Monday, June 23, 2014

Risk and Valuations - A Series

I have been thinking about the effect of changing risk appetites and economic activity, and I believe that the product of these relationships is frequently counterintuitive, so that conventional wisdom about changes in the marketplace is informed by imperfect intuitions.  These wrong intuitions then form the foundations for additional interpretations that are built on shaky foundations.

I hope some of these ideas are new and useful.  I realize that I'm going down the rabbit hole a bit here, and am demanding a bit of attention from my readers.  I hope you find these ideas compelling enough to think about them and follow me all the way through.  Feedback is welcome, especially if you make it through the entire series.

I will post these ideas in a series.  I hope to post about 3 parts per week until the end:

Section 1: Valuations, Interest Rates, and Asset Allocation

Part 1: Leverage and Profit Margins
Valuation ratios and net profit margins measure a moving target.

Part 2: Lower interest rates do not lead to higher leverage (in theory).

Part 3: Lower interest rates do not lead to higher leverage (in practice).

Part 4: Valuations and leverage through the business cycle.

Part 5: A theory of asset allocation
Maybe asset allocation should account for the level of corporate leverage.

Section 2: Risk Trading and Robust Societies

Part 6: At some margin, being short-sighted is rational
We are optimizers.  Certainty is very valuable.

Part 7: A Risk-Based Theory of the Firm
Equity holders buy risk from both labor and creditors.  Can we model firms based on risk-trading?

Part 8:  Beta has its own alpha
There could be discrete changes in risk when moving between asset classes.

Part 9: The Greenspan Put
Stay calm and NGDPLT.

Part 10: Risk Aversion and Demand for High Wage Labor in International Markets
Production doesn't move to where wages are low, it moves to where wages are rising!

Part 11: Allocations with Stocks & Bonds
If risk trading is the main factor determining risk premiums, then inflation-protected fixed income might provide decent diversification benefits.

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