An economist’s warning to stock investors

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) – Current economic theory is far removed from what happens in the real world. Its canonical models portray 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 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 managers of public companies put their own interests first and seek to maximize current stock prices in instead of core 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 fund-management arm of commercial bank SG Warburg, belongs to a venerable tradition of economists whose theory is grounded in practical experience. David Ricardo began his career as a stockbroker, while John Maynard Keynes was treasurer of his Cambridge university and president of a life insurance company. Economic models, Smithers says, should fit known human behavior and be tested against real-world data.

The theory suggests that company managers have the same interests as shareholders. They actually have different priorities. Corporate executives aim to keep their jobs and improve the value of their stock-based compensation.

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

Instead, managers prefer to go into debt to buy back shares at inflated prices. Finance theory suggests that a company’s valuation should not change if it is financed with equity or debt. In reality, debt-financed buybacks serve to boost share prices, says Smithers. He also notes that companies seek to maintain a stable relationship between interest payments and earnings. Therefore, as long-term interest rates have fallen, American companies have taken on more and more debt to buy back their shares.

As a result, the US stock market’s valuation has deviated significantly from its fair value, says Smithers. Financial theory denies that we can identify a stock market bubble in real time: future stock price movements are unpredictable. This is true in the short term, says Smithers. However, over longer periods, stock market behavior has been anything but random. Over the last 200 years, US equities have generated an average annual 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 cost of replacing the underlying corporate assets. This measure, known as Tobin’s Q, is named after Nobel laureate in economics James Tobin. The downside is that the mean reversion process 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 stock price) with bond yields. In recent years, when bond yields fell to their lowest level in history, the valuation of US stocks 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 in their respective investment returns (known as the equity risk premium) has not been stable or mean-reverted.

Furthermore, Smithers argues, stocks should generate a significantly higher return than bonds. Most investment is for retirement, and savers are primarily concerned with maintaining their future purchasing power. Stocks are risky assets, whose value can remain depressed for long periods. After the crash of October 1929, it took about a quarter of a century for the market to recover its previous peak. The marginal investor, Smithers says, requires a significant return to offset the market’s inherent volatility.

Smithers’ analysis suggests that the US stock market is in a dangerous position today. In recent decades, corporate managers have diverted investment resources toward share buybacks. A prolonged period of underinvestment has put US public companies at a competitive disadvantage against foreign-owned companies. The corporate sector has also acquired near-record amounts of leverage. On a replacement cost basis, the stock market is trading at more than twice fair value. The risks of another financial crisis appear high, says Smithers.

Critics will point out that US stocks have been overvalued relative to Tobin’s Q for most of the last 30 years. Also, the fact that stock returns have been stable in the past does not mean that the stock should offer the same return in the future. Critics may also suggest that the growing importance of intangible assets has made Tobin’s Q obsolete, although Smithers vehemently rejects this. The natural monopolies created by the Internet have also allowed technology companies to earn excessive returns on capital for long periods of time.

However, one of the reasons US stock valuations have remained elevated for so long is that the Federal Reserve has backed Wall Street with ever-lower interest rates and successive bouts of quantitative easing. Now, the return of inflation has forced the Fed to back down. Inflation tends to raise interest costs faster than corporate cash flows, forcing companies to deleverage and reduce investment. Under those circumstances, the valuation of US stocks could fall.

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

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(The author is a columnist for Reuters Breakingviews. The opinions expressed are his own.)

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Edited 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, according to the Trust Principles, is committed to integrity, independence and freedom from bias.

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