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Valuing stockmarkets
When the signals flash red
Aug 13th 2009
From The Economist print edition
Wall Street Revalued: Imperfect Markets and Inept Central Bankers. By Andrew Smithers. John
Wiley; 256 pages; $27.95 and £16.99. Buy from Amazon.com, Amazon.co.uk
IN EARLY 2000, just as the dotcom bubble was at its height, two books appeared that argued the
stockmarket was overvalued. One, “Irrational Exuberance”, turned its author, Robert Shiller of Yale
University, into something of a guru. The second, “Valuing Wall Street” received less attention but its
insights were no less perceptive. One of its two authors, Andrew Smithers, a British economist, has now
returned to the theme of stockmarket valuation. This time he expands his remit to argue that it is not only
possible to ascertain a fair value for stockmarkets but that central banks should try to do so and adjust
their policies accordingly.
That would once have been a very controversial assertion. It requires central bankers to second guess the
markets, to assume that they know more about share price values than investors do. Markets were
believed to be efficient, that is to reflect all publicly available information.
But the bursting of the dotcom bubble followed by the credit crunch have dented the notion of perfect
markets governed by rational investors. Mr Smithers prefers the idea that markets are “imperfectly
efficient”, in other words, that they fluctuate around their fair value.
Having argued this, Mr Smithers has to demonstrate two things. The first is a reliable method for
valuation, of which he says there are two. One is the replacement cost of a company’s assets, the socalled
“q” ratio. The other (which was also an important point in Mr Shiller’s book) is the cyclically
adjusted price-earnings ratio, which compares shares with the profits earned over the previous ten years.
When bull markets have reached their heights (as in 1929 and 2000), these ratios have clearly indicated
overvaluation. Mr Smithers makes his case convincingly, dismissing alternative indicators of valuation,
such as the dividend yield, along the way.
But that still leaves Mr Smithers to deal with a tricky second point: if there is a reliable way of knowing
when markets are overvalued, why haven’t investors used it to make their fortunes? Moreover, investors
armed with such information would presumably sell their shares before they reached their peaks, thereby
preventing the extremes from being reached in the first place.
The answer to this conundrum, which is at the heart of efficient market theory, is that valuation is not a
useful guide to stockmarket direction over the short term. On Wall Street there were five valuation peaks
in the 20th century, or one every 20 years or so. Most investors simply do not have that kind of time
horizon. Get market timing wrong and they may lose a fortune (or, if they are a professional fund
manager, their clients will). The market can be irrational for longer than you can remain solvent, as the
saying goes.
A job for the banks
Even so, Mr Smithers argues that central banks should use the valuation data to decide whether
stockmarkets are over- extended. And they should look at house prices and the price of liquidity (defined
as the interest spread on corporate bonds that is not attributable to the risk of default) as well. None of
this is easy. But central banks already try to estimate the “output gap”, the extent to which economic
growth is above or below trend, when setting interest rates—and that’s fiendishly difficult.
In the past central bankers have claimed that, rather than try to pop bubbles, they should clean up the
mess after they have burst. But the cost of the recent financial crisis makes that policy hard to justify. If
all the signals (including house prices and liquidity) are flashing red, then central banks should act. Their
best tool might not be increases in interest rates but changes in the capital ratios of banks. By requiring
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