Due to the budget talks and debt ceiling uncertainty, investors have been largely ignoring the upcoming earnings season. Traditionally, the week or two leading to the first earnings announcement have been accompanied by stocks gathering strength as investors start to position themselves for notable earnings announcements.
The debt ceiling debate hasn't caused much damage to the U.S. stocks, just a mild pullback. I expect the relief for stocks to be stronger than the previous pullback, and to come not from the debt ceiling resolution itself, which can drag on for weeks as there is not really a hard-set default date on Oct 17 or any other specific date. Rather, I think the relief rally for the stock market will come from the earnings season getting back into the limelight, and from the debt ceiling debate losing some of the surprise steam.
I believe that there is one strong factor that could cause strong earnings to surprise to the upside for the third-quarter earnings results. The effect of this factor will be one of the strongest of all quarters for many years. It is the U.S. dollar foreign exchange rate.
The U.S. dollar fell sharply at the beginning of July, the first month of the quarter, and continued to fall throughout most of the third quarter, with the exception of a brief break between the end of August and the beginning of September. In total, U.S. Dollar Index ("DXY") and is approximately represented by the Power Shares U.S. dollar index (UUP) that tracks the strength of the U.S. dollar against a basket of currencies (Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc), lost roughly 5.5% of its value over the past 90 days and roughly 4% from the start of the quarter.
This is not a non-event, but rather a strong factor in the earnings of many companies, practically raising dollar-denominated revenue by 4%. If a company drives 100% of revenue from abroad and has an 8% net profit margin, this rapid dollar weakening can boost margins by 2 percentage points to almost 10%, or add one third to the net profits for the quarter because the time-weighted change in the dollar index for the quarter was roughly 2%. For a company that drives half of its sales from overseas, this effect would naturally be roughly half, or 1 percentage point, but would still move net earnings up by more than 10%.
The following chart shows the value of the U.S. dollar index against the currencies of its largest trading partners, the euro, Canadian dollar, Mexican peso, Japanese yen, Chinese yuan, British pound and Australian dollar. As you can see, the U.S. dollar has weakened the most against the British pound, followed by the euro, and stayed flat versus the Chinese yuan and actually gained on the Mexican peso.
Source: Google finance
Of course there are other factors that can influence whether earnings excel or disappoint this quarter, such as the 2014 guidance and the stabilizing Euro zone. I am not attempting to decipher them all in this short analysis. However, the dollar factor will be certainly one of the strongest, if not the strongest factor in the upcoming earnings season, for the companies with high exposure to the exchange rate risk. Regarding the 2014 guidance, I am much more careful, as I expect many real effects on the economy from tighter government spending next year as a result of the debt-ceiling debate and perhaps even lower consumer confidence caused by the lower government spending effects. Hence, my outlook for the next year's earnings is much more careful. The stabilizing EU and Euro zone economies should provide some support for this quarter's earnings results for companies exposed to this region.
How to profit from this positive earnings surprise?
But just by using just this one strong exchange rate factor, investors can make some very powerful tactical trades going into the earnings season and exit the trades after a strong reaction or later this year. The first, and least volatile option with the lowest downside but also lower upside is to buy the S&P 500 (SPY) broad U.S. large cap stock index, which can be traded through an array of ETFs. The U.S. large cap stocks together draw roughly 40% to 50% sales from abroad (the exact percentage fluctuates quarter over quarter and varies by source as well). Hence, the positive effect on earnings will be roughly 10%.
The second option is to buy the sector with the highest international exposure, which would be the S&P IT sector that draws almost 60% of its sales from abroad and can be traded through the Technology Select Sector SPDR ETF (XLK). Using the technology sector, investors can magnify the positive effect on earnings to approximately 15%.
The third very powerful option is to pick individual stocks that drive most or all of their revenues from abroad. Here, the effect on earnings could reach 25 to 40%, depending on the net margins. The lower the margins, the higher the impact would be, other things being equal. The Coca-Cola Enterprises (CCE) - which is not the same entity as the Coca-Cola Company (KO) but related to it of course - with virtually 100% foreign sales; Philip Morris (PM), a manufacturer and distributor of various brands of cigarettes with almost all revenue foreign; ExxonMobil (XOM), a global major oil and gas company with 73% foreign revenue share; Western Union (WU), a worldwide facilitator of personal cross-border money transfers with 72% foreign revenue exposure and Nike (NKE), a footwear, apparel and sports equipment manufacturer with 74% foreign sales, are good examples of stocks with high and balanced international exposure.
The final option is to leverage the play by picking the stocks that draw a high share of sales not only from foreign countries in general, but specifically from the countries with currencies against which the U.S. dollar depreciated the most during the quarter. That would be the stocks that drive most of their sales from the UK and the Euro zone. Interestingly, Philip Morris drives roughly 60% of their revenue from the EMEA region, and McDonald's (MCD) generates approximately 40% of sales from Europe. With the Euro zone economies stabilizing and some of them even posting modest GDP growth, this European exposure can create double tailwinds for this earnings quarter.
In conclusion, I believe there will be a relief rally, but it will come from the earnings season getting into the limelight, diluting the full attention that the debt ceiling now gets, and I think the earnings will generally surprise to the upside, offering a short-term opportunity for attractive gains. However, I am cautious regarding the 2014 outlook, so any upside pop should be taken advantage of to close these medium-term positions, unless investors are confident in the 2014 outlook for their specific investment.