How Serious Is The Dollar Threat To Dow Stocks?

| About: PowerShares QQQ (QQQ)

Summary

Dollar appreciation is threatening to the overseas business of large multinational firms, of which there is a concentration in the Dow.

The dollar has appreciated significantly already, and significant offsetting factors could come into play to balance influences on the dollar.

Investors still might be wise to reduce allocation to large multinationals and raise stakes in small cap value funds or in cash or alternative investments over the short-term.

Much uncertainty will be removed after the elections in the U.S. in November, the Italian referendum in December, and if the Deutsche Bank situation is mitigated.

The great majority of stocks in the Dow Jones Industrial Average declined on broad weakness this past Tuesday. I could not help but to note that Dow stocks are especially in the line of fire because of the strong drive of the U.S. dollar. But how serious is the dollar threat to stocks moving forward? There are a lot of issues at play both for and against the dollar, so it is hard to say given the dollar's gains already booked. Still, this should be an ongoing consideration for investors.

SPDR Dow Jones Industrial Average ETF stock chart

DIA Chart at Seeking Alpha

PowerShares DB USD Bull ETF stock chart

UUP Chart at Seeking Alpha

This chart of the PowerShares DB USD Bull (NYSE: UUP) contrasts against the move in the SPDR Dow Jones ETF (NYSE: DIA). No stocks faired well this past Tuesday, but Dow stocks seem to be especially threatened by dollar appreciation. That is because the Dow 30 is made up of large multinationals engaged in significant business overseas. As the dollar appreciates against other currencies, American multinationals have increasing difficulty competing against indigenously produced rival goods and services.

American firms have a choice when the dollar appreciates. They can do nothing and risk losing market share to lower priced competition, which means sales will slow or decrease in established markets. Or multinationals can lower the price they charge overseas to enable their goods to compete more effectively. However, that action pressures their profit margins and return to shareholders, unless their costs of operating are also born overseas. In that case, when they repatriate funds to America or buy dollars, there will be less currency to book in dollar terms. It seems that no matter their approach, American multinationals are challenged by an appreciating dollar.

The problem is exponential for commodity producers like Alcoa (NYSE: AA), which reported lower than expected revenues and earnings on Tuesday and played a big role in this week's weakness. You can bet your bottom dollar that Alcoa's results weighed on the entire market Tuesday, because there are also large multinationals in the S&P 500 (NYSE: SPY) and the Nasdaq-100 (NASDAQ: QQQ), and not just in the Dow.

But the Dow, limited to 30 large blue chip names, is just about fully comprised of worldly firms.

Components of the Dow 30

10-11-16

SPDR Dow Jones

-1.1%

PowerShares DB USD Bull

+0.8%

American Express (NYSE: AXP)

-1.7%

Apple (NASDAQ: AAPL)

+0.2%

Boeing (NYSE: BA)

-1.6%

Caterpillar (NYSE: CAT)

-0.9%

Cisco Systems (NASDAQ: CSCO)

-1.4%

Chevron (NYSE: CVX)

-0.9%

E I du Pont de Nemours (NYSE: DD)

-0.0%

Exxon Mobil (NYSE: XOM)

-0.8%

General Electric (NYSE: GE)

+0.2%

Goldman Sachs (NYSE : GS)

-1.2%

Home Depot (NYSE : HD)

-1.1%

International Business Machines (NYSE : IBM)

-1.4%

Intel (NASDAQ: INTC)

-2.0%

Johnson & Johnson (NYSE: JNJ)

-1.8%

Coca-Cola (NYSE: KO)

-0.5%

J.P. Morgan Chase (NYSE: JPM)

-0.5%

McDonald's (NYSE: MCD)

-0.9%

3M Co. (NYSE: MMM)

-0.9%

Merck & Co. (NYSE: MRK)

-3.1%

Microsoft (NASDAQ: MSFT)

-1.5%

Nike (NYSE: NKE)

+0.1%

Pfizer (NYSE: PFE)

-1.4%

Proctor & Gamble (NYSE: PG)

-0.6%

Travelers (NYSE: TRV)

-1.0%

UnitedHealth (NYSE: UNH)

-2.4%

United Technologies (NYSE: UTX)

-1.2%

Verizon (NYSE: VZ)

-0.6%

Visa (NYSE: V)

-1.3%

Wal-Mart (NYSE: WMT)

-0.9%

Walt Disney (NYSE: DIS)

-0.7%

Click to enlarge

The performance of the SPDR Dow Jones on Tuesday, down 1.1%, compared with a 1.3% drop in the SPDR S&P 500 and a 1.4% drop in the PowerShares QQQ . Thus, the Dow performed better than the S&P 500 and the Nasdaq-100. However, that is probably just because of its concentration of names with beta coefficients close to 1.0 and also due to the types of holders of these shares. The much larger indices of the S&P 500 and the Nasdaq-100 will be inclusive of more volatile stocks, though obviously they are benchmark indices (the S&P 500 is broadly considered to be "the market" though the S&P 1500 is a better representative) with beta coefficients at or about 1.0.

The relative risk of longer term underperformance of the Dow and large multinational stocks generally arises if dollar appreciation continues and/or strength becomes anchored. Then we will see impact to the earnings of these firms in coming quarters and in 2017. So in asking the question regarding the threat of the dollar to these stocks, we must assess the outlook for the U.S. dollar. That is not so easy today, though everyone wants to tell you they know.

What we saw until Thursday was undeterred dollar appreciation against a poor economic result of Brexit in the United Kingdom and great uncertainty in Europe due to Brexit, the immigration disruption and trepidation around the Deutsche Bank issue and the European financial system. Plus, Europe contends with a critical referendum in Italy in December and elections in major markets near-term. These issues appear to be stubborn pressures into at least December and more likely deep into 2017 ( Brexit set to start in March).

However, as I've stated previously, mitigation of the Deutsche Bank issue would be extremely helpful to financial market stability near-term, including in the United States. The Department of Justice needs to work something out with the German bank that either is amicable in terms of amount or considerate in terms of the terms of payment (spread out over years). Mitigation of the Deutsche Bank issue would steady the euro a bit and help ease dollar support, and provide certainty to financial markets likely leading stocks higher. The U.S. Federal Reserve might also offer some message on the importance of dollar stability, which might help financial markets see a way through this.

Or things could occur that offset dollar strength. Like, for instance, on Thursday morning when we heard China's exports were down by double-digit percentage in September. China weakness hurts the dollar because China's exports are seen as more relative to the American economy. Or, America might elect Donald Trump to be its president in November. The uncertainty of such a result would probably, due to popular perception both at home and abroad, cost financial market stability, the economy and the value of the U.S. dollar for at least the initial period of digestion of the new situation. The lasting impact will depend on the actions of the candidate who wins, and I expect risk may not be as high as many believe based on the campaign statements. Hillary Clinton has made some economically concerning statements as well, and all candidates do so for the sake of popularity, but few follow through on aggressive campaign statements. Think about how many new tax plans we have heard about over the years and never seen implemented. For instance, I expect you won't see free universal university education anytime soon.

Many believe the markets are pricing in a December Fed rate hike now, so further dollar strength might be limited post an actual action by the Fed, should it occur. There is too much time between now and then and too many possible disruptions that could occur to say for certain what the Fed will do in December.

The factors for and against dollar strengthening seem to be balancing somewhat at this point, especially due to the nearness of the presidential election. The dollar will likely see volatile swings depending on whichever factor is at play on any given day. Still, for as long as Brexit seems to be progressing, and for as long as the Italian referendum is ahead of us, dollar support is in place at least until the election or a shift in the polls.

In conclusion, watch the dollar for your cues on the forward performance of large multinational shares, especially those concentrated in the holdings of the Dow Jones Average. I would favor that funds that are dedicated to equity holdings be shifted in weighting from large multinational exposure into small cap value now. Otherwise, increased cash positioning is not a bad option for the very near-term (through the election) and alternative investments hold appeal. For my regular coverage of markets, I welcome readers to follow my column here at Seeking Alpha.

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