Trends are the lifeblood of long term investors. The longer and more powerful the directional trend, the more money that can be made. Riding powerful trends is one way long term investors profit from the financial markets.
Another way trends are used to earn profits is from inter-market relationships. An inter-market relationship means how one financial market affects another market.
One common and well known inter-market relationship is the bond market and the stock market. The general rule of thumb is that these markets are correlated. This means that when bond prices start to fall, the stock market is soon to follow. This doesn’t happen 100% of the time, but it happens enough to be as close to a sure thing that is available in the financial markets.
A Powerful Trend
The most powerful and long lasting trend across all financial markets right now is the rise of the U.S. dollar.
While the U.S. dollar has been on an upward tear since 2011, the real upside acceleration started in May 2014. As you can see from the chart, the 200 day moving average was violated in August 2014 and the greenback just exploded higher from there.
The U.S. stock market is particularly sensitive to a strong U.S. dollar. The general consensus among financial experts is that the dollar is inversely related to stock prices.
The Negatives to a Strong U.S. Dollar
Powering the USD higher is an international flight to economic safety. Basically stated, investors around the world are buying U.S. dollars as a means of security due to the unstable nature of the European and Asian economies. This widespread buying tips the supply/demand equation which forces the dollar higher.
As you can see, this chart from Jones Trading, illustrates that overall stocks have been inversely correlated to the U.S. dollar for the last 15 years.
If you look closely at this inverse relationship, the reasons become clear. The number one reason that a strong dollar means weaker stocks is the fact that many companies rely on foreign sales to enhance their profitability. When the USD is strong, this means lower profits due to the need for currency conversion between the dollar and the euro or other currency.
Lena Komileva, chief economist at G-Plus Economics in London explained the USD surge higher this way,
“ U.S. dollar strength reflects rising international systemic risk rather than cyclical normalization in global economic conditions.” She went on to add “The dollar’s rise has become a symbol of the de-globalization of capital and rising credit market distress and financial volatility, rather than a sign of U.S.-led normalization in global yields.”
The Benefits of a Strong U.S. Dollar
Now, certainly there are some positives to a strong U.S. dollar for stocks. Despite being a major drag on earnings, the strong USD attracts foreign investment. This helps counteract the reduced earnings headwinds in the stock market.
Another analyst, John Krey from S&P Capital IQ told CNBC, “Anticipated trends among major currencies in the global foreign exchange market should proceed to move decidedly to the advantage of the U.S. unit at the expense of the euro and U.K. pound in the months immediately ahead.”
Many other analysts believe that we are in the midst of a long term bullish super cycle in the U.S. dollar. This means that the greenback could continue to climb for years. Based on the growing U.S. economy and interest rates about to climb higher, the odds are very strong that the upward trend will continue long into the future.
How Can I Use The Super Cycle To Profit?
Fortunately, stocks are not equally affected by the strong dollar. In fact, some seem to benefit, or at the very least, are insulated from the bullish super cycle in the U.S. dollar. These are the stocks and sector that investors should concentrate.
The best way to discover the sectors or stocks that benefit from or are protected from the climbing U.S. dollar is to screen for outperformance in the midst of the roaring dollar bull market.
A rudimentary screen of stocks makes it clear that biotech’s and small caps have thrived during the surge in the greenback. The move upward has been truly astounding.
The iShares Nasdaq Biotechnology ETF (IBB) has climbed over 20 percent over the last three months. This index is made up of 150 stocks. Over 60 of these companies have more than doubled from their 52-week lows. Seventeen of the stocks are up more than 50 percent, while just 28 (19 percent) are down on the year.
As you know, at TradingTips, we love biotech stocks right now. This is another strong support for this bias.
Art Hogan, chief market strategist at Wunderlich Securities told CNBC
“We have priced in bad news of the stronger dollar, but we haven’t priced in the good news of the stronger dollar.”
He went on to state,
“There is some selectivity going on. This is a stock pickers’ market. The negative impact of the strong dollar (is not affecting) the S&P small-caps and the Russell 2000; it is a very domestically focused strong dollar play.”
The reasons that small caps and biotech’s are insulated from the strong dollar are twofold.
First, Companies with smaller market capitalizations, such as the average $1.3 billion for Russell 2000 components, tend to concentrate their business domestically. This results in currency fluctuations being largely irrelevant.
Secondly, the strong dollar lowers import costs for firm that are focused on serving the U.S. market. This means that the company’s costs drop, thereby working to increase the bottom line.
Most interestingly is the fact that small cap and biotech’s have the highest price/earnings ratios with some above 20X earnings. At the same time, these stocks are up by 40% in the last 52 weeks.
Now that it is clear that the climbing greenback helps or at the very least doesn’t affect biotech’s; what is the exact course of action an investor should take to profit from the trend?
Conservative investors who are looking to take a bite of the biotech pie would be well served to consider the iShares Nasdaq Biotechnology ETF (IBB).
This ETF provides investors with the needed diversification across the biotech space. Due to the extreme volatility of biotechs, having the built in diversification in the ETF should create a smoother equity curve.
IBB is higher by over 40% in the last 52 weeks.
The top five holdings of the ETF are as follows:
If you are more risk oriented building your own portfolio of one or more biotechs is the way to even higher profits. To be sure, concentrating your biotech exposure in just a few names is very risky. The good news is that the upside can be huge.
Bullish news is pouring out of individual biotech’s. The largest allocation in the IBB ETF, Biogen (Nasdaq:BIIB) just announced strong results from its Alzheimer’s drug. In addition, Celgene (Nasdaq:CELG) is expecting continued lucrative sales of its cancer drugs. Other leading biotech names are on fire. Examples include Regeneron (Nasdaq:REGN) with the eye drug and Gilead Sciences (Nadaq:GILD ) with its hepatitis C product.
The Key Takeaway
We expect the dollar bull to continue over the next several years. The strong dollar usually hurts large cap stocks that have international exposure and operations. Small cap stocks and biotech’s, in particular, can benefit from, or at the very least, are insulated from the surging greenback.
Investors should look to add biotech’s and small caps to their portfolio to ride the trend higher. While individual names can offer outsized rewards, the risk level remains high. If you are willing to accept the risk, this is the way to go. More conservative investors who still want exposure to biotech’s are better served with the IBB ETF.