To: Tazio Nuvolari who wrote (2464)
From: John Pitera Wednesday, Jun 28, 2000 8:04 AM ET
Respond to Post # 2475 of 2483
A really good article from todays FT-- mkt not ahead by 2008?
Don't blame it on the altimeter
Analysis of companies' net worth suggests that Wall Street's high-flying stocks remain fundamentally over-valued
Published: June 27 2000 19:11GMT | Last Updated: June 27 2000 19:16GMT
The probability that real prices on Wall Street will be lower at the end of 2008 than at the end of 1998 is 85 per cent. This is a startling statement. Yet if history and economic theory remain guides to the future, it is also quite correct.
Its underlying logic is spelled out in a recent book by Andrew Smithers, a London-based investment adviser, and Stephen Wright, a Cambridge University academic.* My colleague Philip Coggan has already reviewed the book (FT April 19 2000), but its argument deserves another look. It is too important to ignore.
It is conventional wisdom that it always makes sense to buy and hold stocks. In the long run, this is true. But, as Keynes said, in the long run we are all dead. It has not been true for the time horizons relevant to most investors. The book shows that there were many years in the last century when it was a very bad idea to buy stocks if one's time horizon was 20 years, or less.
What is needed to identify such bad years is an indicator of fundamental value. There is such an indicator: Tobin's q, after the Nobel-laureate economist, James Tobin. It is the ratio of the stock market value of companies to their net worth. Today, q says that it is more than twice as expensive to buy companies through the stock market than it costs to create them.
Over the long term, the two values have to converge. The question is how. Will it be through a rise in corporate net worth or through a collapse in the stock market's valuation? The answer to date is clear: over the past three-quarters of a century, the correlation between changes in q and in stock prices is very high.
Those bad years for investors were also years of relatively high q. Since q has recently been higher than at any point in the previous 100 years, the conclusion is that the market is highly overvalued and likely to fall.
When an altimeter leads to so unpleasant a conclusion, people react by thinking it must have become unreliable. The core propositions of those who reject q's uncomfortable message are two. The first is that traditional estimates of net worth are no longer valid. The second is that the adjustment to the high q will occur not through a fall in stock prices, but through investment, further stimulated by a lower cost of capital. The first is clearly wrong. The second is logically possible, but at best unlikely.
The most important arguments under the first heading concern so-called intangible assets. Jan Hatzius of Goldman Sachs makes the argument as follows: "Unmeasured intangible assets have most likely grown faster than physical assets... This is because in the process of economic growth, industries that intensively use intangible capital, such as technology and entertainment, tend to grow relative to industries that do not, such as basic manufacturing and services."
But the view that corporate net worth is seriously underestimated for this reason is implausible, for at least three reasons.
First, much investment in intangible assets is already included in net worth.
Second, the measured return on capital must include the return on unrecorded intangible assets. If, as people argue, such assets are a large fraction of the total, then the measured rate of return on capital should be higher than ever before. The rate of return on corporate capital did achieve a good cyclical rise in the 1990s. But it remains well below the level it achieved in the 1960s.
Finally, these moderate actual returns on corporate capital are also inconsistent with the one good reason why corporate assets may be more valuable today than before - a rise in monopoly. In any case, for every new alleged monopolist, such as Microsoft or Intel, one can mention weakened old ones, such as AT&T and IBM.
Thus the belief that the staggering rise in q can be explained by the growth in unrecorded assets is nonsense. Mr Hatzius accepts this, noting that unmeasured intangible assets would have had to increase by $12,500bn since 1990. There is no reason to believe any such thing.
If the rise in q cannot be estimated away, the second line of attack is to argue that it is perfectly reasonable. Here two points are made. One is that it reflects improved prospects for productivity. Another is that there has been a fall in the equity risk premium. Again, neither of these explains q's rise convincingly.
There is no obvious reason why higher prospective productivity growth should raise the value of existing assets, even if it is true. Accelerated technical change is as likely to reduce the value of such assets. Moreover, rational investors should expect returns from higher efficiency to be bid away by competition in favour of workers and consumers. Indeed, if the required return on equity investment has been reduced by a falling risk premium, as many argue, this gain will be more than bid away.
This leaves the last possibility - that adjustments to q will occur not through a fall in equity prices, but via an expansion in corporate net worth. A fall in the equity risk premium (and so of the corporate cost of capital) could then help explain both the increase in stock market value and the subsequent surge in investment.
This is conceivable, but implausible, not least because there is little good reason to believe that the equity risk premium has fallen. But two additional points can be made.
First, it could take a half century for investment alone to bring q back towards its historic average. The slow pace at which the capital stock grows explains why adjustments to q have, in the past, occurred through the price of stocks instead.
Second, people are not behaving as though the prospective real return on equity is lower than for any extended period in the past two centuries. In surveys, investors still talk of the exceptionally high returns enjoyed since the early 1980s. Meanwhile, far from financing themselves with the supposedly cheap equity, companies are doing the reverse. In recent years, US corporations have been enormous net buyers of equity. This hardly suggests they believe equity finance is unusually cheap.
Try as one might, the q ratio's recent levels remain disturbing. It is a theoretically and empirically sound indicator of market value. It is also extraordinarily high. Nobody has given a compelling explanation for this, other than the obvious one. The only sensible alternative is that the desired return on equity is now far lower than ever before. Yet this looks like a fairy story, if one without a happy ending.
In the past, collapses in q have meant falls in stock prices that have heralded recessions. Will this story end any differently?
Valuing Wall Street: Protecting Wealth in Turbulent Markets, McGraw-Hill 2000.
Good Luck,
Lee |
