I read an interesting call today from Toro about shorting the Euro off the top he believes the currency has set against the dollar, and – if he’s correct – there are plenty of side effects with important applications to the equity markets. He notes estimates that the purchasing power parity value of the dollar is $1.10-$1.20 against the Euro, and that the large differential on the short end of the yield curves between the US and Europe should converge as the ECB loosens.

Given how everyone and their mother has been short the dollar, a reversal in that trade would create a dramatic shift in the markets not only because of all the other trades that are associated with it (i.e. long commodities), but because currency changes have actual macroeconomic impacts. The dollar strengthening against the Euro would put even more pressure on commodity bulls to keep prices elevated, especially if the dollar rally isn’t caused so much by an economic resurgence stateside as it is by economic weakness across the pond. Depending upon how other sectors are acting, this could set off a crucial leadership shift away from basic materials, which would suddenly be on the wrong side of the macro trade. Where this money would flow is another question – tech tends to be a combination play on an early-cycle economic recovery, as well as a weak dollar – so I might have to revise my view of that should the Euro continue to decline. Utilities look reasonably priced from a yield perspective, and could look downright cheap if a combination of cost side-benefits from falling commodities combines with stickiness on the (lagging) rate increases that they’ve had to lobby to push through stick. Still, utilities aren’t the kind of leadership of a healthy market…

An alternative would be the light cyclical industrial stocks begin to catch a bid, though this might be dependent on the benefits of the deflation of the commodities run-up outweighing the downsides of a stronger dollar making their product more expensive overseas. The one stock I continue to like in this area is Ingersoll-Rand (IR), whom I think made a series of vastly underappreciated acquisitions, in the process becoming the best company in the profitable climate control business. Apparently someone in Omaha agrees with that sentiment, as Berkshire Hathaway’s (BRK) latest 13F showing they bought nearly five million shares of Ingersoll during the last quarter. Regardless of the economic cycle, climate control is an organic growth market throughout the developing world, and even in saturated countries the recurring revenue stream from maintenance contracts provides sustainable high returns. And don’t think the Buffett news is fully priced in, either – at the risk of sounding arrogant, I seem to be the only person writing about it.
Other stocks that could fit this bill are chemical companies like DuPont (DD) or Todd Sullivan fave Dow Chemical (DOW), as well as a more diversified company like 3M (MMM).

So if a stronger dollar brings commodity prices down and creates the perfect set-up for a new leader to emerge from sector rotation, but that isn’t something defensive like staples or utilities, nor is it something slightly more aggressive like some of the light industrials, what’s the next alternative?

One could make the ultra-contrarian argument in favor of financials, but I think that’s just too much of a stretch. Likewise, consumer discretionary deserves consideration, but the reality is that Americans are likely to continue facing relatively high energy costs as well as weak prospects for near-term economic growth. Thus, I don’t think that’s the place to look either. A very real possibility here would be that a stronger dollar would materially weaken the equity markets because the value proposition for foreign investors would change for the negative. This might take place through some combination of diminished acquisition activity (still too late for Budweiser) and a reduced willingness for sovereign wealth funds, et al., to recapitalize the decimated balance sheets of financial institutions, but regardless, it would be a cause for concern if foreign investors started to see America as “expensive,” given the huge need for debt-funded capital investment over the next several years.

Of course, one can always look to purchase stocks which are largely immune to macro cycles and instead are much more dependent on industry-specific conditions. Be careful with this however – something like aerospace might be thought of as uncorrelated, but a stronger dollar relative to the Euro is going to make Boeing’s (BA) jets more expensive relative to those of Airbus. Here, I’m thinking something like insurance, which has enough of a financial stigma that plenty of historically good underwriters have gotten knocked down to levels near 1x book value. White Mountains (WTM) is trading within a few dollars of that mark, and even Berkshire has come down substantially off its $150,000/A-Share high. For what it’s worth, my investment continues to be an effective short position in credit default swaps on investment grade corporate debt. In my Marketocracy model portfolio, where I have to be diversified, I maintain a large allocation to that position, as well as owning Ingersoll and Accenture (ACN), a smattering of contract research organizations (CROs), some small-cap biotech, a small building materials/energy company, and a land bank selling below book value that I’m actually considering getting rid of should I find something better, or want to cut my 85% long exposure…

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