The MF continues to be weak, which tells us that the bounce was mostly technical, with large players on the sidelines.
The sectors that saw the strongest money outflows Friday are related to energy and commodities, which can be attributed to a strengthening US$. However, the S&P500 gained 20 points!
With this in mind, and knowing that a good part of the S&P500 stocks are commodities related (XLB, XLE,) why is the market not anticipating the negative impact of a strong US$ for the coming earnings season?
The US$ has increased by more than 8% in the past three months compared with a basket of currencies. McDonald's, for example, expects a hit to EPS of $0.25 every time the US$ increases by 10% against four major currencies. This implies a decrease of 4.5% compared with last quarter earnings. In the past 90 days, MCD's estimated earnings have decreased by $0.24. So, this might be priced in already.
What about the estimates of some of the large S&P500 companies? We can see that many are being revised down.
The S&P500's international sales are estimated to make up 40%-45% of total sales. With this in mind, I would not be surprised that for this quarter, S&P500 companies' earnings fall short, on average, by about 1.9% because of the strong US$. Going forward, will the market anticipate more US$ strength in subsequent quarters? How will equities react?
Is this already priced in? If it was priced in already, then the S&P500 should have declined.
Look at the gold miners, for example: investors clearly expect gold to continue its downtrend because the US$ is expected to strengthen, and consequently, this affects gold miners, which are under heavy selling pressure. The bad news is already priced into the gold miners! But I believe that the consequences of the rise in the U.S. dollar -- both past and possibly future -- are not fully discounted in equities yet.
As a matter of fact, between July 1 and last Friday, the S&P500 lost only 0.27%, but the US$ gained 8.53%. I believe that we could be shocked in the next few weeks by many earnings misses or negative guidance attributed to a strong US$.
I performed some research on the US$/S&P500 correlation, which stands at a negative high value of -0.58. We can see below that large S&P500 corrections have been linked to a stronger US$. This is logical: when in a correction, equities are sold against cash.
Seldom do we see an increase in the US$ - which by definition directly affects export-oriented companies and the statement in US$ of earnings produced abroad - that does not weigh on equities. We can see below that we have experienced extreme inversed moves (blue zones) where the S&P500 plunged and the US$ jumped, or the opposite. However, there is no example of a strong US$ together with a neutral or a strong S&P500. This is a first since July 2007. This tells us that the currency elephant has entered the equities china shop.
This is telling us that we are in a "regime change." Indeed, we can see that since 2007, the S&P500 monthly variations have substantially decreased. The same pattern can be seen in the monthly variations of the US$. The only difference is that in the past quarter, the US$ variation has been an outlier because of the Euro weakness. I believe that this is telling us that volatility is about to come back to the US equities markets. This will be justified on weaker than expected guidance which will point to the impact of a strong US$ and the end of QE.
Conclusions:
Either stay in cash or go short during the earnings season.
