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Wednesday, September 19, 2007

Emerging Markets

"A hidden connection is stronger than an obvious one."

- Heraclitus of Ephesus


There has been much talk lately about emerging market equities. Are they overvalued or not? Is a P/E of 14 or 15 too low because of the (potential) growth rate of earnings? Or is the P/E too high because it is now similar to more developed markets and does not provide adequate compensation for the additional risks of emerging markets? Or are emerging markets currently fairly valued?

I confess I don't know the answer to that question.

But let me shift the focus to a related question. Regardless of your opinion of the current valuation, it cannot be denied that (in hindsight) 4 or 5 years ago, emerging market indexes were very undervalued. Now someone might counter that the only reason for the recent stellar returns is that emerging markets have risen way too far and are in a bubble. Hence, the argument would be that perhaps emerging markets were simply fairly valued in 2003 and are overvalued now.

Mathematically, however, this argument does not ring true. Suppose we concede that emerging markets are currently grossly overvalued and we peg "fair value" at half the current price. This would put the current P/E at about 7. While some may argue that such a P/E ratio would be appropriate to discount risks, I seriously doubt that many would claim such markets would definitely be overvalued at that level. So for sake of argument, let's say fair value is one half the current price. Even if emerging market equity indexes were currently 50% less, the appreciation during the last 4 1/2 years would still have been more that 20% annualized.

So it seems to be the case that in the Spring of 2003, emerging markets were quite undervalued, yet there was little recognition of that. The recent returns have been staggering. The total return of the Vanguard Emerging Markets Stock Index Fund from 2003 Q2 to present exceeds 350%, or more than 40% annualized over the past 4 1/2 years.

I tried to search the web for articles and analysis of emerging markets in 2002 and 2003. (The web is probably not the best medium for findings historical articles. A trip to the library to examine the archives for Barron's and Business Week would probably yield better results.) From what little information I've uncovered and pieced together, I don't really find that the attitude about emerging markets was all doom and gloom back then. Rather, it appears that emerging markets were simply totally off the radar screen for most people - unnoticed rather than unloved.

So the example of emerging markets five years ago prompts the question: What asset class is unnoticed and undervalued now? If such an asset currently exists, it's very likely that it's NOT being heavily written about in your newspaper and discussed on the web.

Monday, September 17, 2007

I Love Overdraft Protection


"Life is about timing."
- Carl Lewis


I have previously written about how overdraft protection is a key part of my cash flow financial autopilot.

An example from a few months ago illustrates the value of overdraft protection. It was the night before we left for summer vacation and I realized that a whole bunch of bills were all going to be due within a couple of days of each other. The mortgage payment, electric bill, telephone bill, monthly credit card bill, and the bill for a new dishwasher were all due while we were gone and automatically scheduled to be debited from our checking account. Worse, the checking account had close to zero in it because we had just paid in advance for most of our vacation expenses. The paychecks to cover all this would not arrive for several weeks. This was definitely a worst case scenario.

Normally I would not even think twice about this kind of situation, as my overdraft protection will handle it properly. However, I was concerned that this was really quite a lot of money to overdraft and perhaps I should scramble to see if there was cash available in some brokerage account to quickly transfer. After thinking about it for about five minutes, I decided it was not worth spending a whole lot of effort and worry at a time when I should have been helping my family to pack and preparing to relax. I decided to simply let go of the whole matter and let the overdraft protection work as usual.

In retrospect, this was clearly the right decision. I got a good night's sleep, we left early enough in the morning to beat the traffic to the beach, and we had a wonderful vacation where I never worried about the overdraft situation. When I returned, I noticed a total of $2,700 had been overdrafted from my HELOC (Home Equity Line Of Credit) account. It took two paycheck credits (one of which occurred during vacation) to build up enough in the checking account to pay off the HELOC. As soon as the paychecks hit, I paid off the overdraft in full as I always do.

The total interest bill: $3.66!

What a deal! As I mentioned in my earlier post, with a more typical overdraft for me that occurs a few times a year, the overdraft amount is a couple hundred dollars, the full payoff occurs in less than a week, and the interest bill is usually less than 50 cents. (There are no fees of any sort for my overdraft protection, only interest charges.)

In return for a few dollars a year, I don't have to worry about the exact timing of my cash inflows and outflows. Overdraft protection is a leveler that evens out the credits and debits, preventing the possibility of bouncing a check at any time - even on vacation. On average, I pay about five dollars a year in interest for what I consider an invaluable service. In my opinion, that is practically the definition of a good deal.

Monday, September 10, 2007

Personal Inflation

"Invest in inflation. It's the only thing going up."

- Will Rogers


I have a rather unfortunate habit of saving financial papers beyond their useful life. When it comes to financial documents of any sort, I'm clearly a packrat. It's not that I really want to keep so many papers, but rather that I don't want to take the time to sort out what is not needed and throw it out.

So I continued to save and save and now the four drawer filing cabinet is full, at which point I finally got the message that this has gone on for too long and needs to be confronted. Armed with a good shredder for 90% of the papers and a good scanner for the rest, I've been working through the cabinet for the past few days.

One of the more interesting finds has been a number of old receipts and other papers that show how much the prices of things have increased over a long period of time. This did not really surprise me, but the anecdotal examples from my own past drove the point home very clearly for me. Inflation is real. And very persistent. The current cost of some of the items is pretty amazing compared to the old receipts.

Here are some examples where I could make a fair comparison between an old receipt and the current cost of the exact same item:

  • Apartment lease from early 90's. Cost: $705/month. Current cost: $1195/month.
    Annualized inflation rate = 3.35%
  • Water bill from late 90's. Rate: $1.40/10K gl. Current rate: $1.55/10K gl.
    Annualized inflation rate = 1.28%
  • Sewer bill from late 90's. Rate: $2.70/10K gl. Current rate: $3.66/10K gl.
    Annualized inflation rate = 3.88%
  • Receipt for roll of 100 stamps for early 90's. Cost: $29/roll. Current rate: $41/roll.
    Annualized inflation rate = 2.34%
  • College tuition bill from early 90's. Cost: $490/credit. Current cost: $1012/credit.
    Annualized inflation rate = 4.64%
  • Studio piano receipt from early 90's. Cost: $3290. Current cost: $5900.
    Annualized inflation rate = 3.72%

I have said it before on this blog, but I'll say it again: Because it happens slowly, people tend to underestimate the long term effects of inflation. Even if you are clever and frugal, you will be affected by it. If your income is flat indefinitely, there is only so much substitution one can make until inflation will eventually force a reduction in living standards.

The average annualized inflation rate in the United States over the past century has been about 3.5%, and interestingly enough, a few anecdotal items from the filing cabinet seem to be in the same ballpark.