The law of Conservation of Mass states that, in a closed system, matter cannot be created or destroyed. It can change forms but is conserved. The global economy is a closed system. But there is no conservation of value.
This is obvious to entrepreneurs and venture capitalists, but many find the nature of asset prices and valuation to be very confusing. Some politicians think value can be easily measured and divided up without impacting the total. Some investors think that fundamentals determine prices. Some people think new forms of money like Bitcoin can't have value because it was created from nothing. Some people think that robots are going to take away most of the jobs leaving nothing of value but shares in Skynet.
A deeper understanding of the nature of value and the prices we use to measure financial assets reveals these beliefs to be unfounded.
In this article we summarize four basic principles of asset valuation. These principles have important implications for understanding concepts like the nature of money, meaning of prices, financial risk, asset fundamentals, and sources of value creation and destruction.
Note: We previously summarized three key principles on the money. If you haven't had a chance to read it please take a moment now (link).
Money improved coordination between people. This increased economic growth in a way that benefited everyone.
Inflation is created when demand for goods and services exceeds supply.
The value of money ultimately rests on the issuing government's demand for taxes paid in said money.
In this piece we extend these principles to financial assets more broadly.
Principle #1 - Price Illusion
Value vanishing acts are common for all financial assets...not just money. Global equities exceeded $100 Trillion in value during 2018. During the four week period surrounding Christmas Eve global equities lost 10% of their value or about $10 Trillion and then fully recovered. Risky bonds also fell. A large chunk of global financial asset value simply vanished and reappeared.
Vanishing value seems to defy the laws of physics. Newton's third law states that, "for every action, there is an equal and opposite reaction". This means that in every interaction, there are always two forces acting on the two interacting objects. The size of the force on the first object equals the size of the force on the second object.
But price action need not have any opposing force.
We value financial assets by observing the most recently observed price, but only a tiny fraction of a percent of people realize these prices. What we see is not what we all get.
Very little of what is owned is bought or sold in any given day, month or even year. This can make the total value of an asset, or the concept known as "market capitalization", deceiving.
For example, suppose that our daughters decide to start a business selling lemonade (against my advice) and issue an IPO to raise capital. Suppose further that talk us into buying 10% of their stock for $100 (after all, we want to be supportive). Does that mean their business is worth $1,000? Probably not. The reason is that they would likely not be able to sell the other 90% for $900.
The total market capitalization of all financial assets is somewhere around $500 Trillion. That is roughly 5 times the size of all the goods and services produced in the world (i.e. global GDP is about $100 Trillion). If all holders of financial assets tried to sell them in exchange for real goods and services tomorrow their price would plummet and inflation would skyrocket. Our measures of "market capitalization" would prove to be an illusion because this concept assumes that all shares of an asset can be sold at prevailing prices, an assumption that is ... on the aggregate ... false.
This leads us to asset valuation Principle #1:
Price Illusion - The true price of a financial asset is unknowable unless the entire asset is transacted.
Market capitalization is an approximation of value we derive from extrapolating traded prices. That approximation is crude, and for illiquid assets s really an illusion of value. We can get a glimpse into an asset's true value when an entire asset is transacted, such as a buyout, but even in these situation the flexibility of fundamentals makes value a matter of opinion.
Principle #2 - Flexible Fundamentals
Market prices are not determined by a single set of "fundamentals"...they are driven by a relatively small number of heterogenous people. People that might be very different than you. People with different perceptions of "fundamentals", different situations, different time horizons, and different degrees of psychological biases. Analysis may influence perceptions of value and risk, but at the end of the day markets are moved by the people who choose to buy or sell at an agreed upon price.
Why does this matter?
Because it means that the value of a financial asset to you might be very different than your broker, aunt, neighbor, any everyone else.
For example, suppose you are 30 years from retirement, have enough income to easily cover all your expenses, and believe in the efficient market hypothesis. What "fundamentals" matter to you?
If you are as logical as a Vulcan, only one fundamental really matters to you and that's the return after 30 years. If you really don't need the money for 30 years you don't care about correlation to other assets or volatility. With such a long time horizon what really matters is the range of possible outcomes for that asset: what's my baseline, what's the low end, and what's the high end.
Now most of us are not Vulcans. We tend to feel pain when prices fall even if we don't plan to sell for 30 years. That's why humans tend to also care about near term risk, sometimes proxied by volatility...or how much the price wiggles. Correlation to other assets also matters because of the potential risk reducing impact on the overall portfolio. Young people might hold bonds for decades and accept lower wealth at retirement because the reduced risk helps them sleep better.
Relaxing the efficient market hypothesis opens up a whole bunch of other "fundamentals" like valuation and macroeconomic cycle. Otherwise identical investors might place the same weight on these additional "fundamentals", but have totally different views on what they are. There seems to be an endless number of analysts that believe they know where the future is headed, why prices move, and what the latest economic data really means. This leads to an even greater diversity of opinion regarding the "fundamentals" of assets.
This leads us to asset valuation Principle #2:
Flexible Fundamentals - The true value of a financial asset is going to be different for every investor because every investors has a unique set of psychological biases, circumstances, and beliefs about markets and asset fundamentals.
We like to believe that "fundamentals" provide a reasonable anchor to support valuations. The reality is that much of what determines an assets value comes down to the discount rate, and few "fundamentals" could be more subjective. The discount rate is the rate analysts use to derive the present value of future cash flows, but there is little consensus regarding how discount rates should be applied for risky assets lie stocks.
What discount rate should be used to value a risky company that doesn't yet make profits or pay a dividend?
What equity risk premium (ERP) should I demand for holding stocks?
Reasonable investors can answer these questions in very different ways. That's a big reason for flexibility in fundamentals and helps to explain why there is so much uncertainty regarding how to measure risk.
Principle #3 - Risk Uncertainty
Prices are usually presented as line charts, but this implies that prices are continuous. In reality, prices jump all the time. In a healthy market there are many different participants with many opposing views. This heterogeneity provides "opposing forces" which help smooth price changes. But for any number of reasons, views of market participants can become indistinguishable. This homogeneity creates a single force acting in one direction and can cause large price moves. Sometimes no one is willing to provide an "opposite reaction". Liquidity simply vanishes. There need not be any reaction at all!
Of course, markets are full of reactions. They just don't tend to be equal and opposite. Quite the contrary, they can compound like the after shocks of earthquakes, or create an avalanche.
You can see the avalanche begin when something unexpected happens. All market participants see it...like the price falling in response to a hawkish Fed. They realize that if the price can fall by that much...prices could fall even further. They all re-calibrate their internal and/or empirical models and arrive at the same answer: SELL!
Home prices followed this pattern in the lead up to the Financial Crisis. Prior to 2007 there had never been a material decline the entire nation's housing market. Analysts saw regional declines...some big ones too, but never a simultaneous drop across the whole country. So they build their models on the assumption that this couldn't happen. Home prices stopped rising in mid-2006. Speculative started questioning the fundamentals of the housing market. Demand dried up and the rest is history.
Despite much improved valuation techniques, asset prices are still largely determined by subjective and un-forecastable inputs. One of our all-time favorite commercials was developed by Ally Financial to promote their flexible rate CD. Thomas Sargent, a Nobel-Prize winning economist, is sitting on a stage in front of thousands and asked if he knows what CD rates will be in two years. There is a dramatic pause before he says without flinching..."No".
Government bond interest rates are generally acknowledged to be un-forecastable, but so are the risk premiums we need to value just about everything else.
Risk premiums are what investors demand in exchange for owning risky assets instead of government bonds. For example, stocks in the United States have, on average, returned about 6% more to investors than 10 year treasury bonds. Analysts can easily calculate historical risk premiums. With a little digging they can even back out implied risk premiums. But no one has any clue how these premiums will change in light of future events.
Extrapolating from the past may prove detrimental. Historically low risk premiums can actually cause an asset to become more risky, as investors become accustomed to calling an asset "safe" and bit up prices. Likewise, historically high risk premiums can actually make an asset safer because the investors holding these assets are more likely to prepare for bad outcomes and reducing the probability of a fire sale.
Take subprime loans as an example. We call them subprime loans now...but before the Financial Crisis they were simply called mortgages, and everyone paid their mortgage, or so the story began.
Another all-time favorite commercial of ours features a character named Paul. "The uncertainly of getting a home loan made Paul ... irritable" (as he pops a child's balloon), but nothing can get Paul down after getting a loan from Washington Mutual (even his dentist drilling the wrong tooth). Perceptions of risk in mortgage lending were very low before the Financial Crisis.
Housing and mortgages gets picked on a lot because it was at the center of the most recent recession. The challenge for those working in capital markets is to understand that this can happen to any asset class. Whatever surprises us in the future is necessarily mis-understood today.
According to Nassim Nicholas Taleb (@nntaleb), author of Black Swan, we cannot model our way out of this uncertainty. All we can do is recognize that the range of possible outcomes is wider than what historical data (and through them models and forecasts) suggest. Mr. Taleb goes further than I would in criticizing models, but his point is well taken.
This leads us to asset valuation Principle #3:
Risk Uncertainty - How risky an asset was in the past is not a very good proxy for the future because that which is perceived to be low risk tends to increase in riskiness overtime due to higher demand and complacency.
We saw it with mortgages and in the last cycle. We might be seeing it again today with "Investment Grade" Corporate Debt and "Risk Free" bonds. The world is always changing, and that changes risk just as it changes value.
Principle #4 - Value Creation and Destruction
Humans have a hard time wrapping our heads around how something valuable can appear out of nothing. Crytoassets are a good example. We also have a hard time understanding how something of value can disappear. The bankruptcy of Lehman Brothers is another good example. Many things can destroy value such as war, barriers to trade, lack of incentives to work hard, lack of property right, stupidity, and earthquakes to name a few.
Very few things can create value...namely innovation.
Today, many worry about the robots and AI taking our jobs and leaving everyone unemployed but the engineers who made the robots and capitalists that hired the engineers. This is silly...but its not the first time we felt that way.
We are going through a technological transformation not unlike the industrial revolution in its impact on daily life. The rise of machines made many jobs obsolete, but it also created who new categories of goods and services.
In 1935, the Consumer Price Index (CPI) included just six categories including personal care, food, clothing, transportation, housing, and miscellaneous goods. By 1953 (just 18 years later) the CPI was expanded to include 9 categories...adding medical care, reading, and recreation. Importantly, "transportation" and housing were updated to include the cost of buying an automobiles and owning your own home.
In other words, many worried about losing their jobs to machines back in the 1930s because they couldn't imagine a world just 18 years in later in which many families spend a sizable income on medical care, books and education, taking vacations, buying metal horses, and owning their own homes.
Humans like to put things in buckets. It helps us keep things organized. But our buckets are not reality. We cling to our buckets when we imagine the future because its all we can comprehend. The same impulse leaves us fearful of the future when opportunities to create value are everywhere.
Cryptoassets are a good example because they are new and growing exponentially in usefulness. Just like paper money in the North American Colonies... crypto assets came from nothing. Bitcoin grow from zero in 2008 to nearly a Trillion before falling to over $300 Billion today. Essentially the same thing happened with equity Stocks in 1602 after The Dutch East India Company became the world’s first IPO. All three cases: paper money, crypto assets, and minority ownership in a public company (i.e. equity) all generated value that previously didn't exist.
What value is being created by Crypto Assets you say?
There are two broad types of Crypto Assets including Decentralized Applications (dApps) and Cryptocurrencies. Crypto Assets are being applied to a wide variety of real-world use cases.
Decentralized Applications (dApps) are just like mobile applications except that they run on decentralized platforms that are not controlled by any single entity. One example of a dApp is a Smart Contract which allows two parties to enter binding agreements without a third party. This is particularly useful in countries that lack robust legal systems such as most third world countries. One example of a smart contract that is currently in use is Etherisc which provides farmers with crop insurance based on satellite reads of rainfall data. Etherisc runs on the Ethereum network which requires the token “Ether” to run. Investing in Ether gives the holder exposure to the future value of smart contracts like Etherisc.
Cryptocurrencies as a substitute for fiat money is increasingly being accepted by businesses including Microsoft, Expedia, Overstock, and even governments like the state of Ohio for paying taxes. Another common use case for cryptocurrencies is Cross Border Payments or International Transactions which can be quite expensive (around $50 per transaction) and take 3-5 business days to settle. Bitcoin and other Cryptocurrencies such as Litecoin can be transacted at essentially no cost and settle within minutes if not seconds. Cryptocurrencies are also circulated outside the traditional banking system making them particularly useful for those that lack access to traditional bank account or those that live in countries with capital controls.
Many other innovations are driving today's productivity boom such as artificial intelligence, energy storage, robotics, genome sequencing, and blockchain technology. These and other innovations are causing dramatic cost declines, greater disposable income, and more opportunities to create value.
This leads us to asset valuation Principle #4:
Value Creation and Destruction - Value is not a zero sum game. Wars and lack of incentives will destroy value. Innovation is a driver of value creation. Innovation necessarily causes the future to look very different from today making it difficult to measure and anticipate.
That is why humans will generally find it easier to see value destruction than creation. Like the first measures of CPI, we can't anticipate the future basket of goods and services that will come to dominate the economy.
We summarized the nature of valuation into four principals below. In short, value is not conserved. It is illusive and fragile. Value is impossible to measure precisely because very little is traded and because value means different things to different people. We can create value by enhancing incentives to innovate. We can destroy value by removing these incentives. Value is not a zero sum game. It is a coordination game. One that will necessarily create some uncomfortable change but that has typically leads to a better future for everyone.
Price Illusion - The true price of a financial asset is unknowable unless the entire asset is transacted. Market capitalization is an approximation of value we derive from extrapolating traded prices. That approximation is crude, and for illiquid assets s really an illusion of value. We can get a glimpse into an asset's true value when an entire asset is transacted, such as a buyout, but even in these situation the flexibility of fundamentals makes value a matter of opinion.
Flexible Fundamentals - The true value of a financial asset is going to be different for every investor because every investors has a unique set of psychological biases, circumstances, and beliefs about markets and asset fundamentals. We like to believe that "fundamentals" provide a reasonable anchor to support valuations. The reality is that much of what determines an assets value comes down to the discount rate and components like the Equity Risk Premium which , and few "fundamentals" could be more subjective. The discount rate is the rate analysts use to derive the present value of future cash flows, but there is little consensus regarding how discount rates should be applied for risky assets lie stocks.
Risk Uncertainty - How risky an asset was in the past is not a very good proxy for the future because that which is perceived to be low risk tends to increase in riskiness overtime due to higher demand and complacency. We saw it with mortgages and in the last cycle. We might be seeing it again today with "Investment Grade" Corporate Debt and "Risk Free" bonds. The world is always changing, and that changes risk just as it changes value.
Value Creation and Destruction - Value is not a zero sum game. Wars and lack of incentives will destroy value. Innovation is a driver of value creation. Innovation necessarily causes the future to look very different from today making it difficult to measure and anticipate. That is why humans will generally find it easier to see value destruction than creation. Like the first measures of CPI, we can't anticipate the future basket of goods and services that will come to dominate the economy.