Valuing Wall Street

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.

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.

This book and Shiller's book aren't really competitors but complements. I'd say this book is better on valuation, and Shiller's book is better on the softer side (i.e., hypothesizing about the potential causes of today's frenzy). Furthermore, I think this book's faith in Q vs. other indicators, while well researched, is a bit overdone. Each indicator, including Q, has it's problems, and a rational person probably gives some weight to each (though this current book probably has me giving Q the nod). Conveniently, today's market doesn't make one choose, they all make the market look ridiculously expensive. Any bear in their right mind would be comforted by this agreement. One day, when the market is much lower, perhaps we'll have to consider harder which indicator to believe (i.e., when/if they disagree). But for now, read this book, read Shiller's book, and get very very cynical about the level of today's stock prices.

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.

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.