The Great Unwind and Fair Value of the Market

The two questions that I see asked and answered everywhere in the financial news are:

1. When will we hit the bottom?
2. What is the fair value of the market?
   

I would like to provide my point of view and my (very short) answers to these questions. I keep it short due to the lack of time.

When will we hit the bottom?

In any bear market, the market is hit when all the greed has disappeared and has been replaced by fear. But note that while this is a needed to hit the bottom, it doesn’t necessarily mean that you have actually hit it yet. Let me rephrase: to hit the bottom you need to have replaced all greed by fear. But the reciprocal sentence is not true: you cannot say: you have replaced all greed by fear so you have hit the bottom. Or you might want to have a local short term bottom, but it’s not going to be the real, long term bottom.

Why is that? Because first it might take a while to recover, and second, the bottom will be hit only when everybody will believe that there is no bottom and that all the prices will go forever down.

Have we reached that point yet? Of course not. When the stock market is able to make a huge reversal from -10% to +2% and then rally 11% on the following day, can you really believe that all hope has disappeared? And when everybody is afraid of missing the rebound? When many still believe that the economy is not in recession, that inflation is contained, and that we will be out of the woods in early 2009, have we really reached the bottom?

This holds true for stock markets but also for the real estate market. We have not bottomed yet, and it’s still going to require a lot of losses from bottom fisher to reach it. As long as you will have bottom fishers and people calling the bottom, it’s not going to be the bottom. The bottom will be reached when speculators will have given up on the market, believing that it will never stop sliding further and further down and will never recover. This leads me to the next question:

What is the fair value of the market?

My answer would be: who cares about the fair value? The market is currently driven more by sentiment and even more by the Great Unwind than rationality and fair valuation. To be totally honest, I believe that if it was driven by rationality and fair value, it would be a lot lower than it currently is.

Now think about what is happening: deleveraging and unwinding. During the past few years of cheap money (far below the real value you would have get without the “price-fixing” of central banks). When you see banks and hedge funds and other investment management companies having a leverage of 2, 3, 15, 20, 40, you can easily understand that once they start to liquidate position, it will hurt badly. Moreover, with the Yen carry trade you add insult to the injury. Also note that the saving rate has been close to zero in many European countries and even hit negative values in the US. So it’s more than likely than the markets were not pushed higher by consumer/individual investors.

I cannot really quantify the amount of $ and € and £ etc. that will need to be extracted from the markets to pay back the credit lines with the brokers and the redemptions that will flow from now on that many investors are panicking, but one thing is for sure: forced liquidation will drive prices a lot lower and very likely to level far lower than fair value.