You might think -- you might hope -- that as soon as the Fed finishes with that nasty rate-hike business the bull market will roar ahead. There's a whole school of analysts who believe that. Andrew Smithers is not among them. Smithers is a Brit who heads Smithers & Co., a London-based firm that provides advice to 80 of the world's largest fund money-management companies. To call Smithers a bear would be an understatement. He has just co-written a book, Valuing Wall Street: Protecting Wealth in Turbulent Markets (McGraw-Hill), in which he argues that the stock market is more overvalued than at any time in history.
Smithers was in New York City recently to promote the book. He came by TheStreet.com's world headquarters on Wall Street, the epicenter of the mania. He spoke with TSC Chief Markets Writer Brett D. Fromson, Senior Writer Peter Eavis, reporter David A. Gaffen and Senior Writer John Hardy.
Andrew, describe for us, please, your general overview of the U.S. stock market? Smithers:
Well, we think the market here is in a bubble. And at the moment, we think it's in the biggest bubble it's ever had, and it exceeds the excesses of 1929, 1937, 1968. This is the peak. TSC:
Why is now so much worse? We have the best economy we've ever had; the Cold War is over; the baby boom is moving into its peak earnings period; globalization is taking hold; and one or two other things that slip one's mind. "I think most people are well aware that the stock market is absurd, and equally well aware are the professionals." Smithers:
I think you'll find that the only time you get bubbles is when things are good. You don't find people pushing up the stock market in grim times. But of course, you find that the grim time is the time to buy the stock market, not when everything is going well.
And in fact, the very success of the U.S. economy is a very clear reason. Not solely, but there's a very clear reason why the bubble has developed. TSC:
What kind of job do you think the Federal Reserve and Chairman Greenspan
are doing -- both in managing the economy and, in some manner, attempting to prick this bubble, which they have been concerned about? Smithers:
Well, I think that they have done a very bad job. But I think that you can find very reasonable excuses for them. In my view, the worst thing that a central bank can allow is an asset bubble. We've looked back at history, and we've found that every preceding asset bubble has been followed by a very severe recession. If you want to avoid severe recession, then you should avoid asset bubbles. This isn't just the U.S., you can find it obviously in recent experience in Japan.
Now the question is, therefore, how do you stop them? And this is why one starts to have some sympathy with Alan Greenspan. He observed, in 1996, that a bubble was already in the making. I think he was right. To have prevented that he would have had to put up interest rates in 1995, and I think a number of things probably would have happened. There would probably have been a small recession in 1996, which, objectively, may be better than having a very big one in 2001, but it wouldn't have pleased Americans. If Americans were offered the choice of a small recession in 1996 or a big one in 2001, they would say, please don't have either. And, indeed, if Greenspan had put up interest rates in 1995, he might well not have been re-appointed, by the person we now refer to as ex-President Clinton
, because the chances of Clinton being re-elected in 1996 in a recession would obviously have been a great deal less. TSC:
The only problem is there are no signs of inflation. How could the Fed raise rates simply based on what has happened in history? Smithers:
My view is a good solid case that central banks should try to prevent asset bubbles. There is a very strong practical case that it's extremely difficult for them to do so. In fact, in our book, what we say is the really unmentionable reason [why] the central bankers don't like trying to stop asset bubbles, [which] is the political consequences. It will create a small, early recession with the benefit of avoiding a later, much bigger recession. That is not a benefit which people will appreciate at the time. You'll be hated."The letter q is a ratio ... the ratio between the value that Wall Street puts on business, and the cost of actually creating that business." TSC:
What is the central premise of your book? Smithers:
What we've done is to show that if you measure the level of the market in terms of its q ratio, then, invariably, after very big peaks, there have been crashes and there have been recessions. TSC:
Could you explain q? What is q? Smithers:
The letter q is a ratio. And it stands for the ratio between the value that Wall Street puts on business, and the cost of actually creating that business. It is the ratio of stock-market capitalization to the replacement cost book value of publicly traded companies. TSC:
So is it fair to say that q is the ratio of total market capitalization to total book value? Smithers:
No, book value adjusted for inflation, and your replacement cost. TSC:
And q was developed by Professor James Tobin
In 1969, he published a paper that explained why q should be a mean reverting series. TSC:
And by mean reverting ... ? Smithers:
I mean that the ratio should wobble around, but it should always come back to some average. Tobin put forward this thesis back in 1969, and I think it's fair to say that implicitly, not explicitly, he assumed that the markets were efficient. He didn't assume that the real world was efficient all the time, he assumed that the financial markets were always efficient. The adjustment, he assumed, took place by the real world, as it were, adjusting to the financial market.
Now, my background has been 40-odd years in stock markets, and the idea of a stock market that efficient doesn't appeal to me in quite the same way. And, we looked at it in this way. When Professor Tobin first published the paper in 1969, there were no data available. And over the subsequent years, the Fed has been producing data from 1945 to 1999, and a number of people have produced back data, running back to 1900. And, as far as I know, we were the first people who said, "Well, here is a very good example of science in operation doesn't always happen in economics. The hypothesis is produced, let's test it to see if the hypothesis reverts."
And we did so. And we did a test on q to see if it was mean reverting. And we found that it was. The second thing we found was that the reversion took place not in the way that was, I think, implicit in his [Tobin's] paper, but through the adjustment of prices, the adjusted share prices, rather than the adjustment of corporate net worth. Which is not too surprising -- net worth is something that moves very slowly, where share prices can move very fast. TSC:
Have you discussed any of this with Professor Tobin? Smithers:
Yes, indeed. TSC:
What has been his reaction? Smithers:
I think that he's a little ambivalent. He's a most delightful, charming person, and he sent me helpful data. But I think he is ambivalent. After all, we have suggested things work in a very different way than he originally suggested, and I don't know that he fully accepts that."The economy is, itself, behaving as you would expect it to behave during bubble conditions." TSC:
Can you explain, in the current situation, which you describe as an asset bubble, how you would expect this bubble to revert to the mean? By what mechanism? Smithers:
Well, the mechanism by which the q ratio will go down will be a collapse in share prices. The trigger for that could be a lot of different things. But probably, the most likely is rising inflation, because asset bubbles are basically inflationary. When you have asset prices very high, savings fall. And the result, of course, is you have a fall in savings and a rise in investments.
You get this rather astonishing pattern, which is that you've got a severe shortage of cash in the private sector. The private sector is investing, and it needs to get the cash from somewhere. Now, it could get that cash by issuing lots of shares, or by getting into debt. But if it issued lots of shares, it wouldn't have a bubble. So, debt tends to be an absolutely necessary part of asset bubble.
Now, the next thing, of course, that happens, is that debt expands a lot faster than the economy. Debt in both the household and the corporate sector in America has been rising something like 8% to 10% per annum, and so you can see that there is evidence of a bubble not only in the stock market, but in the economy. The economy is, itself, behaving as you would expect it to behave during bubble conditions. TSC:
So, what then do you think will be the trigger here? You're expecting rising inflation? Smithers:
There are several things that can happen, one very likely is rising inflation. I think we're already seeing that. TSC:
The inflation numbers we have today should be just as good for measuring inflation as in the '60s, '70s, '80s. Smithers:
You get inflation if there is a shortage of savings. Because, in those circumstances, the classic model of inflation is that it's a form of forced savings. Now, what's happened in the U.S. is that there hasn't been a shortage yet because America has imported, every year, an amazingly rapid rise of savings from abroad. And those savings contributed to making this an unusually prolonged period before inflation began picking up. You had to have a Southeast Asian collapse to make sure that there's excess savings for the rest of the world, that there isn't a worldwide shortage. The U.S. has run for the last number of years a very rapid rising external credit deficit, which is the same thing as imported capital. " ... to get unemployment to rise probably will require the economy to go into recession." TSC:
Do you foresee that continuing? Smithers:
No. At the moment, it seems to me that there is a lot of evidence in the data, that, for example, shows you what the CPI is doing, the CPI is picking up. When inflation first started picking up in the U.S., the first statement was that it wasn't. The second statement was that it didn't matter. It wasn't core inflation, it was only people's food, and transport, and unimportant things like that. Then the next thing you have is, you have core inflation picking up and people say, that doesn't matter, it's just reflecting the fact that inflation's picked up; now it's spreading through the whole economy.
It's a wonderful state of denial, I think. Basically, it seems to me that there is abundant evidence that we are now in a period when it is likely that inflation will continue to pick up and wages continue to accelerate unless unemployment starts to rise. And to get unemployment to rise probably will require the economy to go into recession. TSC:
Caused by a higher short interest rates? Smithers:
My guess is that the stock market will crash before there is real evidence that the economy has tanked. And when it does, it is quite likely that interest rates will have to go up enough to slow the economy before they kill the stock market. My view is very simple: The stock market, for the reasons I've explained, drives down savings, drives up investment; it's driving the economy.
You're not going to slow the economy until you slow the stock market. And what rate of interest it takes to kill the stock market, I don't know. I don't know, for one reason, because you could get the stock market tanking for other reasons. It seemed to me it very nearly tanked late in '98. A combination of Russia and Long Term Credit, things like that. Brazil. You can have ... I mean, if China invades Taiwan, I daresay the stock market will crash.
Another thing that could happen, because of all this debt buildup, is that you could find banks and other borrowers are increasingly unwilling to lend money to companies. One of the most surprising things I always find when you point out to people who buys the stock market. And the net buyer of the stock market is not individuals. Even if you include mutual funds, the people who are buying the stock market are companies.
Basically, companies are buying in shares, and they are buying in shares either through buybacks or through mergers and acquisitions. And without them, you would have a single big problem in keeping the stock market where it is because private individuals are, for the most part, not only persistent sellers, but they are larger sellers than all the other people put together -- people like mutual funds, pension funds and foreigners. Without the corporate buying, it's unlikely, I think, that we'd have had such a wonderful bull market. TSC:
Is there any reason to think that that will stop? Corporate buying? Smithers:
Well, I just put it forward as one of the ways it could happen. You see, what we argue in our book is that although this isn't a necessary part of the case, the case is, the stock market's overvalued. But, naturally, people ask you how it got that way, and Bob Shiller
blames the newspapers for it. TSC:
You mean for being cheerleaders? Smithers:
That sort of thing. "The chances of the market going down over the next year, we estimate, are approximately 70%." TSC:
Do you blame the Fed for the stock market bubble? Smithers:
Well, I think the Fed has run recklessly easy money. You can see that in two particular ways. One is the way in which money supply has been growing so rapidly. And the other, of course, is what's happened to real interest rates. I mean, real interest rates, defined as three-month T-bills minus the increase in the CPI. You can see that there's a lot of noise in the data because we know that the inflation number is pretty volatile, but you can see there's a strong downward tendency in real interest rates. So, it looks to me as though the Fed has been -- not just in late '98, but fairly persistently -- feeding the bubble. You've got negative real interest rates. If you measured the CPI over the last three months and annualized it, it has grown faster than the three-month T-bill. And that's even lower than in '98, but I think that's been a fluke. I mean, it wouldn't surprise me a bit if the next CPI number was much better. TSC:
Explain why you use the "real" rate as opposed to nominal? Smithers:
Well, the general economic theory is that you won't get a slowed economy if you put up nominal rates. Because it simply won't pay people very well to invest or even hold stocks. If you own a company and you can borrow money at 2% and all your inventories are rising at 5%, you will have large inventories and it will make you money. So, the general theory is that it requires interest rates to go up in real terms before you can expect an economy to slow. TSC:
What's your expectation of how high the Fed will need to raise short-term rates? Smithers:
The Fed will need to raise short-term rates, in my expectation, until the market crashes. How high that is, I suspect, could at least be another couple of percentage points. I mean, after all, [the U.S. was] pushing towards 4% real rates in early '98 and the economy didn't take them. If you get inflation running around 4% now, assuming it stays around the current level, then that would suggest that you have to get short-term rates up to at least 8%. TSC:
People moving money [into U.S. dollars] for interest rate benefits are not putting it in the stock market. They are selling dollars forward or they're doing it purely as a monetary transaction because they fear that a dollar collapse might result. You'd be hard pushed to argue the dollar collapse should result from rising dollar interest rates vis-a-vis the rest of the world, when that has been the opposite of what's happened over the past several years. Andrew, what's your thinking on that? Smithers:
I suspect that rising real interest rates will be accompanied, in the shorter term, by a strong dollar. And that of course will attempt to slow things a little bit, because as the dollar is strong, so that acts as a damper on inflation. But it won't act as a damper on wage inflation. So, I think that the whole process may take a little while.
I don't necessarily think that the end is coming in the next three months, which might surprise you. If we had come up with an answer and said we can predict when things are going to happen, we wouldn't have believed ourselves. I promise you, if people want to ask us to tell them when the stock market is going to peak, they've come to the wrong people. We can tell them nothing, but we suggest that there's nothing that they can learn from anybody who they think is going to know when the stock market is going to peak.
We argue that what q does -- it acts like a piece of elastic that pulls the market back towards the center. But, it isn't a particularly strong piece of elastic, even at these high levels. The chances of the market going down over the next year, we estimate, are approximately 70%. Now that is very important, because it basically means that it's a chance which is too high for fund managers or investors to take. "And they famously move from greed to fear, and the change is dramatic." TSC:
So, what then? When you say the market will be going down in the next 12 months, how much, going down? Smithers:
The historical evidence is that when markets do come down from high peaks they can move exceedingly fast. TSC:
Why is that? Smithers:
I think it's because when markets are high, people have unreal and irrational expectations, but as markets come down, those expectations change. And they famously move from greed to fear, and the change is dramatic. TSC:
What has been the reaction here in the U.S. to this quite bearish line of thinking? Smithers:
What I've found is that among fund managers, I find nearly all of them, 90% of them, are fully invested there. I think most people are well aware that the stock market is absurd, and equally well aware are the professionals. And that is, again, the thing which I thought came out so nicely in Bob Shiller's book. What he did was he showed that basically the general public was more optimistic and had become increasingly more optimistic about the stock market, whereas the professionals were all bearish. TSC:
Then why don't the pros sell? Smithers:
They're in the business of investing other people's money, and I'm saying that unless they had better timing indication than we have, it is extremely dangerous for them to sell shares just because they're overpriced. Because if it goes up, and you've sold out, your customers will not like you.
I used to run a small money management business called Mercury Asset Management
for a number of years. I found that the time horizon of customers tends to shorten, unfortunately, as the market goes up. TSC:
What would you say to our readers now? What can you say to help them either make money or not lose money? Smithers:
Well, [how] not to lose money is what we try to explain to them. We think that a prudent person would be already in cash, and therefore, your readers, who have then sensibly invested in the stock market are extremely lucky, and have done much better than us prudent people. But they should, perhaps now, take the opportunity to turn prudent now. TSC:
As a general rule, look around the world you're investing in and find the most unfashionable thing. TIPS, Treasury Inflation Protect Stocks, seem to be a very good thing, too. I don't actually see inflation necessarily picking up. I see inflation more likely to be the trigger for the stock market collapse than its medium-term consequences. But if you do get a really sharp recession developing here, I think looking three or four years down the road we could be back into an inflationary era. Because the response, I think, of Americans, will be much more aggressive than it has been, for example, in Japan.