Assessing Currencies by the Big Mac

02/12/2015 10:00 am EST

Focus: ETFs

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

One of the best ways to get your head around relative currency valuations is to look at what the same goods cost in places such as Chicago, London, Tokyo, and Beijing, explains Nicholas Vardy, editor of The Global Guru.

Britain’s Economist magazine has done so since 1986 with its now-famous Big Mac Index—a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity (PPP)—that is, the relative over- and undervaluation of the world’s currencies compared to the US dollar.

By comparing the cost of Big Macs—an identical item sold in about 120 countries—the Big Mac Index calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in the United States as they do abroad, showing which currencies are under- or overvalued.

So, if you were running a currency hedge fund and using the principle of buying undervalued currencies—and selling the overvalued ones—here is what you’d do based on the Big Mac PPP measure.

Among the big six currencies favored by foreign exchange traders, you’d sell the CurrencyShares Swiss Franc Trust (FXF), the only major currency that is massively overvalued.

You’d ignore the Guggenheim CurrencyShares British (FXB) and the Guggenheim CurrencyShares Canadian (FXC), which are roughly within 10% of their PPP values.

The Guggenheim CurrencyShares Euro Trust (FXE) and the Guggenheim CurrencyShares Japanese (FXY) would be long bets based on their current undervaluation of 11% and 34.4%, respectively.

But with both the European Central Bank and the Bank of Japan committed to driving the euro and yen down further, you’d have to be a real contrarian to pursue these trades.

Looking at less mainstream currencies, you’d buy the WisdomTree Dreyfus Chinese Yuan (CYB), which is 42.2% undervalued; the WisdomTree Dreyfus South African Rand (SZR), which is 53.6% undervalued; the CurrencyShares Mexican Peso Trust (FXM), which is 30.1% undervalued; and the WisdomTree Dreyfus Indian Rupee Fund (ICN), which 60.6% undervalued.

My top recommendation to my newsletter subscribers is to continue betting on the greenback’s rise through the PowerShares DB US Dollar Bullish ETF (UUP). After all, the US Dollar Index is only back to where it was in March 2009, right when global stock markets bottomed.

But that also means the US dollar is still 25% below its 2001 peak and 50% below its peak in the 1980s. Predictions about the demise of the dollar notwithstanding, the greenback has a way to go.

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More from MoneyShow.com:

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Shun Tak: Gamble on Macau

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