Thursday, October 8, 2009

Why Dollar Down, S&P Up Makes Little Sense

One of the more interesting correlations we have seen in the markets over the last few months, is the dollar down, markets up relationship.

The theory seems to go that there is asset reflation across all asset classes, so stocks, an asset class, should go up as they represent "real" businesses so these "real" businesses are now worth more nominally.

Let's analyze this a little bit.

Stock ownership represents a claim on future earnings. If those earnings look better now than they did some time ago, then the stock should be up, ceteris paribus.

But are those earnings going to be better, if the dollar weakens more?

The short answer, in many cases, is NO.

There are very, very few non-commodity US businesses that are truly global. The commodity businesses are largely global because both the markets and many of the operations translate directly across geographies: an oil rig looks the same in Mexico as it does in Equatorial Guinea, and mine in South Africa looks a lot like a mine in Australia. So, for example, miner A mines copper in Chile and sells it in China. The real price has not changed but the dollar is now down 50%. Miner A is traded on the NYSE, reports in dollars, so its EPS in dollars goes up and its share price in dollars goes up. These are the exceptional cases.

On the other hand, most S&P 500 companies are still largely US centric. There is a reason for this: for many, many years the US market and the US economy have been the largest in the world, so businesses have not had to expand internationally to grow. The market is large enough to provide excellent scale. Compare this to a business that originates in a small country: it has no choice but to be international from a very early stage. Look at IKEA or Nestle or Nokia or, dare I say it, the Icelandic banks: all major international players not by choice but by necessity.

A second reason is that, culturally, "average" Americans are rarely exposed to foreign customs, and often find cultural adaptation difficult. The US even has a commercial law banning US companies from giving bribes, even in locations where this is considered just a cost of doing business. This puts US companies at a great competitive disadvantage internationally, as, guess what, bribes are required at most places. I am not judging it as right or wrong: I am simply making an observation.
Finally, most Americans do not study any foreign languages which makes conducting international business even more difficult- lacking both the awareness for the cultural subtleties and the language skills is not a recipe for success.

So, in the end, we have a lot of US businesses claiming that they are "international" when only 10-20% of the revenues come from abroad, and most of it is from Canada and the UK.

In addition, there are plenty of service businesses that are very US-specific and as a result, do not scale easily internationally: tax prep services, for-profit schools, payroll processing services, car insurance, some medical services, student loans, you name it: all structurally US-only or near US-only.

So, to recap, for a number of reasons, most US-based companies are not what I call "truly international."

So what does this mean in relation to the reverse relationship dollar/market?

Let's look at an example to better illustrate the point.

Apparel retailer A operates 1,000 apparel stores across the nation, and imports 98% of its products from Asia. The goods get shipped to Long Beach, CA, and then trucked to the three distribution centers that the company has in California, Texas and Pennsylvania for distribution to the 1,000 stores via common carriers.

The company pays for its products in dollars based on a certain exchange rate band, and then pays for shipping three times over thousands of miles for the products to reach the end consumer. What would happen if we have currency devaluation and the dollar drops 50%? Now both the imported garments and the distribution costs are much, much higher because the garments are priced in the foreign currency in effect, while oil is global commodity. The company has a choice: either raise prices drastically to reflect the new realities (and take a hit on volume) or not raise prices, and take a huge hit on margins.

In effect, the company will be playing Russian roulette with a fully loaded gun: it would get hit either way. Does it make sense for most of the non-food retail stocks to go up when the dollar drops? No, in my view.

Similar picture with food retail and restaurants. Their main inputs are agricultural commodities. Agricultural commodities are traded globally, and, in addition to factors like crop yields, a part of their cost is fertilizers and oil, again traded globally. Since those costs will inevitably go up because of the weaker dollar, this means that all agricultural commodities will be going up as well, with some variance based on how good the harvest was. Then, on top, you've got distribution and packaging costs, again commodity based. So the end businesses again have a bad choice to make, raise prices or take a hit on the margins. Why their stocks would be higher because of a weaker dollar is beyond me.

Refineries: same thing. They sell their products in dollars on the local market, but if their costs are determined globally (which they are), what is going to happen to their margins? We found out when gasoline hit over $4 at retail: demand was more flexible than previously assumed. What would happen if oil is at $300, and gasoline has to be at $10/gal for the refiners to break even? I would not want to hold refiners' shares at that time, I can tell you right now.

Distributors: same thing. A smaller food distributor, Nash Finch, had NI of $36mm on $4.7 bn in revenues. This is under 1% NI margin. How much do diesel costs have to go up to push them under 0%? UNFI is under 2% margin, and the single largest distributor, SYY, is under 3%. UPS is, what, 5%?

Since a highly devalued currency would not be popular, of course, the government will have to step in and support it. One of the ways is to increase interest rates. But regular banks have been enjoying some pretty fat interest rate margins recently as they have been able to borrow at practically 0%, and lend at whatever they can charge. A cheaper dollar may well lead to the curve flattening, which will crush banking margins, thus banking earnings. Should bank shares go up when the dollar goes down? Probably not.

Finally, and more broadly, since most "necessities" are globally priced (food, energy), if the average consumer budget has to dedicate more money to those, this allocation will come out of somewhere: entertainment, clothing, or other discretionary. So the money will be going to the global commodity producers (at the end) and not to most others. So why should the S&P be up again? Higher energy/commodity costs act as a tax on everything else.

Dollar down/shares up should hold true only for those businesses who bring in substantial earnings from abroad. Even if the earnings are flat in real terms, they will grow in dollar terms post repatriation, making the equity more attractive in dollar terms. But why have we been observing this relationship across the board for any equity? Beats me.

Update 1 10/08/2009: One, go read this article. Probably the article of the day: weak dollar is not a good thing overall. US GDP per capita in euros is down 25% since 2000. And other fun facts.
I also got some nice feedback from a friend. He makes the a number of valid points, which I think illustrate that investing (especially trying to guess the effects of macro factors) is rarely a black-and-white game. He brings up a few points that I had not considered and are valid as considerations for a dollar vs. S&P scenario.
(1) Competitive devaluations: no one will let the dollar drop too much relative to their own currencies
(2) Tech and natty res (natural exporters) are a substantial chunk of the S&P, and they are first in line to benefit from a cheaper dollar
(3) A cheaper dollar will turn many other companies into exporters, thus increasing their real business
(4) Nominal incomes will be adjusting- possible with lower unemployment, imo- and this will continue to help low-end products and operators
(5) Very interesting distinction: how quickly a currency devaluation happens will affect a lot of outcomes. A gradual sinking will be substantially less stressful than an abrupt one. I agree but I think the latter might be more likely

Update 2 10/21/2009: Here is something good via Einhorn/Winkler/Clusterstock: P/E ratios get crushed during inflation. So, sure, you're getting 25% EPS growth but no one is paying a high multiple for it.

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