The world’s most undervalued currency

The world’s most undervalued currency is the Hong Kong dollar. Most of what I said in my previous post about the undervalued Japanese yen applies to an even greater degree for the Hong Kong dollar.

Hong Kong is a special administrative region of China. This means that China is responsible for Hong Kong’s defense and foreign policy while Hong Kong provides its own legal system, law enforcement, monetary system, and other domestic policies. Hong Kong was originally a territory of China that later was taken over by the British in the 1840s and the Japanese in the 1940s during World War II. After World War II, Hong Kong went back to British rule. In 1997, Hong Kong was handed back to China.

According to the Economist magazine’s Big Mac Index, a Big Mac costs an average of $3.41 USD here in the USA and an average of $12 HKD in Hong Kong. If the USD and HKD were at Purchasing Power Parity, $1 HKD would be worth 28.4 cents in USD. Based on the actual exchange rate, $1 HKD is worth 12.8 cents USD. This means that the Hong Kong dollar is selling for only 45% of Purchasing Power Parity against US dollars. That’s a steal! In fact, based on current exchange rates, no other currency is as cheap on a Purchasing Power Parity basis as the Hong Kong dollar.

It is amazing that the Hong Kong dollar is so incredibly cheap given all the factors that should make it sell at a premium to Purchasing Power Parity against the US dollar. Like Japan, the United States, Australia, Canada, and western Europe, Hong Kong is a rich First World economy with a high standard of living, stable government, and high wages. Natural resources are scarce in Hong Kong, and most of its food, energy, and other supplies must be imported.

Land is especially scarce in Hong Kong, especially after you consider that much of its small land area is too rugged for agriculture and other uses. According to the CIA World Factbook, Hong Kong’s population density is 6740 people per square km (7,018,636 people on 1042 square km of land), compared to 340 people per square km for Japan, 33.2 people per square km for the United States, 2.70 people per square km for Australia, and 3.65 people per square km for Canada. Thus, Hong Kong is not a place where you’d expect land, rents, wages, grain, beef, or other costs of running a McDonald’s restaurant to be cheap.

Why is the Hong Kong dollar cheaper than so many Second World and Third World currencies even though it belongs to a First World economy where wages, rents, commodities, and other costs are expensive? Since 1983, the Hong Kong dollar has been pegged to the US dollar at the rate of $1 USD=$7.8 HKD. Without the peg, the Hong Kong dollar would be considerably higher against the US dollar. The Hong Kong Monetary Authority uses Hong Kong dollars to purchase US dollars to artificially hold down the value of the Hong Kong dollar.

This currency peg will not remain forever. Every day that the Hong Kong Monetary Authority maintains the currency peg, it cedes control of its monetary policy to the US Federal Reserve. While the anti-inflationary Paul Volcker was the US Fed Chair when Hong Kong began the peg in 1983, the pro-inflationary “Helicopter Ben” Bernanke is the US Fed Chair today. Something will happen that will make the Hong Kong Monetary Authority to cease outsourcing monetary policy to Helicopter Ben. Perhaps the upward pressure on the Hong Kong dollar will become so strong that the Hong Kong Monetary Authority will no longer be able to hold down the value of its currency. Or perhaps the day will come when the costs of maintaining the currency peg exceed its benefits. Indeed, the Hong Kong economy is becoming increasingly linked to that of mainland China. Hong Kong may decide to drop the dollar peg in favor of a peg to the Chinese renminbi, another undervalued currency (only 46% of Purchasing Power Parity).

Why did I use an Everbank foreign currency CD to buy the Hong Kong dollar? Again, I am avoiding FOREX brokers due to doubts about their stability and lack of insurance as well as the fact that they are geared for hyperactive traders. Unlike the case with the Japanese yen, there is no Hong Kong dollar ETF. The Everbank foreign currency CD is the only way for reasonably conservative investors to purchase Hong Kong dollars. Everbank’s foreign currency CDs are FDIC-insured. Everbank is a conservatively run bank.

I am confident that when the current peg is dropped, the Hong Kong dollar will at least double in value. It won’t happen right away, but it will happen. Even if it takes a few years, it will be well worth it. A double in 2 years means an annualized return of 41.4%, a double in 3 years means an annualized return of 26.0%, a double in 4 years means an annualized return of 18.9%, and a double in 5 years means an annualized return of 14.9%. A double in 10 years means an annualized return of 7.2%, far better than what US Treasury Bills are likely to return.

Japanese yen

The Japanese yen is undervalued. A Big Mac is cheaper in Japan than here in the USA.

The magazine _The Economist_ uses the Big Mac Index to appraise currencies. The Big Mac Index is an indicator of Purchasing Power Parity. A Big Mac is considered to be representative of goods and services. Although I have been steering clear of the Golden Arches ever since the movie _Supersize Me_ grossed me out, the fact remains that the price of a Big Mac is representative of the cost of many local goods and services, such as land, rent, labor, energy, beef, and grain.

According to _The Economist_ magazine, a Big Mac costs an average of $3.41 USD here in the USA or 280 yen in Japan. Given a current exchange rate of $1 USD = 104.150 yen (10,000 yen = $96.01 USD), an American tourist visiting Japan would only need to convert $2.69 in USD to yen in order to buy a Big Mac. Thus, the tourist would pay 21% less for that Big Mac in Japan than in the USA.

If the US dollar and the Japanese yen were at purchasing power parity, the exchange rate would be $1 USD = 82.111 yen (10,000 yen = $121.79 USD). So the 10,000 yen that currently sells for $96.01 would be fairly valued at $121.79. Again, we can see that the Japanese yen is selling for 21% fewer US dollars than Purchasing Power Parity.

To relate currencies to stocks, the Purchasing Power Parity of a currency is analogous to the book value of a company’s stock. Of course, just as a stock price can remain substantially above or below book value, a currency can remain substantially above or below Purchasing Power Parity. One reason that this disparity can persist is the fact that the real world has substantial currency exchange fees and transportation costs. Additionally, certain countries have persistently higher or lower land prices, rents, wages, and commodity prices.

However, the Japanese yen relative to the US dollar is likely even cheaper than Purchasing Power Parity suggests. Japan has a much higher population density than the US. Land is scarce in Japan, especially after you consider the fact that most of the interior is mountainous and unable to support agricultural, industrial, or residential use. Thus, Japan is a nation with high land prices and high rent. As an industrialized First World nation (like the USA, Canada, western Europe, and Australia) with a high standard of living, Japan has high wages. Natural resources are scarce in Japan, so the nation must import heavily. Thus, one would expect almost everything, including Big Macs, to be more expensive in Japan than in the US. Thus, Purchasing Power Parity provides a very conservative appraisal of the yen.

Why is the Japanese yen so cheap? Because the Japanese economy still hasn’t recovered from the recession and stock market collapse of 1990, most of the the world has given up on Japanese stocks and businesses, and this holds down demand for yen. The other reason is the extremely low interest rates (well below 1%). Low interest rates discourage investment in Japanese debt instruments (bank CDs, corporate bonds/paper, government debt, etc.), also reducing demand for yen. Furthermore, low interest rates encourage both domestic and foreign investors to borrow Japanese yen and invest the money elsewhere for higher yields. Borrowing yen is the same thing as short-selling yen, and this selling pressure also conspires to drive down the yen relative to other currencies. This practice of borrowing money in one currency and investing it in another currency is called the carry trade.

The unwinding of the yen carry trade is a potential triggering mechanism for a rise in the value of the yen. In order to liquidate the yen carry trade, one must buy back yen in order to pay off the loan. Most estimates suggest that at least $1 trillion USD is being gambled on the yen carry trade. If a large number of speculators are simultaneously forced to liquidate their yen carry trades (due to falling financial markets elsewhere or any rise in Japanese interest rates), there will be much more demand for yen. This would boost the value of the yen and force more speculators to liquidate their yen carry trades. This “short squeeze” in the yen would become a chain reaction, like the program trading of US stocks on October 19th, 1987 but in reverse.

Why did I choose to buy FXY (Currencyshares Japanese Yen ETF) to bet on a rising yen? I do not recommend opening a FOREX brokerage account to trade currencies. Unlike the stock brokerage industry, the FOREX brokerage industry does not have SIPC insurance. FOREX brokerage firms are notorious for going under without warning and taking customers’ money down with them. Also, FOREX brokerage firms are geared towards extreme speculators. Given that leverage ratios of over 100:1 and multiple trades an hour are popular among FOREX traders, they make the Dot-Com daytraders of 1999-2000 look conservative in comparison. Everbank offers Japanese yen CDs, but the FXY ETF (which holds 10,000 yen per share) is much more liquid and convenient because it trades like a stock and is not subject to early withdrawal penalties.

Model Portfolio update: bought Hong Kong dollar CD

The Doppler Value Model Portfolio purchased a 3-month Hong Kong dollar CD from Everbank on Thursday, May 15th. According to http://www.exchange-rates.org, the exchange rate was $7.9950HKD/USD. So the $10,000 USD investment was $79,950.00 HKD. The currency conversion fee was 1%, or $100 USD. The interest rate is 1% for the current term.

To conform with the terms of a CD, the CD will roll over every 3 months unless I specify otherwise. Also, any interested earned will be reinvested in the new CD. If I decide to liquidate rather than roll over the CD, I will announce that on this blog at least a week in advance. The fee for converting the CD back into US dollars or into another currency will again be 1%. Interest will be earned in Hong Kong dollars and will be credited upon maturity. As is the case with the regular cash balance, interest will accrue daily.

The current CD will mature on Friday, August 15th, 2008. Assuming that I continue rolling over the CD, the subsequent maturity dates will be:
Friday, November 14th, 2008
Friday, February 13th, 2009
Friday, May 15th, 2009
Friday, August 14th, 2009
Friday, November 13th, 2009 (Yes, that’s Friday the 13th. I hope to get away from Jason on that day, but the only way I can do that is to have an out-of-body experience. Well, I’ll just have to deal with Jason myself.)

The $10,000 USD used to purchase the Hong Kong Dollar CD and the $100 USD currency conversion fee bring down the cash balance from $71,736.58 USD to $61,636.58 USD. The Doppler Value Model Portfolio now consists of:
$61,636.58 USD cash
$79,950.00 HKD Everbank CD
2 shares of Berkshire Hathaway Class B
222 shares of DFJ
103 shares of FXY

:) Ben Bernanke should date Jessica Simpson

Some of of you think I’ve been too harsh on Federal Reserve Chairman Ben Bernanke. I apologize. To show Bernanke how nice I am, I’m writing this post to show him a way to keep his reputation intact no matter what happens to the economy and financial markets.

Until recently, Tony Romo of the Dallas Cowboys has been dating singer Jessica Simpson. The media blamed her for Romo’s mistakes on the field and the Dallas Cowboys losses. Of course, they didn’t credit her when things were going fine for Romo and the Cowboys.

But all this gives me an idea. Helicopter Ben should date Jessica Simpson. She should show up to watch him at FOMC meetings and Congressional hearings. You know that Helicopter Ben would NEVER be too cheap for her, because all he has to do is print extra money to accomodate all her trips to Rodeo Drive. If anything happens to the economy, everyone has an easy scapegoat – her. After all, Jessica is the dumb one who had to ask if Chicken of the Sea is chicken or fish, thought buffalo wings were made out of buffalo meat, and spent $1400 on a set of Egyptian bedsheets that she ended up not even sleeping on. So the media can then blame everything that goes wrong with the economy and financial markets on her, and Helicopter Ben and Easy Al.com can get off scot-free.

NOTE: I hope I made it clear that this is not a serious post.

Model Portfolio update – bought Berkshire Hathaway Class B stock

The Model Portfolio bought 2 shares of Berkshire Hathaway Class B stock at yesterday’s closing price of $4095/share. The cost was $8190 for the two shares and $40 for the commissions, or a total of $8230. This brings the cash balance down from $79,966.58 to $71,736.58.

The Model Portfolio now consists of:
$71,736.58 in cash
2 shares of Berkshire Hathaway Class B
222 shares of DFJ
103 shares of FXY

Buying Berkshire Hathaway Class B

For the Doppler Value Model Portfolio, I am buying 2 shares of Berkshire Hathaway Class B stock, which will be 8%-9% of the portfolio. Under the rules for the model portfolio, this transaction will take place at the end of the day on Monday, May 12th at the closing price. I already am a Berkshire Hathaway shareholder, and I hope you are as well.

Berkshire Hathaway stock is a real blue-chip investment. It’s hard to argue with the long and successful track record of Warren Buffett and Charlie Munger. They have both created a pro-shareholder, pro-value culture that will live on through their successors long after they move on to the great See’s Candy store in the sky. Berkshire Hathaway owns a diversified collection of high-quality businesses, so intrinsic value will not be seriously affected by negative economic conditions or company-specific bad news.

Berkshire Hathaway is also a safer inflation hedge than gold. A Motley Fool article from this past January summarized the case for Berkshire Hathaway over gold.

Although I am convinced that inflation is a major issue, I have not and will not buy gold. Gold is a very risky investment that can go down as well as up. In the long run, gold tracks inflation. Most importantly, gold has no intrinsic business value. A business has a balance sheet and earns income and cash flow. You can analyze the business and make a rough estimate of its intrinsic business value. The same does not apply for gold. If I bought gold, I’d have no exit strategy. I cannot tell you if gold should be selling for $300/ounce or $3000/ounce. Just because inflation is heating up now doesn’t mean that will always be the case. There is always room for surprises. Maybe Helicopter Ben’s efforts to inflate the dollar into oblivion will fail, perhaps because a big enough collapse in housing or credit begins to destroy money faster than it is created. Maybe Helicopter Ben will get caught lip-syncing on “Saturday Night Live” and get replaced by Paul Volcker. If I buy gold but something unexpected happens, I could lose a lot of money.

Berkshire Hathaway, on the other hand, has intrinsic business value and is selling for a reasonable multiple, 1.67 times book value. Berkshire Hathaway has thrived in a variety of different economic conditions, averaging 21.1% annual growth in book value from 1965 to 2007. This period has included multiple recessions, the oil embargo of 1973-1974, multiple bear markets, a 16-year period of stock price stagnation, double digit inflation, double digit interest rates, a prime rate as high as 21%, the decline of General Motors and IBM, Democratic and Republican presidents, the S&L bailout, and much, much more. As Buffett has explained in past annual reports, the best hedge against inflation is a superior business franchise. A company with a superior business franchise can raise prices with little capital investment and with little or no penalty in sales volume. Capital-intensive companies in highly competitive industries, on the other hand, are hit hardest by inflation. A company in a highly competitive industry risks losing sales volume when it raise prices. High inflation means that companies requiring heavy capital investment need to spend even more money just to maintain current operations while the later payoff from such investment is devalued by the higher inflation rate.

Berkshire Hathaway has better long-term returns than gold AND has proven to be MUCH less risky at the same time. Berkshire Hathaway has intrinsic business value while gold does not. If my predictions of higher inflation ahead turn out to be wrong, Berkshire Hathway stock will likely continue to grow in value while gold will likely fall in value. The choice is clear: Berkshire Hathaway is a better and safer inflation hedge than gold.

I’m BULLISH!

I’m bullish onJapanese stocks. Yes, I sound dumb. Yes, I know that Chicken of the Sea is tuna fish. Yes, I know that Japan still hasn’t recovered from the recession of 1990. But Japanese stocks are more reliable and more fuel-efficient. (OK, OK, just kidding.)

Remember what Warren Buffett wrote in a _Forbes_ magazine commentary back in 1979: You pay a very high price for a cheery consensus. The corollary is that you pay a low price for a gloomy consensus, which is the case in Japan. Japan has the world’s cheapest stock market. The stigma of “basket case” Japan is the reason its stock market is so cheap. Without this stigma, Japanese stocks would be more expensive. Back in the late 1980s, the Japanese stock market was gripped by irrational exuberance, and large-cap stocks selling for 50-100 times earnings were common. The situation was similar to that of the recent US housing bubble, the Dot Con bubble of 1999-2000, and the Beanie Babies bubble of 1997. Back then, the popular perception was that the Japanese were taking over the world, had a “special cultural trait” that justified paying 50-100 times earnings for a stock, and were perfect at business management. Today’s perception that the Japanese are incompetent and hopeless is just as flawed as the past perception that the Japanese are superhuman.

The result of the Japan stigma is cheap stocks. According to Yahoo Finance, the WisdomTree Japan SmallCap Dividend ETF (symbol DFJ) is the cheapest diversified ETF at only 92% of book value and 5.56 times cash flow. All of the ETFs with lower price/book value ratios are heavily or completely weighted towards the industries that normally have low multiples, such as home construction and REITs. Even the Rydex “value” funds with lower multiples are biased towards these and other low-multiple industries.

Besides valuation, why did I choose DFJ over the other Japanese stock ETFs? DFJ is a small-cap ETF, and a small-cap company has more room to grow than a large-cap company. At the same time, the risk is limited by its diversification. Because no stock is more than 1% of the portfolio, this ETF is well-protected from company-specific risks. DFJ has low annual turnover (25%) and a reasonable expense ratio (.58%).

Why am I not buying specific Japanese stocks? I don’t know Japanese, and I don’t have access to the financial statements of Japanese companies. Although there are a few Japanese companies that trade on US stock exchanges, these tend to be the biggest companies with lesser growth prospects. These big-cap stocks have a larger following, and that greatly reduces the chance of finding an undiscovered bargain.

It is SO much more fun to be bullish than bearish. You get to deride anyone who disagrees with you as a cynical, faithless, wet blanket, worrywart Chicken Little gloom-and-doomer. Maybe I should go to Japan, tell everyone that I’m bullish on Japanese stocks, and label any Japanese citizens who disagree with me as unpatriotic.

Model Portfolio Update – purchased DFJ and FXY

DFJ (WisdomTree Japan SmallCap Dividend ETF) closed at $44.95/share today. FXY (CurrencyShares Japanese Yen Trust) closed at $96.84/share today. So the Model Portfolio has just bought 222 shares of DFJ for $9978.90+$40.00 in commissions and 103 shares of FXY for $9974.52+$40.00 in commissions.

So the Model Portfolio now consists of:
$79,966.58 in cash
222 shares of DFJ
103 shares of FXY

US Treasury Bills: no longer a safe haven

I used to regard US Treasury Bills and the Vanguard money market funds that hold them as safe investments and a good parking place for money awaiting a cheaper stock market. However, we are now in a new era of consistently negative real interest rates.

Inflation in and of itself isn’t the problem. It’s inflation accompanied by low interest rates that is the problem, and that will fuel even more inflation. Higher inflation accompanied by falling interest rates means an even more negative real yield, and the spiral has the potential to feed on itself.

Bernanke’s decision last September to make a bigger-than-expected cut in short-term interest rates just weeks after he publicly worried about inflation was the incident that finally proved to me that we really are in a new era and that they don’t call him “Helicopter Ben” for nothing. Subsequent events have only reinforced the case for more inflation.

In the 1950s-1990s, you could count on the Fed to maintain positive short-term interest rates. Any time inflation went up, interest rates would follow suit. Thus, Treasury Bills were a hedge against inflation. But the Fed of the 21st century has turned the financial landscape into a bizarre Alice In Wonderland world where Treasury Bills lose purchasing power. We have already seen Easy Al.com drop interest rates to near 0 in 2002-2004. As the credit/economic crisis continues to unfold, Helicopter Ben will keep dropping interest rates, which I think will approach 0% like they did during Easy Al.com’s big loosening. Inflation has been picking up over the last several years, but so much hanky-panky has been thrown into the CPI and PPI calculations that you can’t make an apples-to-apples comparison with 20th century inflation rates.

It is sad that there is now reason to lack confidence in the US dollar. It used to be that only survivalist kooks worried about hyperinflation. But Easy Al.com got the inflationary ball rolling, and Helicopter Ben is working hard to debase the US dollar into oblivion. We are now in a new era. In this Alice in Wonderland world, everything is a risky place for your money.

NOTE: Although cash equivalents are now guaranteed losers as investments, this does NOT mean cash is trash. If you live here in the USA, you still need US dollars to pay your expenses. So you still need to keep your rent money and the customary “emergency fund” in US dollars. It’s your longer term investments that face the big inflationary risks.

Model Portfolio: buying Hong Kong dollar CD

I am buying an Everbank Hong Kong dollar CD for 10% of the model portfolio. To simulate the time it takes to open an account at Everbank, this transaction will take place at the close of business next Thursday, May 15th at the prevailing exchange rate. The transaction cost of the currency exchange will be 1%.