It is common knowledge that the percentage of earnings from overseas operations for large-cap stocks is substantially greater than that for small-cap stocks. The natural conclusion, therefore, is that small-cap stocks should perform better than large caps in a rising dollar environment. This logic makes sense, as the value of overseas earnings will be discounted by the stronger dollar. However, history says the opposite. During non-bear markets since 1985, whenever the value of the U.S. dollar Index was at 95 and rising, large-cap stocks outperformed small cap stocks. Coincidentally, the U.S. Dollar Index (DXY) closed at 94.99 this past Friday.
I think it is misdirected reasoning that causes investors to believe that small-cap stocks outperform large caps during a rising dollar. Yes, small-cap stocks have less foreign exposure, so their earnings will not be whittled down during the translation process. Yet many companies hedge their foreign currency exposure, so this becomes less of an issue. More important, in my view, is that international investors are looking to the U.S. and pushing up the value of the dollar. Today these investors are attracted to the U.S. for non flight-to-safety reasons. First, U.S. GDP estimates are being revised higher, while those for non-U.S. economies, on the whole, are being revised lower. Second, U.S. earnings are projected to advance by more than 5% this year, whereas many foreign benchmarks will be lucky to see any growth in earnings. Therefore, international money managers are attracted to U.S. investments for relative growth reasons. I think one can also conclude that these investors are probably less knowledgeable about U.S. equity opportunities than they are about the size and style sub-sets in their home country. As a result, they are more likely to stick with the highly liquid and well-known large-cap names than fish in a much less liquid and more obscure small-cap pond.
So there you have it. Even though the percentage difference between the U.S. Dollar Index and its 200-day moving average is uncomfortably wide (more than two standard deviations above the mean since 2008), and is likely to experience a counter-trend move in the near- to intermediate-term, we think the long-term trend of the dollar is higher as international investors look to the U.S. for more attractive investment opportunities. Currency hedging should minimize the effects that a stronger dollar would normally have on the translation of large-company earnings derived overseas. What’s more, foreign investors probably won’t add to their risk of going overseas (to them) by investing in illiquid and less well-known names by chasing after small-cap issues. Therefore history says, and we agree, that the S&P 500 and a majority of its sectors will represent a better investment opportunity in the months ahead than their smaller-cap alternatives.
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