Earnings 1, Strong Dollar Doom Mongers 0

Here is a funny thing about economic narratives: They often aren't true. Take the one about the strong dollar, which we are told has hammered US earnings by making exports less profitable. When Q1 ended, analysts penciled in a -4.6% y/y S&P 500 earnings decline. Yet here we are, with 465 of the index's constituents reporting, and Q1 earnings are up 0.2% y/y. Yes, up. As in not down. And stocks are back at all-time highs. Looks like that strong dollar isn't so bearish after all.

This shouldn't surprise, considering US stocks and earnings did great in the late 1990s, when the dollar was even stronger than today. It also makes logical sense: US firms doing business abroad-those theoretically super-vulnerable to the dollar's swings-have overseas costs as well as revenues. A stronger dollar makes foreign sales worth less when converted to dollars, but it also reduces foreign costs, including shipping, imported components and labor. These lower costs can offset much of the dollar's impact on sales. That appears to be the case in Q1, considering revenues fell -2.8% y/y, and some firms offered anecdotal evidence of strong-dollar give and take during their conference calls. Diverging earnings and revenues will probably inspire some whining about firms relying overly on cost cuts, but we wouldn't make much of that. It's not like firms are out there slashing production, payrolls and inventories to brace for recession. They're just dealing with the twin impacts of a stronger currency. Nothing to grouse about here.

Exclude the Energy sector, where earnings and revenues remain under fire from low oil prices, and things look even better. Together, the remaining nine sectors enjoyed 7.8% y/y earnings growth and 2.5% y/y revenue growth. Sectors with big international exposure, like Consumer Staples, Discretionary, Health Care and Technology, did a-ok. Here is a table:

Exhibit 1: Q1 Earnings and Revenues

Source: FactSet, as of 5/18/2015. Year-over-year growth in S&P 500 earnings and revenues, Q1 2015. The correct sound effect to describe Energy earnings is "splat."

To us, the real story here is how the dollar whacked sentiment. Exhibit 2 shows how earnings expectations have morphed since the dollar began sliding last June. Full-year 2015 earnings expectations hovered around 11.5% from April 2014 through September 30, by which point the dollar was up around 4.2% since the end of June. But as the dollar climbed, earnings projections plunged. Ditto for Q1 projections. Yet even as Q1 results surprised massively, analysts haven't revised up their full-year projections-they're still falling, now down to just 1.7%. Q2 projections are also in the red and falling. Overall and on average, analysts haven't acknowledged the strong dollar's benign truth, even though it's staring them in the face. That is a strong indication expectations are too low and actual results should beat handily.

Exhibit 2: The Dollar and Earnings Expectations

Source: FactSet and Federal Reserve Bank of St. Louis, as of 5/18/2014. Nominal Trade-Weighted US Dollar Index (broad) and estimated year-over-year earnings growth, 4/2/2014 - 5/6/2015.

That isn't to disparage all those fine analysts, who we are sure have crunched a lot of numbers and have plenty of math to support their aims. We simply suspect all that math isn't properly accounting for the dollar's impact on costs as well as revenues. Analysts tend to dig in and stand behind their forecasts to give their models more of a chance to work. They usually require a couple quarters' worth of data that confounds their expectations before they'll adjust their models to account for whatever proved them wrong.

This has a happy upside for stocks at times like this: It keeps sentiment lower. Investors aren't extrapolating Q1's earnings surprise forward any more than analysts are-few expect it to last. Even with the dollar down some since March, pundits warn better earnings probably aren't in store. Others warn the dollar could resume rising, and couple with the recent rise in oil prices to deliver a one-two punch. Expectations remain plenty dreary.

Which is all just groovy for stocks! Stocks don't move on earnings results alone. They move on the gap between expectations and reality. Even if earnings do finish Q1 or Q2 down a wee bit, a slight drop (that is in all likelihood positive if you exclude Energy) is better than a -4.5% (or worse) drop. A feeling of "hey this isn't nearly as bad as everyone thought!" can give stocks plenty of relief, and relief is bullish.

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