I came across another excellent piece from Howard Marks, one of my favorite financial commentators and, as always, I learned something new from it. In his latest memo, he explores how investors should think about value, price, and the interplay between them.
He then applies this lens to today’s markets, weighing whether valuations look stretched by historical standards, if fundamentals have weakened in recent months, and to what extent momentum reflects psychology rather than underlying fundamentals.
Here is a section:
If an asset is bought for the right price (or less), its current earnings can give the buyer a good return on his purchase price while he owns it, and increases in earning power can add to the current return it throws off and increase its value and thus the price at which it can be sold. Thus, an investor’s ability to earn an attractive return on an investment will largely depend on whether he accurately appraised the investment’s fundamentals and paid an appropriate price for those fundamentals.
In the long term, the success of an investment will hinge primarily on whether the buyer was right about the asset’s earning power. However, an asset’s current earning power and opinions regarding its future earning power usually do not change much from month to month or even year to year.
Thus, short-term investment performance is likely to stem mostly from changes in the price investors are willing to pay for the asset. That makes price the dominant consideration for anyone whose principal concern is the short run.
Value should be thought of as exerting a “magnetic” influence on price. If price is above value, future price movements are more likely to be downward than upward. If price is below value, future price movements are more likely to be upward than downward.
However, in the short run, price can move in just about any direction relative to value. This is so because an asset’s price at any given point in time is mostly determined by investor psychology, which can be irrational and unpredictable. Thus, while the current relationship of price to underlying value should move in the expected direction, it can only be counted on to do so in the long run at best.