Investors are constantly in search of a single metric that will tell them whether a market is under or over valued, and consequently whether they should buying or selling holdings in that market. With equities, the metric that has been in use the longest is the PE ratio, modified in recent years to the CAPE, where earnings are normalized (by averaging over time) and sometimes adjusted for inflation. That metric, though, has been signaling that stocks are over valued for most of the last decade, a ten-year period when stocks delivered blockbuster returns. The failures of the signal have been variously attributed to low interest rates, accounting mis-measurement of earnings (especially at tech companies), and by some, to animal spirits. In this post, I offer an alternative, albeit a more complicated, metric that I believe offers not only a more comprehensive measure of pricing, but also operates as a barometer of the ups and downs in the market.
The Price of Risk
The price of risk is what investors demand as a premium, an extra return over and above what they can make on a guaranteed investment (risk free), to invest in a risky asset. Note that this price is set by demand and supply and will reflect everything that investors collectively believe, hope for, and fear.
Does the price of risk have to be positive? The answer depends on whether human beings are risk averse or not. If they are, the price of risk will be reflected in a (Read more...)