Hedges and Happy Meals: Big Mac Index

08/17/2015 9:00 am EST

Focus: GLOBAL

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 New York, London, Tokyo, Beijing, and elsewhere, explains Nicholas Vardy, editor of The Global Guru.

Editors at The Economist magazine knew that as well, so in 1986 they created the now-famous Big Mac Index, a tongue-in-cheek but surprisingly useful way of measuring the relative values of global currencies, also called purchasing power parity (PPP).

By comparing the cost of Big Macs—an identical item sold in about 120 countries—the Big Mac Index calculates the relative over- and undervaluation of the world’s currencies compared to the US dollar.

Compare the Big Mac PPP to the market exchange rates and you have a handy way to quickly see which currencies are under or overvalued.

According to the latest data, the average price of a Big Mac in the United States in July 2015 was $4.79.

In China the average cost of a Big Mac was only $2.74 at market exchange rates. That means the yuan is undervalued by over 42.

A Big Mac in the European Union will cost you an average of $4.05, meaning that the euro is undervalued by 15.4%, a far cry from just seven years ago when the euro was overvalued by some 50%.

The perennially overvalued Swiss franc, according to the Big Mac Index, is now overvalued by 42.4%. Norway, Sweden, and Denmark round out the only four overvalued Big Mac Index countries.

India, Ukraine, and Venezuela are at the bottom of the barrel when it comes to relative PPP. In India, a Big Mac will cost you just $1.83 and in the Ukraine, a Big Mac can be had for $1.55. In Venezuela you can grab a Big Mac for a mere 67 cents. That’s an undervaluation of 86%.

If there is one overarching theme over the past few years, it’s that most currencies have gotten much cheaper versus the US dollar.

And with the first Fed rate hike in almost ten years coming up—a move that will be bullish for the US dollar—it is unlikely that the US dollar will be pushed down any time soon.

That’s why the continued strength of the greenback remains my No. 1 long-term recommendation in the currency markets.

That said, if you’re a more active currency trader following the conclusions of the Big Mac Index, you’d buy undervalued currencies and then sell overvalued currencies.

Second, you’d concentrate on the highly liquid, so-called 'big six' currencies. In that case, the latest Big Mac Index would dictate that you do the following:

Sell the CurrencyShares Swiss Franc Trust (FXF), which is the only major currency that remains very overvalued.

Stay neutral on the Guggenheim CurrencyShares British Pound Sterling (FXB) and the Guggenheim CurrencyShares Canadian Dollar (FXC), as they are only slightly undervalued on a PPP basis.

Buy the Guggenheim CurrencyShares Euro (FXE) and the Guggenheim CurrencyShares Japanese Yen (FXY), as they represent a sound long-term bet on an undervalued basis (the euro by 15.4% and the yen by 37.7%).

Buy the dollar via the PowerShares DB US Dollar Index Bullish Fund (UUP). This remains the surest bet.

On a more practical level, there’s been no better time in recent memory to get that passport out and buy yourself a whole lot of Happy Meals in the foreign countries of your choice.

Subscribe to The Global Guru here…

More from MoneyShow.com:

Two Favorites for Emerging Markets

Value Investor Steps into Europe

European Trio for Long-Term Value

Related Articles on GLOBAL