Why Your Brain Is Fooling You on the Stock Market
You’re sitting on a train at the station…
Suddenly, you feel you’re starting to move. Your train isn’t due to leave yet? Something doesn’t feel quite right.
Then you work it out.
It’s the train next to yours moving, not yours!
This sensory illusion is a pretty common experience.
And a funny example of how your brain is easily fooled sometimes by what it thinks it’s experiencing, rather than what is really happening.
I think something similar is playing out in markets right now.
We’re all being fooled, in a way.
Let me explain what I mean…
It’s all relative
You see, the stock market isn’t really going up.
It just looks that way because this is going down.
Source: Incredible Charts
This is a chart of the US Dollar Index.
It’s a measure of the strength of the US dollar relative to a basket of other currencies.
As you can see, after an initial COVID-19 bump as people scrambled to the safety of the USD, it’s now turned full circle and is plummeting.
Those falls correlate with a sustained rise in all sorts of other assets. From stock markets, to commodities, to gold and even bitcoin.
There are two reasons for this.
The first is for trading reasons.
You see, when the US dollar gets cheaper, it encourages people to borrow it and invest it in other higher yielding assets.
So, traders might borrow low yielding US dollars and exchange it for higher yielding Australian dollars, for example.
Sure, Australian interest rates are low but they’re higher than in the US, so this so-called ‘carry trade’ is a trader favourite for the institutions playing with big money.
As Thomas Stolper, chief currency strategist at Goldman Sachs in London, said:
‘The Fed seems to be in no rush to tighten monetary policy. So, if rates remain low, why shouldn’t the dollar be the preferred funding currency?
‘And as you know in foreign exchange, it’s all about differentials between countries and in that respect, that differential is negative for the dollar.’
Other speculators borrow cheap dollars and invest them in ‘hard assets’ like commodities. That’s part of the story behind gold’s price rise.
But it also applies to other commodities like copper and oil.
The thinking is if cash pays nothing and more money is about to be put into the economy via various central bank levers, then it will find its way into commodity prices.
This is the inflation argument.
On that note, I’m starting to see some movement in the junior resources space on the ASX, which is very interesting for Aussie investors given our exposure to commodities as a nation.
In fact, more money was raised in Q2 2020 for the junior mining space than any other quarter, since Q1 2012.
The second reason why a weak US dollar could be pushing other asset prices up, is that simply put, a weak US dollar is good for a lot of economies that have borrowed in US dollars.
They can pay back their debts a lot easier.
And the flip side is that US companies are more competitive in exporting with a weak US dollar too.
So, a win-win for everyone then, right?
Not so fast…
The end of an era
There is a downside to this US dollar weakness.
By losing its ‘store of value’ feature, the US risks the dollar’s reserve currency status. And that can of worms leads to a whole heap of consequences.
As Stephen Bartholomeusz wrote recently in the Sydney Morning Herald:
‘The loss of the US dollar’s prestige not only offers an opportunity to others, but it could threaten other segments of the US economy and financial system.
‘If America can’t rely on its safe haven status to attract funds, then its ballooning borrowing requirements and dearth of domestic savings relative to that requirement may result in the market forcing higher interest rates on the US than might otherwise be the case, regardless of what the Fed does.
‘There is traditionally an inverse correlation between the dollar and the US stock market, but the US market has been inflated by the global search for positive returns in the low-rate post-financial crisis environment and the general perception of the US as a financial safe haven.’
Such a change would be dramatic indeed.
But in the short term, it’s helping fuel an ‘everything bubble’ in most other asset classes.
It’s why I told the story about the moving train at the start. Seen through this perspective, we might not be witnessing a stock market rise as such but rather the end of the Almighty Dollar instead!
It’s worth thinking about.
Editor, Money Morning
Ryan is also editor of Exponential Stock Investor, a stock tipping newsletter that looks for the biggest investment opportunities on the market. For information on how to subscribe and see what Ryan’s telling his subscribers right now, click here.
PS: Check out these four innovative Aussie small-cap stocks before lockdown ends.Download your free report now.