Big Mac Index Supports Japanese Bullishness

The Big Mac Index is the Economist’s whimsical take at purchasing power parity, or the idea that identical products (such as the Big Mac) should cost the same amount (when converted to dollars) wherever they are bought.

A Big Mac in China costs 11 yuan, or $1.45, an undervaluation of 58%. However, local inputs such as low rents and wages tend to be lower in poorer countries and less easily arbitraged across borders, so PPP is a better guide to misalignments between countries at a similar stage of development. Most rich-world currencies are overvalued against the dollar, including the euro (by 22%) and the Swiss franc (by 53%). The yen is an exception, but although it is undervalued by 33% in Big Mac terms, broader PPP measures would suggest that it is close to fair value.

Although it is unlikely that anyone would travel to China to arbitrage hamburgers (good luck finding a buyer willing to pay US prices for the re-imported Big Mac once you get it back to the US) the index has been shown in some studies to have modest predictive power for future currency exchange rates.

I own the IShares Japan ETF (EWJ) primarily because their markets performed so poorly for so long that I think the current rally can continue for many years on the back of mean reversion alone. But the possibility that the returns could be even higher due to a positive currency move while I own the fund is another attractive consideration.

Disclosure: Author is long IShares MSCI Japan Index (EWJ) at time of publication.

Comments

[Lance:]

I keep hearing this drumbeat ... Japan has underperformed ... Japan has underperformed.

On June 1, 2005, the Nikkei 225 closed at about 11,350. On June 1 two years later it closed at 17,958. In case anyone is math challenged, that's a gain of about FIFTY-EIGHT PERCENT in two years. Mean reversion, you say???

Sure, most of the gain came in late 2005. So what? That kind of performance cannot continue forever. This is a market that has more than doubled since the spring of 2003. Yes, it was a depressed low, yada, yada, yada.

Moreover, Japan is now trading at better than 20x earnings by most estimates. Can it go higher? Sure. Can stocks in a mature economy with a potential growth rate of around 2 percent and a declining, aging population also go lower from here? You better believe it. Japanese stocks are presently priced for a continuation of good news. Anyone getting real greedy here may manage 10 percent before the end of the year, or may get a 10 percent haircut.

In case anyone hasn't noticed, this place is not exactly shareholder heaven. The cash yield is barely 1 percent, and managers will use equity warrants like artillery to keep it there.

A POSSIBLE currency play exists with EWJ and dollars, but there is absolutely no guarantee that the yen must rise appreciably from here against the dollar, an no guarantee that it won't be 130 by next year either.

I converted my first US dollars to Japanese yen in the winter of 1992-1993. I still remember getting 121 yen to the buck. Sure, the exchange rate has seen some wild gyrations since then, but look where we are today. Machinery orders were an upside surprise today; the market was up about six-tenths; virtually everyone is pricing in a BoJ rate hike next month. The yen sank nonetheless.

Whenever there is a severe economic disruption, or merely the threat of one, what currency does everyone flock to? The yen?

The BoJ is also likely to be VERY gradual in raising rates, particularly once the sales tax issue re-surfaces after the election. (It's a political IED that nobody wants to get anywhere close to until the election is over.) If commodities keep going higher, the Fed is likely to maintain the rate differential anyway. Then it gets real ugly anyway, as it is bound to get sooner or later.

Like I said, this place (Tokyo) is priced for only good outcomes, with few or no bumps in the road. I'm happy to entertain less risk here at the moment than I was willing to entertain a few years ago.

2007 Jul 09 09:41 AM