Nobody Knows Nothin’

The Wall Street Journal ran an interesting article over the weekend, ‘How Much Should a Currency be Worth?  No One Really Knows.’  Click here for the article, though a subscription may be required.  


We don’t have any direct investment in currencies, but the headline caught my attention because I have the view that no one really knows what anything is really worth. 


The article focuses on the minutia of International Monetary Fund (IMF) currency values, which greatly affects trade.  The IMF has been working on a valuation methodology that everyone can agree on, but their solution provides highly imprecise estimates. 


For example, the article says that IMF estimate shows the Japanese yen 15 percent overvalued and 15 percent undervalued. 


The article then quotes a former Commerce Department official who said, ‘Ask ten different economists for the ‘objective’ market value of a foreign currency, and you will get 10 different answers – all well-argued and backed by econometric analysis, but all different.


While the article was about currencies, I think the idea applies to most, if not all financial assets.


Think about your house: who would have a better handle on its value than you?  You know how well it’s being taken care of, what’s terrific about it and that the plumber said that you will need all new pipes in a few years. 


And yet, you don’t know what it’s worth.  You may have an idea from talking to neighbors about a house that just sold down the street (but is a little smaller than everyone else’s) or looking online at sites like Zillow. 


If you do look at Zillow, be sure to look at the Zestimate range, and not just the single point estimate.  The range on my house is about 20 percent higher, and lower than the single point estimate, much like the Japanese yen.


For a while, I was deeply interested in discounted cash flow (DCF) models that help evaluate the ‘intrinsic’ value of a stock.  I spent a lot of time getting to know DCF models and we subscribe to Morningstar’s equity research so that we can see their models and fuss with the inputs.


Even though DCF models produce a single point estimate of a stock value, even Morningstar suggests thinking about a range around the estimate.  For General Electric (GE), for example (the largest S&P 500 stock not on our Approved List), their model and analysis suggests that GE is worth $30 per share. 


On Friday, the stock closed at $27.27, which is close to a 10 percent discount from the model estimate.  Morningstar says, though, that you should really consider buying GE at $21 per share, a 30 percent discount from their estimate of intrinsic value.


They say that while the model is excellent, there are so many unknowns in creating a model like this that you should have a ‘margin of safety,’ which is a phrase they’ve taken from Ben Graham, the godfather of value investing. 


Essentially, they say, we think it’s worth $30 per share, but we could be wrong, so don’t buy it unless it falls below $21 per share, when it’s cheap.  Of course, whatever caused the stock to fall 30 percent may have also caused the intrinsic value estimate to fall, so you might have to revisit the DCF model and get a new estimate.


Perhaps the only investment where you can really know the value at the time of purchase is a plain-vanilla bond where you have a structured beginning, middle and end with a stated coupon. 


Of course, you have to be confident that the issuer won’t default and if you want to know what your bond will buy you at maturity after adjusting for inflation, you’re back to square one.


Years ago, I read a book that was published decades ago.  I think it was Jessie Livermore’s Reminisces of a Stock Operator, but I can’t be sure (I guess I’m due for a re-read).  In any case, the protagonist in this book is new to the market and is trying to figure it out when a seasoned Wall Streeter essentially tells him, ‘hey kid, nobody here knows nothin.’ 


While I think that’s largely true, the good news is that I think this also helps explain why markets are largely efficient.  One of the basic ideas behind the Efficient Market Hypothesis (EMH) is that the intrinsic value of a security is unobservable, so the best estimate is the price.


They don’t say that the price is correct, only that this estimate is better than the other estimates.  The idea is that the market is competitive with a large number of educated players with something important (money) at stake.


It doesn’t mean that the price is always right – it isn’t.  It only means that figuring out why the price is wrong (what you know that the market doesn’t) is very tough and, on average, may not be worth the cost.  


It makes sense to me and explains why prices flop around so much.  If we all knew what GE was worth, for example, that’s the price it would trade for – there wouldn’t be any volatility or need for diversification, which is obviously a pipe dream.