An economist’s warning for stock market investors
LONDON, April 14 (Reuters Breakingviews) - Economic theory today is far removed from what happens in the real world. Its canonical models portray the corporate sector as a single representative firm that acts in the interests of its owners. Anyone who has worked in finance knows these models are contrived. In his latest book, “The Economics of the Stock Market”, veteran economist Andrew Smithers lifts the corporate veil to reveal a world in which the managers of public companies put their own interests first and seek to maximise current share prices rather fundamental values. In the United States, their actions have produced an overvalued stock market, excessive corporate debt and inadequate levels of investment.
Smithers, who started work in the City of London six decades ago and once ran the fund management arm of the merchant bank S. G. Warburg, belongs to a venerable tradition of economists whose theory is shaped by practical experience. David Ricardo started his career as a stockbroker, while John Maynard Keynes was the bursar of his Cambridge college and chairman of a life insurance company. Economic models, says Smithers, should fit with known human behaviour and be tested by data from the real world.
Theory suggests that company managers have the same interests as shareholders. In reality they have different priorities. Corporate executives aim to hang on to their jobs and enhance the value of their stock-based compensation.
If managements aimed to maximise the net worth of their businesses, they would issue shares when the cost of equity is low (and shares are highly valued in the market) and use the capital for investment. They don’t act in this manner because the immediate effect of new investment is to lower a company’s earnings per share. Along with issuing new shares, this tends to temporarily depress stock prices.
Instead, managers prefer to take on debt to buy back shares at inflated prices. Finance 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 share prices, says Smithers. He also observes that companies seek to maintain a stable ratio of interest payments to profits. Thus, as long-term interest rates have declined, U.S. companies have taken on more and more debt to repurchase their shares.
As a result, the valuation of the U.S. stock market has significantly diverged from its fair value, says Smithers. Finance theory denies that we can identify a stock market bubble in real time: future share price movements are unpredictable. This is true in the near term, says Smithers. Over longer periods, however, the behaviour of the stock market has been anything but random. In the past 200 years, U.S. equities have delivered an annual average real return of 6.7%. Periods of above-average returns have been followed by sub-par returns, and vice versa.
This shows the stock market is governed by the principle that returns will revert to their long-run mean. Smithers suggests the best way to value equities is to compare their market price to the cost of replacing underlying corporate assets. This measure, known as Tobin’s Q, is named after the Nobel laureate economist, James Tobin. The snag is that the process of mean reversion can take decades, well beyond the time horizon of most investors.
Because 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 share price – with bond yields. In recent years, as bond yields fell to their lowest level in history, the valuation of U.S. stocks has soared. But Smithers maintains that comparing the two makes little sense. After all, stocks are claims on real assets whereas bonds represent paper claims. Over time, the difference in their respective investment returns (known as the equity risk premium) has neither been stable nor mean-reverting.
Besides, Smithers argues, stocks should deliver a significantly higher return than bonds. Most investment is intended for retirement and savers are concerned primarily with maintaining their future spending power. Stocks are risky assets, whose value can remain depressed for long periods. After the October 1929 crash it took around a quarter of a century for the market to regain its previous peak. The marginal investor, says Smithers, requires a significant return to compensate for the market’s inherent volatility.
Smithers’ analysis suggests that the U.S. stock market today is perilously positioned. In recent decades, corporate managers have diverted resources from investment towards share repurchases. A prolonged period of underinvestment has put American public companies at a competitive disadvantage to foreign-owned firms. The corporate sector has also taken on near-record amounts of leverage. On a replacement-cost basis, the stock market trades at more than twice fair value. The risks of another financial crisis appear elevated, says Smithers.
Naysayers will point out that American equities have looked overvalued relative to Tobin’s Q for the best part of 30 years. Besides, just because the return from stocks has been stable in the past doesn’t mean that equities must deliver the same return in future. Naysayers may also suggest that the increasing importance of intangible assets has rendered Tobin’s Q obsolete – though Smithers vehemently rejects this. The natural monopolies created by the internet have also allowed technology companies to earn excess returns on equity for prolonged periods.
Yet one reason why the valuation of U.S. stocks has remained elevated for so long is because the Federal Reserve has supported Wall Street with ever-lower interest rates and successive bouts of quantitative easing. Now the return of inflation has forced the Fed to reverse tack. Inflation tends to push up interest costs faster than corporate cash flows, forcing companies to deleverage and cut investment. Under those circumstances, the valuation of U.S. stocks could tumble.
Smithers was one of the few economists to warn about the internet bubble and the dangers posed by the ensuing global credit boom. His current concerns shouldn’t be dismissed lightly.
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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
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