The balancing act: Aswath Damodaran on why fear & greed must co-exist for market to thrive

In 2022, as bond rates have risen, stock prices have fallen, and cryptocurrencies has imploded, even true believers are wondering where the market will bottom out, and how big of a hit they will end up facing.

While some experts might believe that this may be a correction that is long overdue, investors are puzzled over what is next. Valuation guru Aswath Damodaran has tried to answer this using a risk capital lens in his blog “Musings on Markets”.

According to Damodaran, risk capital is the portion of capital that is invested in the riskiest segments of each market and safety capital is that portion that finds its way to the safest segments in each market.

He believes that safety and risk capital approach the market from opposite ends, but safety is driven by fear, whereas greed drives the risk. They need to not only co-exist, but be in balance, for the market to be healthy, he added.

The investment guru has used three proxies to fully measure the ebbs and flows of risk capital, despite their limitations. This includes funds invested by venture capitalists, trend of IPOs and original bond issuance by riskiest companies.

The professor of finance at Stern School of Business said that there are two macro factors that will come into play, and both are in play in markets today.

First is the return that can be earned on guaranteed investments. The other one is inflation, which reduces the nominal return made on all investments, and the effects of rising inflation on risk capital are complex.

He noted that despite the panic in 2020 due to COVID-19 pandemic, all three proxies for risk capital hit their all-time high in 2021. This further clarified that 2021 was a boom year.

The pandemic, which wreaked havoc in 2020, altered the lifestyle at personal, professional and financial levels. It led to pumping of liquidity in the economy, shooting up the inflation to levels which were not seen in decades.

Looking at the 30 months through the lens of risk capital can help us understand not only the journey that markets have gone through to get where they are today, but also perhaps decipher where they may go next.

The first half of 2022 has been a trying period for markets, and as inflation has risen, it is having an effect on the availability of and access to risk capital, Damodaran said in his blog post.

“There has been a pullback in all three proxies for risk capital, albeit smaller in venture capital, than in IPOs and in high-yield bond issuances in the first few months of 2022,” he added. “That pullback has had its consequences, with equity risk premiums rising around the world.”

As inflation and recession fears have mounted, equity markets are down significantly, but the drop in pricing has been greatest in the riskiest segments of the market.

He noted that high growth companies with negative earnings have performed worse than more mature and money making companies. This is tilting balance back to the safety capital from risk capital.

Damodaran said that if that pullback in risk capital is temporary, then one can expect a strong recovery in the riskier asset classes.

However, he feared that if it’s not so and happens to be like the dot-com burst in 2000 or the financial crisis in 2008, the riskiest assets will see depressed prices for much longer.

The investment guru said that viruses had a cure in vaccines, but inflation, if once unleashed, has no quick fix. Even the central banks or governments do not have boosts to resolve the issue.

If a long-term slowdown is in the cards, it is almost certain that the investment strategies that delivered high returns in the last decade will no longer work in this new environment, and that old lessons, dismissed as outdated just a few years ago, may need to be relearned, Damodaran concluded.

(Disclaimer: This article is based on Aswath Damodaran’s blog “Musings on Markets”. Recommendations, suggestions, views, and opinions given by the expert are his own. These do not represent the views of Economic Times)