Strong Dollar Plays

By Matthew McCall | September 07, 2008 AAA

The breakout of the U.S. Dollar Index to a new one-year high has investors scrambling after the currency had been in a downtrend for the last seven years. This dollar index is measured against a basket of top traded currencies such as the euro, the British pound and the Japanese yen. Even thought the U.S. government has been proclaiming its strong-dollar policy for nearly a decade, the greenback has been drifting to new lows on a regular basis.

The policy has not changed, but the direction of the U.S. dollar has. After bottoming in March 2008, the U.S. Dollar Index moved sideways for four months as investors prepared for the next move to new lows. However, that was not the case; in mid July the index retested the March lows and began an explosive move higher. Over the next six weeks the index rallied an unprecedented 10% and is now trading at a new 52-week high.

Reason for the Rally
Everyone wants to know why a stock or index is moving higher or lower. Really there is no right answer to why, but there are plenty of opinions to go around. For what it is worth I believe there are a number of factors at work here and that the U.S. dollar has found a bottom for the near term. In my opinion the reason why the greenback has rallied recently has more to do with weakness in the euro than anything else. Due to the weakening economy in the Eurozone, the euro has taken a beating and thus propped up the dollar. Because the European economy appears to be in worse shape than the American, I believe more weakness in the euro will lead to higher prices for the dollar.

ETF and Small Cap
A weak U.S. Dollar will bode well for the U.S. multinational companies because sales overseas should grow at a solid pace and in this way the currency conversion works in favor of the U.S.-based company. For the last seven years my strategy has been to overweight the U.S. stocks that have a large portion of their sales overseas. With the change in the U.S. dollar, I will lower that exposure and put more emphasis on stocks that generate the majority of their sales here in the U.S.

When analyzing asset classes and the breakdown of sales, the small-cap stocks typically generated a large portion of their sales within the U.S. for numerous reasons. My investment for the small-cap sector is a broad-based exchange traded fund (ETF) that covers 2,000 stocks, the iShares Russell 2000 Index ETF (NYSE:IWM). Since the U.S. Dollar Index began rallying in mid-July, IWM is up 8% versus a gain of 1% for the S&P 500. (For more on how ETFs work, see Exchange-Traded Funds (ETFs)

The second ETF idea for a strong dollar is quite simple: an ETF that moves with the U.S. Dollar Index. The PowerShares DB U.S. Dollar Index Bullish ETF (AMEX:UUP) is the only ETF that offers investors direct exposure to the movement of the index. I am looking for potential entry into the ETF at the $24 area which was last seen in the beginning of September 2008.

Asset Managers and Exchanges
The two major exchanges are the NYSE Euronext (NYSE:NYX) and the NASDAQ OMX Group (Nasdaq:NDAQ). Both have suffered losses in 2008, however the Nasdaq has held up better and this may be due to the fact a smaller portion of its earnings come from overseas. According to a September 4, 2008 Jefferies & Company report, NYSE Euronext gets more than 70% of its operating profit from overseas versus 30-40% exposure for Nasdaq. Therefore, if you believe in the effects of the U.S. dollar, there could be a pairs trade possibility - buy Nasdaq and short NYSE Euronext. (To learn more, read Give ETF Pairs Trades A Chance.)

Over the last few years, stocks based overseas were more attractive to U.S. investors due to the currency conversion. Dollar-denominated assets and companies based in the U.S. are now becoming hot commodities due to the strengthening U.S. dollar. An asset management firm that has a strong presence overseas is Invesco (NYSE:IVZ). Nearly 40% of its assets under management are based overseas according to Jefferies & Company. Another positive for the stock is its ownership of ETF company PowerShares.

Strong Dollar Policy Good for America?
For years the government has been preaching that a strong dollar policy for the U.S. was a good thing. I guess they are right, but the weak greenback has also been very good to companies that export goods. Whichever side of the fence you are on, the bottom line is that fund flow allocations into the U.S. outpaced outflows in the second quarter of 2008 according to AMG Data Services. This hasn't happened since 2005 and you should be aware of how the strengthening dollar and demand for domestic assets will affect stocks.

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