The Problem With Relative Value*

Virtually every asset class looks attractive relative to bonds right now (except for cash**).

And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).

Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.

Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).

*Actually there are numerous problems associated with relative value analysis, but that is for another day.


**But even cash looks attractive if you believe bond rates are going to go up.

***Actually, the misallocation may be less to risky assets, than to risky behavior.

Financial Technique

How I approach a stock depends to some extent upon the present market environment.

For example, in the current environment the first thing I do when looking at a company is to go to the balance sheet and see what its debt load looks like and what its liquidity situation looks like (I love nice cash cushions in this environment). Next I venture to the cash flow statement and look at how well the cash flow generator is working (this also gives me a peak at quality of earnings). Finally, I'll mozy on over to the income statement and look at the company's cost structure and see whether there are any funny things sticking out of the accounts.

After a quick review of those factors, it is then onto the business of digging deeper and getting a handle on operating leverage, debt schedule, cash conversion cycle, etc., and marrying those with future growth and margin cycle implications. The trick is then to condense that into an expected present value of the company and to compare that (with an imputed risk factor) to its current market price.