An economist’s warning to stock market investors

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A trader in London waits for European stock markets to open early on June 24, 2016, after Britain voted to leave the European Union. REUTERS/Russell Boyce

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LONDON, April 14 (Reuters Breakingviews) – Economic theory today is far removed from what happens in the real world. His canonical models portray the corporate sector as a single representative enterprise that acts in the interests of its owners. Anyone who has worked in finance knows that these models are artificial. In his latest book, “The Economics of the Stock Market,” veteran economist Andrew Smithers lifts the corporate veil to reveal a world in which public company executives put their own interests first and seek to maximize current stock prices rather than 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 working in the City of London six decades ago and once headed the funds management arm of investment bank SG Warburg, comes from a venerable tradition of economists whose theory is shaped by practical experience. David Ricardo began his career as a stockbroker, while John Maynard Keynes was bursar at Cambridge University and chairman of a life insurance company. Economic models, Smithers says, should match known human behavior and be tested by real-world data.

The theory suggests that CEOs have the same interests as shareholders. In reality, they have different priorities. Corporate executives aim to keep their jobs and increase the value of their stock-based compensation.

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If managers aimed to maximize the net worth of their companies, they would issue shares when the cost of equity is low (and shares are highly valued in the market) and use the capital to invest. They don’t act this way because the immediate effect of new investment is to reduce a company’s earnings per share. Along with the issuance of new shares, this tends to temporarily depress stock prices.

Instead, executives prefer to go into debt to buy back shares at inflated prices. Financial theory suggests that the valuation of a company should not change whether it is financed with equity or debt. In reality, debt-funded buybacks serve to drive up stock prices, Smithers says. He also observes that companies seek to maintain a stable ratio of interest payments to earnings. Thus, with the drop in long-term interest rates, American companies took on more and more debt to buy back their shares.

As a result, the valuation of the US stock market has deviated significantly from its fair value, Smithers says. Financial theory denies that we can identify a stock market bubble in real time: future stock price movements are unpredictable. That’s true in the short term, Smithers says. Over longer periods, however, stock market behavior has been anything but random. Over the past 200 years, US stocks have generated an average annual real return of 6.7%. Periods of above-average returns were followed by below-average returns, and vice versa.

This shows that the stock market is governed by the principle that returns will revert 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 company’s underlying assets. This measure, known as Tobin’s Q, is named after Nobel Prize-winning economist James Tobin. The catch 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 stock price – with bond yields. Over the past few years, as bond yields fell to historic lows, the valuation of US equities soared. But Smithers argues that comparing the two makes little sense. After all, stocks are claims on real assets while bonds represent claims on paper. Over time, the difference between their respective investment returns (known as the equity risk premium) has neither been stable nor reversed.

In addition, according to Smithers, equities should offer a significantly higher yield than bonds. Most investments are intended for retirement and savers are primarily concerned with preserving their future purchasing power. Stocks are risky assets, the value of which can remain depressed for long periods of time. After the crash of October 1929, it took about a quarter of a century for the market to regain its previous peak. The marginal investor, says Smithers, needs a large return to offset the inherent volatility of the market.

Smithers’ analysis suggests that the US stock market is in a perilous position today. Over the past few decades, corporate executives have diverted resources from investing to stock buybacks. A prolonged period of underinvestment has put US state-owned companies at a disadvantage relative to foreign companies. The corporate sector also assumed near-record leverage. On a replacement cost basis, the stock market is trading at more than double its fair value. The risks of another financial crisis appear high, Smithers said.

Opponents will point out that US stocks have looked overvalued relative to Tobin’s Q for most of the past 30 years. Also, just because stock performance has been stable in the past doesn’t mean stocks should perform the same in the future. Opponents may also suggest that the growing importance of intangibles has rendered Tobin’s Q obsolete – although Smithers vehemently rejects it. The natural monopolies created by the Internet have also allowed technology companies to earn excess returns on their equity for long periods of time.

Yet one of the reasons US equity valuations have remained high for so long is that the Federal Reserve has propped up Wall Street with ever-lower interest rates and successive bouts of quantitative easing. Today, the return of inflation is forcing the Fed to backtrack. Inflation tends to drive up interest charges faster than business cash flow, forcing businesses to deleverage and reduce investment. Under these circumstances, the valuation of US stocks could fall.

Smithers was one of the few economists to warn of the dot-com bubble and the dangers posed by the resulting global credit boom. His current concerns should not be dismissed lightly.

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Editing by Peter Thal Larsen and Oliver Taslic

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and freedom from bias by principles of trust.

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