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The Big Mac Index and Currency ETFs
08/15/2011 11:25 am EST
The “Big Mac Index” suggests a new long-term trend for the Chinese yuan while the US dollar tries to bottom. These ETFs could make good alternatives to stock investing in this volatile market.
Since 1986, The Economist has published the “Big Mac Index,” which strives to determine the correct value of the major currencies based on purchasing power parity, or PPP. Its underlying principle is that a dollar should buy the same amount in all countries, and the McDonald’s Big Mac is used to represent a basket of goods.
See related: Invest with the Big Mac Index 2.0
I have always found the index quite interesting, and the latest results were released late last month. Though I doubt anyone uses the data to trade currencies or currency ETFs, year after year, there are some interesting trends.
The Economist likes to “Estimate the current fair value of a currency (using) the “line of best fit” between Big Mac prices and GDP per person.” This is represented on the left-hand chart with the raw data on the right. The current analysis suggests that the Brazilian real is the most overvalued currency.
Looking back through the data from 2004 through 2007, the Icelandic krona was one of the most overvalued currencies. In 2007, it had its most overvalued raw-data reading of 131. The Krona peaked in July 2007 and lost over half of its value in the financial crisis.
The Chinese yuan has been undervalued for the past few years according to the Big Mac Index, but it has now improved to become fairly valued. Last week, the Peoples Central Bank of China allowed the yuan to strengthen and it moved to its highest level versus the dollar in 17 years. Is this a new trend?
NEXT: Trade Ideas for Two Major Currency ETFs|pagebreak|
- The flag formation (lines a and b) has upside targets in the $26.60-$28.80 area. CYB did close above its weekly Starc+ band, so now is a high-risk time to buy
- Though weekly volume has increased over the past few months, some of it came on weeks when CYB closed the week lower. The weekly on-balance volume (OBV) is still in a longer-term downtrend and is below its weighted moving average (WMA)
- There is short-term support now at the gap in the $25.50-$25.69 area with much stronger support at $25.20-$25.35
The Powershares DB US Dollar Index Bullish Fund (UUP) is designed to track the price and yield performance of the Deutsche Bank long US dollar futures index. It had broken support three weeks ago, but the selling was absorbed well. This suggests that despite the negative fundamentals and widely bearish sentiment, the dollar may be bottoming.
- The weekly chart of UUP shows a short-term flag formation, lines d and e. This is normally a continuation pattern which would represent an interruption in the overall trend, although that is not always the case
- Initial resistance stands at $21.50 and a close above $21.74 would be positive
- The weekly OBV is acting stronger than prices, line g, and could break out above resistance at line f this week. That would suggest a bottom is in place
- First support is at $20.90 and a break below $20.84 would abort the bottoming formation
What It Means: The technical action of CYB combined with the multi-year trend for the yuan in the Big Mac index suggests that last week’s breakout may be legitimate. This is a longer-term trade if my analysis is correct.
After the dollar index and UUP broke support, a sharp decline was expected, especially with the negative fundamentals hanging over the market. Since such a decline has not materialized, it suggests that the dollar may be sold out. This week’s market action could be critical.
How to Profit: As previously recommended for WisdomTree Dreyfus Chinese Yuan Fund (CYB), buyers should be 50% long at $25.56 and 50% long at $25.44. Raise the stop from $24.88 to $25.17. Those not currently long could buy at $25.61 or better using the same stop level (risk of approx. 1.7%).
For Powershares DB US Dollar Index Bullish Fund (UUP), go long at $21.18 with a stop at $20.73 (risk of approx. 2.1%).
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