and predict that the dollar will continue to fall for a while yet.

There is at least some truth in this, for instance Europe will move further from its current lockdowns to wherever they end up when things open up a lot more than the U.S moves from here to that point. The fact that the dollar declined 10 cents since March during a time where the recovery in the U.S. was superior, it having the inferior growth that these economists are predicting would at least be downward pressure on it, although as we can see, these are not things that are correlating very well right now.

UBS is pointing out that the declining premium that U.S. treasuries have over other instruments like the German bund will make the U.S. dollar less attractive and put further downward pressure on it. This is an odd view, because the premium is still pretty significant, and treasuries may not be as good of a deal now but they are still a better deal and still will be preferred.

Stocks follow their own path, and even with a shock to the economy as large as we have had, and still suffer from, if people just want to keep bidding up the price of stocks, this is exactly what we will see. The bidding continues.

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

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