Investor Alert
Nicholas A. Vardy, CFA

Aug. 11, 2015, 1:20 p.m. EDT

The Big Mac Index says the time to travel abroad is now

By Nicholas A. Vardy, CFA

AFP/Getty Images

I've written about The Economist magazine's "Big Mac Index" previously here on MarketWatch, but if you're new to this cleverly conceived and useful method of measuring the relative values of global currencies, then here's a quick summary.

One way 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 on the globe. So back in 1986, the Economist magazine created the now-famous "Big Mac Index," a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity, or PPP. It became so popular that academics have written PhD dissertations on it, and it is cited in several introductory economics textbooks as well.

By comparing the cost of Big Macs — an identical item sold in about 120 countries — the Big Mac Index gives you an insight into the relative over- and undervaluation of the world's currencies compared to the U.S. dollar. It does so by calculating the exchange rate (the Big Mac PPP) that would result in Big Macs costing the same in the United States as they do in a particular foreign country.

Hot off the Griddle

According to the latest data released by The Economist , the average price of a Big Mac in the United States in July 2015 was $4.79. That compares with $4.37 the last time they looked at the data in January 2015, and an eye-popping 9.6% rise in price.

By way of comparison, in China the average cost of a Big Mac was only $2.74 at market exchange rates. That means according to the "raw" Big Mac Index, the Chinese currency is undervalued by 42.8%.

Earlier this year, I noted that the strength in the U.S. dollarrelative to so many rival foreign currencies was so pronounced that it was time for U.S. investors to take that long awaited trip to see the Mona Lisa in Paris.

The recent Big Mac Index confirms this advice. Today, a Big Mac in the European Union will cost you an average of $4.05. This means that the euro is undervalued by 15.4% — a far cry from just seven years ago when the euro was overvalued by some 50% compared to the U.S. dollar. That more than 65% "swing" in the euros purchasing power in favor of the U.S. dollar just might be unprecedented.

The overvalued few and Big Mac parity

The single most overvalued currencies on the Big Mac Index was the Swiss franc. The "Swissie" has been overvalued versus the dollar for as long as I can remember. According to the Big Mac Index, today the Swiss franc is overvalued by 42.4%. That means a Big Mac would cost you $6.82 in Geneva — almost 70% more than in France, just across the border.

Norway boasts the second-most-overvalued currency in the world, by 17.9%, with a Big Mac costing $5.65. Sweden and Denmark round out the only four overvalued Big Mac Index countries, coming in at 7% overvalued for $5.13 in Sweden and 6% overvalued at $5.08 in Denmark.

The Swiss and Scandinavian currencies have always been the most overvalued in the world. What has changed is that the level of overvaluation has plummeted in the past five years.

In March 2010, the overvaluation of the Norwegian krone hit 92.97%, the Swedish krona reached 75.82%, and the Swiss franc stood at 65.88%. I recall paying $22 for a Happy Meal in Switzerland just four year ago. Today it would be a relative bargain at about $13.00.

An undervalued Happy Meal

On the flipside of the valuation coin, you can get a lot of Happy Meals for your money in places such as India, Ukraine and Venezuela.

These three countries are at the bottom of the barrel when it comes to relative PPP. So, in India, a Big Mac will cost you just $1.83, or 61.7% undervalued according to the Index. (Of course, it won't contain any beef, as cows are sacred in India). In the Ukraine, a Big Mac costs $1.55, and in Venezuela you can grab a Big Mac for a mere 67 cents. That's an undervaluation of 86%- the highest I ever recall seeing.

If there is one single overarching theme over the past few years, it's that the U.S. dollar has risen substantially against all major currencies. Ironically, this is precisely the opposite of what was predicted by the gold bug and "demise of the dollar" crowd.

What they missed is that currency valuation is a relative game.

For the U.S. dollar to fall, other currencies have to get stronger.

And today, even as the Fed has pulled back from quantitative easing, the QE policies of both the European Central Bank and the Bank of Japan have hammered the euro and the yen compared to the U.S. dollar. And with the first Fed rate hike in almost 10 years coming up, it is unlikely that the U.S. 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.

And the easiest way to piggyback on the U.S. dollar's strength is via the PowerShares DB US Dollar Index Bullish Fund (PSE:UUP)  .

A Big Mac hedge fund

That said, active currency traders have a different playbook, as they would be making shorter-term, specific trades in some of the biggest, most widely held currencies.

If you'd trade off the "Big Mac Index," you'd buy undervalued currencies and then sell overvalued currencies. You would then concentrate on the highly liquid, "big six" currencies, which consists of the Swiss franc, British pound, Canadian dollar, euro, Japanese yen — and, of course, the U.S. dollar.

And here's what you would trade:

  • Sell the Swiss franc (PSE:FXF) , which is the only major currency that remains very overvalued.

  • Stay neutral on the British pound sterling (PSE:FXB)   and the Canadian dollar (PSE:FXC) , as they are only slightly undervalued on a PPP basis.

  • Buy the euro (PSE:FXE)  and the Japanese yen (PSE: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 (PSE:UUP)  .

Yet there is a huge caveat here. With their respective QE programs, both the European Central Bank and the Bank of Japan still very committed to driving down the euro and yen. So buying FXE or FXY is actually an extremely contrarian trade.

So, in my view, the surest bet remains staying long in the U.S. dollar.

But even if you don't trade currencies, here is some more practical advice:

There's been no better time in recent memory to get that passport out and travel abroad. For U.S. tourists, McDonald's Happy Meals haven't been this cheap since 2003.

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