Hunting for your next great investment? Look for a weak currency

If you are going to invest in stocks, should you do so in a country with a strong and rising currency? Or one with a weak currency?

Odds are you think it is the former. Most investors do. Just look at the endless justifications given for investing in emerging markets.

You'll pretty much always be told that even if the stock market in question doesn't do as well as expected, you'll still get a nice kicker from the rising currency.

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Strong currencies represent strong economies and strong economies have strong stock markets. Or so the story goes.

It's a compelling argument. There's just one problem. It simply isn't true

The weaker the currency, the better

Research out last week from a group of academics at London Business School has demonstrated that when it comes to currencies and investing, weakest is definitely best.

If you want to get the best returns from stock markets, you want to get unhedged exposure to the countries with the weakest possible recent exchange rates.

The research looked at 83 different countries, and split them into five groups based on how strong their currencies were against the dollar over a series of five-year periods from 1900.

The results were striking: as the FT puts it, "the quintile of countries with the hitherto weakest currencies delivered markedly better returns than countries that had had strong currencies in the previous five-year period".

From 1972 (when Bretton Woods gave us floating rate currencies) onwards, the correlation was even more obvious. Returns from the weakest currency countries were almost three times those of the strong currency countries.

Why weak currencies lead to strong stock markets

The academics say that they have no definitive answer as to why this might be the case. And the headline reporting the results in the FT suggests the correlation is somehow "mysterious".

But is it really that complicated? Weak currencies mean cheap exports; that means good profit margins and, more often than not, rising stocks.

Anyone in any doubt that cheap currencies are good for profit margins need only cast their eye towards Germany's giants. Or perhaps to the market reaction to the Bank of Japan's decision to start printing money like everyone else: the yen weakened and the stock market soared.

Japan's not as much of an export economy as everyone likes to think (around 11% of GDP), but there still doesn't seem to be much of a mystery there.

Say the yen continues to weaken against the dollar (and preferably against the Korean won and the other major Asian currencies too) for the next four or five years. I can't imagine why anyone would be surprised to see its stock market massively outperform on the back of a profits boom in the five years after that.

Korean equities have outperformed Japanese equities over the last few years seemingly for one simple reason: the lowly-priced won has made Korean exports cheaper (and its corporate profits higher) than those coming directly from Japan. That might be about to change and the rise in Japan's stock market is anticipating the possibility.

How to profit from the currency wars

The theme of this decade looks like it will end up being currency wars'. Around the world, governments are desperately trying to steal growth from each other. By devaluing their currencies, they boost the competitiveness of their export industries (and cut the real wages of their workers along the way).

So far the only major government not to have joined in the fun is that of China. However, it might not be long before it does.

As Albert Edwards of Socit Gnrale points out, "the recent rapid slowing of export growth certainly seems to be associated with the strength of the exchange rate". If growth keeps slowing or if a slowing turns into a hard landing, why wouldn't China devalue its currency too?

On the plus side, all this does give longer-term investors a pretty clear steer on how to invest: all they need to do is sit back for a few years and watch the currency wars unfold.

Then they'll need to buy shares in the winner's stock market the winner being the government that most comprehensively destroys its currency. Easy.

For those who don't want to wait there is always the UK. The pound has been weak against the euro and the dollar since 2008. Indeed, measured against the dollar, it's been the worst-performing of all 16 major currencies over the past five years, according to Bloomberg.

And for those who want to take the whole weak currency thing to its natural extreme, you could consider looking at Iceland. The krona has been the second-worst performing currency against the dollar over the past five years (the worst has been the Venezeulan bolvar).

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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