Customer Reviews

Valuing Wall Street: Protecting Wealth in Turbulent Markets

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Smithers and Wright have written a very compelling indictment of today's stock prices. They argue that prices are way too high by historical standards, and exhort us to SELL. This is the same conclusion reached by Yale Professor Robert Shiller in his new book "Irrational Exuberance"; however, Smithers and Wright are much more convincing.

Smithers and Wright use as a measure of valuation for stocks a statistic called "q" (or Tobin's q, named after Nobel laureate and Shiller colleague James Tobin). q represents the value of equities divided by the cost of replacing the underlying capital stock. So you might expect the stock market to be worth somewhere near q=1, where companies are worth what it cost to build them; historically, the average value of q is near 1.

Smithers and Wright show that changes in q and equity prices are almost identical, since the cost of replacing the capital stock changes so little. They also show that high values of q are associated with terrible subsequent returns. They show how a simple strategy of selling when q rises to 1.5 and buying again when q falls below 1 * trounces * a buy-and-hold strategy. And they top it all off by showing that today's level of q, around 2.5, is unprecedented. So SELL!

The reason the book is so much better than Shiller's is that Smithers and Wright give a coherent, fact- and theory-based argument for why q should be used to value stocks, not just P/E, stock earnings yield compared to bond earnings yield, or other popular measures. Shiller just used P/E and told us to sell due to today's high P/E; he did not even consider, not to mention try to debunk, other theories of valuation.

Smithers and Wright point out, for example, that in the early '30s, P/E was very high due to the depressed depression-era profits of companies, but that q was very low, providing the buy signal of a lifetime that would have been missed by looking at P/E alone.

The only negatives of this otherwise excellent book are: (1) Like most finance books, this one would gain from adding computations of after-tax returns, which shift us away from fancy trading strategies and towards buy-and-hold in taxable accounts. (2) They should admit that there are significant differences between today's economy and economies of the past. For example, in an economy such as ours where intellectual property is paramount and provides barriers to entry, firms' values may stay above the cost of replacing capital.

Smithers and Wright tell us they have undertaken a statistical study of the relationship between the market value of US equities and the net worth of the underlying firms (as expressed by the ratio known as "Tobins q") and that their analysis reveals a strong tendency for this ratio to revert to its long-run mean of .65. As Tobins q is currently measuring in the area of 1.5, the authors conclude that the US stock market is overvalued and likely to decline by more than 50%. Based on about 100 years of data, the authors provide an estimate (using confidence intervals) of how soon this mean reversion is likely to occur.

The best service Smithers and Wright have provided in VWS is in demonstrating that contrary to popular wisdom (and books by other authors), a "buy and hold" approach to investing in the stock market has not necessarily provided a sure path to riches (or even a comfortable retirement). How well an investor has done depends crucially on, 1) what year he/she began investing in stocks, 2) the duration over which he/she invested, and 3) the year in which he/she retired. Over many periods, investors would have earned a much higher risk-adjusted return by holding bonds or cash instead of stocks. Thus, the authors conclude that with stocks set to decline by over 50% in the near future, any investor with less than, say a twenty year time horizon, would be well-advised to sell their stocks now.

Of course, Tobins q only serves as a reliable indicator of future stock market performance if the factors responsible for its accuracy in the past are still valid today. Some of the other reviewers here have done a good job of pointing out the problem with measuring corporate net worth exclusively in terms of real assets. If US corporations were to capitalize (rather than expense) all of their investments in intangible assets, net worth would be significantly higher and Tobins q would not appear quite so top-heavy. Smithers and Wright attempt to discredit this point by suggesting that for every firm that adds value to its balance sheet (through intangible assets that perform well), there is another firm that destroys value (through intangibles that perform poorly). Thus, their argument goes, in the aggregate corporate net worth is no higher than what is reflected by real assets in the denominator of q. The problem with this defense is that one could logically make the same argument for real assets. For every factory or machine tool that adds value to a company by contributing to profits, there is probably a factory or machine tool at another firm which contributes to loss making. The logical (but absurd) conclusion of this line of reasoning is that in the aggregate, the real net worth of US corporations is ZERO.

Smithers and Wright are supposedly economists by training but they have forgotten the first rule of economic valuation: sunk costs are irrelevant. The reason Tobins q is unlikely to accurately predict fair value in the stock market is that intrinsic value is not calculated by adding up total net assets but rather by discounting to the present time, the future cash flows which those assets can be expected to produce. Clearly, today's investors in the US stock market believe that is a very large figure indeed. Perhaps for their next book, the authors can assess the probability that these expected cash flows will actually materialize. That would tell us whether or not the stock market is overvalued and if so, by how much.

This is far from the dry boring stuff that is usually written on finance. The authors produce an extremely convincing and logical argument that the stock market is overvalued. This is based on comparing Tobin's q to its long term average. Tobin's q is based on flow of funds data and hence overcomes the problem of looking at corporate data. They also discuss other valuation techniques and explain their strengths and weaknesses. The book is full of interesting insights. I particularly like an example they use to demonstrate the power of compund interest. A gem of a book and well worth reading what ever your view on the state of world equity market.

Although there's plenty of evidence one cannot time the market short term--just look at managed portfolios compared to major stock indexes--that does not mean it's not possible over much longer cycles. The usual metric, P/E ratio, for measuring these cycles is occasionally wrong, like once or twice a century, e.g. if earnings are unusually small, as in the Depression. Better to use something similar to price-to-book value, "q". Averaging over all companies, and looking back over the last hundred years of market data, q tells you when stocks are overpriced more reliably than P/E. If you buy stocks at below average q and sell them when q is above average, you'll outperform a buy and hold strategy.

Of course, people already ignoring P/E are unlikely to be swayed by a refinement. That's why the second aspect of this book is important. It's one of few books that tells you *not* to own stocks now. It presents historical data--someone unfortunate enough to have entered the market just before the 1929 crash would have had to wait 25 years to catch up with an all bond portfolio--to show how bad an investment stocks can be.

Holding bonds until P/E returns to single digits, where it was at the start of the bull market in 1982, will never appeal to some people, but that's this book's advice in a nutshell.

The Smithers-Wright book is maybe the best one about stock market valuation written in the past decade. Amidst the growing debate about the "fair value" of the world's capital markets, the book presents a theoretically well-founded point. It gives us a useful tool. Or rather shows us how to use a tool all too familiar for economist, but which, as we can learn it from this book, can be misapplied so easily. At the same time, the authors give a warning concerning the current valuation of the world's equity markets. Hence, practical analysts get a view of where we are heading for. Anyone who has ever dealt with the capital markets knows that having a well-founded fundamental model of what will happen is key in finding the optimal investment strategy path. Beside the professional qualities, the book is also a good read. Even fun, certainly as far out as a capital market text can go. I recommend it to everyone interested in either the theory or the practice of the financial markets.

Smithers and Wright have undertaken an exhaustive 100 year study of U.S. equity prices using Tobin's Q as their primary metric. Tobin's Q is defined as Value of Stock Market/Corporate Net Worth. Their analysis shows that as of the end of 1998, the U.S. stock market was overvalued by about 2 ½ times - the greatest margin in history. This is scary stuff, particularly for the legions of individual investors in the United States that have rushed into the stock market in recent years, and have a naive faith that they should get a God given 20% return per annum compounded. Although the NASDAQ is now down 50% from it's March 2000 highs, it is still above that December 1998 value discussed by Smithers and Wright, as is the DOW. Thus, their warnings are as pertinent as ever.

Smithers and Wright do a good job of taking the reader through various historic tests of Tobin's Q, comparing it to other measures of stock market valuation, such as PE ratios and the dividend yield. They show that Tobin's Q is a better measure of valuation. Their writing is straightforward and accessible to the general reader. Their message is compelling and extremely valuable. Their main conclusion, which psychologically will be very hard for most readers to accept, is that the best thing that most investors can do right now is to get out of the stock market altogether and wait until valuations return to more reasonable levels (their analysis suggests that a 50% decline in the DOW is quit possible). Smithers and Wright show that a "go to cash" strategy would have worked in the past and they do a good job of explaining why it will not be any different this time around.

The book is must read for any individual investor. My only criticism is that they take too long to make their points. A book of half the length would have been appropriate.

This is the most impressive investment book I've ever read, and I have read a few.

I think some reviewers have made criticisms (of the valuation measure "Q") which the authors have already answered in the book.

For example, the authors say paid-for intangibles DO affect net worth as measured by "Q". It is only not paid-for intangibles that must have no aggregate value when considering the stock market as a whole. The aggregate value of all intangibles that have not been paid for (by anyone) must be zero, since there are no free lunches. For example, for every bit of "goodwill" that allows one corporation to make above average returns on capital there must be "badwill" elsewhere that causes another corporation to make below-average returns.

It is said that the ability of managers to find and hold on to outstanding employees ("human capital") is not reflected in net worth. The authors point out that in the absence of slavery human capital is not the property of the corporation. In a competitive economy it is not possible to pay management or workers less than the value of their contribution. Better management cannot raise the aggregate value of corporations, some corporations may be be worth a premium because they have above-average management, but then others must be discounted for having below-average management.

They do address the issue of whether the equity risk premium has fallen. If I understand them correctly, they say that even if it has fallen to zero the market is still two and a half times overvalued.

The latest computed value of Q can always be found at http://www.smithers.co.uk/keydata.shtml . For example I visited that web page on 1-18-2004 and found: "As of 20th June, when the S&P 500 was at 995.73, the market was selling at 1.46 times its long-term average, according to q, and thus needs to fall by 31% to reach fair value." It is strongly advised that investors check this web page at least once a month for possible updates. A word to the wise is sufficient! (Also if you purchase the book, do not forget to look at the Virtual Appendix at http://www.valuingwallstreet.com/VApp.pdf )

Written in 1999 to warn investors to get out of the stock market totally because prices were way too high compared to the underlying securities' net worth, Andrew Smithers and Stephen Wright were proven correct during the next three years as prices spiraled downward. The authors' measuring stick was "q," the Nobel prize-winning economist James Tobin's 1969 invention to value stocks. It is the simple formula of stock price divided by corporate net worth (replacement cost). Essentially, it works over time like an oscillator. They take considerable amount of space to prove it is a more reliable indicator of stock market value than dividends or P/E. And it foretold harrowing events when it was computed and published in early 2000 with NASDAQ at 5000. Now the bigger question: So, what use is it going forward from today?
Their method of argument is to chart 100 years of historical stock prices against historical q, then create "normal," "overvalued," and "undervalued" zones with which you should make investment decisions. A reversion to the mean (in this case downward) is what drives their prediction for an extended period of stock market "under performance" during the foreseeable future. Stocks were and still are overvalued, they say, and therefore should be avoided until values return to more "normal" levels.
By the end of 1999, there were no shortages of bears calling for a crash of monstrous proportions based on any number of indicators, P/E and dividend yield included. As it turned out, all were correct. But as with all "fundamental" analysis, timing was lacking. Some bears had prowled the investment landscape for most of the decade and had come up empty until the turning of the millennium. Smithers and Wright, however, hit the market's nail on the head.
Early on in their presentation, they admit that q is not very important most of the time because most of the time markets are not obviously overvalued or undervalued. And the authors do get sidetracked on whether you should pick stocks individually or go with index funds (they give 3 reasons why individual stock picking doesn't work). They do come through loud and clear that stocks are for buying AND selling, and although stocks are good for the long term, when they get too expensive, they should be avoided like the plague.
The worth of the work is the powerful argument, intelligently presented and documented, as to why stock prices were sure to fall at the time the work was published. And fall they did. For awhile, anyway.
Now, the question for you is not whether or not their data and logic make sense; it's whether you want to base your investment decisions on whether other people think it makes sense. And whether we like it or not, since there is no universal arbiter of stock market value except other people's money, investing comes down to Keynes' beauty contest (General Theory pages 154 - 156). If you want to be on the winning side, you don't vote for who you think is the prettiest; you vote for who you think others will consider the prettiest. Translated here, it means you should value stocks the way stocks have been valued over the past century by previous investors. The idea of q is based on what other people throughout history eventually decided were the limits of value. And yes, q says the market is still dangerously overvalued. But during the interlude of the past 14 months and 3000 Dow points (40% gain) prove, a lot of money has been left laying on the table by simply abandoning the investment environment completely until stocks once again become "cheap." Another Keynesism: "The market can stay irrational (overvalued/undervalued) longer than you can stay solvent."

Although anyone can understand this book, it is nonetheless of scholarly quality. The authors are persuasive. Those who object to their methodology say that intangible assets are not valued in Tobin's Q, and that therefore the market is not as high as it looks; but we have always had intangible assets, and if they have never been valued in, then the historical ratio is unaffected - i.e., this objection is largely irrelevant. Another counter argument is that assets will rapidly rise to cure the problem; but the authors convincingly show that this is highly improbable. Others say that the equity premium has fallen, thus justifying a higher Q ratio; but the reason for the lower risk premium is the public's gradual acceptance of increased risk, precisely the problem with this market - a bear market will do much to restore the risk premium to the historic level. Read this book.