Fair Value

With escalating tensions in Iraq and North Korea, where should we place value investing?

Is the continuing debate that surrounds structural breaks, new paradigms, and new world-orders redundant? How often has the socio-economic system been declared the victim of creative destruction over the last decade? Fortunately, most of the hype about the New Economy has evaporated. Unfortunately, the old economy and global markets are struggling to survive despite the demise of the prophets of economic Never Never Land.

It is indisputable that the collapse of almost 50% of global market capitalisation over a relatively short period is painful. But the aftermath is comparable with the loss of a first love where the onset of experience encourages a more prosaic reassessment — it was exhilarating while it lasted, but with hindsight, few would return to those heady days. Like a lovesick teenager, investors are now struggling for a sense of direction. Where should they look for solace?

Despite recent geo-political developments, notably in Iraq and North Korea, the world is more stable than we think and, if it were not for these escalating tensions, economic rehabilitation towards ‘normal’ earnings growth and rates cycles would probably have been significantly more advanced than it is currently. After all, the economy comprises multiple feedback loops that act automatically to provide stability. The system may drift out of kilter, but only temporarily. Arbitrage opportunities inevitably emerge to drive market prices back to fair value. In a jurisdiction with an excessively strong currency, exporters and domestic producers endure increased foreign competition. If borrowing spirals as a result of low interest rates, not only do creditors lose money because debtors default but they are also subject to the pressures of rising inflation. A spike in equity prices is invariably accompanied by a boom in IPOs (Initial Public Offerings). However, although markets overshoot, the imbalance is unsustainable over the long term.

Nevertheless, normal market conditions are far from dull. It is by no means uncommon for currencies to move abruptly, for recessions to occur as often as expansions, and, of course, for stock prices to move down as well as up. What are sometimes perceived as unstable market dynamics can be quite the contrary. Forecasting the future direction of markets will always be fraught with difficulties. Investing is less problematic, as long as you are content with probability statements as the basis for your strategy. ‘Yes, the dollar is still overvalued. Will the dollar suffer further over the coming quarter? Probably.’

For a professional investment manager, whose performance is evaluated each month against a benchmark, this answer is unacceptable. But if you are managing your own money, and are not required to justify your positions regularly in front of an investment committee, the answer is much easier to accept. If you are in the market for medium to long-term absolute return, you need not worry about timing. Fair value is all that counts.

The obsession with shifting paradigms and structural breaks with its assertion that nothing is as it was and everything has changed implies that measures of fair value convey the wrong signals. However, more often than not, the status quo prevails.

Advocates of structural change claimed that the dollar would remain strong ad infinitum; recessions were a thing of the past — destined to become a footnote in the annals of economic history; and that inflation had been tamed in spite of years of expansionist monetary policy. While some of the observations appear valid, they are nothing but the manifestation of uncertainty in the face of large deviations from the norm.

What if the norm really does change periodically? Well, at least we were already well advanced on our way to the new fair value when we made our investment. If fair value for the EUR/USD exchange rate had stood at 1.10 before the seminal change, and we decided to shorten the USD at 0.85 in the face of a whopping overvaluation according to the old equilibrium, how much would we have lost if fair value had really dropped? Could it have dropped far below 0.80? Value investing probably implies that you are putting your money in quite close to the initially unknown mean of the ‘new paradigm’. If this means that the worst case is close to normal performance, you cannot go far wrong by initially assuming that the world is broadly stable.

Still, you need to be willing to take some risk. We all know about the trade-off between risk and return, but few investors really grasped what risk really meant. For a statistician, risk is nothing but a measure of, to what extent returns fluctuate in either direction. For a private investor, risk means potential loss, and recently loss has been the norm. Or has it? In truth, loss is the exception rather than the rule. Let us not get swept away in a tide of pessimism. The economic rules of the game have not changed. The maxim is keep a cool head, be exposed only to the risk you really want and hedge the rest. Taking risk will be rewarded by the markets. The further they drop, all the more so. So, buy when nobody else does, as long as your investment is in line with basic economic reasoning.

Dr Klaus W Wellershoff
UBS Private Banking
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