What should you look at to determine the value of the benchmark Sensex index on the Bombay Stock Exchange in the months ahead?
You could take a painstaking bottom-up approach and compute earnings growth for all the Sensex companies. Or, you could take a top-down approach and argue that economic growth is going to go up in the next few months, which will increase company earnings. Or, you could take a shot at gauging risk appetite and assume that it is bound to increase, which would mean more money coming into the markets, thereby sending the index up.
But if you want to use just one indicator, the US dollar index could be a good measure to track. The dollar index measures the value of the dollar against a basket of major currencies. As the accompanying chart shows, there’s an amazingly close relationship between the US dollar index and the Sensex.
Also See Remarkable Relationship (Graphic)
The chart plots the Sensex against the inverse of the dollar index because when the dollar index falls, the Sensex rises. The Sensex is plotted against the left hand side of the y-axis, while the right hand side measures the inverse of the dollar index.
The relationship was not there at the beginning of 2008, but was strong towards the end of the year. And the rise of the Sensex and the fall in the dollar since March is also closely correlated.
That is hardly surprising, because the dollar weakens when money flows out of the US. And since the Indian market gets a small share of those flows, the inverse relationship between the dollar and the Sensex is obvious.
Similarly, when funds rushed back to the perceived safe haven in the US in the later part of 2008, markets crashed and the dollar strengthened. A falling dollar also encourages US investors to put their money in non-dollar assets, thus reinforcing the trend.
While the dollar has been falling on fears about the gargantuan US fiscal deficit, opinion is divided about the extent to which it will continue to weaken. But as the chart shows, investors will be well advised to watch the trend in the dollar index to figure out where the stock market is headed.
Graphics by Sandeep Bhatnagar / Mint
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