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03/03/2010

Book Review: Wall Street Revalued


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Wall-Street-RevaluedAndrew Smithers, a London-based economist who advises institutional and private clients on asset allocation, showed great foresight in his previous book, Valuing Wall Street: Protecting Wealth in Turbulent Markets. Cowritten with Stephen Wright, the book appeared in the spring of 2000 and argued that the market was massively overvalued. Few analysts agreed with Smithers and Wright at the time, but over the next nine years the S&P 500 lost nearly half of its nominal value. 

In his follow-up, Wall Street Revalued (John Wiley & Sons, 2009), Smithers argues that investors and central bankers need a new theory, one that does not accept the efficiency and wisdom of the markets but instead gives clear signals when bubbles are developing. For Smithers this demands no less than a paradigm shift to dislodge the efficient market hypothesis permeating academia and guiding central banks. The Federal Reserve’s reluctance to pop the late 1990s equity bubble, which contributed to the terrible consequences that followed through unnecessary monetary easing, is cited as evidence of the need for a new theory. 

While Smithers’s book addresses the need for a new and expanded focus for central bankers, it primarily examines the fundamental underpinnings of equity and credit returns. Smithers proposes an alternative model, which he calls the “imperfectly efficient markets hypothesis,” and suggests two measures for equity valuation and corresponding returns: the Q ratio and CAPE (cyclically adjusted price-earnings) ratio. The Q ratio divides a company’s market value by its replacement costs; over the long run, the result should hover around one in a competitive economy. In reality, however, adjustments for intangibles (e.g., R&D, advertising), depreciation, and other factors result in a ratio less than one. The CAPE ratio, also known as the P/E 10 ratio and detailed in Robert Shiller’s Irrational Exuberance (Princeton University Press 2000), calculates fair value by comparing current stock market prices with a real 10-year average of earnings per share. 

Smithers helpfully makes extensive use of graphs to illustrate model results. He uses a testing method with holding periods ranging from 1 to 30 years because this gives “the average return that investors with different time horizons would have received from the given starting point.” Investors, however, typically have holding periods much longer than one year, so it is unclear how the average return applies—especially to taxable investors. Nevertheless, as an example, he determines that the US market was almost exactly at fair value at the end of 1976, noting “the return from the end of 1976 to the end of 2008 was 6.1% compared with the return from 1899 to 2008 of 6.02%.” This method seems unorthodox because using a 109-year average to determine fair value assumes constant risk. Having suffered a devastating civil war and being an industrial lightweight compared to Europe, the US had risks closer to an emerging market in the early decades of this time series and should have had much higher expected returns. 

Both measures of equity valuation produce comparable results. Yet for all this effort in calculating fair values, Smithers notes that only twice has the market become so overvalued that it was worth selling. He observes that “there have been only five peaks in the market’s overvaluation since 1900.… The average time between peaks has been 24 years but the average is far from regular and each of the last two swings has taken over 30 years from peak to peak.” Given the degree of difficulty in timing a bubble, a comparison to a simple buy, hold, and rebalance strategy would be helpful. 

Smithers’s fresh perspective and quantitative approach is thought provoking. His belief that the equity risk premium is “unstable and therefore cannot be used sensibly to value equities” is easy to dismiss but reflects a macroeconomic approach. 

Those hoping to uncover insights that enhance their portfolio management processes will need to exercise patience and care with Smithers’s approach. Avoiding asset bubbles preserves wealth, but the warning signs are few, and exiting equity markets early, due to imprecise signals, may actually result in lower long-term returns. The debate over whether markets efficiently reflect all knowable information remains contentious. Even the most ardent supporters of market efficiency acknowledge it is not perfect, information has costs, and theory does not preclude huge volatility.

--Paul Tanner, CFA

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