Sunday, August 17, 2008

The Dollar, Oil and Equity Prices

(I originally posted the following article on The DIV-Net website on August 10, 2008.)

Many critical factors are having dramatic moves of late that could impact the future direction of stock prices. In this article I will address factors an investor should consider as a result of declining oil prices and a strengthening dollar. Several weeks ago I did post an article on my blog dealing with the potential currency impact for international investments titled, Be Aware Of Currency Impact With International Investments. Below I will look at factors that will impact U.S. firms.

The price of a barrel of oil reached nearly $150 in early July. Fast forward to today and the barrel price of oil is around $115. This represents a 23% decline in per barrel oil prices in just one month. From my perspective, one does not see price moves of this magnitude unless speculative investing was a part of the recent rise in oil prices. With respect to the dollar, a peak in dollar weakness seemed to be reached in early July when one Euro was equal to 1.59 U.S. Dollars. Over the course of the last month the Dollar has experienced significant strengthening closing at 1.50 dollars per Euro on Friday. Why does all of this matter?

As one evaluates the attractiveness of potential investments, attempting to understand the impact macroeconomic factors such as changes in commodity (oil) prices and currency are important. Unfortunately, the outcomes are not black and white.

As the below chart details, oil and the S&P 500 Index seemed to be highly correlated from early 2007 through August of 2007. However, from late 2007 through July 2008, oil and the S&P 500 Index seemed to have a high negative correlation.

(click on chart for larger image)

oil and S&P 500 index stock chart August 2008
Is it possible that oil was at such an extreme over valuation that its negative impact to company input cost caught some firms unprepared. If so, the reduced level of oil and related energy inputs could have a strong positive impact to future earnings growth. This would be a positive for multinational firms that could be facing a headwind due to increasing strength in the U.S. Dollar.

As noted earlier, the dollar has strengthened against the Euro over the course of the past month. As the below chart portrays, a weak dollar (upward sloping red line) and a rising S&P 500 Index seem to go hand in hand. What could be partially at play here is the fact companies in the S&P 500 Index generate a large portion of their earnings (over 40%) from international sources and this has been growing. A weak dollar provides a positive earnings boost to U.S. companies as they convert foreign earnings back into the U.S. Dollar.

(click on chart for larger image)

US dollar and S&P chart August 2008
If a weak dollar is good for U.S. stocks, then the recent U.S. Dollar strength will likely serve as a headwind for U.S. multinational firms. The offset though, and I think this could be a stronger influence, is the reduction in oil and other commodity costs. Reduced commodity inflation will benefit company earnings via reduced cost of sales. Also, lower commodity prices will take the pressure off of inflation and stimulate more positive consumer sentiment.

Undoubtedly, there are many more factors that will impact stock prices, interest rates, the real estate market, etc.; however, getting a handle on the oil and currency impact to company earnings will go a long way in accurately forecasting future earnings growth. Keep in mind though, some companies have aggressive currency and oil hedges in place in an attempt to mitigate the volatility these price swings have on corporate financial results. Reading company 10-Qs and 10-Ks will provide more insight into some of these factors.


The Dollar-Euro Exchange Rate and U.S. Stocks
CXO Advisory Group
October 17, 2007

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