Pack the bags, kiss the grandkids, it’s time to do some traveling!!! Maybe to Europe?
From a global perspective, for those whose wealth and income is generated in US dollars, you can arguably buy more with one US dollar today than at any other time in the past 12 years, according to a popular index that measures the value of the dollar versus a basket of other currencies. Expectations are being ratcheted up for impending interest rate hikes by the Fed, and this means that assets are flying into US greenbacks from all over the world. The dollar is strengthening against the euro, the pound, the loonie, the aussie, the rand, and the list goes on and on.
This decade may mark a time of unprecedented wealth for Americans. The US economy has probably never been stronger. Though under-employment is a concern, unemployment is at full levels of ~5.5%, corporate earnings are strong and expected to continue to expand, and input costs have fallen considerably. Crude oil prices have settled in the mid-$40s, down from over $100 per barrel just a few short months ago, and iron ore prices have been halved as miners work through a global supply glut. The strengthening dollar is in part why dollar-denominated gold prices have collapsed. The thesis of the dollar being replaced as the world reserve currency can almost be thrown out the window in light of recent developments, if the somewhat “doomsday” view made any real sense in the first place.
But what does all of this mean? This is a great question, and how to address the topic continues to be of great debate among our team. Though it is commonly accepted that as the US dollar strengthens, dollar-denominated commodities such as crude oil prices are expected to continue to fall, the answer is more complex in relation to equity valuation. Through most of the past decade, currency movements have been relatively muted, and we’ve generally held the opinion that long-term investors should be basing investment decisions on the operating aspects of a company, not on currency movements, which may be impermanent and can effectively be hedged away via financing decisions, if desired.
In stock valuation, what we’re primarily after is assessing the entity’s normalized operating earnings, which are largely independent of currency movements. Because they can be hedged away, currency considerations are a financing dynamic, independent of the operations of the business, and as a result, should not represent a key driver behind an entity’s long-term intrinsic worth. Furthermore, it is widely-accepted that earnings expectations over the next year or two, the time period that may be most impacted by any change in currency pairs, represent a minor fraction of the total intrinsic value of an entity, whose value hinges more on its nature as a going-concern (i.e. intermediate and long-term expectations, or the stage II value and the perpetuity value in the model). This makes sense, as once currency pairs are “reset” in the near term (if they do not revert back), changes in the out-years may again be muted.
Though our view on this topic may be somewhat resolute, we maintain the long-held assessment that it makes little sense to tie a company’s fair value estimate, which is based on future free operating cash flows over the long run, to short-term changes in currency pairs, which vary every single day and can be hedged away via financing transactions. The US dollar has strengthened so rapidly against other currencies across the globe, however, that it has become difficult to ignore the topic. In fact, the reported unadjusted earnings of multi-nationals may continue to be negatively impacted, and some may experience pain far worse than originally expected. In this context, it can only be assumed that in certain cases share prices will face pressure.
But in the context of valuation, such dynamics are near-term considerations that may even potentially reverse themselves in the future, if not during the first phase of our enterprise free cash flow model (over the next five years) than likely during the second phase (which extends through year 20). Some minor adjustments may be required in certain cases, but we wouldn’t expect to make any material changes to our valuations of companies solely on the basis of the strengthening dollar. The preponderance of news headlines on the topic won’t abate anytime soon, however.
The challenge in communicating stock market dynamics today has probably never been more difficult. With almost every edition of the newsletter, released on the 1st and 15th of the month, we find ourselves either addressing the prospects of the market making new highs due to a resilient US economy and the technical support that follows, or addressing concerns over the Fed raising interest rates and the various recessions that ultimately follow or operate coincidentally with a credit tightening environment. We’ve also addressed the tipping point that might occur with respect to dividend growth investors swapping into other higher-yield instruments, should yields become incrementally more attractive as a result of rate hikes.
The market today is incredibly difficult to explain to the individual investor. On March 12, for example, news was released that February retail sales fell for the third consecutive month, coming in weaker than expected. But instead of investors focusing on the implications of this news on forward-looking operating cash-flow dynamics (a negative), the market rallied considerably because such “bad” news may mean the Fed will not start the long-anticipated rate-tightening cycle. Continued accommodative policy means that discount rates within the valuation context, which are based on the 10-year Treasury, are then muted, and by extension, valuations, which are arguably already stretched, are reinforced. Hence, we had a rally.
How can we explain to the investor that “bad” news is sometimes “good” news and have them take us seriously? We’re trying. We don’t want to whipsaw you around. In fact, this is the last thing we want to do. Instead, we’re trying to explain the unusual, complex dynamics that have the market in a stranglehold at current levels.
The long-term technicals of this market following a 6-year bull run can almost be considered extended, by definition, even if in the near term we still look okay. But we’ve tripled off the March 2009 panic bottom and only had one 10% “correction” along the way! We simply can’t ignore this fact. From a valuation standpoint, the S&P 500 looks overpriced, in our view, but that doesn’t mean that stocks can’t continue to become even more overpriced. This is one premise of the Valuentum strategy, or even the value strategy – that stocks can and do become both underpriced and overpriced. It’s a natural part of the markets.
What are we doing now? We’re letting our winners run, and we’re not chasing ideas that are trading at an irrational 25 times, 30 times forward earnings or more – no matter how much we like their business models or growth prospects. We’re going to capture the last fumes of this bull market, because if we don’t, we’d look silly. We remember how Warren Buffett felt when he was left out of the dot-com boom, but he had the last laugh. Similar to the Oracle of Omaha, we’re not going to lead members head-first into disaster. We’re going to be smart, and we’re going to lay out all of the risks. We always strive for balance in our writings, and nothing should ever come as a surprise to our readership. Sometimes, we are too diligent and too prudent in our process (if there is such a thing), and this can scare some members away from the markets entirely.
But that’s just a risk good research firms take. We want our members to be successful.
Related tickers: UUP, FXE, FXB, FXC, FXA, GLD, SLV, BHP, RIO, VALE, USO