Friday, January 30, 2009

Pricing Risk

Pundits on the various financial media are still trying to call a bottom to the U.S. equity market. So far even the fastest talking heads have been frustrated in their attempts to declare the bear market over and the bulls back in charge. I empathize with them, as I have also tried to use some of the usual indicators such as the Relative Price Index, the Volatility Index, the Ratio of Advancers to Decliners and other measures of aggregate equity trading activity.

The Advance Decline Ratio and the Volatility Index suggest continued uncertainty and confusion. Why are investors so confused? First of all, it is difficult to re-calibrate future earnings and by extension then difficult to measure stock value using an earnings based measures. Second, investors are now gun shy. They realize they made mistakes in pricing risk over the past several years.

Mispriced risk! How could so many smart people be so wrong? Were the calculators of financial people in need of new batteries? Or were they just incompetent? Perhaps the answer lies somewhere in between in the packaging of risk. We are all now beginning to understand that risk, particularly in the mortgage securitization business, was “mispackaged” - sliced and diced a few too many times such that risk could not be easily calculated by even the smartest bankers.

So as far out as the pendulum swung over the past five to ten years in the credit markets, it must now make that wide swing to the other side as investors return to more accurate and more diligent risk assessments.

It is yet to be seen whether investors are prepared to apply the same valuation metrics to equities in the future. My guess is that higher discounts for perceived risk will be required across the board for some time to come. This is likely due to the perception that the "mispackaging" implies a structural defect in our capital markets.

This means that measures such as the Relative Price Index may be a faulty mechanism for determining a market bottom. Price indices capture changes in pricing but often fail to account for qualitative changes such as changes in required discounts for risk.

The small-cap investor, indeed investors in all market cap segments, is pressed more than ever to make smart company-specific choices. Those particularly skilled at value investing should be rewarded if they have the time horizon to wait.

So take the week-end off to watch the SuperBowl or go for a long walk. There is no rush to be the early bird. As an aside…notice that Wall Street is no longer clamoring for expanded market hours?

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