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Mark Hulbert: The U.S. dollar hasn’t been this strong against the euro in 20 years. Here’s what happened next.

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A gutsy contrarian bet right now is that the strong U.S. dollar will weaken, particularly versus the euro. A secondary bold bet is that U.S. stocks will lag international equities.

Dollar weakness would represent a reversal of a trend dating back several years. The U.S. Dollar Index
DXY,
-0.43%
,
which reflects the dollar’s strength vis-a-vis a basket of foreign currencies, is 50% higher than where it stood a decade ago — and has risen more than 20% since the beginning of 2021. The dollar’s strength has been especially evident this year against the euro
EURUSD,
+0.56%

: Earlier this week the euro traded below US$1, in fact — 20% cheaper relative to the dollar than where it stood at the beginning of 2021.

The last time the dollar traded at parity with the euro was late 2002, two decades ago, and what happened afterward fits the contrarian narrative. Over the subsequent five years the dollar weakened considerably against the euro; by early 2008 it took more than US$1.50 to buy one euro, compared to US$1.00 in late 2002. Over this same period, the U.S. Dollar Index fell by 40%.

Not surprisingly, given that the dollar-denominated returns of non-U.S. stocks rise when the U.S. dollar weakens, the S&P 500
SPX,
+1.55%

seriously lagged the world stock markets over this five-year period. It lagged the FTSE World Ex-US index by almost five percentage points annualized, and the FTSE Europe Index by almost three percentage points.

This five-year period through 2008 represents just one data point. To develop a more comprehensive picture, I measured the correlation between the dollar and the euro going back to the late 1990s, when the euro first started trading on foreign exchange markets. I found that the correlation is inverse: 12-month periods in which the dollar was stronger than the euro were more often than not followed by 12-month periods in which the dollar was weaker — and vice versa.

This correlation was of only moderate statistical significance, so it would be risky to bet everything on it. The strongest conclusion you can draw is that you should by no means bet that the trend of the past 12 months will persist. A somewhat less strong implication is that the past 12 months’ trend may soon reverse itself.

There is a strong correlation between contemporaneous changes in the dollar-euro exchange rate, on the one hand, and the performance of the S&P 500 relative to that of the dollar-denominated return European stocks, on the other. The chart above shows the difference: In those months in which the dollar gained ground relative to the euro, the S&P 500 beat the Vanguard European Stock Index Fund
VEUSX,
-1.61%

by an annualized 16.3%. In those months in which the dollar lost to the euro, in contrast, the S&P 500 lagged the Vanguard fund by 9.5% annualized.

U.S. versus European equities

Even if the euro isn’t stronger than the dollar anytime soon, contrarians would still bet that U.S. stocks will lag European equities. That’s because European equities trade at much lower valuations than their U.S. counterparts, so even if the dollar-euro exchange rate stays constant they offer better value. If the euro strengthens against the dollar, then the return these stocks produce for dollar-denominated investors will be even better.

One indication of how undervalued European stocks are, relative to U.S. stocks, comes from comparing their Cyclically-Adjusted Price-Earnings (CAPE) ratios. On this basis, according to Barclays Indices, European stocks as a whole currently are 31% more undervalued than the U.S. equity market (or 31% less overvalued, depending on your perspective).

If you want to bet on European equities, an index fund is the cheapest way to gain diversified exposure. The ETF in this space with the most assets under management is the Vanguard FTSE Europe ETF
VGK,
+1.56%
,
with an 0.08% expense ratio (or just $8 per $10,000 invested).

If you want to try individual stocks, below are the stocks of European companies that currently are recommended for purchase by top-performing newsletters that my auditing firm monitors:

Stock

Headquarters

AerCap Holdings NV (AER)

Ireland

Allianz SE Unsponsored ADR (ALIZY)

Germany

Amcor PLC (AMCR)

United Kingdom

AXA SA Sponsored ADR (AXAHY)

France

BASF SE Sponsored ADR (BASFY)

Germany

BP p.l.c. Sponsored ADR (BP)

United Kingdom

Cimpress Plc (CMPR)

Ireland

Credit Suisse Group AG Sponsored ADR (CS)

Switzerland

Eaton Corp. Plc (ETN)

Ireland

Exscientia Plc Sponsored ADR (EXAI)

United Kingdom

Holcim Ltd Unsponsored ADR (HCMLY)

Switzerland

Janus Henderson Group PLC (JHG)

United Kingdom

Koninklijke Philips N.V. Sponsored ADR (PHG)

Netherlands

Logitech International S.A. (LOGI)

Switzerland

Medtronic Plc (MDT)

Ireland

Nokia Oyj Sponsored ADR (NOK)

Finland

NXP Semiconductors NV (NXPI)

Netherlands

Pershing Square Holdings Ltd Public Class USD Accum.Shs (PSHZF)

United Kingdom

Rio Tinto plc Sponsored ADR (RIO)

United Kingdom

Sage Group plc Unsponsored ADR (SGPYY)

United Kingdom

Sanofi Sponsored ADR (SNY)

France

Seagate Technology Holdings PLC (STX)

Ireland

Shell PLC Sponsored ADR (SHEL)

United Kingdom

Siemens AG Sponsored ADR (SIEGY)

Germany

TotalEnergies SE Sponsored ADR (TTE)

France

Vodafone Group Plc Sponsored ADR (VOD)

United Kingdom

Volkswagen AG Unsponsored ADR (VWAGY)

Germany

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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