What a Weaker Dollar Could Mean for Earnings

Why VIX weakness could translate into SPX strength

Senior Vice President of Research
Apr 27, 2015 at 10:23 AM
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"… many indexes -- including the SPX -- now face another potential short-term hurdle from round-number levels, including 18,000 on the Dow Jones Industrial Average (DJIA - 18,019.35)."
-- Monday Morning Outlook, February 16, 2015

"… the shorts have built up positions to the highest level since March 2014, perhaps driven by dollar strength and the resulting downward earnings revisions. We discussed the potential positive implications of the lower earnings expectation bar in last week's commentary … the fact is that the current sentiment backdrop favors another earnings-related breakout above round-number resistance levels."
-- Monday Morning Outlook, April 13, 2015

With the height of earnings season now upon us, and following the expiration of the "call wall" on April 17 at the equivalent of the 2,100 level on the S&P 500 Index (SPX - 2,117.69), the index again closed above the round 2,100 speed bump this past week. It is the SPX's fourth attempt since late February to sustain a move above 2,100. Despite the heavily advertised downward earnings revisions and expected negative earnings growth rate, the SPX is roughly 2% higher since the beginning of earnings season two weeks ago.  

Moreover, the round number that everyone has been focusing on during the past couple of months -- 5,000 on the Nasdaq Composite (COMP - 5,092.08) -- was taken out again last week, following multiple failures in this area that began in early March. In fact, there have been four consecutive closes above 5,000 -- doubling the two consecutive closes above 5,000 at the peak in March 2000, this past March, and earlier in April. After the COMP closed above its previous all-time closing high at 5,048 on Thursday, the 5,132 level comes into focus -- the intraday high on March 10, 2000.
Not to be forgotten, the Dow Jones Industrial Average (DJIA - 18,080.14) pushed higher, closing back above 18,000, after closing at year-to-date breakeven support the week before last. The DJIA remains locked in range, with sellers in recent months showing up at Dow 18K, and buyers flexing their muscle on pullbacks to the 2014 close in the 17,800 area.


With positive reactions running roughly 20% higher than negative earnings reactions, it appears uncertainty related to earnings season is slowly being alleviated. This may be one of a couple reasons why investors are less inclined to sell when these benchmarks hit key round-number levels.

"Higher Prices Fail to Salvage Profits: American companies struggle to offset damage from the strong dollar without hurting sales"
-- The Wall Street Journal (subscription required), April 23, 2015

As you can see from the headline above, dollar strength and its impact on earnings is still front and center on investors' minds.  But could this present headwind, as it relates to earnings, be a future tailwind?

Two graphs below point to potential dollar weakness in the months ahead that could be a positive for earnings looking into the future. The first chart below displays large speculator net long positions on the U.S. dollar. This data comes from the weekly Commitment of Traders (CoT) report. As you can see, the long dollar trade is crowded, with the net long position at multi-year highs.

But as you can see on the second chart, the U.S. Dollar Index (DX/Y) peaked in mid-March around the round $100 level, which is about the time that "strong dollar" talk was all over the financial media. And late last week, the DX/Y broke below its 40-day moving average for the first time since July 2014, which is when the dollar strength began.

While it is dangerous to call tops in a strong uptrend, it is possible amid the recent technical weakness that current long dollar positions will be unwound, putting pressure on the dollar and enhancing the odds of stronger-than-expected earnings in the future -- with analysts projecting a higher dollar in their earnings models.  

This development is certainly worth tracking in the weeks and months ahead. In fact, with the dollar weakening since March, crude oil futures -- which are denominated in dollars -- have risen, and energy stocks have rallied.  The energy rally has supported the broader market, despite the constant reminders we see about the risks to the market posed by lower oil prices.

 CoT report -- large speculators with multi-year high net long position, crowded trade
U.S. Dollar Index -- failure at round $100 level, followed by break of support at 40-day moving average (click to enlarge)

Finally, remember the numerous warnings early in the year that 2015 would be the year of higher volatility, due to the threat of Fed rate hikes, low oil prices, overseas political uncertainty, etc.?  Well, for what it is worth, the CBOE Market Volatility Index (VIX - 12.29) settling below its 2014 year-end close of 19.20 on Friday marks 57 consecutive days in which this volatility-expectation measure closed below its year-to-date breakeven point.  Since 1990, there have been only three prior instances in which the VIX experienced 50 consecutive closes below the prior year's close (1991, 1998, 2012).  

Per the table below, while in two of the three previous instances the market struggled in the short term (1-3 months), the SPX also went on to rally by a double-digit percentage into the rest of the year in two of the three instances, and closed higher the rest of the year all three times. This is a small sample size, but given the negative sentiment heading into this year, the implications for the rest of 2015 could look a lot like 1991 and 1998, as plenty of cash and short covering can drive the market.


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