Purchasing Power Parity: Is the U.S. Dollar Overvalued and Likely in Trouble?

by Dr. Steve Sjuggerud

Purchasing Power Parity: Is the U.S. Dollar Overvalued and Likely in Trouble?

By Dr. Steve Sjuggerud, President, Investment U

Thursday, January 2, 2003: Issue #201

"Europe is so expensive," Americans used to complain. I used to hear that a decade ago. But you don't really hear that anymore. Why?

It's simple. The U.S. dollar has been on a tear, strengthening dramatically, particularly in the last eight years. A hotel in Paris that would have cost $300 or more a night can now be had for under $200. What was "expensive" is now reasonable.

A stronger dollar has been great for us as Americans, and our wealth. We can get more for our buck - literally.

Unfortunately, the opposite is true as well - when the dollar weakens, a trip to Europe becomes out of the question. We get less bang for our buck. We've got to work harder to maintain our existing standard of living.But why should any of this matter to you TODAY? After all, the dollar has been doing well, so there's nothing to worry about, right?

Wrong. Unfortunately, when I shake up my Magic 8 Ball after asking it about the future of the U.S. dollar, it responds "Outlook Is Not So Good" Now let me explain what this means to you as an investor

The Only Two Things That Affect The Value Of Your Money

In doing my Ph.D. work on international currencies I found that there are only two clear things that affect the value of a "rich country" currency: its "purchasing power" relative to other currencies, and its real interest rate differentials.

People will say other things matter - things like budget deficits and current account deficits. But they don't. I ran the numbers on everything, and the two things above are the only things that truly matter. These two things sound complicated, but I can explain them quickly and clearly

The concept of "purchasing power parity" is simple. Think of it this way the price of a Big Mac should be roughly the same wherever you are. The ingredients are homogenous, cheap, and widely available. And so driving across the border from the U.S. to Canada, you shouldn't see a huge difference in Big Mac prices. But sometimes you do

In fact, right now a Big Mac is US$0.37 cheaper for Americans in Canada than it is inside the U.S. So if you're planning a trip to Niagara Falls, you can check out the falls from the U.S. side. But make sure you spend your money on the Canadian side. You'll save a heck of a lot.

Should a McDonald's in Niagara Falls, Canada sell a burger for US$0.37 less than a McDonald's in Niagara Falls, New York? Does this discrepancy in prices in rich countries make sense? Not in the long run. Over the long haul, currencies revert back to equal valuesto their purchasing power parities. Of course, that long run can be a very long time. But they always return.

Second, interest rate differentials, and this one is easy to understand too

Money flows to where it's treated best. All things being equal, if one country is paying 5% interest, and another is paying 1%, money will flow to the country paying 5% interest. That flow will cause the value of the 5% currency to increase as people flock to it. It's simple supply and demand.

So based on the only two factors that I've found to influence the value of a rich-world currency - purchasing power parity and interest rate differentials - the U.S. dollar is likely in trouble. Our Big Macs are expensive, and the U.S. is a 1% currency.

What You Can Do To Protect Your Purchasing Power from Parity

I explain this concept in full to my Oxford Club subscribers. And I give my readers my favorite investment recommendation outside of the U.S. dollar - where Big Macs sell for $0.87 cheaper than in the U.S. And where interest rates are three times what they are in the States.

But my mission here at Investment U is not to give you a fish. It's to teach you to fish.

The lesson here is that there are two things that move currencies. When you understand that idea, you realize that - like the U.S. stock market was in 2000 - the U.S. dollar is clearly overvalued now.

So the choice is yoursyou can either let your wealth dissipate as the dollar shrinks. Or you can use portfolio diversification strategies to include a few investments outside of the U.S. dollar.

You need to spread your risk. You need to have some of your assets outside the U.S. dollar. Not everything. But you must do something.

Simple Ways To Spread Your Investments Around

There are many relatively simple ways to spread your investments around:

  • You can buy an international bond fund. (Visit www.morningstar.com to find the right one for you, and keep in mind that since the dollar was strong, the past returns on these might not look good. But chances are they will look very good going forward.)

  • You can directly buy an international bond or short-term investment in Australia or New Zealand. (If you've never done this before, you may want to consider dealing with an expert that I trust in these. Try Howard Goldstein and Sam Jacobs at 877.539.1004 or hgoldstein @ pfmail.com. I've known these guys well for 10 years now. Say "hi" to my bright and friendly cousin Alison, who has been their assistant for many years).

  • Consider owning gold in some form. I wrote a short and simple story on gold, called The Basics of Gold Stock Investing. It covers all the basics, including my favorite gold investment, which has risen considerably since I wrote that.

  • If you're looking for stocks, consider foreign stock markets. Foreign stocks offer great portfolio diversification (lowering your overall portfolio risk), and foreign markets are substantially cheaper than U.S. markets right now. (U.S. P/E ratios are close to 30, while many foreign markets are about a third of that right now, offering good value.) Jeff Winn at International Assets (800.432.0000 or jwinn @ iaac.com), one of my best friends, is a good place to start. (Jeff does complete financial planning as well, right through your insurance needs.) I just saw him over the holidays, and he's currently on a much-needed vacation in San Francisco. So if you contact him, he'll get back to you Monday.

Good investing,

Steve

Today's IU Crib Sheet

  • We tackled some complex topics in today's issue. But here's all you need to remember: based on the two measuring sticks for evaluating currencies (namely, purchasing power parity), the dollar is poised for a drop in value. This can have a significant impact on you as an investor, as your purchasing power will be reduced. You can protect yourself against this by spreading your risk by moving some of your assets outside the U.S. dollar.
  • For a more detailed definition of Purchasing Power Parity (PPP), visit the Investment U Glossary.

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