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Description of Wall Street Revalued

Andrew Smithers, one of the world's foremost economists, showed that at its peak in 2000 the US stock market was wildly over-priced and argued that central bankers should adjust their policies to prevent asset bubbles. But the Federal Reserve claimed that assets could not be valued and that they should ignore asset prices. In "Wall Street Revalued", Andrew Smithers argues that the Federal Reserve was wrong on both counts and that these errors were the major cause of the current recession and financial crisis. He shows how investors and central banks can value assets, so that incipient bubbles can be identified and a repetition of today's problems avoided. Indifference to overvalued asset prices by investors, central banks and much of the financial press is the root cause of the current crisis. Bubbles in stock markets, house prices and financial assets cause huge damage when they fall, not only to their owners, but also to the world economy. An understanding of how to value assets is therefore vital for managing the economy as well as for investors.

"Wall Street Revalued" explains how assets can be valued and shows how much incorrect and inaccurate information is published on the subject and how to spot this. Among investment bankers and financial journalists the two most common claims to value are, as Andrew shows, unadulterated nonsense. One of these is that 'Shares are cheap given the level of current (or forecast) PE multiples' and the other is that 'Shares are cheap relative to interest rates'. Andrew also explains how asset prices affect the economy and how central banks lose their ability to stabilise it when bubbles collapse. The denial that markets can be valued has caused great damage. Markets are not perfectly efficient, nor are they are irrational casinos. This book sets out a new model for understanding the limited efficiency of financial markets, which is the key condition for improving investment and economic management today.

Title Information

ISBN:

9780470750056

Pages:

256 pages

Format:

Hardback

Product Code:

412274

Publisher:

John Wiley & Sons Ltd

Published:

24/07/2009

Press and Industry Reviews

"IN EARLY 2000, just as the dotcom bubble was at its height, two books appeared that argued the stockmarket was overvalued. One, "Irrational Exuberance", turned its author, Robert Shiller of Yale University, into something of a guru. The second, "Valuing Wall Street" received less attention but its insights were no less perceptive. One of its two authors, Andrew Smithers, a British economist, has now returned to the theme of stockmarket valuation. This time he expands his remit to argue that it is not only possible to ascertain a fair value for stockmarkets but that central banks should try to do so and adjust their policies accordingly.

That would once have been a very controversial assertion. It requires central bankers to second guess the markets, to assume that they know more about share price values than investors do. Markets were believed to be efficient, that is to reflect all publicly available information.

But the bursting of the dotcom bubble followed by the credit crunch have dented the notion of perfect markets governed by rational investors. Mr Smithers prefers the idea that markets are "imperfectly efficient", in other words, that they fluctuate around their fair value.

Having argued this, Mr Smithers has to demonstrate two things. The first is a reliable method for valuation, of which he says there are two. One is the replacement cost of a company's assets, the so-called "q" ratio. The other (which was also an important point in Mr Shiller's book) is the cyclically adjusted price-earnings ratio, which compares shares with the profits earned over the previous ten years. When bull markets have reached their heights (as in 1929 and 2000), these ratios have clearly indicated overvaluation. Mr Smithers makes his case convincingly, dismissing alternative indicators of valuation, such as the dividend yield, along the way.

But that still leaves Mr Smithers to deal with a tricky second point: if there is a reliable way of knowing when markets are overvalued, why haven't investors used it to make their fortunes? Moreover, investors armed with such information would presumably sell their shares before they reached their peaks, thereby preventing the extremes from being reached in the first place.

The answer to this conundrum, which is at the heart of efficient market theory, is that valuation is not a useful guide to stockmarket direction over the short term. On Wall Street there were five valuation peaks in the 20th century, or one every 20 years or so. Most investors simply do not have that kind of time horizon. Get market timing wrong and they may lose a fortune (or, if they are a professional fund manager, their clients will). The market can be irrational for longer than you can remain solvent, as the saying goes.
A job for the banks

Even so, Mr Smithers argues that central banks should use the valuation data to decide whether stockmarkets are over- extended. And they should look at house prices and the price of liquidity (defined as the interest spread on corporate bonds that is not attributable to the risk of default) as well. None of this is easy. But central banks already try to estimate the "output gap", the extent to which economic growth is above or below trend, when setting interest rates - and that's fiendishly difficult.

In the past central bankers have claimed that, rather than try to pop bubbles, they should clean up the mess after they have burst. But the cost of the recent financial crisis makes that policy hard to justify. If all the signals (including house prices and liquidity) are flashing red, then central banks should act. Their best tool might not be increases in interest rates but changes in the capital ratios of banks. By requiring banks to hold more capital, the flow of lending would slow and the fuel for speculation would diminish.

Such a policy would not eliminate financial crises or recessions altogether. But as Mr Smithers rightly says, the aim of central banks should not be to avoid an occasional mild recession but a big downturn, such as the world has been suffering."
- The Economist, August 2009

"There is a good reason to welcome a new book by Andrew Smithers, an economist with a good record in identifying bubbles, that offers a frontal assault on flawed central bank thinking...But as Mr Smithers fairly remarks, interest rate changes are currently made on the basis of judgments about the output gap, which is notoriously difficult to estimate."
- Financial Times

"One bad theory is the unjustified belief that financial markets are perfectly efficient. This is nonsense. Warnings about overvalued stock markets, sky-high house prices and excessive debt were widely ignored.

The results have included massive losses to private investors and pension funds plus a dramatic fall in output and employment.

Stock markets can be valued; though we can't predict when they will crash, how high they will rise, or how low they will subsequently fall. If such predictions were possible, share prices would never become badly misvalued.

After their fall, the major stock markets of the world are, once again, reasonably valued. While they could still fall (a lot) from today's level over the next year or so, they should give decent returns to those who hold shares for the long term.

Short-term investors are always at risk if they buy shares, and today is no exception. Two valid methods of valuing the stock market are explained in Wall Street Revalued (published by Wiley).

In my book, I also debunk a lot of the piffle that is written about value. The two most common sources of nonsense are the investment bankers and economists who preferred a poor theory to the evidence of events.

Naturally enough, the stock market is expensive roughly half the time and cheap the other half. Investment bankers want markets to be cheap all the time since they think this is good for their business.

They have produced many bogus ways to value markets and managed to persuade investors that markets were not expensive - even at their ridiculous peaks in 2000 and 2007.

Attachment to bad theory in preference to good observation has caused central bankers to make bad decisions.

The US Federal Reserve (under Alan Greenspan and then Ben Bernanke) stupidly claimed that markets couldn't be valued but also that it didn't matter if they became overvalued. They were wrong on both counts, as is abundantly obvious today. Fortunately these views are now discredited.

Central banks can affect the real economy through asset prices, which usually respond by rising when interest rates fall and falling when they rise. These changes in assets prices affect the real economy.

The impact on asset prices is however only temporary - in the long run shares and other assets rotate around their fair value. When asset prices rise too much, they will fall even if interest rates come down. The result is just what we have seen recently. Central bankers lose control of the economy.

Both investors and central bankers urgently need to learn how to value markets so we can avoid repeating the costly mistakes that have been made in recent years."
- Sky News, 17th August 2009

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About Andrew Smithers

Andrew Smithers is the founder of Smithers & Co., which provides economics–based asset allocation advice to over 100 fund management companies worldwide.

Andrew is a regular contributor in Japan to the Nikkei Veritas. He was a regular contributor to the London Evening Standard and Japan's Sentaku magazine, and has written for many other newspapers and magazines, including the Financial Times, Forbes (US), Sunday Telegraph (UK), Independent on Sunday (UK) and Genron (Japan).  Andrew is an invited contributor to the prestigious Economist's Forum on the FT website. Andrew is a member of the Advisory Board for the Centre for International Macroeconomics and Finance (CIMF) at Cambridge and has also been a member of the Investment Committee at Clare College, Cambridge since 1998. Prior to starting his own firm, Andrew was at S.G.Warburg & Co. Ltd. from 1962 to 1989 where he ran the investment management business for some years and which, by the end of his tenure, was the acknowledged market leader. This was subsequently floated off as a separate company, Mercury Asset Management, which was acquired by Merrill Lynch in 1998.

Contents of Wall Street Revalued

1 Introduction
2. Synopsis
3. Interest Rate Levels and the Stock Market
4. Changes in Interest Rates and Changes in Share Prices
5. Household Savings and the Stock Market
6. An Imperfectly Efficient Market
7. The Efficient Market Hypothesis
8. Testing the Imperfectly Efficient Market Hypothesis
9. Other Claims for Valuing Equities
10. Forecasting Returns without Using Value
11. House Prices
12. The Price of Liquidity
13. The Return on Equities and the Return on Equity Portfolios
14. The General Undesirability of Leveraging Equity Returns
15. A Rare Exception to the Rule against Leverage
16. Profits are Over rather than Understated
17. Intangibles
18. Accounting Issues
19. The Impact on q
20. Problems with Valuing the Markets of Developing Economies
21. Central banks' Response to Asset Prices
22 Deflation, Inflation, Prevention and Cure