Editor’s Letter

Abstract

In this letter, I would like to revisit a topic we have covered several times in the past: the apparent dichotomy between reality and perceptions, or facts and opinions. I do not mean to focus on the causes of the phenomenon, if only because I am really not qualified to offer anything definitive. Rather, I want to focus on a couple of distortions against which one should develop defenses: wild volatility swings and changing investor behavior. As the last several quarters demonstrated, but even more so as illustrated in the past few months, the oscillation of views between reality and perceptions has the potential to create substantial volatility swings in markets. Volatility is in part a function of the classic discounting process: it increases and decreases as market participants change their views of what to expect in the future. In a world where everyone is focused on more or less the same variables and the same sources of information and insight, the discounting process can be viewed as somewhat predictable if not always smooth. While market adjustments are gradual most of the time, they have at times been quite drastic—and not always the result of a massive and unpredicted change in fundamentals. One of the most frequently quoted investment principles has argued over time that the best investment opportunities tend to be found when there is an extreme of valuation and a fundamental change. This argument usually accepted that one should wait to be rewarded, but presupposed that the wait would be measured in months or occasionally quarters, but certainly not in years or decades. If we go back far enough in time, one major adjustment to the pound sterling exchange rate occurred as a result of a major change in fundamentals: the so-called “return of the sterling balances.” (These were holdings of pound sterling by countries that were formerly members in the “sterling zone.”) Others, just as extreme from a market standpoint, also occurred in part because of a fundamental change; the massive falls in Hong Kong stock prices in the fourth quarter of 1982 is a good example. Hong Kong, then a British colony, would revert to China in 1997. However, the dramatic decline in Japan from late December 1989 onward arguably involved no real fundamental change. Yet, in both these examples, market participants had allowed themselves to disregard fundamental developments and risks that were plain to see if one bothered to look for them. Whether in Hong Kong or in Japan, a US Dollar–based investor would have lost around 75% peak to trough, and, at least in the case of Japan, would still be in the red nearly 30 years later. Admittedly less dramatic events could be mentioned—the Southeast Asian currency debacle of 1997, the Russian ruble meltdown of 1998, the infamous “dot.com bubble” of 2000. They Spiral Bowl 3 Heather root, with pewter inlay and some parts patinated with pigment oil 2012 7.87 inches (20cm) × 7.87 inches (20cm) Photo Credit: Cavin-Morris Gallery