This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

The dollar surged in early 2015, rising 5.0% from Dec. 31, 2014, to Jan. 30, 2015, and 16.6% in the 12 months to January 2015.1  The dollar has benefited from relatively high US interest rates, stronger economic growth, and the ECB’s decision to aggressively expand its balance sheet.

A strong dollar weighs on profit growth and lifts volatility

Historically, there has been about a nine-month lag between changes in the dollar index and changes in the growth rate of earnings per share for the S&P 500 Index.  A rising dollar tends to pressure earnings growth, while a falling dollar lifts it. The graphic illustrates the relationship going back to the 1970s and displays earnings per share (EPS) growth against the year-over-year (Y/Y) change in the dollar index—with the dollar’s movements inverted in order to highlight the idea that a strong dollar is a drag on profit growth.   The financial crisis in 2008 generated some volatility in the relationship due to the magnitude of write offs and the economic fall-out of credit stress.

The graphic also indicates that the dollar is seeing one of its greatest periods of strength since the early 1970s.  At current levels, we expect that the dollar could see gains last experienced during the 2008 financial crisis and when the Reagan tax cuts and tight money of the Volker-led Federal Reserve combined to fuel extreme dollar strength.

The headwind to earnings may lay the foundation for higher equity market volatility in our view.  Equity market volatility, as defined by the VIX, is influenced by the growth rate in S&P 500 earnings per share.  As seen in the chart below, declining earnings growth has signaled higher volatility, while rising earnings have signaled lower volatility.  The graphic highlights the relationship.

VIX vs S&P 500 EPS Growth Y/Y (Inverted) 3 Quarter Average

Other factors supporting volatility

We believe additional arguments for higher volatility also rest in:

  • Divergent monetary policy. The Fed is moving toward tighter monetary policy, while the European Central Bank undertakes quantitative easing.
  • Unease over Greek politics and its impact on eurozone unity and the sustainability of the euro currency.
  • Rising valuations. The S&P 500’s P/E ratio has been expanding since late 2011 and is at levels last seen in the mid 2000s before the financial crisis in 2008.2   Although there is room for P/E multiple expansion, the market is not cheap anymore and could make it harder for investors to experience “easy” capital appreciation.
  • The current bull market started in March 2009 and will be six years old this year.  Going back to 1929, the current bull market will be the third longest without a 20% correction – only the 1987 to 2000 and 1949 to 1956 bull markets were longer.2

Strategies to consider

After talking to a financial advisor, investors may want to consider quality and low volatility equity strategies* for their portfolios in the face of a more adverse economic landscape:  Examples include:

  • The PowerShares S&P 500 High Quality Portfolio (SPHQ) provides exposure to constituents of the S&P 500 Index that are identified as stocks reflecting long-term growth and stability in earnings and dividends.  Companies exhibiting stability and growth in earnings and dividends are expected to see lower volatility and better handle the fall-out from adverse macroeconomic conditions.
  • The PowerShares S&P SmallCap Low Volatility portfolio (XSLV) invests in the 120 stocks in the S&P Small Cap 600 Index that have experienced the lowest realized volatility over the past 12 months.  Small-cap stocks are more domestically focused, and low volatility stocks should experience less variability during periods of economic uncertainty.

*There is no guarantee these strategies will provide low volatility.