The relevance of global currency movements is tough for most American investors to get their heads around.
Looking to make the difficult and remote even more philosophically complex, currency speculator extraordinaire George Soros once opined that investing in currencies is an “existential choice.”
Now before you reach your well-thumbed copy of existential philosopher Jean-Paul Sartre’s “Being and Nothingness,” understand that Soros’s point has nothing to do with the thinking of this Gauloises cigarette-smoking, womanizing French rake.
Soros’ point is that no matter what you invest in, you are always also betting on a currency — whether you know it or not.
So when you buy a share of Facebook (FB), this U.S.-dollar denominated stock carries U.S. dollar risk with it. You just don’t think about it because the U.S. government does not have a history of announcing an overnight currency devaluation — as governments elsewhere in the world have done in the past.
Throw in the fact that Facebook gets a growing percentage of its revenues from overseas in non-dollar denominated currencies, and you start to see why currencies matter. And that’s even if you are comfortably ensconced far afield on the beach in Naples, Florida.
Enter The “Big Mac” Index
Britain’s Economist magazine has just updated its measure of global currencies — the “Big Mac Index.”
The “Big Mac Index” has provided a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity (PPP) since 1986 — that is, the relative over- and undervaluation of the world’s currencies compared to the U.S. dollar.
The Big Mac Index is useful tool for assessing the relative over- and undervaluation of the U.S. dollar — according to the textbook measures of “purchasing power parity.”
According to the theory of purchasing power parity, a U.S. dollar should buy the same amount of the same good across all countries.
The “Big Mac” Index compares the cost of Big Macs — an identical item sold in about 120 countries — and calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in the United States as they do abroad.
Once you compare the Big Mac PPP to the market exchange rates, you see which currencies are under- or overvalued.
I like to think of purchasing power parity as the “fundamentals” of a currency.
But as with stock prices, exchange rates can often diverge substantially from their fundamentals.
The Economist highlighted the following example:
Nicholas Vardy is currently editor of the monthly investment newsletter, The Alpha Investor Letter, which provides longer-term global investments. He also writes two weekly trading services, Triple Digit Trader and Bull Market Alert, which focus on making short-term profits in the hottest markets in the world.