Repeat Performance in Brazil? When a Booming Currency Compounds Stock Gains
When foreign economies recover from a bust, their stock markets usually boom. But that’s not all… Their currencies also boom. They soar in value against that of the U.S. dollar.
This phenomenon is not simply a curiosity; it can be a big-time moneymaker. The combination of rising stock prices and a rising currency can produce supercharged gains for a dollar-based investor. The past is full of many such examples. This chart shows just a few of the most memorable ones…
In each of these examples, a foreign stock market delivered gains of about 500% in U.S. dollar terms. And in each instance, a large percentage of the gains came from the local currency’s appreciation against the value of the dollar.
One truly remarkable aspect of this effect is that it does not simply add currency gains to stock market gains; it compounds the combination of the two to produce an even larger total return.
As powerful as this phenomenon can be, it often confuses investors. So let me simplify it with an example I’ve used in the past…
For illustration purposes, let’s say $100 would buy 100 Indian rupees on the day you decided to invest in the Indian stock market. So you exchange your $100 for 100 rupees and invest all those funds in the stock market.
After one year, the Indian stock market has doubled and the rupee’s value against that of the dollar has doubled, such that each rupee is now worth $2, rather than $1.
In this scenario, your gain is not the sum of your 100% stock market gain and your 100% currency gain – i.e., 200%. Instead, your gain is 300%!
Here’s why: The 100 rupees worth of stock you purchased would be worth 200… and 200 rupees would now be worth $400 – or a 300% return on the original $100 you invested.
The chart below shows a real-world example of a currency’s power to supercharge returns…
According to Bloomberg, between May 2004 and May 2008, the Brazilian stock market gained 810% in U.S. dollar terms. Less than half of that gain – 358% – came from the stock market’s performance in local currency terms. All of the rest came from compounding the Brazilian real’s appreciation against the value of the U.S. dollar.
I believe a repeat performance is underway in Brazil right now. Over the last two years, the iShares MSCI Brazil Index ETF (NYSE: EWZ) has produced a total return of more than 180% in U.S. dollar terms, according to Bloomberg. A big chunk of that gain has come from the appreciation of the Brazilian real against the value of the U.S. dollar…
If this trend continues, the Brazilian stock market could deliver truly spectacular gains over the next few years. To give a sense of the market’s potential, this chart shows the performance of Brazilian stocks during the last two years alongside the performance of these stocks between 2004 and 2008…
Obviously, the risks in this rosy scenario are numerous. A global stock market sell-off, for example, could halt the Brazilian rally in its tracks. Or a new political scandal in Brazil could do similar damage to the bullish stock market trend.
On the other hand, Brazil’s stocks and currency are both very cheap relative to those of most of its global counterparts. And good things tend to happen when cheap stocks and an undervalued currency begin moving up from their depressed valuations at the same time.