Prediction vs. Valuation

Two weeks ago we hosted a quarterly investor call, discussing our strategy and our viewpoint on the financial markets. Afterwards we took questions.

The first question we got was, “When will the Fed raise rates and what will happen when they do?”

Our answer was to quote Warren Buffett’s observation: as investors, we are better at valuation than prediction. We can’t know what will happen in the future, no matter how badly we wish to, but even if we could confidently predict a future event, we would still be unable to reliably forecast its effects.

This past week, events demonstrated Buffett’s acumen yet again, and our borrowed wisdom in aping his viewpoint. With many investors publicly worried that the Fed would raise rates, and that the end of free money would hurt the markets, instead the Fed chose to stand pat on rates.

So the market went up, right? No, the market went down, concerned that the Fed’s restraint proved the world economy was in worse shape than we thought. (We are not the first to observe that the Fed is trapped in a Catch-22 of its own making.)

There are two takeaways here. First, forget about predicting. Second, markets that want to go up will interpret most news as bullish, while markets biased toward decline will go down on a similarly broad span of news. Right now the markets see the glass half-empty. Which helps us not at all, since sentiment can swing from greed/bullishness to fear/bearishness with shocking speed and unpredictability.

This leaves us with valuation. U.S. stocks remain very expensive by the long-term measures we find most persuasive, though another week or two of declines would change “very expensive” to merely “quite expensive,” with some limited implications for asset allocation. Foreign stocks are, relatively speaking, unusually, even extraordinarily cheap. That we can act on, never mind the Fed.

2 thoughts on “Prediction vs. Valuation

    • There are multiple problems with buying undervalued assets based on a relative-price model. First, they might not be truly undervalued, if something fundamental has changed in the underlying economics. Second, even if the relative value relationship is durable, it is almost never the case that it reverts to the mean right after you make your commitment to the cheaper assets. A good case in point was tech, where we went severely under-weight in early 1999, a full year before the tech collapse. Being early cost us full participation in that last spectacular +85% year, though over the full cycle it also saved us from the -80% collapse.

      Keep in mind that visible factors, and anticipated actions, are usually priced-in. The expectation that current trends will continue, and that pending changes will occur, is what drives valuation anomalies in the first place.



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