Andrew Smithers believes that companies are too indebted and their stocks are overvalued
Current economic theory is far removed from what happens in the real world. Its canonical models present the business sector as a single representative firm acting in the interests of its owners. Anyone who has worked in finance knows that these models are gimmicky. In his last book, The Economics of the Stock market (The economy of the stock market), veteran economist Andrew Smithers lifts the corporate veil to reveal a world in which the directors of listed companies put their own interests first and seek to maximize current stock prices rather than fundamental values. In the US, his actions have produced an overvalued stock market, excessive indebtedness and inadequate levels of investment.
Smithers, who joined the City six decades ago and once headed the fund management arm of SG Warburg bank, belongs to a venerable tradition of economists whose theory is shaped by practical experience. David Ricardo began his career as a broker, while John Maynard Keynes was the bursar of his Cambridge college and chairman of a life insurance firm. The models, Smithers says, must be adjusted to known human behavior and tested against real-world data.
The theory suggests that managers have the same interests as shareholders. In reality, they have different priorities. The goal of the former is to keep their jobs and increase the value of their compensation in shares. If they were aiming to maximize the net worth of their companies, they would issue shares when the cost of capital is low (and the shares are highly valued in the market) and use the capital to invest. They don’t do this because the immediate effect of new investments is falling earnings per share. Together with the issuance of new shares, this tends to temporarily depress the price.
Instead, they prefer to borrow to buy back at inflated prices. Theory suggests that a company’s valuation should not change whether it is financed with equity or debt. In reality, debt-financed buybacks serve to boost the price, says Smithers. He also notes that companies try to maintain a stable relationship between interest payments and earnings. Thus, as long-term rates fell, US firms borrowed more and more to buy back their shares.
So the stock has deviated considerably from its fair value, he says. The theory denies that we can identify a stock market bubble in real time: future price movements are unpredictable. This is true in the short term, says Smithers. But, over longer periods, stock market behavior has been anything but random. In the last 200 years, the US has offered an annual average real return of 6.7%. Periods of above-average returns have been followed by below-average returns, and vice versa.
This shows that the Stock Market is governed by the principle that returns will return to their long-term average. Smithers suggests that the best way to value stocks is to compare their market price to the replacement cost of the underlying corporate assets: Tobin’s Q. The problem is that the mean reversion process can take decades, well beyond the time horizon of most investors.
Since Tobin’s Q is not a practical valuation tool, most investors prefer to compare earnings yields—a company’s earnings per share divided by its price—with bonds. In recent years, when it fell to its lowest level in history, the valuation of US stocks soared. But Smithers argues that this comparison makes little sense. After all, stocks are claims on real assets, while bonds represent claims on paper. Over time, the difference between their respective returns (the equity risk premium) has not been stable or mean-reverting.
Also, according to Smithers, stocks should offer a much higher return than bonds. Most investments are for retirement, and savers are primarily concerned with maintaining their spending power in the future. Stocks are risky assets, whose value can remain sunk for long periods. After the crash of 1929, it took a quarter of a century for the market to recover its peak. The marginal investor, says Smithers, requires a significant return to offset the inherent volatility of the market.
His analysis suggests that the stock market is in a dangerous position today. In recent decades, managers have diverted resources from investment to share buybacks. A prolonged period of underinvestment has put listed companies at a competitive disadvantage against foreign-owned ones. The corporate sector has also taken on near-record amounts of leverage. Based on replacement cost, the Stock Exchange is trading at more than double its fair value. The risks of another financial crisis seem high, says Smithers.
Critics will point out that equities have been overvalued relative to Tobin’s Q for nearly 30 years. Also, just because the stock’s return has been stable in the past doesn’t mean it should offer the same return in the future. Critics may also suggest that the growing importance of intangible assets has rendered Tobin’s Q obsolete, although Smithers vehemently rejects this. The natural monopolies created by the internet have also allowed tech companies to earn excessive returns on capital over long periods of time.
But one of the reasons the valuation has been high for so long is that the Fed has propped up Wall Street with ever-lower rates and successive bouts of quantitative easing. Now, the return of inflation has forced the agency to back down. Inflation tends to push up interest costs faster than companies’ cash flows, forcing them to deleverage and reduce investment. In these circumstances, valuations could plummet.
Smithers was one of the few economists to warn of the Internet bubble and the dangers of the ensuing global credit boom. His current concerns should not be dismissed lightly.