Martin Wolf, chief economics reporter for the Financial Times, recently reviewed a new book by Andrew Smithers: Wall Street Revalued: Imperfect Markets and Inept Central Bankers.
The big points of the book are four: first, asset markets are only "imperfectly efficient"; second, it is possible to value markets; third, huge positive deviations from fair value - bubbles - are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles. "We must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones." I have been unwilling to accept this view. That is no longer true.
The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a "random walk". Mr Smithers shows that this conclusion is empirically false: stock markets exhibit "negative serial correlation". More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. "Markets rotate around fair value." There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets - including housing.
A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon.
Mr Smithers proposes two fundamental measures of value - "Q" or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: "Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth."
Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back. Trees do not grow to the sky and markets do not attain infinite value. When stocks reach absurd valuations, investors will stop buying and start to sell. In the end, the value of stocks will move back into line with (or below) the value - and underlying earnings - of companies. House prices will, in the long term, also relate to incomes.
The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. "Leaning against the wind" requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned.
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