Weakest Currencies Deliver Best Returns

In today's FTfm on page 3 is an intersting article about a study on a market anomaly: Marsh, Dimson and Staunton have analyzed the effect of currency movements on stock and bond returns from 1900 until 2011. There findings:

Stocks and bonds of currencies which were weakest in the last 5 years, outperform (currency adjusted) in the subsequent 5 years. Stocks and bonds of currencies which were strong, underperform.

http://www.ft.com/intl/cms/s/0/941121c8-61f9-11e1-807f-00144feabdc0.html#axzz1oEDIBAke

The findings are also true for the time after Bretton Woods (1972 - 2011).

Explanation: Currency weakness increases export opportunities and competitiveness, which are not noticed immediately but over time. This contradicts market efficiency (equity prices should jump immediately and not over 5 years) and is another nail in the coffin of modern portfolio theory. However, it is a big argument for value investing. 

Implication on portfolio strategy: The belief of investors that emerging markets with strong currencies will out perform is to be doubted. It also explains why the German economy and the DAX have performed that well over the last 6 months. Since the study suggest that the movement has another 4.5 years to go, we should buy more DAX on dips.

Big Mac

The beefed up Big Mac index of the Economist illustrates the under and over valuation of currencies in terms of purchasing power. The new recipe which adjusts the original index by taking into account GDP differences per person culminates in following table:

Bottom line: Brazilian Real and Swiss Franc are heavily over valued against the US Dollar. Brazil and Switzerland are victims of the expansive US monetary policy and the raging debt crisis. The Chinese Remninbi is not over valued after controlling for the GDP difference because it is pegged to the Dollar.