Seeing the Forest
Market professionals often find themselves focused on what will happen tomorrow, or in the next few hours, or maybe the next few days. It is often wise to step back and gain perspective. My framework for this approach includes four risk-reward steps, each of which requires specific analysis:
- What is the probability of the principal downside risk?
- What are the likely consequences if these risks occur?
- What is the probability of any upside catalysts?
- What is the upside potential?
A sound conclusion requires addressing all four questions. Here is an amazing Wall Street Insight:
Most pundits and reseachers do only ONE of these four steps!
You can test this yourself. Just read any commentary with a scorecard for how many of the four steps are covered. Most bearish analysts currently discuss the potential for an economic recession. The well-known theme is that a decline in housing will drag the U.S. economy into a recession. The bears see this potential as 70% to 80%. The "default" recession odds are about 20%, based on long-term history. The current consensus, due to the Fed’s intentional effort to slow the economy, is a 25% chance of recession in the next year. The bearish analysts generally make this sound like an apocalypse, but a careful reader will note that these reports do not do the following:
- Predict earnings results from the recession
- Discuss how much of this potential is already "baked in"
The same can be said of bullish analysts. Many bulls focus on the prospects for an improving economy, or the chances for a cut in interest rates. Just like the bearish analysts, there is no real perspective on what is already factored into the market. There is no sense of where we are, and where we might go.
The result is a complete lack of perspective.
- Bears are astounded that a market they see as overextended keeps going higher.
- Individual investors see new highs in the DJIA and ask whether it is "too late" to invest.
- Many, especially traders and hedge fund managers, look at the approach to old highs in market averages and wonder whether we face a repeat of 2000.
This all comes from a failure to answer all four crucial questions and the lack of some overall valuation model. When we analyze individual stocks, we look to long-standing metrics for valuation. For a good market perspective, it is wise to do the same.
What should these be? Hedge Fund Job Applicant #4 attempted to answer this question, but some of the assumptions seem sloppy. Most market professionals, based upon what we can read online and reinforced by my personal conversations, focus only on the recession potential.
Is there an answer? At "A Dash" we are going to discuss valuation models as the key to gaining the needed perspective.
If my readers are not convinced by this description of the necessity, go back to 1999 and 2000. At that time the big money was all on board with buying the Internet stocks, telecommunication stocks, and related technology issues. Old valuation metrics did not matter. Whatever was right last year was expected to be right this year.
We all know how that worked, so it is a topic worth exploration. More to follow.