Haven't you had more than your portion of market volatility recently? The actions (or inaction, depending upon your political leanings) of the EU Central financiers to address debt issues over its more profligate member countries show a fiscal 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 market pricing into a range which suggests the oft-mentioned recessionary double dip.
The market's 2011 decline reflects the dramatic day-to-day variances that unnerve stockholders and sadly invite comparisons of the exchange to a casino. We believe it's vital to revisit this topic basically to provide perspective and comfort that the world economy will survive. The mathematical derivation tells you nothing you don't already know: the market has been volatile. But then, we've all felt that agony.
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 two and three percentage points have made you reconsider your stock distribution please ask yourself this question: Has the natural value of the Standard and Poor's 500, an index of 500 of the biggest American firms, changed by 2, three, or 4 percent in a single day?
Everybody can agree that the idea of 500 corporations ceasing to exist is a fallacy so a value of 0 need not be addressed. The natural price of any one company can be estimated by working out its Net Present Value of cash flow. Implicitly inserted in that formula is the statement that a company is actually worth the value of all cash flow (available to equity investors) both present and future. Lacking the presence of another metric the case for using cash flows to value a company and its stock isn't just intuitive, but common-sense. If you are still not convinced please note this is the method employed by Warren Buffet and a number of other highly successful investors. The fundamental investment grounds is that it's not always what you buy; it is what you pay for it! Without a point of reference â€" that of intrinsic value â€" how would stockholders define an attractive "buy" price?
The point we're laboring to make is best demonstrated by the answer to this seemingly simple question: Given daily market volatility and associated declines how much does a corporation's inbuilt worth change over these short period frames? The answer is nearly none. Changes in natural value are totally the results of cash flows not yet realized. The degree that a company's outlook dims the stock price reflects the expectation of lower future cash flows and reduced growth trajectory. These unfortunate events sometimes occur slowly and the stock price follows, or on occasions leads, in an appropriate way. For the sharp-eyed reader the leftover unanswered expectations and resulting query are: If future cash flow use implies a forecast which cannot be stated exactly, and this mistake results in a price calculation that may and will change, are daily price adjustments are valid? In our estimation, cash flows demonstrate variance. But , the consequences of any one cash flow has small effect on the final intrinsic value calculation that, in reality, should be regarded as a price approximation. With very little change in a company's inbuilt value why should daily (even monthly) price fluctuations concern the financier? Short-term market noise and static isn't useful information in the choice making process. At such times it may be sensible to revisit an old The Street adage: During bear markets company shares go back to their rightful owners. Those providing investment management advice and managing their portfolios believing risk is defined as short term survival usually create opportunities for backers who know that real risk is failing to reach a long term target.
The market's 2011 decline reflects the dramatic day-to-day variances that unnerve stockholders and sadly invite comparisons of the exchange to a casino. We believe it's vital to revisit this topic basically to provide perspective and comfort that the world economy will survive. The mathematical derivation tells you nothing you don't already know: the market has been volatile. But then, we've all felt that agony.
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 two and three percentage points have made you reconsider your stock distribution please ask yourself this question: Has the natural value of the Standard and Poor's 500, an index of 500 of the biggest American firms, changed by 2, three, or 4 percent in a single day?
Everybody can agree that the idea of 500 corporations ceasing to exist is a fallacy so a value of 0 need not be addressed. The natural price of any one company can be estimated by working out its Net Present Value of cash flow. Implicitly inserted in that formula is the statement that a company is actually worth the value of all cash flow (available to equity investors) both present and future. Lacking the presence of another metric the case for using cash flows to value a company and its stock isn't just intuitive, but common-sense. If you are still not convinced please note this is the method employed by Warren Buffet and a number of other highly successful investors. The fundamental investment grounds is that it's not always what you buy; it is what you pay for it! Without a point of reference â€" that of intrinsic value â€" how would stockholders define an attractive "buy" price?
The point we're laboring to make is best demonstrated by the answer to this seemingly simple question: Given daily market volatility and associated declines how much does a corporation's inbuilt worth change over these short period frames? The answer is nearly none. Changes in natural value are totally the results of cash flows not yet realized. The degree that a company's outlook dims the stock price reflects the expectation of lower future cash flows and reduced growth trajectory. These unfortunate events sometimes occur slowly and the stock price follows, or on occasions leads, in an appropriate way. For the sharp-eyed reader the leftover unanswered expectations and resulting query are: If future cash flow use implies a forecast which cannot be stated exactly, and this mistake results in a price calculation that may and will change, are daily price adjustments are valid? In our estimation, cash flows demonstrate variance. But , the consequences of any one cash flow has small effect on the final intrinsic value calculation that, in reality, should be regarded as a price approximation. With very little change in a company's inbuilt value why should daily (even monthly) price fluctuations concern the financier? Short-term market noise and static isn't useful information in the choice making process. At such times it may be sensible to revisit an old The Street adage: During bear markets company shares go back to their rightful owners. Those providing investment management advice and managing their portfolios believing risk is defined as short term survival usually create opportunities for backers who know that real risk is failing to reach a long term target.
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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