Haven't you had more than your portion of market volatility recently? The actions (or inaction, depending upon your political leanings) of the European Central financiers to try to address debt worries over its more profligate member countries expose a finance scenario harking back to the U.S. In late 2008. Financial and banking doubt stemming from Europe combined with a small and declining U.S. GDP calculation has helped drive stock exchange pricing into a range which suggests the oft-mentioned recessionary double dip.
The market's 2011 decline reflects the dramatic daily variances that dishearten speculators and unfortunately invite comparisons of the stock market to a casino. We think it is crucial to revisit this subject primarily to provide perspective and reassurance that the global economy will survive. The mathematical derivation tells you little you don't already know: the market has been unsteady. But then, we have all felt that pain.
Mathematics, being accurate by definition, announce that this time is little different from the past. We are seeing times of low daily variance usually connected with Bull markets only to be interrupted by frequent violent day-to-day price swings. This transition from relatively quiet advancing markets to clamorous declines is usually the result of the imbalance of investors over-estimating market returns and, more importantly, under-estimating risk. This appears to occur curtly and is highly influenced by headlines. We've reached that stage of adverse events, intensified by the ever-present media, and the resulting uncertainty.
If daily market changes of plus or minus 2 and 3 p.c. points have made you rethink your stock allocation please ask this question: Has the intrinsic cost of the Standard and Poor's 500, an index of 500 of the largest American corporations, changed by two, 3, or four % in a single day?
All of us can agree that the thought of 500 companies ceasing to exist is a misconception so a valuation of nil needn't be addressed. The inbuilt value of any one company can be predicted by figuring out its Net Present Value of cash flow. Implicitly embedded in that formula is the statement that a company is really worth the cost of all money flow (available to equity investors) both present and future. With a lack of any other metric the argument for using money flows to price a company and its stock is not only intuitive, but common sense. If you're still not convinced please note this is the process employed by Warren Buffet and a bunch of other seriously successful financiers. The base investment premise is that it is not necessarily what you purchase; it's what you pay for it! Without a point of reference â€" that of natural price â€" how would investors determine an attractive "buy" price?
The point we're laboring to make is best demonstrated by the answer to this reputedly straightforward question: Given daily market volatility and associated declines how much does a firm's intrinsic value change over these short time frames? The answer is almost none. Changes in intrinsic value are entirely the results of cash flows not yet realized. The degree that a firm's outlook dims the stock price reflects the expectation of lower future cash flows and lessened growth path. These unfortunate events generally occur slowly and the stock price follows, or on occasions leads, accordingly. For the sharp-eyed reader the leftover unanswered guesses and resulting question are: If future cash flow use implies an outlook which cannot be stated accurately, and this mistake ends in a price calculation that may and will change, are daily price changes are valid? In our estimation, cash flows demonstrate variance. However the effects of any one cash flow has little impact on the final inbuilt worth calculation that, incidentally, should be seen as a price approximation. With very little change in a corporation's natural price why should daily (even monthly) price fluctuations concern the financier? Short-term market noise and static isn't valuable information in the choice making process. At such times it may be smart to revisit an old Wall Street adage: During bear markets company shares go back to their lawful owners. Those providing investment management advice and managing their portfolios believing risk is generally accepted to be short term survival usually create possibilities for investors who know that real risk is failing to reach a long term objective.
The market's 2011 decline reflects the dramatic daily variances that dishearten speculators and unfortunately invite comparisons of the stock market to a casino. We think it is crucial to revisit this subject primarily to provide perspective and reassurance that the global economy will survive. The mathematical derivation tells you little you don't already know: the market has been unsteady. But then, we have all felt that pain.
Mathematics, being accurate by definition, announce that this time is little different from the past. We are seeing times of low daily variance usually connected with Bull markets only to be interrupted by frequent violent day-to-day price swings. This transition from relatively quiet advancing markets to clamorous declines is usually the result of the imbalance of investors over-estimating market returns and, more importantly, under-estimating risk. This appears to occur curtly and is highly influenced by headlines. We've reached that stage of adverse events, intensified by the ever-present media, and the resulting uncertainty.
If daily market changes of plus or minus 2 and 3 p.c. points have made you rethink your stock allocation please ask this question: Has the intrinsic cost of the Standard and Poor's 500, an index of 500 of the largest American corporations, changed by two, 3, or four % in a single day?
All of us can agree that the thought of 500 companies ceasing to exist is a misconception so a valuation of nil needn't be addressed. The inbuilt value of any one company can be predicted by figuring out its Net Present Value of cash flow. Implicitly embedded in that formula is the statement that a company is really worth the cost of all money flow (available to equity investors) both present and future. With a lack of any other metric the argument for using money flows to price a company and its stock is not only intuitive, but common sense. If you're still not convinced please note this is the process employed by Warren Buffet and a bunch of other seriously successful financiers. The base investment premise is that it is not necessarily what you purchase; it's what you pay for it! Without a point of reference â€" that of natural price â€" how would investors determine an attractive "buy" price?
The point we're laboring to make is best demonstrated by the answer to this reputedly straightforward question: Given daily market volatility and associated declines how much does a firm's intrinsic value change over these short time frames? The answer is almost none. Changes in intrinsic value are entirely the results of cash flows not yet realized. The degree that a firm's outlook dims the stock price reflects the expectation of lower future cash flows and lessened growth path. These unfortunate events generally occur slowly and the stock price follows, or on occasions leads, accordingly. For the sharp-eyed reader the leftover unanswered guesses and resulting question are: If future cash flow use implies an outlook which cannot be stated accurately, and this mistake ends in a price calculation that may and will change, are daily price changes are valid? In our estimation, cash flows demonstrate variance. However the effects of any one cash flow has little impact on the final inbuilt worth calculation that, incidentally, should be seen as a price approximation. With very little change in a corporation's natural price why should daily (even monthly) price fluctuations concern the financier? Short-term market noise and static isn't valuable information in the choice making process. At such times it may be smart to revisit an old Wall Street adage: During bear markets company shares go back to their lawful owners. Those providing investment management advice and managing their portfolios believing risk is generally accepted to be short term survival usually create possibilities for investors who know that real risk is failing to reach a long term objective.
About the Author:
Terry Rau, CFA at Fonders Bank & Trust - A Community Bank in Grand Rapids, MI a senior member of our Investment Management team.
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