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When the dollar weakens, large capitalization U.S. firms benefit from their international footprints, generating substantial revenues around the globe in local currencies and converting those revenues into an increased number of dollars on their income statements. Investors should therefore shift toward (away from) large capitalization stocks when the dollar is weak (strong). To test this hypothesis, we compare the performance of the Dow Jones Industrial Average (DJIA) (representing large capitalization stocks) and the Russell 2000 Index (representing small capitalization stocks) as the dollar fluctuates against the euro. Using daily data since introduction of the euro in October 2003 (937 trading days), we find that:
The following chart shows the behavior of the DJIA and the dollar-euro exchange rate over the entire sample period. In general, the dollar weakens and the DJIA rises, but there is no obvious relationship between the detailed behavior of the two series.
For a closer look, we examine the relationship between daily changes in the exchange rate and daily changes in the DJIA.
The following scatter plot relates daily changes in the DJIA to same-day changes in the dollar-euro exchange rate. The Pearson correlation for the two series is 0.01, suggesting no relationship. The R-squared statistic is practically zero, indicating that exchange rate behavior does not influence DJIA behavior on a daily basis. A plot of the daily change in the Russell 2000 index versus daily change in the dollar-euro exchange rate looks similar, with Pearson correlation 0.04 and R-squared 0.0017. These results do not support the hypothesis that a weak dollar favors large capitalization stocks.
Might relationships between stock indexes and the dollar become significant over longer intervals?
The next scatter plot relates changes in the DJIA and the Russell 200 index over 21 trading days to changes in the dollar-euro exchange rate over the same interval. The Pearson correlation between changes in the DJIA (Russell 2000 index) and changes in the exchange rate is 0.26 (0.17), suggesting some tendency for large and small stocks to benefit from a falling dollar. However, the R-squared statistics are small, indicating little predictive power for the exchange rate on a monthly time scale. While there is a difference in the responses of large and small stocks to variations in the exchange rate, as depicted by the two trend lines, the difference is slight. Sample size (45) is modest for this analysis. These results do not substantially support the hypothesis that a weak dollar favors large capitalization stocks.
Might changes in the dollar-euro exchange rate, due to a delayed effect on corporate earnings, lead effects on stocks?
The next chart shows correlations between 21-day changes in the dollar-euro exchange rate and 21-day returns for the DJIA and the Russell 200 index for exchange rate lead times of 0 to six months. Results suggest that any effect the exchange rate has on stocks is most likely contemporaneous. Most correlations for lead times of one to six months are smaller in magnitude than same-month correlations. There is some indication that the effect of exchange rate variations on small-capitalization stocks reverses the next month. Note that the sample of 21-trading day intervals (a maximum of 45) is modest for this analysis. These results may offer a little support for the hypothesis that a weak dollar favors large capitalization stocks.
Might differential effects of changes in the dollar-euro exchange rate on returns for large-capitalization and small-capitalization stocks emerge more clearly on longer time scales?
The final chart compares average daily returns for the DJIA and the Russell 2000 index for several ranges of the dollar-euro exchange rate. Subsample sizes range from 126 to 288 trading days. When the dollar is strongest ($/Euro < $1.20), the average daily return for both indexes is negative, with the Russell 2000 index slightly worse. When the dollar is somewhat strong ($/Euro = $1.20-$1.24) and somewhat weak ($/Euro = $1.28-$1.32), the Russell 2000 index outperforms the DJIA. When the dollar is mid-range ($/Euro = $1.24-$1.28), returns for the two indexes are about the same. When the dollar is weakest, the DJIA somewhat outperforms the Russell 2000 index. These results do not consistently support the hypothesis that a weak dollar favors large capitalization stocks.
In summary, evidence based on the dollar-euro exchange rate does not reliably support the belief that large capitalization stocks outperform when the dollar is weak or weakening.
For related research and discussions, see Blog Synthesis: The Size Effect and our blog entry of 12/18/06 on the dollar-euro exchange rate as an indicator for overall stock market behavior.
