Does a Weak Dollar Favor Large Capitalization Stocks?
Posted in Economic Indicators, Size Effect
September 28, 2009
When the dollar weakens, large capitalization U.S. firms may 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. Should investors therefore shift toward (away from) large capitalization stocks when the dollar weakens (strengthens)? To check, we compare the performance of the Dow Jones Industrial Average (DJIA) (representing internationally positioned, large capitalization stocks) and the Russell 2000 Index (representing small capitalization stocks) while and after the dollar trends against the euro. We focus on non-overlapping three-month measurement intervals to match the corporate earnings release schedule. Using data for the stock indexes and the dollar-euro exchange rate over the period January 2000 through (most of) September 2009 (about 38 complete quarters), we find that:
First, based on the suppositions that investors can predict dollar-euro exchange rate trends and that they anticipate hypothesized effects of these trends on corporate earnings, we look at contemporaneous changes in the exchange rate and stock returns.
The following scatter plot relates 3-month returns for DJIA and the Russell 2000 Index to the change in the dollar-euro exchange rate over the same three months during the entire sample period (38 non-overlapping 3-month intervals).
The Pearson correlation for the DJIA relationship with the dollar-euro exchange rate is 0.16 and the R-squared statistic is 0.02, suggesting a slight tendency for DJIA to rise as the dollar weakens (exchange rate variations explain 2% of DJIA returns).
The Pearson correlation for the Russell 2000 Index relationship with the dollar-euro exchange rate is -0.03 and the R-squared statistic is 0.00, indicating no relationship.
These results offer very weak support for the hypothesis that a weak dollar favors large capitalization stocks.
For a different perspective, we try rankings.
The next chart summarizes average 3-month returns for both DJIA and the Russell 2000 index according to whether the dollar-euro exchange rate decreases (dollar strengthens) or increases (dollar weakens) during the same three months. Over the entire sample period, the dollar strengthens (weakens) over 16 (22) independent 3-month intervals. Results suggest that the small effect seen above derives from weakness in large capitalization stocks while the dollar strengthens.
The subsamples are small and the observations fairly dispersed, so these results are of very low reliability.
What if investors cannot predict exchange rate trends but instead react to observable trends?
The next scatter plot relates 3-month returns for DJIA and the Russell 2000 Index to the change in the dollar-euro exchange rate over the prior three months during the entire sample period (37 non-overlapping 3-month intervals).
The Pearson correlation for the DJIA relationship with the dollar-euro exchange rate is -0.03 and the R-squared statistic is 0.00, suggesting no relationship.
The Pearson correlation for the Russell 2000 Index relationship with the dollar-euro exchange rate is 0.10 and the R-squared statistic is 0.01, indicating hardly any relationship.
These results do not support the hypothesis that a weak dollar favors large capitalization stocks.
For a different perspective, we again try rankings.
The final chart summarizes average 3-month returns for both DJIA and the Russell 2000 index according to whether the dollar-euro exchange rate decreases (dollar strengthens) or increases (dollar weakens) during the prior three months. Over the entire sample period, the dollar strengthens (weakens) over 16 (21) non-overlapping 3-month intervals. Results suggest that small capitalization stocks derive some benefit from past weakness in the dollar, perhaps representing some kind of reversion in the exchange rate or stock returns.
Again, the subsamples are small and the observations fairly dispersed, so these results are of very low reliability.
In summary, evidence form simple tests on a fairly small sample does not convincingly support the belief that investors can exploit the difference in responses to variations in the dollar-euro exchange rate between large and small capitalization U.S. stocks.
