Forget Earnings. Watch Currency!

In the past few days we have received better-than-expected 1Q earnings reports from Walmart, Home Depot, and Lowe’s. The late reports from these and other retailers (the fiscal 1Q at retailers generally ends in April rather than March) round out a strong first quarter earnings season for the types of large, multi-national blue chip companies that we favor at Farr, Miller & Washington. By and large, big blue-chip companies are executing well and have very strong balance sheets. In fact, the debt of several large-cap US multi-nationals is yielding less than like-duration US Treasury bonds. This is the first time in history this has happened. So why are the stocks of large-cap multi-nationals so cheap, and why are they lagging the broad market?

“Greece is the word.” Actually, Europe is probably the word, but it doesn’t rhyme so well in the song. As the European Central Bank (ECB) tries to collect itself and figure out how to prevent a Lehman-like meltdown in sovereign debt, investors are scrambling to protect themselves from losses in the event of a worst-case scenario. Yesterday’s plunge in the Dow Jones Industrial Average was in tandem with a rally for the dollar to $1.22 vs. the Euro. As that currency rally reversed, stock prices began to climb from a 184 point loss to a very small gain. The recent market message has been stronger dollar = weaker share prices.

If that seems counter-intuitive, you’re in good company. The rationale, as we understand it, is that dollar strength correlates to Europe’s weakness. Dollar strength, therefore, represents a flight to safety from weaker currencies. As bad as our rising deficit and growing debt may be, the US looks less bad than alternatives. That’s not a resounding endorsement by any stretch, but water is precious in the desert. Stock prices are unhappy because European austerity measures combined with a debt crisis stifle hopes of a vigorous global economic recovery. That makes Europe a weaker customer for US goods and services. The stronger dollar makes US goods and services more expensive for all of our trading partners and therefore threatens to further skew the trade deficit.

The headline on Bloomberg this morning is Stocks Rally, Oil, Copper Rebound as Concerns Over European Debt Subside. There is no mention of strong earnings gains. Based on the corporate results posted to date, including those from HD, LOW and WMT, it appears as though the economic rebound is on track. However, the European debt issues, as well as lingering problems in the US housing and employment sectors, warrant continued caution going forward. Walmart CEO, Michael Duke said that “customers, especially in the US, are still concerned about personal finances and unemployment.” And the 1Q sales strength at HD and LOW (relative to expectations) can at least partially be attributed to government stimulus initiatives and better weather. Lowe’s CEO Robert Niblock said, “We’re optimistic we’ll continue to see solid sales through the balance of the year with gradual improvement in core demand, but we still view 2010 as a year of transition for our industry, and it will likely be 2011 before we see significant growth,”

Faithful readers may recognize consistent themes from our weekly commentary becoming manifest in these recent reports. The growing importance of international demand supports our long-held argument in favor of large, blue-chip multi-national corporations. Our portfolios maintain a defensive posture, and earnings news for theses types of names has been very positive. Stay the course, and fight the temptation to lean too far over your skis.

Hang in there,