Wall Street Revalued E-Book

Andrew Smithers

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 367

Veröffentlichungsjahr: 2009

Beschreibung

In 2000 one of the world’s foremost economists, Andrew Smithers, showed that the US stock market was widely over-priced at its peak and correctly advised investors to sell. He also argued that central bankers should adjust their policies not only in light of expected inflation but also if stock prices reach excessive levels. At the time, few economists agreed with him, today it is hard to find those who would disagree.

In the past central bankers have denied that markets can be valued and that it did not matter if they fell. These two intellectual mistakes are the fundamentals cause of the current financial market crisis. In addition, a lack of understanding by investors as to how to value the market has also resulted in widespread losses.

It is clearly of great importance to everyone that neither these losses nor the current financial chaos should be repeated and thus that the principle of asset valuation should be widely understood.

In this timely and thought-provoking sequel to the hugely successful Valuing Wall Street Andrew Smithers puts forward a coherent and testable economic theory in order to influence investors, pension consultants and central bankers policy decisions so that thy may prevent history repeating itself. Backed by theory and substantial evidence Andrew shows that assets can be valued, as financial markets are neither perfectly efficient nor absurd casinos.

Leseprobe

Table of Contents

Title Page

Copyright Page

Foreword

Chapter 1 - Introduction

Chapter 2 - Synopsis

Chapter 3 - Interest Rate Levels and the Stock Market

3.1 Nominal Bond Yields and PEs

3.2 Real Bond Yields and PEs

Chapter 4 - Interest Rate Changes and Share Price Changes

Chapter 5 - Household Savings and the Stock Market

Chapter 6 - A Moderately Rather than a Perfectly Efficient Market

Chapter 7 - The Efficient Market Hypothesis

Chapter 8 - Testing the Imperfectly Efficient Market Hypothesis

8.1 The Test of a Measurable and Relatively Stable “Fundamental”

8.2 Testing Whether the Ratio of Price/ Fundamental is Mean Reverting

8.3 Testing Whether the Criterion Is Justified in Terms of Economic Theory

8.4 Testing if It Has a Weak Ability to Forecast Future Returns

8.5 The Close Accord of q and CAPE

Chapter 9 - Other Claims for Valuing Equities

Chapter 10 - Forecasting Returns without Using Value

Chapter 11 - Valuing Stock Markets by Hindsight Combined with Subsequent Returns

11.1 The US Stock Market as a Test Case

11.2 The World

11.3 Comparative Values of 17 Equity Markets at End 2008

Chapter 12 - House Prices

Chapter 13 - The Price of Liquidity - The Return for Holding Illiquid Assets

Chapter 14 - The Return on Equities and the Return on Equity Portfolios

Chapter 15 - The General Undesirability of Leveraging Equity Portfolios

Chapter 16 - A Rare Exception to the Rule Against Leverage

Chapter 17 - Profits are Overstated

Chapter 18 - Intangibles

Chapter 19 - Accounting Issues

Chapter 20 - The Impact on q

Chapter 21 - Problems with Valuing the Markets of Developing Economies

Chapter 22 - Central Banks’ Response to Asset Prices

Chapter 23 - The Response to Asset Prices from Investors, Fund Managers and ...

Chapter 24 - International Imbalances

Chapter 25 - Summing Up

Appendix 1 - Sources and Obligations

Appendix 2 - Glossary of Terms

Appendix 3 - Interest Rates, Profits and Share Prices

Appendix 4 - Examples of the Current (Trailing) and Next Year’s (Prospective) ...

Appendix 5 - Real Returns from 17 International Equity Markets Comparing ...

Appendix 6 - Errors in Inflation Expectations and the Impact on Bond Returns

Appendix 7 - An Algebraic Demonstration that Negative Serial Correlation can ...

Appendix 8 - Correlations between International Stock Markets

Bibliography

Index

Published in 2009 by John Wiley & Sons, Ltd

© 2009 Smithers & Co Ltd

Registered office

John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

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Library of Congress Cataloging-in-Publication Data

Smithers, Andrew.

Wall Street revalued : imperfect markets and inept central bankers / Andrew Smithers. p. cm.

eISBN : 978-0-470-68510-5

1. Capital market-United States. 2. Monetary policy-United States. 3. Finance- United States. 4. Banks and banking, Central-United States. I. Title.

HG4910.S565 2009

332’.04150973-dc22

2009019921

A catalogue record for this book is available from the British Library.

Set in 11.5/13.5 pt Bembo by SNP Best-set Typesetter Ltd., Hong Kong

Foreword

by Jeremy Grantham

Rumor has it that the first time I met Andrew Smithers when he came into my offic e almost 20 years ago, I offered him a job, which he gleefully declined as preposterous since he already had a job he was perfectly suited to and was quite happy being an independent financial economist. Andrew is a unique mix of professional, analytical, skeptical, independent and crusty. No one quite like him had come my way until then. He goes straight for the point and attempts to beat it to death, usually successfully. He has complete disdain for any hint of self-interest, of which he finds bucket loads in what he describes as “stockbroker economics,” always written in a manner that implies a curled lip.

The first important experience we went through together was the breaking of the Japanese bubble. We had arrived independently at the same point of considering Japan the biggest equity and real estate double bubble of all time. It was not the last time we agreed. In fact, my only complaint with Andrew is just that. We don ’t get to argue with each other enough. Arguing with Andrew is not an experience you would want to miss. If you could imagine being attacked by an eight-armed Indian god equipped with eight razor-sharp swords, you would get the picture. After speaking at one of our client conferences in London, for example, he answered a question by pointing out the three or four implicit fallacies in the question!

As Japan crashed and crashed some more, Andrew would come up with ever more rigorous arguments for leaving it alone. Half price: not even close. Six years into a decline: just warming up. Twelve years into the decline with Japan’s Nikkei blown to 15¢ on the S&P 500’ s dollar, and Andrew’ s merciless logic was still keeping our enthusiasm for Japan down, and rightly so. He helped give us confidence for one of the largest, longest, and most profit able bets of our career. What is more remarkable is that he more or less said how it would unfold nearly 20 years ago and told everyone it would be the longest running bear event in history, which it has indeed been.

Of other coups, I will highlight “Valuing Wall Street,” co-authored with Stephen Wright. This book came out with impeccable timing in early 2000, and explained the doom that awaited us. (Together with Robert Shiller’s “Irrational Exuberance” they made the best-timed and most accurate 1-2 punch in financial history!)

Now, in this volume, he is attempting something even more important: to wage war on both the retreating efficient market academic establishment and the recently proved incompetent central bankers who were in its thrall.

Andrew rips the basic tenets of the Efficient Market Hypothesis to shreds, and that is the easier part. Much more difficult, he replaces it with a new, more complete and more complex theory of Imperfect Markets, which he holds to the far more stringent tests of being useful in investing and testable. The current theory of Market Efficiency fails each of these. Along the way, he skewers central bankers everywhere.

Established academic schools of thought have an enormous reluctance to change their theories. They have careers, awards and reputations involved and they defend their work tenaciously. Very, very few senior academics change their minds profoundly. Max Planck, the physicist, described this process succinctly: “Science advances one funeral at a time.” One can imagine that theories in the softer sciences like economics are even harder to move. One theory in particular - the Efficient Market Hypothesis (EMH) - has dug in its heels. It has proven resistant to decades of data that are incompatible with its theory of efficiency … data that suggest that in real life markets are jungles of behavioral excesses that can result in manias and panics. The theory holds fast to the belief in “rational expectations” that investors are cool, collected, rational machines optimizing their economic vitality at every turn. The EMH ruled the academic waves for 50 years, and for the majority of the time - say, 1968 to 1998 - it was found to be nearly impossible to get tenure or peer reviewed articles published in prestigious journals if you espoused views deemed heretical by the high church of “rational expectations!” The assumption of rationality meant that markets were always efficient and, as such, econometricians could build precise mathematical models, just like physicists. Indeed, the theory was described as suffering from Physics Envy. But the models had a drawback: they were precise, but unfortunately precisely wrong. The EMH therefore led generations of researchers away from messy reality to precisely modeled assumptions. As we have seen recently, though, a world modeled on such profoundly wrong assumptions can be extremely dangerous to economic wellbeing. The EMH has been described as the most expensive mistake - or simply the biggest mistake - in the history of finance. (This assessment has been attributed to Summers and to Shiller but, if neither want it, I’ m sure Smithers or I will be pleased to accept it.) Since the EMH is so at odds with the historical facts of irrational booms and busts, it has not played well with economic historians. The Dean of this group, Charles Kindleberger, in his famous “Manias, Panics, and Crashes” fingered the EMH in his last paragraph. He said, “Dismissing financial crisis on the grounds that bubbles and busts cannot take place because that would imply irrationality is to ignore a condition for the sake of a theory. ”

At this brick wall of belief in the EMH, a few score of us have tilted, shattering our lances time and time again. Solid data documenting inefficiency was ignored, bouncing off their defenses. All these little behavioral twitches can never amount to a useful comprehensive theory the academic establishment seemed to say, so let us ignore them, for what we have now is a neat and useful theory.

For people who worship hard data and intellectual rigor, this dismissiveness has been irritating and frustrating for a long time, but in the last 10 years even the high priests of the EMH have begun to notice a few nicks in their brick wall. But now they should really worry, for the remorseless argument presented by Smithers in this book resembles a large sledge hammer rather than a lance. Starting with the proposal that the EMH in its strong form is probably wrong and in its weak form can never be tested and is therefore not science, Smithers sets about building an alternative case. He calls it the Imperfectly Efficient Market Hypothesis, and it is both testable and useful. His theory holds that prices wander around fair value - the efficient price - sometimes as far away as in the 2000 tech bubble described in the previously mentioned “Valuing Wall Street.” It was here that he and Wright argued that in early 2000 the US market was - astonishingly to most readers - over twice fair value. (Adjusted for inflation it indeed passed way below half its 2000 peak early this year.) In contrast to such an extreme event as 2000, much of the time the market is merely moderately away from fair value and every few years it indeed passes through fair value. In this sense the market is occasionally efficient. As Smithers points out, the market does not fly out of orbit entirely, moving to hundreds of times earnings or approaching zero. Rather, it behaves as if tethered to a central value, loosely controlled by longer-term economic arbitrage. Sometimes this gravitational pull of value works quickly, but sometimes very slowly, reflecting the nature of a necessarily uncertain future and, occasionally, very irrational players. When it is slow in reverting to fair value, Smithers argues that it produces amazing risk for professional investors - who hate to lose business - as impatient clients leave.

Central to Smithers’ concept is that valuing markets is entirely possible and useful. It is useful for predicting future returns for careful, very long-term investors: buying more when stocks are occasionally very cheap and less when very expensive not only increases returns, but lowers risk. In a mean reverting world, overpricing is indeed a risk and a badly underestimated and understudied one at that.

Smithers points out that the crushing consensus behind the EMH in earlier years - it is now finally creaking and cracking - diverted serious work in the financial end of economics away from the concept of value. (Franco Modigliani, one of a tiny half handful of my heroes, told a conference in Boston in 1982 that a market at 8 times depressed earnings was below half price, and in 2000 he sat [very frail] and told the Boston Quant Society that the market at 35 times above normal earnings was over twice fair price. But he had bigger or at least more interesting theoretical fish to fry, and unfortunately never seriously wrote this up, nor was anyone of his stature around to take up his cudgel. In a nutshell Modigliani implied that markets could be valued.) Now Smithers returns to the central point of “Valuing Wall Street”: the market does have a fair value that can be measured. Such a value is provably useful as the market will fluctuate around it allowing profitable investment decisions to be made.

This leads Smithers to the associated key thought in this book: that Greenspan’s and Bernanke’s belief in EMH and the resulting belief that bubbles cannot be identified led us into our current grief. My own favorite illustration of their views was Bernanke’s comment in late 2006 at the height of a 3-sigma (100-year) event in a US housing market that had had no prior housing bubbles: “The US housing market merely reflects a strong US economy.” He was surrounded by statisticians and yet could not see the data. My view, reflected in the Kindleberger quote, is that his profound faith in market efficiency, and therefore a world where bubbles could not exist, made it impossible for him to see what was in front of his eyes.

Greenspan before him was also not sure - at least from time to time - that bubbles could exist, and even if they might, who was he, he argued, to contest the views of tens of thousands of well informed individuals? To be safe, they both adopted the Greenspan Put position: With all our doubts, let us see how the market plays out - bubble or not - and we can still deal with the downside consequences of any bubble bursting by rushing in to provide liquidity. Today we are dealing with the results of that policy.

So these are the two critical monsters of misunderstanding that Smithers has to slay: first, that the market is efficient and valuing it is therefore irrelevant, even if it could be done, which it can ’t; and second, the Fed and central bankers everywhere can ignore the consequences of asset class bubbles forming, and simply deal with the consequences, if any, when they come along. For all of us, unfortunately, the main consequence is that asset bubbles always break, and their breaking can have terrible economic repercussions, as we found out in the US in the 30s and the 70s and in Japan in the 90s. We are relearning this lesson as we speak.

In my opinion, Smithers nails these two monsters in their coffins along with a swarm of their smaller progeny. I certainly hope they stay there. I look forward to a more complicated future where we can start to build on the messy real world as Smithers proposes, and avoid the substantial pain that comes from dangerous oversimplifications.

Jeremy Grantham, Chief Strategist and Chairman, Grantham, Mayo, Van Otterloo

1

Introduction

This book is based on two principles: first, that assets can be objectively valued and, second, that it is extremely important that central bankers should adjust their policies when asset prices get substantially out of line with their underlying values. I seek to show 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 assets which are most liable to be badly mispriced are shares, houses, and private sector debts, including bonds and bank loans. In 2002, Stephen Wright and I wrote a paper explaining why the Federal Reserve should adjust its policy, not only in the light of expected inflation, but also if stock market prices reached excessive levels. But at that time we doubted whether “this view would yet receive support from the majority of economists”.1 As I write, in March 2009, it is quite hard to find economists who disagree. Opinions tend to be moved more quickly by events than by arguments, and this change is no doubt the result of fin ancial turmoil and the threat of a severe recession. I aim to show, however, that the change is sensible, soundly backed by evidence and capable of being supported by theory.

Financial turmoil and recessions are closely linked. Crashes do not occur randomly, but generally follow the booms which are associated with asset bubbles. When these are extreme, the subsequent turmoil is most severe. The three most extreme examples of modern times are today, Japan after 1990 and the US in the 1930s. Falling asset prices, among their many undesirable consequences, make it difficult and sometimes impossible for central banks to control their economies simply through changes in short -term interest rates. The current turmoil has its origin in the series of asset bubbles which began with the stock market in the latter part of the 20th century. If the agreed policy of central banks had been to restrain asset bubbles, and they had acted to do so, the current pain could — and probably would — have been avoided. But while the view that we were then putting forward seems to have been justified in retrospect, it will not command, and should not command, the necessary authority to influence future policy decisions unless it has the support of a coherent and testable economic theory, which it is the purpose of this book to provide.

The symptoms of the financial mania, which began in the 1990s, were many. Not only were asset prices driven to absurd levels, but bankers and others believed that these prices had some fundamental validity and, on the basis of this confidence, created complicated additional structures whose assumed values became, in turn, articles of faith and the basis for further leverage. Loans were extended on the assumption that the assets which backed them were reasonably valued and, in the resulting boom in business, it was the bankers who believed in these follies who were most likely to be rewarded with extravagant bonuses. It has been well remarked that the most successful sellers of snake oil believe wholeheartedly in the virtues of their product, and in recent times bankers became the quintessential sellers of snake oil. When asset prices fell, the whole house of cards came tumbling down and there is a tendency to see the fundamental problem in terms of these symptoms of absurd asset prices, complicated financial structures, extravagant bonuses and undisciplined bank lending. But these symptoms were not the fundamental cause of the mania, although the asset prices alone should have given sufficient warning of the looming problems. Human nature doesn’t change quickly, and people respond to opportunities and incentives. Bankers and other financiers will always hang themselves, and us with them, if provided with sufficient rope. The excessive rope provided by central bankers was not only a necessary condition of the current turmoil, it was a sufficient one. We have a world of fiat money — that is, money which can be created at the whim of our central bankers, as distinct from one based on gold, for example, and if their whims are wayward, the results will be disastrous, without any other conditions for disaster being required except the normal human responses and frailties.

The cause of our present troubles was the actions of incompetent central bankers, who provided excessive liquidity on which the asset price bubbles and their associated absurdities were built. When too much liquidity is being created, the results will appear either in consumer or asset prices. Central bankers were alert to the former and, if the symptoms of excess liquidity had appeared in consumer prices, they would no doubt have responded to dampen them down, even at the cost of having a much earlier recession than the one which is deepening as I write. But an earlier recession would have been relatively mild with a limited loss of output and welfare. Unfortunately, it was in asset rather than consumer prices that the excesses were revealed and, equally unfortunately, the Federal Reserve, which in this instance deserves far more opprobrium than other central bankers, announced that this did not matter.

The central concerns of this book are why the Federal Reserve held this view, why it was wrong and how things could and should be managed better in the future. The single most important element in the Federal Reserve’s view was the claim that asset prices cannot be valued. This was modified at various times and different arguments were regularly trotted out as changing circumstances made each previous claim less credible. But the ability to value assets is the central issue and claims that it can be done run against the long-held view that, while the real economy operates in a less than fully efficient way, financial markets are different. This view is no longer widely held in its starkest form but, in practice, many of the arguments that are produced about financial markets involve the same underlying assumptions, even though those who are making them seldom recognize the implicit, rather than explicit, assumptions that they are making. It is therefore necessary to show that assets can be valued and that financial markets are not perfectly efficient. But this is not enough. It is also necessary to expose arguments which rely implicitly on these assumptions. Otherwise the same follies will return by the back door. For example, as I will show, almost all arguments that involve the Equity Risk Premium and its so-called “Puzzle” include in practice an implied assumption that financial markets are perfectly efficient.

The ability to value asset prices is obviously important for investors, fund managers, actuaries, pension consultants and those concerned with the regulation of financial institutions, as well as for central bankers. This book is therefore addressed to all these audiences.

Shares are not the only assets with which central bankers need to be concerned. House, bond and loan prices are also extremely important. Even assuming that agreement can be reached on the importance of asset prices and how they should be valued, it is necessary to consider the actions that central banks, investors and consultants should take or recommend in the event that assets become markedly misevaluated.

While many people have poured justifiable scorn on the idea that financial markets are perfectly efficient, it is necessary not just to debunk the theory but to put an alternative in its place. I call this alternative the Imperfectly Efficient Market Hypothesis. One aspect of this book is therefore to show that the Efficient Market Hypothesis is not testable but that the Imperfectly Efficient Hypothesis is and proves robust under testing. This involves the ability to value markets and here I am helped by the useful circumstantial evidence provided by having claimed in 2000 that shares were extremely overvalued and by their subsequent fall. In March 2000, Stephen Wright and I published Valuing Wall Street in which we explained that the stock markets were far from being perfectly efficient, and that it was possible to value them. We also expected the results of the overvaluation of the market to be dire. The last sentence of the book was “We therefore doubt whether it will be possible to act promptly and strongly enough to stop a major recession developing in the USA in the new millennium ”.

As we showed, the US stock market could be valued by using the q ratio. At the same time Professor Robert Shiller published a book claiming that markets could be valued by using the cyclically adjusted PE ratio (“CAPE”).2 Both books showed that the US stock market was extremely over-priced and were published at the peak of the bubble. The precise timing, which was (at least in our case), a matter of luck, thus proved to be extremely fortunate since the market, as measured by the S&P 500 index, had by early 2009 halved from its 2000 peak in nominal terms and fallen even more in real ones. These two separate approaches to value produce very similar results and this has great advantages. Not only must two valid answers to the same question agree, but CAPE is unaffected by the issue of valuing intangibles. This has been used as an objection to q, which in turn is unaffected by claims raised as an objection to CAPE that the long-term returns on equity and thus the equilibrium PE are not stable. The way in which the two metrics of q and CAPE agree is evidence against both these objections, though I will also show in other ways that neither are valid.

I shall show that it follows that the stock market can be valued and that this is essential if central bankers are to take note of asset prices. They must know the warning signs. But there are other vital elements that must be explained. One is why asset prices matter for the economy and central bankers, as well as for investors. To do this I demonstrate that interest rates affect asset prices and, as asset prices affect the economy, this is a major transmission mechanism whereby central banks influence demand in the real economy. I show, however, that the impact of interest rates on asset prices is ephemeral. The result is that this transmission mechanism breaks down if share prices rise too high. Ideally, therefore, central banks need to be able to use interest rates to control demand in some way which does not involve the impact of interest rates on asset prices. This reinforces the logically straightforward case that if central banks are asked to have two targets, in this instance both consumer and asset prices, they need more than one policy weapon to deal with them. We must hope that the provision of such an additional weapon will be agreed and will improve central bankers’ ability to manage the economy by not allowing asset prices to be seriously misvalued.3 But whether or not such an additional policy instrument can be agreed and will prove useful, we must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones and, if this is correct, to accept the consequences.

If the market is not perfectly efficient, it is necessary to show why this doesn’t provide an easy way to make money. Demonstrating that imperfectly efficient markets are not a “free lunch”, due to the practical limits of arbitrage, is thus an important element in this book. Associated with this is the question of leverage. The gap between the return on equities and the return on bonds or cash on deposit has been large, and this has led people to question how this gap is not reduced by the simple expedient of investors borrowing and leveraging their equity portfolios. I show that these arguments contain an implicit, rather than explicit, assumption about the way in which such leverage works which involves ignoring the fact that market returns are less volatile over the longer term than they would be if share prices behaved in a more random way.

Partly no doubt because of its fortunate timing, Valuing Wall Street has resulted in many letters of thanks from readers who took our advice and saved themselves from major losses as a result. But there were a number of issues regarding value which we did not discuss or only touched on briefly and which I seek to cover more fully here. For example, I treat in greater detail the alternative approach to value, to which I refer as CAPE, taken by Robert Shiller. This produces very similar answers to those that resulted from our use of q and this element of agreement is itself important. Another is the issue of intangibles. Since 2000, Stephen and I have been teaching a regular course to fund managers, MBA students and others, on how to value stock markets, and questions about intangibles are the ones raised most frequently. In addition, when teaching this course I have encountered a whole string of doubts, problems and interesting questions, which I have also sought to address. As well as dealing with issues not previously or fully covered in Valuing Wall Street, this book is concerned with the interaction of the central banking policy with share prices, with their interaction with the economy and with the responses to misvalued asset prices which should sensibly be taken by investors and consultants.

The issues discussed are therefore important at both the personal, national and, indeed, international levels. Investing in overvalued assets often brings loss, pain and misery and it would clearly be better if these results can be avoided, or at least modified. But violent fluctuations in asset prices also produce more general misfortune, through their impact on the real economy. Asset prices are one of the key transmission mechanisms through which changes in interest rates by central banks influence the real economy. But the more overvalued they are, the weaker this influence becomes. As I write, the Federal Reserve seems, under the impact of falling asset prices, to have lost control of the US economy at least temporarily, and become unable to prevent a recession through its control of interest rates. Fortunately, I expect them to be able to regain it with the help of fiscal stimulus and a large-scale refinancing of the banks. Nonetheless, it would have been better, even if my optimism proves justified, if the Fed had remained in better control, if the economy had been less volatile and if massive additions to the US public sector debt had not been required.

Working on stock market valuation seems never to have been fashionable among economists. One unfortunate side effect has been that otherwise well-informed economists and central bankers often appear to have been ill acquainted with the subject and this has led them to make erroneous and ill considered pronouncements about the difficulty or even impossibility of valuing stock markets. Had the matter been the subject of wide and serious debate, it is likely that they would have studied the subject more thoroughly before pronouncing upon it. This lack of debate was a significant cause of the indifference, or worse, that the Federal Reserve showed towards the stock market bubble as it rose to its peak in 2000. The Federal Reserve was, nonetheless, mildly sensitive to criticism and responded by a series of claims that varied over time. The first was that assets could not be valued and their prices should therefore be ignored. 4 Furthermore, that any adverse consequences resulting from the collapse of asset bubbles could readily be prevented by monetary policy - if necessary, by sprinkling money from helicopters. When it was pointed out that monetary policy had not been ignoring asset prices, but had been responding to falls but not rises, the argument shifted and the excuse was made that the Fed need only respond to asset price falls since these were much more violent than the rises. 5 It seems to me to be a valid observation and criticism that the way the debate developed showed that the Federal Reserve ’s determination to ignore asset prices had driven their arguments rather than, as things should have been, that the strength of the case determined their policy.

The financial turmoil that burst in 2008 appears to have had its origin in the stock market bubble which broke in 2000, and the Federal Reserve policy to offset the impact of this on the real economy fuelled the excesses of the subsequent asset bubbles. These, which took share prices back to their previous nominal heights and house prices to new real ones, finally broke in 2007. It seems likely that the Fed’s policy response, after the stock market fell from its 2000 peak, was all the more excessive for fear that those who criticized its indifference to the stock market bubble would have had added ammunition if the economy had fallen into a marked recession shortly afterwards. The result of the Fed ’s policy, whatever its motivation, was that the stock market bubble of 2000 became by 2007 a bubble which was not confined to shares but common to all asset prices. This chain of causality cannot of course be proved; we cannot tell what might have happened had monetary policy been different or whether those implementing it had unrecorded or even unacknowledged motivations. It could be, though it seems to me unlikely, that the excesses of the 2007 bubble were due to errors unconnected with the stock market bubble that broke in 2000. The sequence of events is, however, clear. The break in the stock market in 2000 was followed by a recession and then by monetary conditions which allowed and encouraged the asset price excesses which peaked in 2007.

Events change views. The slump of the 1930s probably contributed as much as Keynes’s arguments to today’s widespread, though sadly by no means universal, acceptance that intentions to save and to invest are not automatically balanced under conditions of full employment and that such a balance cannot necessarily be achieved by monetary policy alone. The problems of the late 1970s and early 1980s led to renewed emphasis on monetary policy and the recognition that unchecked inflation could, through its impact on expectations, lead to an unpleasant combination of inflation and lost output, which became known as stagflation. The financial turmoil of 2008 is likely to bring about another reassessment. I hope that the importance of asset as well consumer prices for central banks will be increasingly recognized. Already there are encouraging signs, notably in reports, that even the Federal Reserve has decided to reconsider its attitude.6

While I naturally find evidence of such a change of heart welcome, it will not have any practical influence on policy unless some broad agreement can be established as to how assets can be valued. This is not going to be easy, as any discussion encounters strong prejudice in both popular and academic debate. Central banking is subject to strong political pressure and a degree of popular understanding and discussion in the financial press is essential rather than just desirable. This book is therefore addressed to a wider audience than academics. I hope that it will prove useful to those with a broad interest in finance and macroeconomics. This aim is reflected in the book’s structure. In the main text I set out the arguments in a non -technical way, with the algebra and technical details set out in the appendices. I have also made extensive use of Charts as I find that these are often a telling way to communicate important points. The heroine of Alice in Wonderland wonders “what is the use of a book without pictures or conversation”. In this book the absence of conversation is at least offset by many pictures.

In presenting a serious debate on value I find myself in opposition to the majority of the views that I have encountered from stockbrokers and investment bankers. While there are some admirable exceptions, I have come to the harsh conclusion that they are a major source of misinformation encouraged, perhaps, by concerns that a general understanding of the issues involved was unlikely to be helpful for business. Except in rare and extreme times, value has very little influence on the way share prices move, looking even three or more years ahead. However, the claim that “shares today are good value” is believed to be an aid to sales. If it becomes generally understood how shares can be valued, then it must follow that this claim will be known to be nonsense around 50% of the time. In practice, this would be unlikely to matter very much, as the stock market is often a sensible place to invest, giving a higher return than other possible choices among asset classes, even if mildly overvalued. But the stock market, while not wholly irrational, encourages irrationality in its participants, whose instincts are to see reason as a threat to their livelihood.

Financial journalists can seldom afford the time to engage in their own research and are therefore dependent on the work of others. They receive most of their information from stockbrokers and investment bankers and only a few can therefore be expected to offer a view which is independent of these sources. Popular views on value, which are largely derived from the media, are thus naturally biased towards irrational claims whose sole aim is to be always, under any circumstance, amenable to demonstrating that “shares are cheap”. It is therefore no surprise to find that among investment bankers and financial journalists the two most common claims to value are, as I plan to show, 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”. As popular views influence economic policy, it is important that popular nonsense should be exposed rather than ignored, and by doing so I hope to add some lighter touches, which can often be in short supply in any discussion of the dismal science of economics, particularly in the current economic climate.

While the problems of opening up a serious debate on asset value among academics have been reduced by the recent turmoil in financial markets, they remain powerful. Because the fluctuations of financial markets are of vital importance to the real economy, policy makers need a soundly based and broadly shared understanding of financial markets. No such paradigm exists today. The various theories that are held by academics and fin ancial practitioners cannot be readily pulled together and no simple statement can be made that “As generally agreed this is the way that markets work”. Financial economics today has similarities with macroeconomics in the earlier part of the 20th century, when it became increasingly clear that markets did not necessarily work without friction on the lines assumed by perfect competition and some modifications to the model were therefore needed. In the 19th and even in the early 20th centuries, neither governments nor central banks were held responsible for managing the economy and, even if such responsibility had been acknowledged, there was no agreed economic theory on which such management could be based. There were no agreed methods for offsetting the consequences of policy errors or boosting the economy in the face of sharp contractions in demand. Today there is a large degree of agreement on how to respond to macroeconomic problems of this sort, though recent debates show we are well short of unanimity. But financial economics is without a broad basis of agreed theory on how to prevent or respond to financial turbulence and as the output of the financial sector has increased as a proportion of total GDP, the consequent potential for misfortune has risen.

In academia, the main problem is the hangover from the Effi cient Market Hypothesis (EMH). Despite the doubts and scepticism that it aroused even at its peak of popularity, its one-time dominance has left a feeling that discussion of value is not a serious activity for economists. This has been reinforced by a concern that if value could be ascertained it must somehow involve money making and this was beneath the dignity of economists even if they succeeded and, even more, if they failed.

The article7 which set out the opinions of Stephen Wright and myself on the importance of equity prices for central banking, while more detailed than any previous comments we had made on the subject, reflected views that we had been expressing as the US stock market went to its peak in 2000. When the market fell the following recession was quite mild, partly due to fiscal stimulus and partly to the Federal Reserve’s policy of extreme monetary ease. While this was successful in achieving the short -term aim of moderating the weakness of demand, it did so by driving up asset prices, including houses, and virtually all forms of risky assets as well as equities. As asset prices are one of the main transmission mechanisms by which monetary policy affects the economy, it is common, but by no means invariable, for the prices of different types of assets to move together. This was, for example, the experience of Japan in its asset bubble of the 1980s. But one bubble differs from another and there are often bubbles on bubbles in which one particular asset class, or sub-group, becomes even more absurdly priced than others. Telecommunication and internet companies were particularly prone to overvaluation in 2000, real estate companies were exceptional in the Japanese market of the late 1980s and leveraged investment trusts stood out in the US in 1929. These particular excesses have provided a source of euphemism and excuse for those who like to assume that the problem was specific rather than general. Thus the 2000 stock market bubble, which led to the greatest recorded overvaluation of the US stock market in general, has its apologists who like to refer to it as the “high tech or dotcom bubble”. Central banks therefore need to look at asset prices in a broad way and consider how excesses may be reflected in house and other property prices, as well as in the prices of risky financial assets such as equities and credit sensitive debts. Robert Shiller has also emphasized this. In Irrational Exuberance, he wrote in part 5, “A Call to Action”: “It is a serious mistake for public figures to acquiesce in the stock market valuations we have seen recently and to remain silent about the implications... The valuation of the stock market is an important national — indeed international — issue.”

Economists have sometimes been accused of such attachment to their theories that they take a cavalier attitude to conflicting evidence. Although I have found occasions when this critique has had some measure of justification, I doubt whether economists ’ attachment to their theories and their response to threats to them are as a rule any worse than those found in other sciences. But it is clearly vital that such excess attachment should be avoided and I will therefore support the arguments set out in this book with a careful study of the data. But in order to prevent the detail that this involves from distracting attention from the central case, I first set out a synopsis in Chapter 2 and then seek to show that each of the key points are supported by evidence.8

The neglect from which asset value analysis has suffered is reflected in the limited amount of work that has been devoted to the construction of reliable long term data series for stock markets and, as a result, there are marked weaknesses in the available statistics. For example, share prices are available in many stock markets for over 200 years but, with the exception of Professor Siegel’ s admirable compilation of US data, I have not been able to find reliable indices dating before the 20th century. Even for data since 1899, it is only as recently as 2002 that the excellent work by Elroy Dimson, Paul Marsh and Mike Staunton9