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4 ways to play a strong dollar as earnings begin

Getty Images. Protectionism may be a problem for the U.S. dollar.

It's earnings season, and that means CEOs will be citing currency headwinds based on the strength of the dollar. But there's a more fundamental question for stock market investors amid what will be lots of dollar noise:

Should you toss out your carefully crafted investment portfolio because of big moves in the dollar?

No. And in my opinion, the answer is that clear. Though if you really want to know how to work your investment portfolio regardless of moves in the greenback, there is plenty more to learn about shifts in currency strength and your portfolio.

First, here are the three essentials to get you to think in "dollar terms" before even trying to figure out what that means for your stock portfolio.

1. The dollar isn't like a stock in the sense that it goes up or down on its own. The dollar, like all currencies, is valued based on how much more or less it is worth only when compared to foreign currencies, like the euro or the yen.

2. Many factors affect the relative value of the dollar, but generally speaking, countries with diverse economies and a strong adherence to contractual law typically have highly valued currencies compared to countries without those characteristics. It should be clear, based on this, why developed nations' currencies are valued over those of developing nations.

3. When a country's central bank raises short-term rates, it often means investors earn a better return on that host country's money. If the European Central Bank and the Bank of Japan are taking steps to keep their interest rates very low, which they are, and if our Federal Reserve is preparing the world for the day it raises short-term interest rates, you understand why the dollar surged in value compared to the euro and yen. The dollar looks more attractive to investors because it is perceived to offer a better return, which creates demand for it-more demand drives up price, right?

Now let's discuss what dollar strength or weakness means to investors.

1. Your typical global dividend-paying blue chip will see its sales overseas become slashed in value if the dollar surges. For example: If an American company does a Euro1 billion in European sales, which you may have thought were worth $900 million, that could end up being worth only $700 million after the company brings the money home-just like that, $200 million vanished.

It's akin to getting paid with a depreciating asset. That means domestic companies with big overseas sales exposure are at risk of missing earnings projections. Since nearly half of S&P 500 (INDEX: .SPX) member earnings come from overseas, it gives you a strong sense of how currency fluctuations potentially impact earnings at these companies. A weaker dollar has the opposite effect: It makes overseas earnings more valuable to American companies.

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2. A strong dollar does have the positive impact of tamping down inflation for American consumers, because commodities that are priced in dollars become cheaper, i.e. oil. Also, foreign-produced goods could become cheaper to American consumers. And since most of what we buy is made overseas, we could see continued lower prices at retailers in addition to at the gas station.

3. A strong dollar could make American-produced products more expensive domestically and to consumers overseas, which hurts exports and manufacturing jobs and further boosts service jobs.

So now you know why everyone is talking about the strong dollar. But the dollar has always gone through long cycles of strength and weakness; it's just that when a move happens as fast and as much as it did over the last year, corporate managements don't have enough time to adjust their business models to account for the currency fluctuation.

Too late to do anything about that now, but I'll share with you advice that I have learned over the last 25 years, in which I have seen plenty of big dollar moves.

1. Diversification should not end because the dollar went up or down a lot. If anything, diversification helps you because it'll help protect the entirety of your portfolio from being impacted by just one thing.

2. Rebalance! We had several years, thanks to the Fed's ultra-low interest-rate policy and three quantitative easing programs, of a weak dollar that greatly benefited American multinational companies, and that drove their stock prices much higher. Now would be a good time to evaluate how proportionate this class of companies is within your investment portfolio and trim it back some.

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3. Look to areas that may have lagged in terms of asset appreciation due to the aforementioned weak dollar. International investing seemed to have gotten short shrift because Europe, Japan, China and, in general, emerging markets were for a long time underperforming the U.S. equity indexes. Well, that has been reversing, and if these areas are now underrepresented in your portfolio, then it may be time to recommit a portion to it.

4. Don't go all in or all out based on dollar plays. That may work for hedge funds, but for individual investors, remaining diversified helps prevent the need for knee-jerk and emotional reactions. After all, the dollar moves in both directions, and whatever it has been doing over the last few months, that trend won't last forever.

So enjoy all the banter about how strong the dollar is currently, but remember: If you're a long-term investor, you'll look back at these days and see it for what it really is. Just a bunch of noise.

-By Mitch Goldberg, president ClientFirst Strategy, a Dix Hills, New York-based investing firm.

Follow Mitch @mitch_goldberg

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