Financial news

Irving Fisher was a celebrated American economist who was at the origin of numerous concepts in finance. Nonetheless he was vilified at the time of the Great Crash, because he maintained that stock prices had reached a plateau. In autumn 1929, the market value of all shares listed on the New York Stock Exchange plummeted by 30 percent. Many analysts then and now have taken the view that stocks were overvalued and that the market stood in need of a correction. Irving Fisher argued at the time that in fact the fundamentals were sound and the market was undervalued. In a paper published in December 2001, Ellen R. McGrattan and Edward C. Prescott, both of the Federal Reserve Bank of Minneapolis, estimated the fundamental value of corporate equity in 1929 and compared it with actual stock valuations. They came to the conclusion that the Great Crash was not attributable to overvaluation. The evidence strongly suggests that on the contrary, even at their 1929 zenith when the Dow Jones reached 379.61, stocks tended to be quoted low. However, the Dow fell to 41 in June 1932. In another article the same authors demonstrate that in the first half of 2000, the overall value of US corporate equity was close to 1.8 times that of GNP and that because it was equal to the value of all productive assets in the US corporate sector, at that price it was correctly valued. In 2000 the Dow Jones was at around 12000, only to fall to 7500 two years later. Two tales of a bubble that wasn’t! As Adam Smith observed in the Wealth of Nations, the word value has two meanings: the value in use measures the utility of an asset,the value in exchange its purchasing power. In one of his afterthoughts on the history of capitalism, Fernand Braudel explains that everything that stays outside of the market has only a value in use, all that pass the footstep of the market acquires a value in exchange. The value in use can be defined as the value of an asset calculated by discounting the future cash flows obtainable from its continued use. Many market economists in America explain that the market price reflects long-term cash flow prospects, a value in use. On the contrary, there are a number of economists in Europe who consider that the stock price is only a value in exchange. They are very critical of the so-called investor’s rationality in determining market prices. They have adopted Keynes’ view that investors are concerned, not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. For most European economists everything depends on waves of irrational psychology. The relationship between price and value is a puzzle that has baffled economists since times immemorial.

There are two basic approaches to financial markets and their fundamental logic. The first (which will be considered again when we analyze investor behavior, corresponding to passive or index fund management) draws on double diversification in space and time. Diversification in space involves a multitude of financial instruments designed to reduce the risks proper to each and to accept only non-controllable, systematic risk. When investing in stocks you should remember that it is important to diversify into more than 20 of them to make the most of the diversification effect in accordance with the correlation existing between these different stocks. However, this is equally the case when you invest in gold, real estate, bonds or Treasury bills.
Concerning possible stocks, observe the way in which the firm defines its ‘‘corporate strategy’’. Choose those that are focused, as Zook and Allen showed,33 on expanding and innovating in and around their core business. It is up to the investor – and not to the company – to diversify. Such reduction of risk is accompanied by diversification in time; you have got to invest over a long period. If you go for the long haul, you tend to render your investing steadily less hazardous. This is a form of passive investment corresponding both to Warren Buffett’s practices and to the classic definition of the speculator. Speculate on the future, invest and stay invested.
The second approach is more speculative in the sense of speculum, a mirror; Keynes’s beauty contest comes immediately to mind. In this case, a speculator buys stock only for the sake of short-term capital gains rather than for long-term income. Keynes used the term ‘‘speculation’’ for the activity of forecasting the psychology of the market and ‘‘enterprise’’ for the activity of forecasting the prospective yield of assets over their whole life. He despised speculators’ gambling instincts. He felt that they were simply trying to outguess and outwit one another ‘‘to beat the gun’’, rather than striving to project and compute the cold mathematics of future cash flows and associated risks. This analysis explains the highly erratic stock variations registered from one day to the next. Keynes claimed that the valuation of capital assets consequently established was ‘‘arbitrary’’ in so far as it had devolved into a forum for speculation rather than entrepreneurship. This is still the case. But since Keynes’s time, the financial world has learned how to measure the state of confidence with which we forecast the prospective yield of financial assets over their whole life. We now know that long-term investment in a well-diversified portfolio bolsters our confidence in financial investments. Within this framework, the selection of assets relies on more subjective and qualitative factors.
Thus there are two approaches at work. The first is long and diversified; the second is necessarily limited in time. There exists a quantitative philosophy predicated on the past history of returns and volatility as well as indicators of responsiveness such as the beta coefficient. There also exists a qualitative philosophy through which one endeavors to identify factors that will orient prices in the near future. In the end these two philosophies come together. Expectations for the future are based on statistical analysis of results recorded in the past. The short-term qualitative approach fits into Chinese boxes with regard to the long-term quantitative approach. Asset allocation is in conformity with long-term quantitative analysis and selection of individual assets remains qualitative and short term.