Why Stocks Are (And Will Remain) Undervalued

“Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments.”

Remarks by Chairman Ben S. Bernanke
May 15, 2007: Regulation and Financial Innovation

Chairman Bernanke’s remarks yesterday to the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference highlight an issue that I have written about on numerous occasions – the degree of uncertainty brought about by financial innovation. As with Globalization, financial innovation has produced many benefits. However, what is often ignored is the downside, the risks that accompany our brave new world. As Mr. Bernanks goes on to say:

“Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.”

A major component of the Fed’s plan to deal with this complexity is a reliance on what is known as market discipline. Harry Paulson cites it often and Mr. Bernanke referred to it in yesterday’s speech as follows:

“…part of an effective risk-focused approach is the promotion of market discipline as the first line of defense (emphasis added) whenever possible.”

Investment Strategy Implications

Isn’t the first line of defense the one that bears the greatest risk? If credit derivatives and other financial innovations that have sprung up over the past years have become so complex that most professional investors have little full knowledge of their consequences (a point referenced time and again at the hedge fund seminars that I have conducted), then shouldn’t stocks always reflect that enhanced risk* and, therefore, never close the valuation gap to fair value (see Fed Model to your left) thereby remaining undervalued for the foreseeable future? I think so.

*Along with other macro risk factors such as the unknown consequences of Globalization as well as geo political issues.

Note: Chairman Bernanke’s remarks can be found at http://www.federalreserve.gov/boarddocs/speeches/2007/20070515/default.htm