Wall Street Revalued by Andrew Smithers

Andrew Smithers’s book “Wall Street Revalued” is not a light read, but it is interesting reading. It is based on two principles: (1) assets can be objectively valued, and (2) it is important for central bankers to adjust policies when asset values are substantially inconsistent with underlying values. Not observing these principles got us into the current problems. The book is full of interesting historical charts.

Both Smithers’s ‘q’ (q=market value of equities/net worth of companies) and Shiller’s CAPE  or cyclically adjusted PE (CAPE=current price to 10-yr average earnings per share ) flashed ‘red’ as the markets peaked in 2000….and again in 2008 (You can see Shiller’s monthly CAPE data at his website). AT Smithers’s website there is a combined US CAPE and q chart for your viewing.

Observations for investors’ consideration:

-when interest rates are lowered, asset prices are driven up; also the stock markets are driven up but this effect is ephemeral. There are no long-term effects on the stock market and the economy is affected by stock prices. The greater the distance from fair value, the greater the force pulling it back to fair value. However, interest rates have strong influence on house prices

-equity risk premium (ERP), which is difference between equity returns and gov’t or risk free bank deposits, “has not been stable nor does it show any indication of rotating around some long-term average” between 1801 and 2007 (disturbing and interesting since a lot of the asset allocation work for retirement planning is done based on some expected long-term ERP)

-the three most important asset price changes which can have dramatic impact on credit conditions are: shares, houses and the “price of liquidity” (i.e. the return to investors when sacrificing liquidity, or price of liquidity= return for holding illiquid assets)

-equities have a dual nature in that they are both financial assets (discounted value of all future income/cash flows) and titles to ownership of real assets (the value cannot diverge significantly from cost of creating those assets, independent of interest rates)

-stock market returns are determined exclusively by two variables: (1) return on corporate net worth and (2) the ratio between the value that the stock market put on corporate net worth at any time and the underlying value

-30 year real return on corporate net worth is 7%; and the average return to investors over time must be same as return made by the companies on their equity, and this will be equilibrium return over time

-over 25 year period 50-60% equity allocation is the best from return and volatility standpoint (4.5% return with minimum volatility2.5%); however from a Sharpe ratio perspective 80% equity is the best.

-the following are identities: (1) average earnings yield, (2) return on corporate net worth adjusted for inflation and (3) average dividend yield + growth in dividend per share; however since 1871 average dividend yield (4.3%) + dividend growth/share= 5.5% which is less than 7.4% (average earnings yield next 12 months), the likely reason is that profits are overstated; same is true for return on corporate equity (5.4%) which is less than 7.4%…also due to overstated profits

-if market was not efficient, then it would be possible to opportunistically profit from mispricing, but if timing and rotation around the correct value is not predictable then can’t take advantage of mispricing

-:markets exhibit “variance compression” with returns varying less over longer time periods than over shorter ones; so it is less risky for investors to hold equities if they expect to invest for 30 years than for those saving for next year’s holiday

-central banks should have acted when share, housing, and liquidity cost signaled bubble, raising interest rates and banks’ minimum capital ratios

-asset bubbles raise the risk of both inflation and deflation

-only twice in history would have made sense for long-term investors to sell, and even then they would have had trouble deciding when to reinvest

-so while value is an indispensible piece of information, it is little guide to action for most investors; however the nearer one get to retirement, the more important in assessing risks and returns

-share prices fluctuate around their fair values, house prices fluctuate around their affordability (affected also by taxation, Interest rates and  willingness to spend more on housing, i.e. higher proportion of disposable income)

-only two metrics pass all the tests of over/under valuation and they agree with each other: (1) q=market value of equities/net worth of companies (only good for non-financials, but also measures private companies) and (2) CAPE(cyclically adjusted PE)=current price to 10-yr average earnings per share (by the a recent David Rosenberg letter indicated that the current S&P500 is overvalued by 27% according to CAPE and 22% according to Q measures.)

-historically: cash real return very variable (1-2%), US stock market real return6-7%

-“invalid approaches to value typically belong to the world of stock brokers and investment bankers whose aim is pursuit of commissions rather than pursuit of truth”

-profit margins are strongly mean-reverting, but they have some negative short-term correlation with inflation

-changes interest rates are highly correlated with stock prices; when interest rates drop, stock prices increase 6-9 months later, but there no significant effect after 18 months. As market becomes significantly overvalued, the impact of interest rate changes on stock markets declines

-good quote: “If data are tortured hard enough, they will always confess”…like in data mining…tell me what you want to prove and I’ll find the data to prove it. (People must use all available data not just a, conveniently, selected subset.)

-another actuarial surprise: conflict of interest distort the judgment if pension consultants and actuaries who are appointed by pension plan sponsors, encourages them to look for opportunities to minimize the sponsor’s contribution to the plan (to the detriment of the plan beneficiaries)