Purchasing Power Parity (PPP) versus historical (or statistical) currency valuation :An over-simplified example.

By B. Hathi , 17/Sept/2010

The acronym ‘PPP’, or its fuller version ‘Purchasing Power Parity’, gets a mention in my earlier article, in which I mention that it (i.e. PPP) is one of the ways of determining a currency’s long term [exchange rate] value. So what exactly is PPP? I am sure you will find many formal definitions by doing a web search, my intention here is to explain its meaning in simple terms.

PPP is one of many ways of deriving a currency’s value, in terms of whether it is overvalued or undervalued, by comparing the cost of chosen product(s) in two currencies. The idea is to choose a product (goods or services) that is mainly locally produced and has no known tax skews; for example, alcohol or cigarettes are not good choices as they are heavily taxed in some countries (even illegal in some), while hardly taxed in other countries.

A chosen product should mainly reflect the local costs (labour, producing, marketing etc) against a backdrop of stable demand. Economists keep coming up with many such examples of ‘ideal’ products, one particular example I like is the Economists “Big Mac” index. Here the idea is that a Big Mac hamburger can be produced and sold locally and since it is a food item, not many taxation regimes explicitly go after it. If a price of the Big Mac is permanently higher in one country compared to the other, then at some point arbitrage would occur: i.e. people will start profiting from taking cheaper produced Macs and selling where they get more money, hence in the long run a levelling of prices will occur. So it is not possible to have a permanently established asymmetry in prices and therefore the PPP concept is widely used as a measure of a currency’s intrinsic value.

Looking at data from the last available Big Mac index from July 2010 (Ref: http://www.oanda.com/currency/big-mac-index), we can see that a hamburger in China costs (on average) 13.2 Yuan, while in USA it costs 3.73 Usds. So if we take the ratio; [hamburger in China] / [hamburger in USA] , the we should get the currency value of Yuan/Usd (13.2 / 3.73) = 3.53 . At present (as at 16th Sept 2010) we see that the value of Yuan/Usd is 6.7 . This is what makes those in charge of US trades - US Treasury Secretary and the likes – angry. With a 52% undervalued currency and being a major trading partner to the US, China is coming under pressure to revalue its currency. There are many interesting examples and skews one can point to, e.g. the Norwegian Krona’s is nearly overvalued by two times when compared to the dollar.

One further example I would like to bring out is the Japanese Yen. Those who follow the Forex markets and news will no doubt know that Bank of Japan, BoJ carried out a currency intervention to weaken the Yen (on 14th Sept ’10) versus the Usd from a rate at the time of Usd/Jpy ~ 83 to 85.5. If we go by the PPP index, then the Yen’s nominal value versus the Usd should be, according to the Big Mac index, around 320/3.73 = 85.8 . Looking at it from this valuation perspective, a value of 83 hardly seems like a point that needs BoJ to intervene. So why did the BoJ intervene? I knew that the action was imminent, though due to lack of friends at BoJ, I did not know the precise timing.

If you look at the chart below, showing the Yen’s range versus the Usd, you can see why they (BoJ) were getting nervous. The two charts below show Yen valuation pre-intervention.

If the Yen’s value had broken the ~ 82 level on the left of the top plot and had constantly stayed below that level for sometime, then potentially there would be a loss of confidence in the Usd/Yen valuation – investors would pile on buying the Yen as they leave all historical benchmarks behind. Yen’s strongest valuation was around the 80 Yen mark in April 1995.

The situation at present, despite being just 2.5 Yen above the recent minimum, seems to be more comfortable (see the two plots below and compare the position of the red line). Although ideally many in Japan would be more comfortable with Yen values hovering between 90 to 95.

Source | The Currency Forecasting Blog (CFB) | http://currency-forecasting.blogspot.com/2010/09/purchasing-power-parity-ppp-versus.html

DoubleLine Capital Valuation Hint

So here's another followup post, this time for my OAK/DoubleLine post (here).

Jeffrey Gundlach was on CNBC yesterday and talked about the markets and surprisingly talked about what he sees for the future of DoubleLine.    Gary Kaminsky conducted the interview and he asked a really good question that lead to Gundlach's discussion of DoubleLine's future which may have implications for DoubleLine's valuation (for OAK shareholders).

Anyway, firstly, here is what he said in general about the markets:

• The 10 year treasury yields bottomed out in July.  What more is there to gain here?  How much lower can rates go?   Even if rates go down a little more, there isn't much gains to be had.
• This feels like the mirror image of the mid 80's when treasury yields were very high and everybody hated it.
• 10 year rates can go up 100 bps from here even before year-end.  People ask him what the catalyst for rising rates would be and he says that they are already going up; the catalyst is simply the bad return the low rates provide.
• QE3 is not going to be effective.  Can't see any connection between QE3 and increasing employment.
• Quotes Jim Grant; the markets now is a "hall of mirrors" due to the extensive market manipulation by central banks around the world.
• Wouldnt' buy equities now as risk assets are at a high level.  So short term not positive on stocks, but over the long term due to the central bank actions there will be inflation so real businesses and assets would be good.   Gundlach doesn't think there will be another lost decade in equities.
• He liked Spanish stocks in May because they were bombed out.  Liked it not because he thought Europe would solve problems, but just because it was bombed out.  Now the market that is bombed out to a scary extent is the Shanghai composite.  World markets at their highs and yet Shanghai and some other emerging markets are at multi-year lows.
• Apple obsession / fixation means it is over-bought and over-believed.
• Would (or said in the past) short Apple and the S&P and be long things like natural gas and commodities.  Apple is up 14% since he said that but natural gas is up 40%, so please don't look at only one leg of the long/short, pair trade idea.
• Where to invest?  Get away from traditional ideas and indexation.  He likes bank debt for the first time in a long, long time.  International bonds are interesting as U.S. treasuries are no good.  Some mortgages around the edges.  Also, really, really safe dividend paying stocks.  Not tech stocks, but really safe ones (he later mentioned Campbell Soup).
• Returns going forward, 5%.  Buy-and-hold is out the door.  Investors have to be more active, or have to find someone to do it for them.
• Bank stocks not short but wouldn't own them for dividends.  They are not safe.  If something happens in Europe they are still vulnerable to significant shocks.

So that's the sort of things he said.

DoubleLine's Future
But what really got my attention was when Kaminsky asked Gundlach what level of assets is too much for a bond fund.  What AUM level would his investors have to start to worry as it might be getting too big.

At first Gundlach went off on this tangent about counterparty risk but Kaminsky got him back on track and asked the question again.  And then Gundlach said:

• Maximum AUM is 0 billion, probably south of that.
• For the Total Return fund (their flagship fund), they probably won't be open after -60 billion in assets.
• Not interested in having offices in Singapore and Mumbai, travelling around the world.
• Sees DoubleLine as a company with "mid-size staff and a mid-size culture".
• Wants a manageable business, know what they're doing with people working together.
• Maybe 100 employees, they now have 80.
• Current AUM north of billion.
• Will probably close fixed income strategies at billion.

So there you have it.  For those hoping for DoubleLine to become the next Pimco, this may not be very encouraging (Pimco AUM is over trillion).

DoubleLine's Valuation
So going back to my other post and looking at the table there, if 0 billion AUM is going to be the maximum, DoubleLine would be worth .47/OAK share or .93/OAK share (at 1% of AUM or 2% of AUM respectively).

Of course, this doesn't mean that AUM can't keep going up with performance; just because they close funds doesn't mean AUM won't grow, so over time they can still get much bigger than Gundlach envisions at this point.  But it is one (and pretty significant) input we can use to value DoubleLine.

Source | The Brooklyn Investor | http://brooklyninvestor.blogspot.com/2012/09/doubleline-capital-valuation-hint.html