Investment Strategies II – The Dollar and Corporate Profits

In my first investment article (, I argued that asset allocation strategies make no sense: don’t by a mix of hi-cap, low-cap, aggressive, etc. I also warned that you should not be late in getting back into equities since much of the rebound takes place in the first year. Unemployment is still rising so you are not late yet. In this piece, I will focus on two key investment questions: the future of the dollar and corporate profits.

The Future of the Dollar

This question is important. If the dollar increases in value, you want to hold dollar investments; if it loses value, you want to buy commodities or invest via other currencies. There is considerable misunderstanding on the meaning of the terms “inflation” and “deflation” how they relate to the dollar. Here are the key points:

In common parlance, inflation/deflation relates to the buying power of a currency (we will focus on the dollar) – deflation (prices go down) means the dollar can buy more; inflation (prices go up) means the dollar can buy less.

There are two elements that affect the dollar’s value, one domestic and one international:

  • Domestic if an economy (we focus on the US economy) is operating at full employment/full capacity utilization, increasing aggregate demand cannot increase production; instead, prices will be bid up – inflation. Today, and for the next couple of years, this will not be a problem for the US. The following table provides estimates from the Congressional Budget Office of both capacity under-utilization (GDP Gap – the percent below full capacity production at which the country is operating) and the unemployment rate for the next few years.

CBO Estimates

Item 2009 2010 2011
GDP Gap (Percent) -7.4 -6.3 -4.1
Unemployment Rate (Percent) 9.0 8.7 7.5

In these circumstances, increasing aggregate demand should result in higher production and lower unemployment; it should not result in domestic inflation (the value of the dollar falling relative to the goods it is used to purchase). Incidentally, at the end of March, the US unemployment rate was 8.5% (13.1 million out of work in a labor force of 154 million). At least on the unemployment front, things will get worse before better.

  • Global inflation the dollar could also weaken relative to other currencies. There are three pretty convincing reasons to expect this will happen:
  1. The Congressional Budget Office is now projecting Federal government deficits of  $1.7 trillion and $1.1 trillion for 2009 and 2010, respectively. The absolute size of these deficits is unprecedented. As a percent of GDP, they are 12.1% and 7.5% in 2009 and 2010, respectively. These percentages have only been exceeded during the Second World War. As I have indicated in an earlier posting (, it is unlikely the public and private market for US securities is large enough to absorb these amounts. As a result, the Federal Reserve will have to buy up a considerable portion of these deficits. The Fed will buy this debt with US dollars, thereby putting more dollars in circulation.
  2. The US trade deficit has come down somewhat this year, but it is still running near $700 billion annually. This means Americans are increasing the global dollar supply by that amount every year. In past years, this increase in dollars supplied to the global market has been absorbed by foreigners buying US equities and governments (most notably the Chinese and Japanese) buying US government debt. After the stock market collapses, foreigners are less likely to be eager purchase US stocks. And the Chinese government has warned it is increasingly uneasy about its large holdings of US Treasury securities.
  3. Since the global financial panic started, US dollars and other forms of US government debt have been extremely popular worldwide. The world does not believe the US government will renege on its debt. But as the panic subsides, the demand for US government debt should also fall, and this should mean a weaker dollar.

All of this should mean an expanded supply of dollars globally with no corresponding increase in demand. This should make the price of the dollar fall relative to other currencies and commodities – a dollar inflation. And if this happens, it is better to be invested in commodities or financial assets via other currencies.

One can argue that other countries are in worse shape than the US, e.g., Great Britain. But the absolute magnitude of the coming US government deficits is unprecedented.

Corporate Profits

We are in uncertain times. Nevertheless, there is still reason to believe that stock prices will in the future bear some relationship to earnings. The following chart provides price to earnings ratios for the Standard & Poor’s 500 stocks going back to 1936.

Until recently, price/earnings ratios have been in the 10 to 20 range. From 1990 on, they have been somewhat higher – mostly between 20 and 30. The spike to 60 at the end of 2008 was caused by the $23.25 earnings per share loss in the last quarter of 2008. That attests to just how bad the last quarter of 2008 was. Standard and Poor’s now estimates that for the 12 months ending September 2009, the S&P 500 will record a per share loss of $1.83, the first loss in index history. But note: a significant portion of those losses came from financial asset write-downs, and aside from the yet-to-come credit card losses, we are hopefully through most of them.

When we start looking ahead, what do we see?  The estimated earnings in the following table come from Standard & Poor’s. I have no idea of how accurate they are. But in the right two columns, I estimate P/E ratios using those estimates and using S&P 500 prices of $900 and 1,000, respectively (as I write this, the S&P 500 is at approximately 900).

S&P 500 Earnings and P/E Ratios

Quarterly PE Ratios PE Ratios
Earnings trail 12 mo. trail 12 mo.
Date Per Share @ 900 @ 1000
12/31/2010 $7.81 25 28
09/30/2010 $8.56 26 29
06/30/2010 $9.30 27 30
03/30/2010 $9.64 29 32
12/31/2009 $7.09 32 35
09/30/2009 $7.46 -492 -546
06/30/2009 $6.64 2,045 2,273
03/31/2009 $7.32
12/31/2008 -$23.25
09/30/2008 $9.73

Source: Standard and Poor’s

Take a look at the graph above. These are pretty high P/E ratios by historical standards. Certainly nothing about this exercise makes me feel I have to get back in the market today or tomorrow.

In my next posting, I will be specific on what my investments strategy will be in the coming months.

I am not an investment adviser and nothing I write should be taken as a recommendation to buy or sell an asset.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of
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