Paper Tiger

5/25/2015


Quarterly earnings season is winding down, which means we Forecasts editors can finally remove the telephones glued to our ears for much of the last four weeks. We listen to a lot of corporate earnings calls, a time-consuming process but one that enhances our research and stock-selection process.

Quarterly earnings calls often have a topic-du-quarter, and this earnings season's topic was the strong dollar.

On Dec. 31, one euro equaled $1.21 in U.S. dollars. On March 31, one euro was worth about $1.07. And if you go back to the first quarter of 2014, the comparable quarter for the latest earnings season, one euro cost $1.37. The dollar's 18% rise versus the euro over the last 12 months — not to mention its 16% rise relative to Japanese yen and single- and double-digit appreciation versus a host of other currencies — played havoc with the results of U.S. companies, especially those with substantial overseas operations.

A strong dollar can hurt U.S. companies' earnings and sales for at least three reasons:

1) U.S. firms operating abroad are usually paid in foreign currencies. When they convert those revenues back to U.S. dollars, sales and profits are worth less.

2) American companies' goods and services become more expensive for foreign buyers, which can impact demand for U.S. products, especially if the trend persists long enough for customers to switch to cheaper competitors.

3) The strong dollar can provide a windfall for foreign competitors, who may be inclined to press their advantage by discounting prices to steal market share.

How much did the strong dollar pinch first-quarter results? According to Thomson Reuters, the S&P 500 Index's revenue declined 3.0% — the first year-over-year decrease since the first quarter of 2013 and the largest since the third quarter of 2009. We can't blame all the weakness on currency, but the numbers tell a scary story. Going into the quarterly reporting season, FactSet estimated that for U.S. companies deriving more than 50% of revenue overseas, sales would fall an estimated 10%. Firms that generate less than 50% of revenue overseas should have delivered roughly flat sales.

Of course, a strong dollar isn't all bad. It reduces the costs of imports, which puts a brake on inflation and benefits U.S. consumers. The dollar's strength also boosts the purchasing power of Americans traveling abroad.

And despite the strong dollar's impact on corporate earnings and revenues, there is little proof that it hurts stocks as a whole. Not that a rising dollar is a consistent positive force, but evidence tilts more toward the positive than the negative. As the chart on this page shows, U.S. and foreign large-cap stock benchmark indexes have advanced in recent months despite the dollar's strength.

Investors often feel pressure to respond to short-term economic changes. For example, some pundits have advised people to increase international exposure, peel back positions in large U.S. multinationals, and perhaps buy small and midsized companies less exposed to the dollar. However, I would caution most individual investors against making big bets based on the dollar's strength.

Today's strong dollar could become tomorrow's paper tiger.

Instead, focus on establishing an investment allocation that makes sense for your time horizon and risk level. Own quality companies, even if those firms face some near-term headwinds because of the strong dollar.

The pendulum eventually swings back. And that reversal may already be starting. Since the end of the first quarter, the dollar has weakened 4% against the euro.


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