A Mean-Variance Approach to Fundamental Valuations

’i H i! ere I consider a risk asset to be an equity title to the stream of earnings from a unit of physical capital. The “fundamental valuation” of such an asset is the valuation of those earnings. It excludes speculative capital gains and losses, arising from variations of market prices of the equities. The fundamental valuation takes account of earnings whether or not they are distributed as dividends. Reinvestment of retained earnings may be reflected in appreciation of actual equity issues, but we regard such retention as equivalent to the issue of new shares. That is, a share here is always title to one unit of capital at replacement cost. Then fundamental valuations will depend on the means, variances, and covariances of the joint probability distributions of the earnings per share of the various risk assets; on their supplies relative to one another and to the safe asset, and on the return available from the safe asset. On the other hand, 1 certainly would be the last person to assert that asset markets in fact generate fundamental valuations. The speculative content of market prices is all too apparent in their excessive volatility.’ Keynes’s classic description of equity markets as casinos where assessments of long-term investment prospects are overwhelmed by frantic shortterm guesses about what average opinion will think average opinion will think and so on, to the nth degree rings as true today as when he wrote it.’ Indeed, this is a decisive reason to be skeptical