Investment Theory and Instrinsic Value : continued

Are Prices Reasonable?

Do We Care About Intrinsic Value At All?

Although the Irrationality Axiom states that market players are often irrational, this does not mean that the market is always irrational or that we should ignore the idea of intrinsic value.

We can not ignore the idea of instrinsic value

When markets are priced signficantly above intrinsic value, there is always a risk that rationality may suddenly return, inspiring investors to take actions that force prices down.
When markets are severely undervalued, there is a potential that this condition may come to be generally recognized, causing investors to buy and prices to rise.

In other words, an evaluation of the instrinsic value of securities that make up a market provides information as to the possible stability and reliability of a price trend.

When prices are rising far above intrinsic value, the market may be more susceptible to reversal than when prices are rising from a level far below intrinsic value.

Security prices may diverge from intrinsic value for a very long time

Nevertheless, security prices may diverge from intrinsic value for a long time.

U.S. equities, relative to dividend yields, have been over-valued for two generations.
the American stock market relative to earnings has been over-valued for at least a decade.
U.S. stocks relative to the discounted current value of dividends have been over-valued for at least a generation.

This means that expectations that security prices periodically 'return to the norm' are not realistic.

Don't stake your reputation on the presumption that the over-pricing of securities necessarily will lead to a collapse in market prices in the short term.

Explaining motivation is central to Capital Flow Analysis

However, we do care about the relationship between intrinsic values and market price because of what it tells us about the motivation of market players; explaining motivation is central to Capital Flow Analysis.

For over a generation stock prices have been over-valued as compared to dividends, both in terms of current yields and discounted future returns. However, individual investors have persisted in buying equity mutual funds, despite this departure from reasonable value.
In examining the motivation of mutual fund investors we find that, in general, most are unsophisticated believers in the Common Stock Legend and are separated from the companies in which they invest by multiple layers of fiduciaries.

In this context, the over-valuation of equities makes sense. Not only have prices been driven up by corporate buybacks, but also by unsophisticated mutual fund investors with little concept of the intrinsic value of the securities they are buying.

Indicators of Reasonable Value for Equities

This site has resources regarding the value of corporate equities, as an investment class, compared to historical values in the U.S. market. For a more thorough discussion of the concept of reasonable value:

Review lesson 5; and
Read the learning module.

For further discussion of equity valuation, read the essays, 'The Value of Dividends', 'The Hidden Shortage', and 'Mr. Clendenin's Suggestion'.

The value tab leads, on the horizontal bar above, leads to a page with three equity risk measures.

When all of these three equity risk indicators are negative, it is highly likely that stock prices are above 'reasonable value'.
When all these equity value measures are positive, which has not occured in the last generation, this indicates that equities are under-valued.

On this same value page, there is a measure of 'Equity Supply' that indicates the degree of shortage or surplus of equities in trillions of dollars.

These indicators are useful when judging the motivation of players in the equities and mutual fund markets.

However, they should not be used, in isolation, to predict trends in the equity market.

Reasonable Values in the Fixed Income Market

As indicated in lesson 5, we generally assume that prices are reasonable in fixed income securities markets.

Paradoxically, there may be more talk of securities being over- or under-priced in the fixed-income market than in equity markets.

There are reasons for this:

Bond markets are dealer markets.

Intermediaries have a direct financial interest in the short-term direction of the market because dealers hold positions in fixed income securities.

In contrast, equity markets are dominated by stockbrokers who usually do not have an undisclosed financial interests in the stocks they recommend to investors.

From the point of view of a stockbroker, eager to sell shares to clients, it would be bad business to say that the stock market is over-valued.

However, a fixed-income security dealer is on the other side of every trade and is more likely to be value-oriented.

They 'put their money where their mouth is' and stand ready to either buy or sell for a dealer's spread.

Furthermore, since bond investors focus on income, they are less likely to be enticed into buying bonds by the prospect of falling yields — even though bond prices may be rising.

In bond markets, issuers and investors focus on interest paid or received.

When interest rates fall, investors complain that yields are too low.

When rates rise, issuers complain that borrowing costs are too high.

Although one or the other side of the market may be unhappy, the complaints show that both sides are acting rationally.

In contrast, in equity markets, for extended periods, investors eagerly buy stocks with no yields and with price-earnings ratios of infinity, while issuers borrow money at 12% to buy back their own stock at fifty times earnings.

Bond markets have many 'efficient market mechanisms'.

Bond ratings, interest rate derivatives, wide publication of bond-yield curves and spreads, and predominance of long-term institutional investors (such as insurance companies and pension plans) makes fixed-income securities markets closer to the ideal of an 'efficient market' (at least in the U.S.), than does the structure of equity markets.

It is difficult for participants in the bond market to get too far away from the notion of intrinsic value.

Wild flights of fancy, such as the dot.com craze that swept stock markets in the 1990s, are less likely.

If the fixed-income markets are to get out of whack, this is more likely to occur in commercial banking and over-the-counter derivatives trading, where disclosure is less regulated, where non-securitized instruments are predominant, and where irrational motivation is apt to appear.

Examples can be found in commercial banking failures in Latin America in the 1980s and in Asia in the 1990s, which were driven by professional banking executives desires to meet lending goals and borrowers' willingness to overlook currency risk.

Another example of 'irrational exuberance' in fixed income markets, is the failure of Long Term Capital Management in which major brokerage houses and banks were willing to invest vast sums with little understanding of what they were doing.

As yet, we have not devised an easy indicator that tell us of the lack of reasonable pricing in fixed-income markets.

Consequently, we assume efficient markets for securitized fixed income securities and inefficient markets for equity based securities.

Summing up

The value tab on the horizontal navegation bar, above, leads to pages that describes how to make indices of reasonable valuation of equities.

This information is useful in explaining and understanding the motivation of market players, but should not be used alone for predicting market trends.

Price information on equities and corporate bonds appears on the flow tables on this site at the top of each column.

Price trends and the direction of flows are clues to motivation

Price information for other kinds of securities can be found in the research links associated with each flow table.

Price trends over the period plus the direction of flows on the instrument tables indicates motivated buyers or sellers that drive prices in that market.

Having identified the sectors that are the motivated buyers or sellers, the next step in Capital Flow Analysis is to try to understand the reasons that buyers or sellers act as they do.

By the Irrationality Axiom, we do not assume that these reasons are necessarily 'rational' in the economic sense.

Before proceeding, check your progress:

Self-Test

A principle of Capital Flow Analysis is that: Market prices equal intrinsic value. The Efficient Market Hypothesis is true. Prices may diverge from intrinsic value. Prices periodically return to the norm.
This site has indicators of reasonable value for: Bond markets. Equity markets. Commercial loans. Derivatives.
Bond prices are usually reasonable because : Most bonds are traded on the NYSE. Bonds are usually rated. Intermediaries are dealers. Prices are quoted as yields.