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(This article has been excerpted from the 1/8/94 Decision Point Alert)

I have spoken often about the concept of the discount or premium that is built into the price of just about anything that is for sale. Discount/premium can be thought of as an index that oscillates above and below a horizontal line representing the intrinsic value. When it can be measured, the presence of the premium or discount usually indicates the direction of the trend, so buying at a discount is not necessarily a good thing or vice versa.

Normally, the discount/premium can only be implied, but it is important to be aware that it exists, because this distortion to intrinsic value evaporates as soon as the particular security rotates back into favor or loses favor as the case may be. When this happens, you can often observe moves of 30-50% or more in a few days or weeks.

In the 1/5/94 issue of IBD there was an article titled, "Are Foreign Closed-End Funds Overpriced?", that raises this issue again. Shares of open-ended funds are traded strictly on the basis of NAV, but closed-end funds are interesting because their shares trade like stock and are subject to being bid higher or lower than their NAV. The cited article points out that closed-end funds carry a double-whammy, because, when the Mexican stock market dropped 4% on Monday, the premium of closed-end Mexico Fund dropped from 9% to 1%.

If you don't trade closed-end funds, your reaction might be, "So what?" Well, I believe that the discount/premium that exists on closed-end funds can help us get a handle on how much discount/premium exists on the stocks making up the fund's NAV and on the market in general.

I think that it is a reasonable (although completely unprovable) assumption that the discount/premium on the underlying securities is roughly equal to that of the closed-end fund itself. Those securities are subject to the same bidding pressures as the closed-end fund itself, so why wouldn't there be a similar deviation from intrinsic value? So, if the fund is selling at a 10% premium, the stocks that comprise its NAV probably have an additional 10% premium built into their market price.

While we can never actually know the actual or intrinsic value of the market or of a specific stock, keeping an eye on closed-end fund deviations from NAV can help us stay grounded in reality. As a rule of thumb, the average closed-end fund discount/premium published each week in Barron's is probably a good gage for the broader market. The amount of deviation that might apply to an individual stock is probably directly related to the amount that it out performs or under performs the general market.

The discount/premium phenomenon is, I believe, one of the best gages of market psychology in existence. While it is mostly obscure and hard to interpret, at its best it helps us sense the mood of the powerful force that lurks just outside our field of vision.