By Martin Wolf
Published: October 27 2009 20:27
How did the world economy fall into such a deep hole? It is recovering, but painfully, and after a deep recession, despite unprecedented monetary and fiscal easing. Moreover, how likely is it that a balanced world economy will emerge from this force-feeding? The very fact that such drastic action has been necessary is terrifying. The fact that there is little room for a policy encore is yet more terrifying. Most terrifying of all is that this is not the first time in recent decades the world economy has had to be guided through a post-bubble collapse.
In his latest book – a successor to Valuing Wall Street, which appeared in time to help alert readers avoid the 2000 meltdown – Andrew Smithers of London-based Smithers & Co, provides an invaluable guide to past errors of analysis and policy.* He is a rare guide – a man with a deep understanding of economics and a lifetime’s experience of financial markets. His work helps to explain the stock-market bubble of the 1990s, the fiscal errors of Gordon Brown and the recent credit excess.
The big points of the book are four: first, asset markets are only “imperfectly efficient”; second, it is possible to value markets; third, huge positive deviations from fair value – bubbles – are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles. “We must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones.” I have been unwilling to accept this view. That is no longer true.
The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a “random walk”. Mr Smithers shows that this conclusion is empirically false: stock markets exhibit “negative serial correlation”. More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. “Markets rotate around fair value.” There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets – including housing.
A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon.
Mr Smithers proposes two fundamental measures of value – “Q” or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. The two measures give similar results (see chart). Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: “Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth.”
Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back. Trees do not grow to the sky and markets do not attain infinite value. When stocks reach absurd valuations, investors will stop buying and start to sell. In the end, the value of stocks will move back into line with (or below) the value – and underlying earnings – of companies. House prices will, in the long term, also relate to incomes.
Anybody interested in investing would gain from reading this book. They would then understand, for example, why the “buy and hold” strategy advocated by many pension advisers, even at the peak of the stock market bubble, was such a catastrophe. Value matters, as Warren Buffett has said so often.
Yet, for those interested in economic policy, Mr Smithers’ arguments have wider significance. If markets can be valued, it is possible to tell whether they are entering bubble territory. Moreover, we also know that the bursting of a huge bubble can be economically devastating. This is particularly true if there was an associated surge in credit. This is also the conclusion of a significant chapter in the latest World Economic Outlook. In extreme circumstances, monetary policy loses its impact, as the financial system is decapitalised and borrowers become bankrupt. What we see then is what Keynes called “pushing on a string”.
So what are the policy lessons? The International Monetary Fund concludes, ponderously: “Simulations suggest that using a macroprudential instrument designed specifically to dampen credit market cycles would help to counter accelerator mechanisms that inflate credit growth and asset prices. In addition, a stronger monetary reaction to signs of overheating or of a credit or asset price bubble could also be useful.” Mr Smithers suggests that policymakers should monitor the price of stocks, houses and liquidity. If one of these, and especially if all three, are flashing red central bankers should respond. He recommends measures that raise capital requirements of banks in the boom. I would also support measures that directly limit the leverage among borrowers, as asset prices soar, particularly house prices.
The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. “Leaning against the wind” requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned.
(Click to enlarge)
* Wall Street Revalued: Imperfect Markets and Inept Central Bankers, Wiley 2009
Copyright The Financial Times Limited 2009.
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