Stronger greenback has investors rethinking U.S. exposure

Not sure what U.S. stocks to play now that the U.S. dollar is rising? You may want to consider telecoms, utilities and financials, among others, according to a study done by Merrill Lynch & Co. Inc.

Those sectors are overrepresented among the industries that depend on the U.S. market for their sales, rather than offshore markets.

It makes intuitive sense that stocks with purely domestic sales might outperform those with substantial foreign exposure when the greenback strengthens, and work done by Savita Subramanian, a quantitative strategist at Merrill, shows that is indeed generally true. "We confirmed that there is a very strong relationship between the dollar and the subsequent performance of stocks with pure domestic sales," she said, looking at data going back to 1995.

But U.S. stocks with a pure domestic focus didn't wait for the dollar to rally. They outshone last month by 1.8 percentage points, possibly in part because of expectation of the greenback's rally. And they are doing well this month.

Her work also found that stocks with pure domestic sales benefit more from a strengthening dollar than those that depend on foreign sales. The reason stems from the fact that some companies are better hedged than others, Ms. Subramanian said.

The performance data suggest some investors may want to rethink their strategy. Over the past year, investors have generally done well by zeroing in on U.S. stocks that had heavy foreign exposure, thanks in part to what was then downward pressure on the U.S. dollar and the impact of that on those firms' profits.

But times may be changing.

The U.S. dollar has been climbing since mid-July against the euro. At that time, one U.S. dollar was worth €0.628. Yesterday, it stood at €0.6755, helped by increasing worry about spreading economic weakness, particularly in Europe, and a feeling that the greenback is undervalued.

(A survey of global fund managers conducted by Merrill Lynch earlier this month found 68 per cent of respondents felt the U.S. dollar was undervalued, a factor that is contributing to the increasing appeal of U.S. assets to foreign investors. Just 10 per cent thought it was overvalued.)

A strengthening dollar can have an impact on industries' earning power, some much more than others, Ms. Subramanian noted. The industries whose profitability was helped by a strong dollar over the 12 months following the dollar strengthening include pharmaceuticals, food products, insurance, household products, tobacco, commercial banks, gas and electric utilities, and food and staples retailing.

Conversely, those hurt by a strong greenback include machinery, chemicals, semiconductor equipment, electronic equipment and instruments, metals and mining, oil and gas, and consumable fuels.