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US Stocks in Euros

Adam Hamilton
February 11, 2005

Since Washington launched its invasion of Iraq in March 2003, the US stock markets have generally been performing strongly in varying stages of a cyclical bull I call the war rally. Not surprisingly, this recent strength is the primary driver of the dazzlingly bullish sentiment prevailing in the markets today.

Yet, initial perceptions can often be deceiving. On the surface the markets may feel strong, especially if one just considers the cyclical-bull-to-date gains since March 2003 or the occasional market-darling success stories like Google. Digging a little deeper, however, soon dispels much of the basis for the unbridled optimism of the perma-bulls.

The behind-the-scenes decay stealthily eroding the very visible bullish foundation of the war rally is primarily advancing on two fronts. I discussed the first about a month ago, the fact that the war rally probably peaked in early 2004, which was a crystal-clear downtrending bearish year prior to the anomalous election rally of recent months. Almost all of 2004's gains happened in November and December, barely salvaging an ugly year.

In addition to the election rally that won't be repeated for four more years and the extraordinarily dangerous complacency that it spawned, there is a second internal threat to the war rally. It surrounds the rapidly depreciating international purchasing power of the US dollar. Whether you are an American investor or live outside the States, this is an extremely important issue to consider.

With subscribers and consulting clients in 49 countries now, I am blessed with countless opportunities to discuss the ongoing US dollar bear with investors from all over the world. In my experience, investors living outside the States understand its implications all too well and think about if often. Sadly though, my fellow American countrymen often seem largely oblivious to the insidious erosion of our fiat currency.

All American investors today have grown up since World War II, in a peculiar era where the US dollar utterly dominated global commerce. As such, it is really hard for us Americans to think in terms outside of the mental dollar box we are locked in from childhood. Thinking in multiple currencies is challenging for Americans, but nevertheless this important skill can certainly be learned.

Since the war rally erupted in March 2003, the US dollar has fallen rather dramatically, 21% in US Dollar Index terms. Thus a given pile of dollars saved over the past two years is worth a frightening 1/5th less in terms of what it can actually buy on the global markets. Thanks to the Fed's monumentally negligent mismanagement of the US dollar, it is rapidly inflating away into oblivion.

Unfortunately most Americans don't perceive this huge loss in dollar purchasing power, primarily for one big reason. I suspect that the majority of Americans buy most of their necessities from giant discounters like WalMart. The giant discounters help keep their prices low by sourcing their goods largely from China, which has a decade-old artificial peg with the US dollar.

Thanks to this Chinese 'dollar standard' near 8.3 yuan to the dollar, the yuan is insulated from dollar weakness. Chinese exporters love this, as the yuan being shackled to the falling dollar ensures that American consumers will be paying the same number of nominal dollars for Chinese stuff regardless of currency trends. Indeed the lower the dollar goes, dragging down the pegged yuan, the more China can export into the States as its competition like Europe with free-floating currencies is priced out of the US markets.

I suspect that without the yuan/dollar peg, the falling dollar would have led to higher wholesale prices of goods for major discounters and hence higher prices for American consumers. And even the most economically naive American would certainly notice a huge 21% increase in the cost of everything we use in such an extremely short two-year time span.

This ongoing secular dollar bear is even more important in stock-market terms. We Americans look at the US markets and assume that a dollar we invested two years ago is worth the same as a dollar today. That is absolutely not true of course. Today's cheapened US dollars, at best, are only worth about 4/5ths of the international purchasing power of an early 2003 US dollar.

The only way we can analyze this effectively, especially as myopic Americans, is to somehow render the US stock markets in constant-dollar terms. My favorite approach to this analytical puzzle is to express the US markets in euros, the dollar's primary competitor and the fiat currency most likely to achieve global dominance as the dollar's international value continues to relentlessly erode.

Our charts this week express the Big Three US stock indices in euros. They reveal how the US markets look to a European investor who sold euros to buy dollars to buy US stocks just after the initial violent spike up as the war rally launched in March 2003. Not surprisingly, the picture painted of constant-dollar US markets is not pretty and shows just how anemic the US stock markets' true performance has been in international purchasing-power terms.

In all of these charts, the original US stock indices, the ones we Americans watch everyday in the headlines, are rendered in red. The blue lines, as well as the white, yellow, and black technical tools, correspond to the US markets as they look to a European investor after adjusting for the weakening dollar exchange rates. After fully accounting for the massive dollar losses, the war rally's bravado deflates considerably.

As usual, the hyper-speculative NASDAQ witnessed the greatest war rally gains. For reasons that continue to utterly elude me, even after the wicked bubble and crash the lessons from the NASDAQ bust have already been largely forgotten. Speculators, and even investors, continue to madly chase stocks with bubble valuations and minuscule profits compared to their market capitalizations. Obviously they haven't felt enough pain yet to learn the folly of buying high, but history says they almost certainly will.

All the gains numbers in these charts run from the respective war-rally lows in the lower left corner. Prior to the election rally, the NASDAQ was up 69% in early 2004 before grinding relentlessly lower in a very clear bearish downtrend. The election rally breakout catapulted the index back up to squeak out a slightly higher rally-to-date gain of 71% in late December. From a euro perspective, however, the NASDAQ's gains were much less impressive.

The war rally in the NASDAQ only went 41% higher in constant-dollar terms, and today it is only up 33% in the last two years from the perspective of foreign investors. In fact since mid-2003, the NASDAQ has actually been grinding sideways, with zero gains, if the rapidly deteriorating dollar purchasing power is considered. While the red nominal NASDAQ line may excite some, the blue constant-dollar NASDAQ line steals most of the war rally's thunder.

Why is this the case? Because foreign investors have to buy dollars before buying US stocks and sell dollars after selling US stocks in order to make a round-trip trade in their own local currency. Thus exchange rates are a crucial component of final realized gains. A real-world example helps make sense of it all.

Imagine a European investor back in March 2003, seeing the dazzling first week of the war rally and deciding to invest €10,000 in the US markets to ride the growing wave of bulldom. In order to actually buy US stocks though, the European first has to sell his euros for US dollars. I doubt many US brokers accept euros directly!

On March 21st, 2003, €10,000 would have been worth $10,522. Since he can't play the US markets directly with euros, our European investor would have traded them for dollars and purchased US stocks. But, since any foreign transaction is a two-staged trade, he could not fully realize his profits in the US markets until he sold his US stocks for dollars and then sold the dollars to repatriate his capital back into euros.

From March 21st, 2003 until this past week, February 8th, the NASDAQ was up a rather impressive 47%. So our European investor's €10,000 stake grew from $10,522 to $15,449. But the moment he decides to repatriate his gains back into euros, the dollar's secular bear looms up and mauls away a great portion of his dollar gains. On February 8th, it took $1.2763 to buy one euro, far more than the $1.0522 on March 21st, 2003.

So when the European's $15,449 US equity position is sold for dollars which are then used to buy euros, the European investor only ends up with €12,105, or a 21% gain over the period. This gain, which would be even lower after all the transaction costs are considered, is vastly inferior to the 47% that American investors achieved in wasting dollars over the same period. It reveals the true nature of the war rally, which was not very impressive in constant-dollar terms.

The war rally's real gains really ended in late summer 2003, and since then the US markets priced in other currencies have just been grinding relentlessly sideways. All gains beyond NASDAQ 1800 have been nothing but an illusion fostered by the plummeting US dollar. The contrast between the blue NASDAQ euro line and the red usual NASDAQ line is very striking and quite profound.

This international purchasing-power perspective is very important because the reason everyone ultimately invests is to increase their future purchasing power. A 20% investment gain is useless, for example, if one needs 30% more dollars to buy the same standard of living by the end of the investment period. Americans have to understand that they have not done as well as they think since March 2003 because the dollar's international value is plunging.

Fascinatingly, this constant-dollar view of the US markets illuminates the true nature of the election rally as well. As you can see above, the election breakout from the 2004 downtrend resistance line that happened in the headline US indices was not mimicked by a breakout in the NASDAQ in euros. Almost the entire election rally in late 2004 was directly offset by a plummeting US dollar. While Americans rejoiced over the election rally, foreign investors watched the constant-dollar markets continue to grind right on lower.

This really intrigues me because it was well known that most foreigners were hugely opposed to Washington's imperialism and did not want the incumbent president to win in November. After the incumbent did win, foreign investors put their money where their mouths were and sold the dollar hard in anticipation of more years of Washington imperialism. The dollar fell so fast that it completely erased the election rally in constant-dollar terms!

Thus, when the dollar's bear rally and rapidly eroding international purchasing power is considered, the war rally loses a great deal of its luster. Not only is this constant-dollar view of the market utterly flat since NASDAQ 1800 in mid-2003, but it reveals the false nature of the election rally and the continuing bearish trend in the most speculative of US markets.

And since the NASDAQ was the best performer of the flagship US indices since March 2003, the mighty S&P 500 and the elite Dow 30 are bound to look even worse in constant-dollar terms. Through the eyes of European investors, the US markets have not earned any gains since the late summer of 2003. This is not an encouraging sign for the American bulls' desperate dream of a newly emerging stock superbull.

The S&P 500, widely considered to be the best proxy for the US markets in general by professional money managers worldwide, has languished flat in constant-dollar terms since mid-2003. Neither the second stage of the war rally in late 2003 nor the late 2004 election rally ever really happened if the erosion of international dollar purchasing power is considered.

In order to see our own markets through the world's eyes, imagine that the blue S&P 500 euro line is what we have seen in the States in the past couple years. The war rally started strong, running from just above 800 to nearly 1000 in less than six months. But after that, the S&P 500 has oscillated relentlessly between 900 and 1000 like a dying fish flopping on land, failing to break decisively above this crucial level after five tries. If you bought near 1000 in mid-2003, you would actually be down slightly today about 18 months later.

Can you imagine the devastating psychological impact to American investors if the markets had just been flat for 18 months in a row? How bullish would even Wall Street and CNBC be if the S&P 500 just could not manage to get over 1000 after a year and a half of valiantly trying? My guess is not very bullish at all. This bearish perspective would radically change today's hyper bullish sentiment.

Foreign investors, who have to buy and sell dollars to invest in the States, are seeing a vastly different perspective on the US markets than us Americans. Just as the blue trading range above would not excite you or I one bit, neither is it endearing to foreign investors who have watched the US markets flatline in their local currency terms.

The ironic part of this whole depreciating dollar mess is it is not the foreign investors who are being deceived, but we Americans. Much of our gains in the stock markets in recent years have been directly offset by a precipitous loss of international purchasing power in our fiat currency. We may have more dollars, but they are worth a lot less in the world except in temporary artificial dollar-peg cases like China.

This final chart is the worst of the lot. The Dow 30 is composed of the best of the best of elite US companies, and this index is often considered to be a bellwether for the American markets and economy as a whole. If some of the greatest industrial corporations on the planet can't make real headway in the past couple years, it certainly doesn't bode well for the US markets as a whole.

Unlike the NASDAQ euro and S&P 500 euro that are essentially grinding sideways, the venerable Dow 30 is actually in a very distinctive downtrend in constant currency terms! It challenged 9250 in mid-2003 but has since fallen all the way back to 8000 before the election rally erupted. Even that was only good enough to briefly carry it above 8500, although the index is once again challenging 9000 today thanks to the dollar's latest bear rally.

Once again, the dollar bear obliterated any ethereal election rally gains that ensued and there was no breakout from the Dow's relentless grinding downtrend. In constant-dollar terms the Dow 30 is carving a massive multi-year top, not a foundation for a huge new bull market. Foreign investors understand this well, and American investors can only ignore it at their own great peril.

The war rally was indeed spectacular for its initial six months off of its March 2003 bottoms. But in the past 18 months or so, US stocks have done absolutely nothing when considered in international purchasing power terms. All nominal gains have been offset by direct losses in the amount of goods and services that a dollar can buy around the world. And all the rallying in late 2003 and late 2004 was a total charade in real terms.

If you are an American, you need to realize that all is not as it seems in our stock markets. The headline indices may look good, but the purchasing power of our savings and investments is swirling down the toilet thanks to the Federal Reserve and the abomination of a fully-fiat dollar backed by absolutely nothing. Today's dollar is not a constant like our gold-backed dollar of a century ago, but it is a rapidly depreciating target that must be considered in any long-term investment decisions.

If you live outside the States, think carefully of what the ongoing dollar bear will do to your overall US gains before you actually deploy capital in the US markets. If the dollar bear continues dragging US fiat down at a similar rate to recent years, then you are going to need stellar gains indeed to offset dollar losses. If you can't ultimately earn profits in your local currency via US investing, then there is no reason to invest in the US. Look to markets where you can earn strong real returns even after currency fluctuations.

And if you are interested in more innovative analysis like this that you simply cannot find in mainstream sources, please consider subscribing to our acclaimed Zeal Intelligence monthly newsletter. We originally predicted and have monitored the entire dollar bear, and are striving to launch investments and speculations that will gain in all currencies despite the dollar weakness.

In the current issue recently published, I technically analyzed all of the elite gold stocks in preparation for the next expected gold upleg. While gold has languished in euro terms, gold stocks' enormous triple-digit gains have been very large in all currencies, not just the US dollar. In addition to preparing for a major gold-stock redeployment at appropriate technical signals, we are also layering in shorts on the increasingly precarious US equity markets. Please join us today!

The bottom line is not all is as it seems in the US stock markets today. Yes, the war rally's gains were impressive initially, but since mid-2003 in constant-dollar terms the real advance of US equities has stalled. Any gains have been largely offset by chronic weakness in the dollar. It is foolish to ignore this insidious erosion of purchasing power whether you are American or not.

One way to keep abreast of the real state of the US markets in international purchasing-power terms is to view them through the lens of another major currency like the euro. We will certainly continue to periodically monitor this unique perspective going forward.

Adam Hamilton, CPA
February 11, 2005

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