The Sad and Depressed Dollar

Every day it seems the dollar hits a new record low against foreign currencies (Just last week we paired with the Canadian Dollar, the Looney!-hasn't happened in over 30 years). Obviously this cannot continue forever, and is not good for the US consumer, but as an investor it is something we can take advantage of.

Let’s talk about why the dollar is worth what it is. There are many theories of currency valuation; two that I find interesting are purchasing power parityand asset market model.

Purchasing power parity is the idea that a currency is worth what it is based on what it will buy. For example, by using the Chinese currency, in China, you can pretty easily buy a meal for eight remembi or about a dollar. In California, the same meal might cost you eight dollars and that difference means that if you go to China to get a meal you only have to pay a dollar. I definitely think this is part of the difference between currencies, but I don’t think it accounts for the entire difference, and most importantly, I don’t think it explains very well why the valuation ratios change. The asset market model is pretty good for that.

The basic idea is convert your dollar into a US treasury short term bond, currently yielding about 4.75 percent. Then convert your neighbor’s pound into a British short term treasury note yielding about 5.25 percent. Which one would you rather have? I’d rather have the pound, and would sell my dollars to buy pounds. If everyone thought the same way the it wouldn’t be so good for dollars – which is the situation we are in right now. Given that piece of the puzzle let’s back off and consider the very long term view. There is no fundamental reason why purchasing power parity means that the US should have a currency advantage with other countries. This advantage only exists because of our position in the world and that people, thus far, have more trust in the transparency and robustness of American capitalism than other countries, such as Communist China. So why don’t we raise our interest rates and make our currency more valuable?

The simple answer is, we are approaching an election year and the powers that be want to avoid a recession before the election. In most of the country housing prices are declining rapidly (http://money.cnn.com/news/newsfeeds/articles/prnewswire/NYTU06528082007-1.htm), mostly because they ran up so quickly.

The Federal Reserve had a choice of whether to allow this decline to become more evident, or to mask it by simply making the dollar less valuable. The decline still happens, but part of it occurs because of your purchasing power parity with the rest of the world declines. This will show up in inflation, but not as much as you’d think. Our trade deficit, at $838 billion last year (2006), is still small compared to $13.13 trillion GDP in 2006. This will mostly show up as your ability to purchase things outside the US, whether as a touristor, or an investor, will decline. The obvious thing to buy is foreign equities.

If you look at foreign stock markets, particularly emerging markets, they have done really well in the last few years. (http://money.cnn.com/quote/mutualfund/mutualfund.html?symb=PRMSX) . This would make one suspect that maybe the transparency and robustness of Chinese Capitalism (I mean Communism) is getting close to that of the US. But we know that’s not true.

So here is my suggestion:

The US isn’t the only country with a subprime mortgage mess – but it is the first to deal with it – and the fact it is more visible in the US is because of the transparency of our financial system.

Therefore, the current devaluation of the dollar won’t continue forever, but will until other countries deal with their mortgage issues. As evidence of this I’ll pull acouple data points.

First, search the internet for housing bubble in any other country.

I’ll pick Canada(1.9 million links -http://www.google.com/search?hl=en&client=firefox-a&rls=org.mozilla%3Aen-US%3Aofficial&hs=9c1&q=housing+bubble+canada&btnG=Search)

or Spain (1.6 million links -http://www.google.com/search?hl=en&client=firefox-a&rls=org.mozilla%3Aen-US%3Aofficial&hs=XJM&q=housing+bubble+spanish&btnG=Search)–

both numbers almost as high as the US housing bubble

(2.2 million links -http://www.google.com/search?hl=en&client=firefox-a&rls=org.mozilla%3Aen-US%3Aofficial&hs=Lxg&q=housing+bubble+US&btnG=Search), but for much smaller countries!

In the longer run, the shit is going to hit the fan all over the world – just take the recent bank run in the UK as an example:

(http://investing.reuters.co.uk/news/articleinvesting.aspx?type=bankingFinancial&storyID=2007-09-24T070126Z_01_L23582276_RTRIDST_0_SP_PAGE_012-L23582276-OISBN.XML).

This will probably cause each of these other countries to lower their short term interest rates for similar political reasons. As the world deals with its housing and credit issues, the ability of world banks to deal with inflationary pressures will be reduced and the cost of basic materials will go up.

So, if you buy into my thoughts, I’ll suggest a couple things:

1. In the near term buy equities in any foreign market. Riskier markets are better because of beta, a concept we will discuss later.

2. In the near term, but for the long term, buy basic materials or equities that own basic materials. (Southern Copper with their 6% dividend is my favorite right now).

3. In the medium term, as every country you might invest in will have a bank run or two – stop investing in them as questions arise as to the strength of their financial systems.

4. At that point (maybe 6 months to a year away), increase your position in US equities, as the fact US financial markets have already gone through the turmoil associated with declining asset prices will make US assets relatively more valuable.

This strategy I offer as an opportunity to play off my thesis presented above. The US market is declining and it will take asymmetric strategies to profit in the turbulence we will face ahead. Why is Housing bombing? That's another article to stay tuned for. As always, I want to hear your take and suggestions to my strategy.

-Wageslave