I recently watched the movie 'Moneyball', for those of you who have not seen it, I will really recommend it because the message of the movie really mirrors the trends we are seeing in the financial markets.
In the movie, a general manager of a low budget baseball team struggles to compete for the best players with the larger teams with the bigger budgets.
This is until he meets a young economics graduate from Yale who proceeded to help him revolutionize how players are selected and how they are valued. With this new knowledge, they were able to uncover and select undervalued players that their stats suggest that they can be very successful.
The message of this movie is by approaching the challenge from a new perspective, we can develop new approaches and measures for uncovering value in the markets.
This message is especially true for the financial markets where the traditional methods of discovering value do not work anymore. Further, there is an ongoing search in the market for newer methods of identifying and measuring value.
In speaking about value, it is important to note that there are really multiple dimensions to that term. When many people speak about value, it is in the Graham and Dodd sense; they are speaking about ascertaining the underlying monetary value of a security as this relates to the market price of that security.
There is another dimension to this concept and that is time. Time is a very important but underutilized component of investments and risk management that is missed by many market participants.
The central thesis of Graham and Dodd analysis is that a wise investor is betting against the irrationality of the market mob but that irrationality also relates to timing. It was Maynard Keynes that was supposed to have said that 'the market can remain irrational longer than you can remain solvent'.
In determining whether a market or a stock is overvalued or undervalued, I am not simply looking the historical trend but also asking myself whether it is time for the correction.
An example of this is the S&P 500, from looking at the chart, at the first glance, it is clear that the index is overvalued but do I believe it is time to short the S&P 500, the answer is no because general conditions and sentiment can still force it higher in the short term.
When we speak of financial risk, whether it is credit risk, commodity risk, cash flow risk, interest risk or even vale at risk, the foundation of that analysis must also be market irrationality.
Estimating the bounds of market irrationality is the challenge to determining financial risk. In this article, the discussion is about the exposure to crude oil prices in three of the largest banks in the US.
In this case, before risks can be adequately measured, we need to understand how low oil will go. Each day oil prices remain low, it creates greater financial risks for all of the financial markets because of the centrality of the oil benchmark to the pricing of a myriad of assets.
Furthermore, pension funds and other types of institutional investors have significant exposure to the price of oil through fixed income securities, stocks ETFs and so on but until the markets can correctly identify and measure the irrationality then it poses a significant financial risk to the whole financial system.
These crises further highlight the importance of identifying the hidden risks of our investments and furthermore, take steps to mitigate these risks.
Every investment whether it is a stock, bond, real estate, oil well, and private equity is a bundle of risks that needs to be taken apart to understand the manifold dimensions and how that asset will behave under various market conditions.
An example of this is investing in the S&P 500, there are various investment vehicles that gives exposure to the S&P 500 like SPDR S&P 500 ETF , Vanguard's S&P 500 fund (NYSEARCA:VOO) and iShares (NYSEARCA:IVV).
Nevertheless, as this article points out, the companies in the S&P 500 are carrying more than $5 trillion of debt so essentially purchasing the S&P index is a short bet on the future direction of interest rates at least in the short and medium term.
This is because an increase in interest rates will greatly affect profitability as higher interest payments will drive down earnings. This interest rate risk is one of the risks inherent in investing in the S&P 500.
Another risk of investing with the S&P 500 is foreign currency risk; in this article, it suggests that at least 30% of the S&P's total earnings were from foreign jurisdictions with different currencies.
In this case, investing in the index is the equivalent to shorting the dollar. These are some of the various financial risks that are bundled within investments in the S&P 500.
What is the solution to this challenge? Having identified these possible risks, the next stage is to measure it.
A rough way to measure this is to gauge your possible exposure to the risks. So if we assume based on the above article that a total amount of trade between S&P 500 companies and Europe is 7%, we can roughly say that 2% of that will be exposure to pound sterling and about 4% will be exposure to the euro and the other 1% will be smaller currencies like the Swiss Franc, Norwegian Krone, Swedish Krone and so on.
At this point, the investor needs to make a choice, he/she can begin to hedge the exposure on individual currencies. Alternatively, they can construct a basket of the currencies to identify the total range of movements within European currencies since the year 2000.
This can work well because broadly speaking, the European currencies move in tandem because they are subject to the same underlying movements and their international trade patterns are very similar.
This can then be plotted against the USD to identify the possible trading range and based on this, one can now begin to hedge their total exposure to Europe which is 7%.
The final step of this process is finding the correct instruments to use for the hedges and here, investors have access to a whole range of choices depending on the price, complexity and size of the hedge.
Personally, I like options over other instruments because of its flexibility and how I can continually adjust the risk profile by legging in and legging out.
In conclusion, as investors, our investment world is getting increasingly complex primarily because of the speed at which the markets operates these days and also the immense volumes traded every day.
With these complexities, risks are also greater and our risk management strategies must also get correspondingly nuanced and responsive to changes in the global markets.
This is the essence of going deep and going wide, one has the opportunity to go deep into the granular details of the market and also go wide with the plethora of instruments available today to invest and also to manage risks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.