Fundamental value estimates
Fundamental value seems like a straightforward investment approach. One simply looks for assets that are “cheap” or “expensive” relative to their rationally expected risk-adjusted discounted cash flows. In reality, conscientious estimation of fundamental value gaps is one of the most challenging strategies in asset management. Value opportunities arise when market prices deviate from contracts’ present values of all associated entitlements or obligations. This requires a lot of information and estimation. Instead, analysts prefer simple valuation ratios, such as real interest rates or equity earnings yields with varying enhancements. Moreover, value strategies can take a long time to pay off and positive returns may be concentrated on episodes of “critical transitions”.
However, there are ways to make value trading more practical. Historically, it has been easier to predict relative value between similar contracts rather than absolute value. Also, simple valuation ratios become more meaningful when combined with related economic indicators. Thus, long-term bond yields are plausibly related to inflation expectations and the correlation of bond prices with economic cycles and market trends. Equity earnings yields can be enhanced by economic trends and market information. And effective exchange rates become a more meaningful metric when combined with inflation differentials and measures of competitiveness of a currency area.