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Home / Hawkes Bay Today / Business

Putting a brave face on the markets

By Caroline Ritchie
NZME. regionals·
27 Jan, 2016 03:00 AM4 mins to read

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Sharemarkets are 'nothing more than human emotion transferred into money'.

Sharemarkets are 'nothing more than human emotion transferred into money'.

Reporting in from Australia this week. The Aussies are putting a brave face on it, but having gambled their house on an imploding commodity super cycle, they know a few annoying realities are probably around the corner.

The good news is that, while they wait, all other major sharemarkets are crashing alongside, this time in quite an orderly fashion, which takes the heat off Oz and her digging up of rocks and reliance on China.

However, in amongst it, as we are back home, Aussie brokers are now "looking for value".

Looking for value is a guessing game, played by the players, sold by the suckers and bought by the believers.

It is anyone's market and always happens after a big downturn.

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It is a tricky piece of action to get right as no man can predict the absolute peaks and troughs in advance.

In the past though, sharebrokers have traditionally had a small secret weapon, the research note, to help them determine "intrinsic value", or in other words what an analyst thinks a company is really worth, regardless of where it trades.

The notes have been moderately useful where share prices have whipped around like a bunch of demented banshees and behaved unpredictably.

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They have been something to cling to in the equity flotsam when it all got really nasty.

More recently, there is a problem.

Bring in the zero interest rate. Just as zero interest rates are having a devastating effect on the income of retirees, they are also causing havoc with traditional models of valuing companies.

It works like this: the analysts who write the notes all use basically the same model, a formula.

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They then overlay their personal little jingles and jangles on top and hey presto, out pops a valuation. One element in the formula is called the Risk Free Rate (RFR).

This is usually assumed to be the government cash rate of the country concerned.

There are obvious shortcomings with that if you look around the world but that is not the point.

The formula assumes a RFR, then some other stuff on top, eventually giving you an estimated stock valuation.

Here is the issue: the formula is exquisitely sensitive to the Risk Free Rate.

Tiny changes to it cause big ripples, like running with a pebble in your shoe or trying to drive a car 1000km with tyres that are all different sizes.

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Having a RFR of zero or near zero positively cocks things up for everyone.

Inserting a zero into any formula is a pain, so analysts may or may not use a long-term average instead (rearranging the equation to suit yourself, a fraught situation on its own) deviating a bit from the pure maths, but hey, it is probably better than all of your company valuations coming out at, you know, zero ... This model works OK, sort of, in stable conditions and for mature companies, but throws its hands up in terror at zero rates, tech stocks, lurching indexes and anything else that wasn't invented 60 years ago when it was thought up.

So how on earth can we value things now? How to get some bottom-feeding action once the bull-market fire goes out and the cold, cold ashes are waiting to be sifted through?

How does one "buy the dip and sell the rip"? The answer may lie in behavioural models rather than unreliable old numbers.

I believe sharemarkets are nothing more than human emotion transferred into money, so I think this field is pretty cool.

Models that can accurately track (not predict) fear, greed and irrationality will be the next golden goose of the analytica age. I have seen some prelims.

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They look very exciting. Stay tuned.

Caroline Ritchie is a former AFA, sharebroker & portfolio manager. She runs Investment Stuff, an investment coaching service. Visit her at www.investmentstuff.co.nz. Statements in this column are not financial advice.

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