When Dollar Rises and Euro Falls, U.S. Stocks Will Take a Hit

One of the most fascinating daily challenges for any investing expert is trying to understand what makes the market move. On Thursday night, I appeared on New England Cable News, and said that my biggest concern about stocks on Friday was how investors would feel about the situation in the eurozone. That's because lately, when investors sell euros and buy dollars, U.S. stocks go down.

The euro has been tanking while the dollar just hit a 14-month high. From the euro's peak value of $1.60 in July 2008, the euro today is trading at $1.245, down 22.2%. And Bloomberg estimates that the euro is still roughly 11% overvalued against the dollar, based on so-called purchasing power parity, which calculates how much of a basket of goods and services a comparable quantity of different currencies can buy.

To understand why this might be happening, it is helpful to think about two questions: First, what factors cause the euro/dollar relationship to change? Second, why would a strong dollar hurt U.S. stocks?

Politics Trumped Economics In Euro's Birth

It is worth pointing out that some countries admitted into the common currency never satisfied the fairly strict economic performance criteria required. Yet those countries were able to cut deals with countries in the EU vanguard to obtain admission. And while the eurozone carried some of these weaker countries for years, the cost of keeping these laggards in the club has recently skyrocketed.

A case in point is Italy. According to Bloomberg, Italy did not meet the criteria for admission into the euro due to its enormous debt levels. But Italy's then-prime minister, Romano Prodi, said he struck a deal with Germany in which Italy would buy more German milk if Germany let Italy into the euro. Prodi argued that a three-year 40% decline in the value of the Italian lira was blocking Italy from importing German milk. If admitted to the common currency, Prodi said, Italy's ability to use the stronger euro would boost its imports. Rules were bent, and Italy joined, as did other countries with weaker economies. Now, the entire eurozone is paying the price.

Currency Strength Is a Matter of Political Stability

Greece is economically the sickest of the eurozone countries, whose financial challenges led the EU to agree to a $1 trillion bailout plan. But there are deep disparities in the economic health of the eurozone's members.

Bloomberg notes wide variations in productivity, debt and unemployment among the member countries. For example, GDP per person ranges from "69,300 euros in Luxembourg to 18,100 euros in Slovakia." Meanwhile, debt levels as a percentage of GDP range "from 14.5% in Luxembourg to 115.8% in Italy." Finally, there are enormous differences in the job markets across the countries -- for example, the unemployment rate ranges from 4.1% in the Netherlands to 19.1% in Spain.

At the core, the reason the euro is growing weaker and the dollar is growing stronger is the difference in relative political stability between Europe and the U.S.

Simply put, the eurozone is a collection of countries that share some common monetary operations, but the members have independent governments and budgeting processes. And as the Italy example highlights, under those conditions, political calculations trump economic ones.

Falling Commodities, U.S. Exports, Threaten Stocks

For the moment, the political and economic situation in the U.S. appears more stable to investors than that of the eurozone, which now faces conditions that could seriously destabilize its currency. The idea of a $1 trillion European bailout was surely not contemplated when the eurozone was originally assembled. Nor do investors view draconian budget cuts by its member countries, or the possible expulsion of countries from the euro, as signs of stability.

And while the flow of funds from the euro to the dollar certainly offers benefits to the U.S., the costs of a stronger dollar are pretty significant. While a strong dollar lowers U.S. interest rates and sends down the price of dollar-denominated commodities such as oil, it also makes it harder for big U.S. exporters to sell their goods overseas.

It is this combination of declining commodity prices and slumping exports that appears to be threatening the U.S. stock market.

How long this dynamic will hold is anybody's guess. But for the time being, it looks like a strong dollar and weak euro will be a drag on the values of U.S. stocks.