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Stock Market Fights Tug-of-War Between Earnings, Valuation

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Wednesday, 14 Feb 2018 08:07 AM Current | Bio | Archive

What about the dollar? It has been weak since early 2017.

The good news is that should boost S&P 500 earnings. The bad news is that it might revive inflationary pressures. If so, then Jerome Powell, the new Fed chairman, might feel compelled to normalize monetary policy more aggressively than did his predecessor, Janet Yellen.

The stock market seems to have entered a tug-of-war phase in recent weeks between a very bullish outlook for earnings and a potentially bearish outlook for valuation multiples.

The multiples took a dive in early February on concerns that inflation may be heating up, forcing the Fed to raise rates more aggressively. The resulting rise in bond yields has weighed on P/Es as well.

Debbie and I track three measures of the trade-weighted dollar. The Fed compiles two daily series of the “major” and the “broad” trade-weighted dollar (Fig. 1). They tend to be reported with a lag of a few days, so we also track the more timely JP Morgan broad measure of the dollar (Fig. 2). The two broad measures start in 1995, while the Fed’s major index starts in 1973.

Dollar bulls have been surprised by the weakness in the dollar since early 2017. They were expecting that it would continue to strengthen given that the Fed was gradually normalizing US monetary policy, while the ECB and BOJ remained committed to their ultra-easy monetary policies. What they missed was that the JPM dollar index had already appreciated dramatically, soaring 26% from a 2014 low of 99.89 on July 1 to a 2017 high of 126.21 on January 11.

What they also missed is that the foreign-exchange markets were starting to discount a rebound in global economic activity outside of the US. Debbie and I previously have shown that the trade-weighted dollar is inversely correlated with our Global Growth Barometer, which is simply an average of the CRB raw industrials spot price index and the price of a barrel of Brent crude oil (Fig. 3 and Fig. 4). We figure that commodity prices are the most sensitive, real-time indicators of global economic growth.

We agree that a weak dollar should boost corporate earnings. However, strong global economic growth is much more important for boosting earnings. Both together is even better, especially since they often do go together. Adding a major cut in corporate tax rates puts this bullish scenario for earnings on steroids, as Joe and I discussed yesterday. Debbie and I aren’t convinced that the bullish scenario for growth and earnings has to cause trouble on the inflation front. Consider the following:

(1) The dollar, revenues, and earnings. There is a relatively strong inverse correlation between the yearly percent change in the dollar and S&P 500 revenues (Fig. 5). That’s not surprising since nearly half of S&P 500 revenues comes from abroad. So in theory, the 8% y/y drop in the dollar should boost revenues by 4%. In practice, there is no such simple rule of thumb since US companies must pay more for the imported goods they use. All we can say with some certainty is that a weaker dollar tends to be good for the revenues of US companies.

The same story applies for S&P 500 forward earnings growth on a y/y basis. It is also inversely correlated with the dollar (Fig. 6). Again, there is no simple rule of thumb that can easily translate a given percentage drop in the dollar to a percentage increase in earnings.

(2) The dollar and inflation. The relationship between the value of the US dollar and inflation in the US is even fuzzier. There is a fairly loose inverse relationship between the yearly percent change in the dollar and the yearly percent change in the US import price index excluding nonpetroleum imports (Fig. 7). In turn, there is a weak correlation between the latter and the yearly percent change in the PPI for finished goods excluding food and energy (Fig. 8).

(3) The dollar and the Fed. The dollar did rise sharply after the Fed started to normalize monetary policy at the end of October 2014, when QE was terminated (Fig. 9). It had already started moving higher during the summer of that year in reaction to the drop in the prices of oil and other commodities. It basically made a top following the Fed’s first post-crisis rate hike at the end of 2015. That’s because the prices of oil and other commodities troughed in early 2016.

After falling in early 2016, the dollar slowly recovered, then jumped above its high at the beginning of the year on Trump’s Election Day victory. It is now down 9.8% from its peak at the beginning of 2017 despite four Fed rate hikes since Trump’s win.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
The stock market seems to have entered a tug-of-war phase in recent weeks between a very bullish outlook for earnings and a potentially bearish outlook for valuation multiples.
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2018-07-14
Wednesday, 14 Feb 2018 08:07 AM
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