EC Purchasing Power Parity Shifts In 2018

Nearly every investment strategy seems to fall in one of three buckets. There is trend-following--go with the underlying direction of prices--and its opposite, mean reversion, look for the trend to be reversed. Lastly, there are arbitrage strategies. We would put carry trades, where a low yielding currency is borrowed to finance the purchase of a higher yielding currency (or asset).  

The Bollinger Bands offer one way to operationalize reversion process. When a currency moves more than two standard deviations from the 20-day moving average, it is often seen as over-extended, signaling a likely loss of momentum and a reversion to the average. It is a dynamic mean.  

Another way to implement a mean reversion strategy is almost the equivalent of the Dogs of the Dow, where the worst performing Dow stocks or the next-to-worst Dow stocks are bought. In the currencies, one can buy the under-valued currencies and sell the over-valued currencies. 

Valuation is particularly difficult in the currency market, which has become unmoored to gold or silver. What is the value of a fiat currency? Economists have developed a valuation metric: Purchasing Power Parity. In its simple form, it says that the price of an internationally traded basket of goods (Big Mac, Starbucks coffee, iPhone) should sell for the same price in different currencies. To the extent they do not, implies a currency misalignment. 

Like with other tools, PPP is often misused. Here's how. Consider that ant. Reports suggest that depending on the particular species (and what they had for breakfast?), an ant could lift 10, 20 and even 50x their weight. Average people cannot even come close. In this sense, an ant is stronger than a person. Consider a lightweight boxer. Given how much weight she can lift proportioned to her weight, she might be said to be pound-per-pound stronger than a heavy-weight boxer. It does not mean she can bench press or squat more. The heavyweight fighter is still absolutely stronger.  

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Read more by Marc on his site Marc to Market.

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