A more comprehensive analytical framework for analysing asset classes
When it comes to analyzing the value of an asset, for example, stocks, ideas of discounted cash flow, competitive advantage of a business and whether the prices are reasonable enough came to mind. However, when investing in a particular asset classes and sub classes as a whole, you need some other perspectives that will assist greatly in generating higher returns and further reducing risk. These additional mental models include social conditions, market cycles, worse case scenarios analysis, financial analysis and financial market analysis.
When considering investing in any of the major asset classes, it will be wise to see through the above mentioned perspectives so as to identify major trends, length of these trends and how these trends affect asset prices in terms of extend and magnitude. Savvy investors should consider all the following modes of analysis for better investment performance.
1. Social conditions analysis
There are many aspects of a country that affects the prices of assets in that country in both the long and short run, not only commonly used factors like interest rates, price-earnings ratios or present value of future cash flows of an asset. The overall economic health of a nation consists of political, social, financial and economic spaces that are not mutually exclusive to one another.
For the case of political space, conditions favorable to rising asset prices are including but not limited to credible legal and regulatory frameworks, privatizations of assets, checks and balances, and of course respect of human rights of the general populace. In contrast, nationalizing of assets and unstable political environments leads to declining asset prices. In the economic domain, more integration into the world’s and regional markets, with increases in living standards over time and rising GDP points to favorable asset prices. In reverse, reducing domestic consumption, savings and investment in businesses as a whole leads to drop in value of assets.
In addition, economic policy of trade barriers and declining standards of living for residents will be destructive to assets generating income from the place. For financial realm, efficient financial markets would promote the formation of capital for investment, coupled with free markets.
2. Market cycle analysis
Be it stocks or any other asset classes, you seldom see their prices remain stable throughout the time. Not only equities, but other assets like bonds, gold, silver and commodities go through market cycle characterized by five distinct phases. In general, at each stage of the market cycle, people valued assets differently. People don’t always value a piece if financial asset by their discounted cash flows or fundamentals like supply and demand of the products and services that the businesses are procuring. There are times when other factors like liquidity and psychological play a part.
There are three major factors that determine asset prices. They are psychological, fundamentals, technical and valuations. Psychological simply means investors’ emotions from greed, fear, panic to euphoria while valuations means things like present value of future cash flows and riskiness of future cash flows. Technical factor refers to the attractiveness of an asset comparing with other assets.
i) Bear market
At this stage, investors are more affected by psychological factors. That is why one can find various blue chips sell below their intrinsic values when there is a bear market.
ii) Bottoming
This basically means bottom of the market cycle. Note that there is no way for a normal person to determine when bottoming occurs exactly and accurately every time.
iii) Early stage recovery
At this point, the bottoming prices lead investors to buy at a bargain, hence lead to a small rally.
iv) Middle stage bull market
During this stage, fundamentals and valuation of intrinsic value of assets will be reflected in the prices. In other words, reversion to the mean will occur much more frequently during this stage of the market cycle.
v) Peak bull market
This is similar to the bear market in the sense that rational valuations are thrown out of the window and people’s greed elevates prices to high levels. Formation of asset bubbles and high price-earnings ratios are the norm.
3. Financial analysis
Financial analysis simply means to determine the value of a financial asset, be it exotic investments like art and wine, stocks, bonds or real estate. Be it investment research or ordinary investors, all have to answer one particular question at the end of the day.
Is the value of an asset < , > , or = to its given market price?
The inequality signs refers to greater than, less than or equal to.
There are many quantitative and qualitative concepts and tools to find out the answer to this question. But many people uses the following two, hence by using these two concepts to determine value of an asset relative to its market price, one can reasonably certain that the estimation is correct to a great extent, though no guarantee since what people will pay for in future for the same asset is based on what ideas they used to value the same asset in future. One other asset valuation is simply by comparing the market prices of similar assets and another is by using the many different discounted cash flows models available.
4. Financial market analysis
The climate for financial markets can decide to a great extent how major asset classes will perform for long holding periods of five years or more. As a result, when doing asset allocations, that are allocating investment capital among different asset classes, there is a need to analyze the financial market climate also since it will result in either positive or negative returns from asset classes with their respective distinct characteristics.
Prevailing signs in certain financial market conditions point to a reduced holding in equities and assets that behave like equities. These are when there is dramatically expanded use of financial leverage, increase in magnitude and complexity of derivatives and you started seeing highly leveraged institutions surfacing here, there and everywhere, like Lehman Brothers and Bear Sterns. In addition, traditional equity valuation measures like price-earnings ratio and price-to-book value show unrealistically high values and coupled with low dividend yields.
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