Inflation, E/P, and valuation |

Inflation, E/P, and valuation

As I’ve mentioned, I recently reread the must read work by Ed Esterling, Unexpected Returns, and continue to view it as critical reading for long term investors. A few thoughts have emerged for me that I’ve been trying to crystallize.

For starters, his discussion of beginning valuation determining realistic return expectations rings true with my value oriented mentality, but his discussion is based on it’s own average, namely, stock market averages. If you, like me, are trying to find those undervalued securities on an ongoing basis, aren’t we always investing in a “low valuation” portfolio? How then do we use his information in implementing an investment decision? My current thoughts are that we are always making relative value investment decisions. We are therefore investing in undervalued securities relative to the market, and thus are expecting to outperform, rather than any statement on absolute performance. His discussion of the benefits of absolute performance strategies are more questionable in my mind, as are his thoughts on implementation, especially using hedging strategies. In essence, my issue is that the theory seems easier than reality. It becomes difficult to evaluate hedge funds without transparency and thus the predictive value of evaluations becomes questionable at best.

Also, the book has some interesting main stream implications, backed up by the data. Cliff Asness had an interesting article called “Fight the Fed Model” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=381480.

Given the recent inversion of stock and bond yields, TIPS implied inflation levels, etc. it is a good time to re-evaluate our long term investment strategies and the underlying drivers of future returns. In an environment moving away from price stability (either inflation or deflation – it doesn’t matter based on the Y-curve discussed by Esterling), multiples will continue to contract. Conclusion, be careful of prematurely calling a bottom.

Last 5 posts by Yaron Sadan

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