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During the past year, the U.S. stock market surged to a record high while the dollar posted its biggest appreciation in nearly a decade, rising by 7% on trade-weighted basis, according to Bloomberg.

The dollar’s surge in the fourth quarter mainly reflected investor optimism about Donald Trump’s decisive U.S. presidential election win. But a strong dollar could add to U.S. equity risks if it leads to a wider U.S. trade imbalance and Trump responds with higher tariffs.

In a previous commentary, I noted that the S&P 500 market valuation based on economist Robert Shiller’s cyclically adjusted price-to-earnings ratio is the highest since the internet boom in the late 1990s. At the same time, the real effective exchange rate for the dollar as calculated by the Bank for International Settlements is the highest since the mid-1980s (see chart below).

Real Narrow Effective Exchange Rate for uS

This combination is unusual, because stocks typically do well when a currency is cheap rather than when it is expensive. The reason is a cheap currency makes it easier for companies to compete internationally, whereas a strong currency is an impediment for exporters and domestic producers.

U.S. businesses learned this lesson during the mid-1980s, when the strong dollar undermined their competitiveness and the U.S. current account deficit swelled to a then-record 3% of GDP. The dollar began to decline in early 1985 when investors realized........

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