Interactive Investor

Strong pound fears have no weight

5th May 2015 16:22

Ken Fisher from ii contributor

Straitjacket. Drag. Threat. Pundits have used these and other fearful words to describe the rising pound's impact on Britain's economy and stocks. Sterling is now near its highest level of this cycle. Time to panic?

No! Tune out the noise. Currencies don't drive stocks. No relationship - UK stocks have risen and fallen with a strong pound. Ditto for a weak one. Returns go both ways equally.

Currency and stock markets are extremely liquid, and all liquid markets efficiently discount widely known information. You can't use movement in one to forecast another - one liquid market can't know something the other doesn't. Strong sterling foretells nothing for UK stocks. Same for the strong dollar and US stocks. Arguments otherwise are mythology.

Bias leads folks to assume relationships where none exist, but this is easy to tear apart. Consider securities that are actually linked, like a stock and an option or convertible bond. The option and bond prices don't respond to past stock movement. They move simultaneously with the stock. Not identically - magnitude differs! But timing and direction are synchronised. Take Volkswagen, which issued a three-year convertible bond in November 2012. Since then, the bond's ups and downs have tracked Volkswagen's stock. The stock moved bigger, which you would expect, but directionally, the daily wobbles and longer-term moves sync near-perfectly. One doesn't predict the other.

Euro proves the point

That's one anecdote, but it's illustrative and holds across capital markets. If two actually linked securities don't predict each other, how can two unlinked assets like stocks and currencies?

The euro further proves the point. If currency moves drove stocks, all eurozone countries would move in lockstep. They don't! Over the last year (through 30 April), national returns range from -46.2% (Greece) to 32.5% (Belgium). Portugal is negative. Austria, Italy, Lithuania and Estonia are up single digits. Ireland, the Netherlands and Finland topped 20%, with Germany a shade behind. (All in euro to remove the skew from conversion to sterling.) Random distribution, based on country-specific issues. Not currency.

Since October 1992, after the dust settled from Black Wednesday, the pound and UK stocks have moved independently. Their correlation coefficient - statistical jargon for mathematical link - is 0.16, implying almost no relationship. Sterling fell from Black Wednesday through mid-1996. UK stocks rose. The pound then surged, gaining nearly 30% from May 1996 through March 1998. UK stocks zoomed, up nearly 60% in that span. Sterling stayed strong for a decade, hovering in a narrow band while UK stocks rode an entire market cycle. Then the pound plunged during 2008's crisis and stayed low. Weak sterling accompanied UK stocks' 148% rise since this bull market began in in March 2009. Recency bias makes folks believe weak sterling is bullish - a behavioral error. Folks forget earlier cycles disproving the myth.

Some argue strong sterling whacks UK exporters' earnings and will thus sink stocks - a fallacy. One, markets pretty efficiently pre-price such widely known fears. Two, the pound's earnings impact is frequently overstated. It is true stronger sterling hampers UK multinationals' overseas revenues - the currency conversion takes a bite. But few UK exporters ship goods made start-to-finish with British components. Most import parts and raw materials - a strong pound lowers these costs. Good for earnings! Multinationals' lower overseas costs offset much of the strong pound's impact on revenues. Big UK exporters did great with a strong pound in the late 1990s. Big US multinationals led smaller, more domestically focused firms then, too, as the dollar roared.

Two US firms to buy

Ironically, many who fear a strong pound today feared the newly weak pound in 2009. Folks always try to have currency swings both ways, perpetuating the wall of worry no matter which direction the pound moves. Same goes for the dollar and US stocks. Here are two US firms to buy.

Western Digital and Seagate Technology have done well and should continue to. Buy them if you haven't already. Together they dominate the hard-disk memory business, which is central to cloud computing. It's like a fast-growing duopoly. Yet Seagate is at only 1.3 times revenue, ten times my June 2016 earnings estimate, with a 3.2% dividend. Western Digital is 1.6 times revenue, 12 times my June 2016 earnings estimate with a 1.5% dividend yield.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.