BOOK REVIEW : Wall Street Revalued

Wall Street Revalued: Imperfect Markets and Inept Central Bankers (Wiley 2009) by Andrew Smithers, 246 pages.

Since the eruption of financial crisis in 2008, a spate of books has appeared seeking to explain the cause, and identify the culprits of the financial crisis. Andrew Smithers’ Wall Street Revalued is one of the very best of these books.

In the late 1980s Smithers declared that Japan was in the biggest equity and real estate double bubble of all time, described how it would unfold and predicted correctly that it would be the longest running bear event in history. In early 2000 Smithers and co-author Stephen Wright published Valuing Wall Street: Protecting Wealth in Turbulent Markets which said that the U.S. stock market was dangerously over-priced and predicted correctly that the U.S. stock market was certain to fall a long way and commented that economic recessions have always accompanied such major stock market declines.

In Wall Street Revalued Smithers contends that over the past 20 years flawed policies of the Federal Reserve, intended to minimize stock market declines and economic recessions, instead have been a fundamental cause of our current financial troubles.

The main theses of the book are:

1. The Fed should be concerned about excessive prices in the stock market and the housing market and should take action to restrain the formation of asset price bubbles in these markets because of their extremely negative impact on the overall economy.
2. The market for shares fluctuates around fair value, usually neither too far above or below fair value to cause concern, but sometimes reaching levels dangerously above fair value. House prices fluctuate around their affordability.
3. High precision about the extent of overvaluation is not essential for the purpose of forming a reasonable judgment as to whether stock market prices are moving into dangerous territory. On the basis of two measures of stock market valuation (described below) it is relatively easy to form such a judgment. In the past, whenever asset prices have reached a dangerously high level there was a subsequent market fall accompanied or followed shortly by economic recession.

Smithers writes: “While the invention of new and complex financial instruments, and the incentive to managements’ folly given by their absurd bonuses and remuneration may have added zest to the flames, the fuel on which the fire relied was the excessive liquidity provided by central banks and the asymmetric management of interest rates [by the Fed which] had, justifiably . . . given the impression that it would reduce interest rates in response to falls in asset prices while remaining indifferent to any rises.”

The fundamental error of the Fed was its reliance on the “Efficient Market Hypothesis” (EMH) which posits that market prices incorporate all available information on value, and therefore no one could identify a bubble in asset prices as it was forming, and the best that could be done was to clean up the aftermath of a collapsed bubble. Although the EMH has been falsified for a long time, its adherents in academia, Wall Street, and government continue to treat it as orthodoxy.

Smithers finds that there are two reliable measures of fair value in the stock market:

1. q, which is the ratio of the aggregate stock market value of non-financial U.S. corporations to the aggregate net worth of the companies; and
2. The cyclically adjusted price/earnings ratio (CAPE).

In the q ratio, corporate net worth is the replacement value of the tangible assets of non-financial corporations. In his first book Smithers said that at the end of 1998 the stock market was outrageously over-priced in terms of q.¹ The stock market validated his opinion with its negative total return over the ensuing ten years, 1999-2008.

As illustrated in the accompanying graph, in Wall Street Revalued, published in 2009, Smithers said that as of the end of 2008, when the S&P was at 903, the U.S. stock market was over-priced by 30.6% in terms of q.

Smithers’ other reliable measure of stock market value is the cyclically adjusted price/earnings ratio (CAPE) which is the ratio of a stock market index such as the S&P 500 to the inflation-adjusted average earnings of the companies in the index over the preceding ten years. Smithers finds that CAPE confirms q and that using either measure the stock market was dangerously over-priced at the end of 2008. Having gone up 40% since then the market is now still more over-priced according to a recent statement by Smithers.²

Over the past 20 years the Fed time and again stimulated the economy to avoid recession. However, this has led to an economic downturn that appears far worse than the Fed expected, with a real estate downturn of almost five years’ duration, persistently high unemployment, and banks whose capital is so badly impaired by loans made imprudently in the past that they are unwilling now to make the new loans that could be the lifeblood of economic recovery.

Smithers contends that the Fed’s continually stimulative monetary policy was the most significant contributor to the double bubble in shares and houses. Smithers wrote this book to argue that the Fed should have taken action to restrain the bubbles forming in shares and houses.

“The price of liquidity” is another measure of financial danger cited by Smithers. The price of liquidity measures the difference between the interest rate on the most risk-free, short-term debt obligations (such as U.S. Treasury debt) and the likely future returns from the stock market and house prices.

The price of liquidity is high when shares and houses are so cheaply priced that prospective returns from cash equivalents are relatively low compared to prospective returns from shares and houses. I.e, one gives up a lot of future return by holding too much cash in an under-valued market for shares and houses. Conversely, the price of liquidity is low when share and home prices are higher than fair value, so that investors are likely to be better off with large cash positions.

The Fed believed in the EMH—that markets cannot be valued. Therefore, they believed it is impossible to know if markets are over-valued and futile to attempt to prevent them from going to over-valued. Accordingly, Fed policy was to wait until a bubble deflates then clean up the aftermath.

During the latter part of the 1990s the Fed failed to recognize the formation of a huge stock market bubble which collapsed in the stock market crash of 2000-2002 and the accompanying recession of 2001. From 2001 through mid-2004 the policy of the Fed was to stimulate the economy by extremely low interest rates. In Smithers’ analysis, the market response to “these follies of the Fed” was large increases in the prices of shares and houses and a large fall in the return to investors for holding the most liquid assets such as cash equivalents.

The author writes, “[h]ad the [Fed] adjusted its policy and succeeded in avoiding the excesses of the 2000 stock market bubble, the subsequent bubbles in house prices and many financial assets would probably not have happened. . . [H]ouse [prices] had become extremely expensive well before they actually peaked in 2007. The danger presented by this was widely recognized, but did not result in action being taken by [the Fed] . . . If the Federal Reserve . . . had been concerned with asset prices, as this book argues [it] should, then [it] had plenty of evidence that house prices had risen to dangerous levels.”

Smithers also argues that the debt level of US corporations is at a record high level³ and, therefore, another “major threat to the US economy . . . is that bank lending to nonfinancial corporations will, in retrospect, appear to have been as ill-considered as mortgage lending and the need for a satisfactory resolution of the latter is only a part of the challenge currently faced by the US banking industry and therefore by the US Treasury and the Federal Reserve.”

The author’s view is that central banks can know if the prices of shares, homes, and risky debt assets have reached excessive levels and in such case should take action to reverse bubbles in asset prices. He opines that “[e]ven if it is accepted that a recession would have resulted, it is reasonable to think that mild recessions are preferable to the costs of avoiding them if that cost is, as subsequent events suggest, very high in terms of subsequent large losses in output, financial turmoil and large increases in fiscal deficits and government debt levels. Until recently, such ideas ran completely contrary to the attitudes of the remarkably confident and optimistic era which has ended so suddenly.”

Smithers concludes that “We can . . . measure the extent to which financial asset prices move away from fair value. The claim that this is not possible is without merit and has been a major cause of central banks’ failure to address the problems that come from exorbitant asset prices . . .

“[T]here is no long-term relationship between interest rates and asset prices. If the latter rise too much they will fall independently of changes in interest rates and, as a result, monetary policy in its usual form ceases to be effective. We are currently suffering from this [as shown by the Fed’s extreme monetary stimulus measures of 2009 to date, which have failed to reinvigorate the economy].”

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