The difference between market price and fundamental value estimate is one type of “valuation gap” indicator. It is arguably the most challenging approach, since it must encompass all important relevant information simultaneously and requires both financial and macroeconomic modeling skills. Popular valuation ratios, such as equity earnings yields or real effective exchange rates, can form the basis of a valuation gap, but what is critical is their relation to a plausible theoretical value that accords with the economic environment.
Some basic points
Fundamental value versus valuation metrics
The fundamental value of a security or derivative contract is conventionally viewed as the expected risk-adjusted present value of all associated entitlements or obligations from the angle of a financial investor. Estimating such value typically requires
- a full understanding of contract or security properties,
- an appropriate modeling of the uncertain environment, and
- the application of an asset pricing or return model to both.
In practice, most investors have limited funds and capacity for research. The assessment of over- or undervaluation is often just an “opinion” (a view without much evidence) or “marketing”, a semi-informed view published by broker-dealers to stimulate discussions with clients and to solicit trading business. The preferred references are simple price-based valuation ratios, such as trade-weighted real exchange rates or earnings yields. These simple ratios are easy to understand and to monitor in real time on Bloomberg. And they are intuitive: real trade-weighted currency values inform on the sustainability of exchange rate trends, real interest rates help assessing the plausibility of a particular path of monetary policy rates, and in the equity space forward earnings yields in relation to real bond yields are a basic sanity check for stock prices.
However, simple valuation ratios are not valid approximations for fundamental value gaps. That is because there is always a reason why these ratios are high or low. The point is to sort the right from the wrong reasons. In other words, judgment on whether valuation ratios are too high or too low depends completely on context. Moreover, because standard valuation ratios are so popular and easy to monitor they cannot, by themselves, offer much information advantage. Hence, without further analysis valuation ratios cannot plausibly be a great source of investor value.
It is usually easier to detect relative fundamental value rather than absolute fundamental value. Asset prices withing one class have many joint determinants, which can be neglected for relative value comparisons. What remains is usually simpler to understand and to model. Empirical analyses suggest that that it is easier to predict relative returns within an asset class than to predict absolute returns (forthcoming post).
The absence of observable objective metrics for fundamental value can offer great opportunities for macro trading when markets undergo critical transitions, i.e. structural changes in economic backdrop, operations and institutions that precipitate a re-evaluation of prices or “new trading ranges”. Quantitative indicators can help identifying the times when such a transition is underway, particularly metrics of instability, autocorrelation and skewness of price moves (view post here).
Popular areas of fundamental value research
Most research of fundamental value in the macro space compares prices, yields or other valuation metrics with the relevant economic environment:
- In the fixed income space longer-term yields can be decomposed into expected real rates, real term premia, expected inflation rates, and inflation risk premia (view post here). Fundamental value gaps can arise with respect to either of these components. Often the main challenge is to separate term premia from unbiased forward rate expectations. A simple practical approach is to adjust conventional yield curves for median error curves (view post here). A more advanced approach to estimating term premia is to enhance the classical affine (linear) term structure model can be enhanced by macroeconomic factors to capture the non-stationary of the long-term equilibrium yield and the cyclical fluctuations in yield slope and curvature (view post here). Inflation risk premia can be both positive and negative, depending on whether inflation is perceived to be negatively or positively correlated with equity returns and economic growth (view posts here and here).
Overtime the character of a fixed income markets evolves in accordance with the economy’s key structural parameters, such as sovereign risk, inflation expectations and the central bank regime. Hence, models must consider time-varying parameters, time-varying volatility and even model uncertainty (view post here).
- In the equity space forward earnings yields are a valid basis for fundamental value estimates, particularly if they are adjusted for risk and volatility (view post here). Earnings yields and differentials between equity dividend yields and bond yields have historically been indicators of misalignments and future stock market corrections (view post here). Compared to bond yields, equity yields require greater qualification and cash flows depend directly on the economic environment. Estimating fundamental value gaps often requires adjusting off-the-shelf conventional valuation ratios. For example, market-wide forward earnings forecasts usually follow price adjustments with a lag and this predictability predictions can be used to increase the quantity of real-time forward earnings yields (view post here). More fundamentally, the information value of equity dividend yield can be enhanced, by measuring a “shareholder yield” that integrates dividends with other forms of cash returns such as share buybacks and debt redemption (view post here), which have played a crucial role in the U.S. market.
- In the foreign exchange space valuation gaps are often analyzed based on “smart” concepts of real trade-weighted exchange rates, typically some combination of real effective exchange rate and economic performance data. For example, empirical research suggests that real exchange rates that are adjusted for relative productivity growth and product quality differences are indicative of currency over- or undervaluation (view post here). Currency value measures that reflect a country’s competitiveness plausibly have some predictive power for a currency’s future trajectory and its equity market’s relative performance (view post here). Moreover, apparent misaligments of effective exchange rates that go against the desired relative monetary policy stance are key indicators of FX intervention risk (view post here). A complementary indicator to trade-weighted exchange rates are debt-weighted exchange rates. The latter use weights based on foreign-currency denominated debt and measure the effect of exchange rate changes on the cost of funding. While trade-weighted depreciation supports economic growth through the “trade channel”, debt-weighted depreciation usually slows economic growth through the “financial channel”, particularly in EM economies (view post here). That is why these two concepts are best watched simultaneously.
- In the emerging market space, external current account balances are the most popular indicator of valuation gaps for currencies and local-currency bonds. Thus, most investors believe that current account deficits measure overvaluation and addiction to external financing. In reality, external balances and cross border financing are only vaguely related. Vulnerability to “stops” in financial flows does not depend on trade and capital flows (“net concept”) but only on the volume and origin of financing (“gross concept”) (view post here). In order to diagnose “overvaluation” one needs a broad set of competitiveness indicators and to diagnose vulnerability one needs the international investment position.
Each iteration that makes valuation ratios more meaningful, while keeping the cost of data and maintenance acceptable improves decisions and value generation.
Contract and market specifics
A necessary condition for estimating fundamental value is a full understanding of the contract and the underlying asset. This is should not be taken for granted. Investment managers engage in some contracts only sporadically and for narrow purposes. They may not have time and patience to consider the implications of all detail. In the past areas of negligence included:
- consideration of counterparty default risk for the overall risk profile of over-the-counter derivatives,
- sector and company profiles of country equity index futures,
- restrictions to convertibility and exchange rate flexibility in emerging market currencies,
- scope, triggers and consequences of default events for constituents of CDS indices.
Even simple standard exchange-traded contracts may not deliver the underlying at the time and place it would be needed. In instructive example have been commodity futures in the base metal space, where at expiry holders looking for delivery would have had to accept long delays in the load-out from designated warehouses. This actually led market rationing and high premiums for physical metals over exchange traded spot prices (view post here).