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Policy error?

If the Central Banks got it wrong on monetary policy, can we also assume that the valuation models that we have done and relied on for the last two decades are also flawed?

Though hard to mathematically quantify, truth is: Liquidity drives a huge part of value. Put simply: an asset is only as valuable as the next guys who wants it. Against the current backdrop of monetary tightening to fight inflation and funds becoming more cautious about their investments, asset prices seem to have reacted and dramatically fallen.

Growth is another key driver of value - which in this case, is being eroded by rapid inflation, adding to the further discount in prices. The double whammy here is that the same high growth companies that sold astronomical prospects of the future will face the real test over the next two years as they fight against a policy that encourages the cool down of the economy.

Is there a playbook to rectify this? Was it an error on the part of Central Banks when QE was introduced in the aftermath of the 2008 financial crisis? Did early bitcoin and cryptocurrency adopters see this gradual erosion in the value of money coming? I'm not sure.

Most of the existing infrastructure we know is build around a set of 'stable' economic assumptions. Capex for power grids and oil exploration / refining (which are easily 10 to 20-year projects) have been traditionally modelled around $60 oil. Cap rates for real estate (another presumably long term asset class) are largely driven by interest rates. Likewise with breaking down the cost of any manufacturing plant, which is driven by the input prices of raw materials including commodities. The world just cannot absorb the sudden change in prices that would dramatically disrupt these economic models that we have relied on for many decades.

Beta quantifies risk by measuring the standard deviation of an asset price against a reliable index benchmark over a long term dataset - the key word being long term. Furthermore, assuming that the immediate future would follow a reversion to the historical long-term would be borderline laughable given the current state of world affairs.

So if we can't rely on beta and the pricing assumptions of today, the best thing to do is to probably wait it out until the world finds some sanity (and stability) amidst the current circus of events.


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