Truth Is, Intrinsic Value, not Price, Is Truth in Investing

 | Aug 18, 2017 | 10:00 AM EDT
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Stock quotes in this article:

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Should investors and traders be reactionary by following and trusting stock prices, or should they be anticipatory and take advantage of the difference between stock prices and a derived calculation of intrinsic value?

To me, one of the most difficult parts of investing over the last nine months has been holding on to a bearish market view in the face of rising share prices.

Throughout this period (and longer), I have had a continuing and respectful debate with Rev Shark on the merits of being anticipatory versus being reactionary.

Rev Shark, a technically minded fellow, believes "price is truth" and has adopted a very profitable trading technique and career that follows and does not anticipate price trends.

By contrast, I am fundamentally minded and I believe intrinsic value is truth, not price. My investing technique relies on my calculus of fair market value as determined by a set of probabilities. To me, the discount/premium to the calculation of intrinsic value changes daily. The larger the discount, the more attractive the long, and the larger the premium, the more attractive the short. In other words, unlike Rev Shark, I grow more confident in larger long and short weightings despite prices that may be going against my investment positions.

Horses for Courses

It can be debated which is the proper strategy. While Rev Shark has his methodology and I have mine, I believe they can coexist. As it is, we provide subscribers with a menu of thoughtful tactical strategy and different ways of looking at the markets.

The bottom line is that most investors and traders should consider both the existing price trends and their assessment of fair market value.

That said, during periods of clarity in price trends being reactionary (like Rev Shark) may prove to be a more effective strategy.

However, my view has been that the growing popularity of passive investing (ETFs and quant strategies such as volatility trending and risk parity) has produced an artificiality and inefficiency in prices -- a non-truth, so to speak, that has been materially unrecognized by many.

As stock prices, catalyzed by animal spirits following the November election, began to ascend, it was my view that prices began to leap well ahead of my calculation of intrinsic value. A second leg of advancing prices seems to have occurred as "machine spirits" replaced those animal spirits. Share prices, I thought, then moved even higher relative to intrinsic value. (Remember machines/algos buy high on strength and sell low on weakness -- it is the nature of those beasts!)

My approach, which appears on its face simply to be looking for tops in shorts and bottoms in longs, is really not looking for near-term inflection points. Rather, it is a strategy that anticipates the inevitable adjustment in the spread between real-time stock prices and the calculation of intrinsic value.

My approach is based on my perception of stock price inefficiencies that occur continually through a plethora of influences.

I recently concluded, based on my analysis of the S&P 500 Index, that the potential downside exceeds the potential upside by a factor of four times. Though stock prices were trending higher and as recently as a week ago were at all-time highs, my view of the very unattractive reward vs. risk and the widening of stock prices relative to intrinsic value caused me to be more aggressive and anticipatory rather than waiting for a price trend change; it is the essence of my approach to trading and investing.

I get more bullish or bearish based on the spread and not on the basis of price trends.

This sort of unfavorable reward relative to risk had me ink the following Diary entry and produce an extreme viewpoint/strategy about one week ago:

Going Long-Less for the Third Time in All My Days

Prior to Tuesday, there were only two times in my life that I held no long investment positions in my personal investment account (I still have many longs in my managed accounts and hedge fund).

The first time was in January, 2000. The second time was in August, 2007.

This is the third time.

--Kass Diary, "Going Long-Less for the Third Time in All My Days" (Aug. 10, 2017)

How I Implement My Strategy

In recognition that there is more uncertainty about market outcomes and that there are agents such as ETFs that rebalance daily, producing extreme and often artificial price outcomes, my tactical approach has been to average into both my longs and shorts regardless of conviction. For example, let's say I have a target 3.5% of my entire portfolio for an individual long holding. I typically will purchase a 1.5% initial stake and average in as the relationship between current share price and intrinsic value widens. Similarly, I typically will target 2% of the entire portfolio for a short holding. I typically will short a 1% initial stake and average in as the relationship between the current share price and intrinsic value widens.

In terms of selling longs and covering shorts the same approach applies. Even though the price trends may persist as the spread between share price and my calculation of intrinsic value narrows, I will reduce my longs and shorts.

Examples of longs that I recently have reduced -- the share prices of which have approached my intrinsic value calculation -- are Hartford Financial Services Group Inc. (HIG) and DuPont & Co. (DD) . Examples of longs to which I recently have added, where the share price has fallen further relative to the intrinsic value, are Dillard's Inc. (DDS) and Twitter Inc. (TWTR) . Examples of shorts that I recently have increased because the share price has widened relative to the intrinsic value are long ProShares UltraShort QQQ (QID) and ProShares UltraShort S&P 500 (SDS) and shorts of SPDR S&P 500 (SPY) .

Where Do We Go From Here?

On Wednesday, in "Ludacris Forecast" and "The Turning Point?," I outlined my short-term market concerns and the reasons why I tactically raised my short trading book to maximum positions.

Yesterday's "Not Surprisingly, Trump Makes Bad Surprises Become Reality" provided the nail in the market's coffin and likely led to yesterday's nearly 40-handle drop in the S&P Index and 125-point decline in the Nasdaq.

The Barcelona terrorist attack exacerbated the market's decline -- proof positive that it remains important to remember this question I ask myself every morning:

In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are?

The S&P Index now has had two 35- to 40-handle daily declines in 10 days. Whether this is the start of a price trend change or not (see Rev Shark's views this morning) can be debated and discussed.

To me, what is more important is that, based on my calculus, the upside/downside opportunities are still profoundly negative, and this is what I base my portfolio's composition and structure of longs/shorts upon.

I remain at my largest net short exposure in years.

(This commentary originally appeared on Real Money Pro at 8:30 a.m. ET on Aug. 18. Click here to learn about this dynamic market information service for active traders.) 

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