London is a money town. It has been the center of the whole Western world’s currency transactions for three centuries. Until 1945, the British pound sterling was the world’s primary reserve currency. The pound is less popular than the dollar or euro now. But whatever currency is king, London is likely to bank it, trade it and exchange it.

London bankers and brokers were old in the business when the New York Stock Exchange was born under a buttonwood tree on Wall Street. London bankers and fund managers were master investors when U.S. stock markets could barely support the capital needs for the greatest new technology boon known to man, that force of creative destruction that changed a continent… railroads.

When it comes to money, London knows the ins and outs.

That’s why I was so interested in a study from London Business School and ABN Amro Bank that I found recently about the effects of strong and weak currencies on the stock market.

As you know, our American dollar has been a shuffling invalid among world currencies these past few years. Many predicted the euro would never appear, and then when that prediction was wrong, these same people predicted it would soon fail. That euro—has trounced the dollar in recent years.

But suddenly the news is getting a new theme. The dollar has gained strength in the past week. I for one am quite happy about that and hope for a continuation. Of course, I will probably be the only financial writer on the planet who will fail to predict the dollar will soon self-destruct. I don’t know what the dollar will do in December or next July, and that’s a fact. But for now, it is getting stronger, and that has some implications for us.

What would a stronger dollar mean?

The obvious implications are mentioned everywhere: interest rates tend to go up (good if you’re a lender, saver or buying bonds); imports tend to cost less. Also, manufacturers, who import raw materials like steel, benefit from lower costs and their margins tend to improve. Commodity prices usually fall as a currency strengthens. That includes oil and gold.

The downside is that U.S. exports go up in price to whoever is importing. That can make them less competitive.

That last reason is why so many politicians and business people love a weak dollar. They say it favors imports and makes them more competitive in a world where cheap labor gives other countries a great advantage.

I am not a big fan of the notion that a cheap currency is desirable. Nobody says that in Switzerland. The Swiss currency tends to remain strong, and every time it goes down a bit, it finds its way back up. Switzerland is a rich country.

But one effect of a strong currency is more worrisome. Against all intuition, strong currencies apparently don’t favor great stock returns. Look at what the London Business School study found:

On the left side: From 1900 to 2005, 17 countries gained from 9.5% to 11.2% annually, based on which group they fell in—strong, middling or weak currencies. It was the weak-currency countries that did best. “Weak currency” in the study referred to a five-year weakness, not a passing slip.

On the right side, ABN Amro and London Business School looked to closer history and more nations. The numbers changed, but not the results. In fact, weak currencies were even more effective. From 1972 to 2005, 53 countries were grouped by currency strength. The weak currency countries averaged 12.1% annually, and the strong currency countries only averaged 3.9%.

Of course, since these differences apply to currencies that have been weak or strong for a five-year period, we dollar holders needn’t worry yet. We should have lots of bad years to our credit because the dollar has fallen against the euro since 2005 and has dropped against the pound since 2000.

And the Swiss laugh last. The dollar has been sliding down a pile of Swiss francs since the dollar’s early-1980s peak ended in late 1984.

The interesting thing about this, though—the stock market effect was consistent. The Swiss franc may have trounced our flimsy dollar, but U.S. stocks have far outpaced Swiss equities, as the second chart shows:

Only Sweden, Australia and South Africa surpassed U.S. stock market results from 1900 to 2005. The mighty and always-strong Swiss franc sat atop a market that returned 4.5% on average compared to 6.5% for the U.S. and 7.8% for Sweden.

Lynn Carpenter

Source: A Warning for the Dollar and the Stock Market, Currency Strength Can Sap Returns