On March 9th the S&P 500 stock index bottomed; the closing price of the S&P 500 on that day was 676.53 and the US Dollar Index was at 89.19. Today the S&P 500 is at 1002.63, a nominal gain of 48.2% since March 9th, but the US Dollar index has fallen to 77.59. This means that about 40% of the gains in the S&P 500 since March 9th are due to the dollar depreciation and thus not real. Let me explain…
The US Dollar Index is a measure of the value of the US dollar relative to a basket of foreign currencies. The higher the index the more the US dollar is worth compared to other currencies and the cheaper it is for people in the US to buy foreign goods. The lower the US dollar index the less the US dollar is worth compared to other currencies and the more expensive foreign goods becomes.
The value of the US dollar is very important to foreign investors looking to invest in the United States. Let’s say for example an investor from Britain, Nigel, wants to invest in US stocks. For the sake of this example, let’s say one British Pound will buy one US Dollar. Nigel wants to buy 100 shares of a US stock at $10 per share for a total investment of $1000. He decides this is a wise investment so he converts 1000 British Pounds into dollars and then purchases 100 shares of the US company.
One year later the price of the shares doubles to $20 per share; 100 shares at $20 apiece means his shares are now worth $2000. Nigel thinks this is great because has just made $1000 dollars on his investment. He then sells his shares for $2000. However, he cannot buy anything in England with US dollars so he has to convert his dollars into pounds. Let’s also say the dollar lost half of its value relative to the pound. Thus it now takes $2 to buy a British pound. Nigel then convents the $2000 he received from the sale of his shares into 1000 British pounds. Nigel has now discovered he has not actually made any money in British pounds because it took 1000 pounds to buy the shares a year ago.
All the perceived gains his stock in US dollars were due to the fact the US dollar lost value relative to the pound. There were no real gains in British pounds for him. This risk of an investment's value changing due to changes in currency exchange rates is
known as foreign exchange risk.
Way does this matter? Well since the March 9th lows in the S&P 500, the S&P 500 has gained about 48% in value in dollar terms. It went from a March 9th close of 676.53 to a 1002.63 close on August 3rd. However, the US dollar has lost a good deal of value relative to other currencies. The US dollar index was at 89.19 on March 9th and on August 3rd it was at 77.59. This means that the value of the dollar has declined by about 13.5% relative to foreign currencies since March 9th.
So to get real returns one has to adjust for the fall in the dollar which I have done in the graph below. Nominal gain is the percentage gain in the S&P 500 not adjusted for the depreciation in the dollar and the dollar index adjusted gains are the gains adjusted for the fall in the value of the dollar relative to other currencies. The real dollar index adjusted gain since March 9th is only about 29% this compares to a nominal gain of about 48% (see Graph below).
**A technical note for people who want to know how I did the calculations for the graph:**Example: On Aug. 3rd the S&P closed at 1002.63 and 676.53 on March 9th. The dollar index was 77.59 on Aug. 3rd and 89.19 on Mar. 9th. To make the adjustment take 77.59/89.19 = .87. Then multiply 1002.63 by .87 to get real value of S&P 500 in a constant US dollar index adjusted value: 1002.63 * .87 = 872.23.
Finally to get % real gain take (872.23 - 676.53) / (676.53) = 28.9%
% of gains due to dollar depreciation calculation:
Real gains since March 9th = 28.9%
Nominal gains since March 9th = 48.2%
To get % of gains due to dollar depreciation take 1 – (28.2% / 48.2%) = .400 or 40.0%
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