The dollar's recent strengthening against other major currencies may have slowed, but it has not stopped -- and it has certainly not reversed course. As we have seen with the Fed's quantitative-easing program, the results of a massive shift like this do not always show themselves immediately. And the shift has been massive. Below is a chart reflecting the dollar's relative performance against the euro and the Japanese yen over the past six months:
Six percent may not sound like much -- but consider that, over the four years prior, the greenback had been losing value in relative terms:
We are now seeing downside surprises on both earnings and guidance from U.S. blue-chip stocks such as Boeing (BA), Coca-Cola (KO), McDonald's (MCD) and IBM (IBM). Now, these are still U.S.-based companies -- as of this writing, anyway -- that do a huge portion of their business outside the U.S. You have to believe the strong dollar has impacted their overseas results. It's not just downbeat numbers and guidance that cause stocks and sectors to fall, necessarily. It's the element of "surprise" to the downside that creates added (and often irrational) selling pressure.
If large U.S. companies have the capability to issue surprisingly poor numbers and guidance -- and if we are comfortable assigning blame to a strong dollar -- is it possible the opposite holds true for their European competition?
Yes, we are hearing about how the eurozone and even its strongest player, Germany, are on the "verge" of recession. That sounds pretty bad. Just the word "recession" has a negative connotation, especially among men. A recession simply means that the gross domestic product (GDP) of a region shrank a little bit, either over the most recent quarter or year. OK.
The Silver Lining of Downbeat Expectations
Good entry points into stocks or funds do not tend to coincide with known, clear, positive catalysts. Of course, as investors we want to know what could go right, just as we want to know what could go wrong. Securities become priced attractively when nobody wants them -- when the general consensus is that there is "just too much risk" right now. Is there more risk in European than U.S. stocks right now? If so, why?
To me, risk means potential downside, and from current levels I see more opportunity for upside surprises than I do for further share-price depreciation. Here's why.
1. Favorable foreign-exchange conditions could lead to a more positive picture for European companies than many are expecting. Below is a chart reflecting the price of the Vanguard FTSE Europe ETF (VGK) overlaid with the CurrencyShares Euro ETF (FXE), an index reflecting the eurozone currency's strength (or lack thereof).
You ought to be able to see a direct correlation between the FXE taking a dive and a short-term bottom forming for VGK shares. Maybe European companies aren't growing as quickly as investors would like, but a weakening currency may serve as a counterintuitive catalyst for slow, or slowing, growth.
2. European stocks are priced for (almost) the worst-case scenario. They are priced for recession, not depression. While it is certainly possible, if not unavoidable, that another global depression will materialize at some point in our lifetimes, it is extremely unlikely today due to global central-bank coordination. There is a current level of interconnectedness, if not codependency, among major economies that we've never seen before. It is literally in the U.S.'s best interest that the world's other economic powerhouses are growing, and vice versa. Why not buy the cheapest one with the best yield? At today's valuations, VGK pays an annual dividend of 4.52% -- more than twice that of the 10-year U.S. Treasury bond, and 50% more than a 30-year U.S. Treasury.
To say the least, it is unlikely that an investment today in Treasury bonds will be worth more than a basket of high quality, large-cap European stocks over the next decade.
3. U.S. companies could -- and probably should -- go on a European shopping spree, snapping up competition at rock bottom prices. So far we've only heard about such deals for the sake of tax inversion. But U.S. corporations are as fiscally healthy as ever, and such moves might make a lot of sense, especially with their easy and inexpensive access to U.S. debt markets. This could do quite a bit to pump up valuations across Europe.
4. Last is the most obvious, and most talked about, but also perhaps the most underestimated -- stimulus. European Central Bank (ECB) President Mario Draghi's promises are starting to feel a little "boy who cried wolf"-ish. But what if one of these rounds of stimulus actually has the intended effect? Thus far the efforts have simply been too small, but it appears Germany may be recognizing that it needs to concede to some non-austerity measures for its own sake.
We admit that we have been early on this call so far: We put on half positions back in September, and these are now down about 10%. However, we added the second half last week. The yield is juicy, and we believe the current risk-reward story is compelling.