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The Gravity of Finance

Gravity is one of the physical forces we most consider when living our daily life in the physical world. We are all aware of our limitations to jump up, and the ease of falling down.

There is an equivalent force in the financial world. It is most commonly perceived as being interest rates. Your author disagrees. Interest rates can be manipulated and changed by mankind as they chose. Gravity does not have that property, and neither does the gravity of finance. That force is valuation.

History suggests market cycles fluctuate significantly over a period of days, months, years, but they are deeply mean reverting when looked over thirty year periods. If a passive investor would initiate investing in risk assets only when they are priced below their average valuation, and start selling when they are priced one standard deviation above their “fair value”, history suggests you are likely to generate returns greater than being continuously invested in the market.

How much mankind will pay for a future flow of cash flows changes over time depending on how “animal spirits” are being fed. However, it changes in the same way, again and again. It as if throughout our history the only constant is the fact we react as humans: emotionally. That emotional component seems to express itself in a constant manner when imprinted on the valuation of risk assets. As we have said in the past, market valuation can be interpreted by how much investors are reacting to uncertainty, whether they are ignoring it when they are very greedy, or obsessing too much on it when very fearful. The reality is that uncertainty is always present. All that changes is our sentiment towards it. Need I have to state that we are strong followers of Mr. Buffett’s philosophy: be fearful when others are greedy, be greedy when others are fearful.

Disclosure: No positions mentioned