Wednesday , 20 September 2017

"Wall Street Revalued: Imperfect Markets, Inept Central Bankers" – A Book by Andrew Smithers

The crucial assumption of the book is that “the market” does have a central value and that the world of stock markets is a “mean reverting” world. As a consequence, the market can be over-valued or under-valued but will, over time, return to its central value. Words: 1317

In further edited excerpts from the original review* at, John Mason goes on to say:

Smithers states at the beginning of the book that it is based on two principles:

1. that assets can be objectively valued
2. that it is extremely important that central bankers should adjust their policies when asset prices get substantially out of line with their underlying values.

He concludes that it was the denial of these two principles that led to the errors by central bankers which are the fundamental cause of our current troubles.

The denial of these two principles came about because investors and policy makers have explicitly, or implicitly, assumed that the Efficient Market Hypothesis (EMH) as created and applied by academic economists, and its derivative assumption, the Random Walk Hypothesis (RWH), have dominated the investment community and central bank thinking. The condition that defines the EMH, according to Smithers, is that current market prices contain all the information that is available to investors and, therefore, assets are efficiently priced so that share prices must always be at fair value and there can be no difference between price and value. Since information comes to the market randomly, then price movements within the market must themselves be random so that the RWH is closely connected with the EMH.

Smithers proposes an alternative hypothesis which he calls the Imperfectly Efficient Market Hypothesis because markets are not totally efficient but are only moderately efficient. Crucial to this conclusion is that empirical tests of the EMH do not support the theory and, as a consequence, the theory must be rejected. The primary empirical test that leads to this view is that the underlying assumption about the RWH does not hold, that the variance of market prices does not remain constant through longer investor holding periods. It has been found that the variance of market prices declines as holding periods get longer and that this results in a negative serial correlation of returns. That is, this is evidence that markets “rotate around fair value.”

Two approaches to determine fair value are presented by Smithers and these, he argues, are consistent with the Imperfectly Efficient Market Hypothesis.

1. The first method was developed by James Tobin and is captured by the variable q. The value q is the ratio of the market value of the firm divided by the reproduction costs of the assets of a firm or market less the debt of the firm or market. If the value of q is equal to one, then the net value of the assets and the market value of the company are equal. If the market value of the company or market is above the net value of the assets the company or market then the company or market is over-valued and vice versa if the net value of the company is above the market value, then the company or market is under-valued. (Since profits have tended to be overstated historically, the average value of this ratio tends to be below 1, but the movements in the ratio still give the correct signals.) Over time, there is the distinct reversion to the mean that Smithers looks for.

2. The second method is the one develop by Robert Shiller and is called the cyclically adjusted price/earnings ratio (CAPE). The long-term average of the PE ratio is stable so that this variable represents more of an “equilibrium” value rather than a value just based upon the current level of earnings.

The research conducted and reported by Smithers supports the use of these two variables in analyzing whether or not the stock market is over- or under-valued. The remarkable thing is that the two variables move very closely together and this “reinforces the probability that the real return on equities is stable.”

Since the author concentrates on whether or not stock values are over- or under-valued, he also expresses concern about the over- or under-valuation of other assets such as the price of housing or the price of bonds. Within the book he develops methodologies for determining whether or not these assets might be over-priced or under-priced. In this he is very concerned about the existence of asset bubbles because he perceives that much of the turmoil that financial markets face results from the existence of, and subsequent collapse of, asset bubbles.

Developing his approach in this way allows him to focus on three different asset markets so as to develop information about bubbles that can reinforce a conclusion. In this way Smithers can review the historical record and show how the evidence from each market generally supported the over-all conclusion about the valuation of assets and whether or not they were out-of-line with fair value.

Here is where he introduces the rationale for the “inept” behavior of central bankers. Central bankers, Smithers argues, are strong advocates of the EMH and hence believe that market prices are always correct while at the same time following a random walk. Hence, asset bubbles cannot occur, and, since asset bubbles cannot occur, there is no way the Federal Reserve can either identify asset bubbles or introduce a policy that can combat asset bubbles. The assumption that market prices are always “correct” results in central bankers doing things that are not only not helpful but can result in them doing things that make situations worse.

The primary example here is the action of the Federal Reserve System over the past 15 years or so. Smithers argues that the monetary policy of the Fed created the stock market bubble of the 1990s. Around the year 2000 the United States stock market was more over-valued than at any time during its history and this judgment was supported by the “q” ratio and the CAPE variable. The stock market had to break and it did. The response of the Federal Reserve was to lower its policy interest rate to an extraordinarily low level and keep it there for an extremely long period of time. The result was the bubble in housing prices and the loss of liquidity in the bond markets. Thus, in the decade of the 2000s all three market indicators were flashing the “over-valued” sign but this did not deter the Fed. According to the author, a reaction had to come and we are now working through the results of the “inept” leadership at the Federal Reserve.

The author addresses how a central bank should approach the conduct of monetary policy and how it should react to the performance of financial markets and the economy. Smithers argues that the Fed should focus on several market variables in order to set policy: these are the price of stocks, housing prices, the price of financial market liquidity, and consumer prices. He further argues that the Fed needs a tool or policy instrument to apply to each target so that the manipulation of a short term interest rate is not sufficient for the conduct of monetary policy and the control of asset bubbles. One other policy tool he suggests is bank reserve requirements.

“Wall Street Revalued” is an important work to read. One can get lost in the detail and the side-trails that the author takes us through but it is worthwhile to work through the research results that Smithers presents and the history he relates it to. It is not that the book is difficult to read it is just that there is a lot to be covered in 198 pages of text.


Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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