“Favorable” Foreign Exchange

…is one way of saying that a weak U.S. dollar helps boost quarterly revenue and earnings. This observation is made by companies with significant international sales and who report financial results in U.S. dollars.

This is extremely important for equity investors using the S&P500 as their benchmark. According to Standard & Poor’s research, around 48% of S&P 500 company revenues are generated outside of the U.S.

So, one could argue that the weak U.S. dollar partially explains why the S&P 500 has done so well in the last six months. In March, the S&P hit its low of the year when the dollar hit its high. When you overlay a chart of the S&P500, which is now trading at a year-to-date high, with the U.S. Dollar Index (DXY), which is now trading at a year-to-date low, you will easily notice the inverse correlation.

The U.S. dollar was actually at lower levels for much of Q3 2008, which means it should have an unfavorable impact on year-over-year comparisons this year. However, most corporate managers assume stable foreign exchange rates when issuing guidance. As such, if the U.S. dollar weakened since the last time earnings guidance was issued, Q3 sales and earnings will be better-than-expected…ceteris paribus.

But based on the persistent divergence in stocks and U.S. dollar, this may already be priced in.

If you’re unwilling or unable to sell your internationally exposed equity positions and you’re concerned that a rising dollar could eat into earnings, then you may want to hedge your position by going long the dollar. You can do so with an ETF like PowerShares DB U.S. Dollar Bullish Fund (UUP).

Mega Millions Mentality

Last Friday, I did not win the $336 million Mega Millions jackpot. But I played. Sure, the chances of hitting the right numbers are only 1 in 175 million. Even if you hit the numbers, you may have to split the winnings. And this is all before taxes.

But how often are you presented with an opportunity to earn a 336,000,000% pre-tax ROI on a minimum investment of $1? And in the worst-case scenario, you lose a buck.

Obviously, playing the lottery is not a prudent investment strategy. But the mentality of taking unreasonable risks for unlikely returns exists in the stock markets. Consider bankrupt companies whose stocks are worthless. Lehman Brothers (LEHMQ.PK) hit 32 cents on August 31, just a day after trading at 5 cents. Motors Liquidation Company (MTLQQ.PK), formerly known as General Motors, traded as high as $1.20 on August 12. Each stock sees millions of trades every day. But neither is trading on fundamentals. Even if a company were to emerge from bankruptcy, the old common equity is almost always cancelled. In other words, the stock price movements of bankrupt companies are not signs of life; they’re more like postmortem muscle spasms during rigor mortis.

However, if you were savvy enough to buy low and sell high in August, you could’ve gained up to 700% on LEHMA and 140% on MTLQQ.

Then there are the stocks on government-sponsored life-support including Freddie Mac (FRE), Fannie Mae (FNM), and AIG (AIG). Even after significant declines in recent days, these stocks are up between 260-350% in just six months. However, many question the rationale behind these price moves. Some analysts have suggested the common equity in these companies could be worth nothing. Even the more bullish arguments for these stocks come with warnings of high uncertainty.

My favorite pitch goes like this: “FRE and FNM were $60 stocks two years ago! They’re trading at under $2 right now! I could see them at $10. But if I get $5, that’s still a pretty good return.” It’s an unsound argument but not unused. Structurally, it’s very similar to the rationalization that goes into buying a lottery ticket: limited downside and tremendous upside. And you have to pay to play.

Perhaps you’re disciplined enough to avoid irrational investment decisions. But it would be totally irrational to ignore the existence of irrational behavior in the markets. According to La Fleur’s World Lottery Almanac, Americans spend around $50 billion each year on lottery tickets. Surely this includes a lot of amateur and professional traders and money managers who are unknowingly bringing that mega millions mentality into the stock markets. They see tickers for FRE, FNM, and AIG go across their monitors. Some might also follow the pink sheet action of bankrupt companies. They know these are not good investments, but the allure of outlandish gains is irresistible, even if those gains are highly unlikely.


Full Disclosure: Author is long FRE and 1 mega millions ticket.

Cash For the Credit-Worthy

Cash for clunkers will not generate major incremental sales for automakers like Ford (F). Some of the 489,000 cars sold under the program were made by consumers who were already in the market to upgrade their vehicles. Some represent future sales that have been pulled forward. This sentiment is shared by J.D. Power and Associates, who recently boosted their 2009 auto sales forecast by 300,000 units, but cut their 2010 forecast by 100,000 units. This reflects a net gain of 200,000 over a two year period, during which 21.8 million cars are expected to be sold.

However, on a per dollar basis, cash for clunkers will be more effective in stimulating the economy than the 2008 tax rebate checks. While much of the tax rebates went toward paying down debt, the clunker cash is more likely to go back into the economy through personal consumption.

Consider those who are participating in cash for clunkers. If Jane Smith qualified for a $4,500 rebate and purchased a $15,000 Toyota Corolla, she has to make a $10,500 financial outlay. This is not a small amount of money. She is likely to take out an auto loan, which is only available to the credit-worthy. Furthermore, if she were in a tight financial situation, she would probably stick with her clunker, which is in driveable condition.

Jane is a confident consumer who won’t save that $4,500. She will spend it on a big screen TV, a family vacation, or a fancy dinner-all good for the economy right now.

This isn’t the only government program that rewards credit-worthy consumers who are likely to spend before saving. There’s also the $8,000 first-time homebuyer tax credit. The Wall Street Journal recently reported on a pending cash for appliance program. Again, this program will not provide a major long-run incremental sales boost to Whirlpool (WHR) and Electrolux (ELUXY). It just puts extra cash in the pockets of the customer, who can spend it on something else.

Obviously, I’m not happy that my tax dollars are going to people who don’t need it. But when it comes to economic stimulus, I prefer programs that reward the credit-worthy and encourage them to spend over programs that bailout the debt-laden.

The Emperor's New 787 Dreamliner

Boeing’s 787 Dreamliner was originally scheduled to fly in September 2007. Just a few days before the maiden flight, management announced what would be the beginning of a 2+ year delay. That’s long even by airline standards. In its five or six announcements—it’s hard to keep count—management blamed everything from a shortage of fasteners to incomplete software to a labor strike.

The latest delay was announced on June 23, 2009. Management said, “first flight of the 787 Dreamliner will be postponed due to a need to reinforce an area within the side-of-body section of the aircraft.” I’m not an aerospace engineer, so I won’t say how I really feel about that. Regarding first flight and aircraft deliveries, they said, “It will be several weeks before the new schedule is available.”

Several weeks later on July 22, 2009, Boeing announced their Q2 financial results. Regarding the 787, they said “The company expects to complete its assessment of the schedule and financial implications during the third quarter.” Not only have they delayed first flight, they have also delayed the new schedule for first flight. They also added that they recently completed “low-speed taxi tests on the first flight test aircraft.” I guess you learn to walk before you run…or fly. Again, I’m not an aerospace engineer.

At this point, I have lost confidence in management and I am only 99% sure that the Dreamliner will eventually get off the ground. While I think it would be risky to bet against BA stock at current levels, I would not recommend you buy it either. If that 1% disaster comes true, shares will take a Black Swan-style swan dive.

S&P 500's Stealth Earnings Growth

How can analysts expect S&P 500 earnings to grow from $49 in 2008, to $55 in 2009, and $74 in 2010? One explanation is turnover on the index.

Let's consider the impact of General Motors. According to data compiled by S&P's Howard Silverblatt on June 2, Q2 consumer discretionary sector earnings were expected to fall 75.6% year-over-year. This was due to the massive loss estimated for GM. But now that GM has been removed from the S&P 500, Q2 consumer discretionary earnings are expected to jump 36.6% year-over-year. It's clear how changing a constituent can have a material impact on the index's earnings estimates and valuations.


And GM isn't the only money loser that got booted from the index in the last year or so. Lehman Brothers, Freddie Mac, and Fannie Mae bled money for the S&P 500 in 2008, but they're not in the index today. This could at least partially explain the expectation for 300% year-over-year earnings growth in the S&P 500's financials sector in Q2.

Morgan Stanley and the Future of Research

The Financial Times recently reported Morgan Stanley tapped a 15 year old summer intern for some insight into "How Teenagers Consume Media." The introduction reads, "Without claiming representation or statistical accuracy, his piece provides one of the clearest and most thought provoking insights we have seen."

So, as the requirement to provide independent third party research expires in the next few weeks (Global Research Analyst Settlement), is this a preview of research to come? It's cheap (Hello, cost savings!), it has no statistical basis (Nassim Taleb would be proud), and it's independent (How corrupt could a teenager be?).

Of course, I don't really expect research departments to be taken over by high school kids. However, I do expect to see an increasing use of unconventional research. Surely, statistical study will reveal that conventional research made you very little, if any, money in recent years.

Religionomics

Here's a conversation topic you might not want to bring to the dinner table. (and I can't take credit for coining the term.)

On Tuesday, the Vatican published Caritas in Veritate (Charity in Truth), an encyclical of Pope Benedict XVI. Among other things, there is a need "To manage the global economy; to revive economies hit by the crisis; to avoid any deterioration of the present crisis and the greater imbalances that would result...," proclaimed the Holy Father. "For all this, there is an urgent need of a true world political authority...regulated by law, to observe consistently the principles of susidiarity and solidarity..." et cetera. And only a month ago, we were arguing that President Obama's financial reform plan would give too much power to the Fed.

As I see it, in order to establish a "world political authority", you need world agreement, which is another way of saying world peace. At the very least, world peace is a long ways off.

The Pope isn't the only renown religious figure to dabble in economic commentary. Famed ultra-conservative televangelist, Pat Robertson, annually makes a set of predictions for the year. On January 2, 2008, he claimed God told him that oil would rise to $150/barrel, the stock market would crash, and the world would enter a recession. But before you run to your nearest church, you should know that he doesn't have stellar track record of annual forecasts: Robertson predicted there would be a major terrorist attack on U.S. soil in 2007.

Obviously, the Pope and Pat Robertson are very different indeed. But despite the Protestant Reformation, the two spiritual leaders share some similar beliefs. For one, they are both opponents of abortion and contraception. And here's where our conversation gets freaknomic (to borrow a term from Stephen Levitt and Stephen Dubner).

Set aside your stance on abortion and contraception for a moment. In Irrational Exuberance, Robert Shiller notes:

"Advances in birth control technology (the pill was invented in 1959 and became widely available by the mid-1960s in the United States and many other countries) and social changes that accepted the legality of contraception and abortion were instrumental in lowering the rate of population growth, as were growing urbanization and advances in education and economic aspiration levels. Now the Baby Boom and the subsequent Baby Bust have created a looming social security crisis in many countries of the world: when the Boomers grow old and finally retire, the number of young working people available to support the elderly population will decline worldwide."

In other words, contraception and abortion are taking taxable individuals out of our future workforce.

But Shiller's point may be an oversimplification. More people could mean more unemployed. Also, anyone who read Freakonomics could tell you that Stephen Levitt has long argued falling crime rates can be traced back to the legalization of abortion due to Roe v. Wade in 1973.

I won't try to get to the bottom of any of the issues mentioned above. The point I'm trying to make is that economics, religion, sociology, et cetera, are not mutually exclusive. Social and religious choices are not without economic consequences. It's popular for young people to claim that they are social liberals/economic conservatives. But even that distinction doesn't get rid of the highly contentious political gray area.