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The Actuary The magazine of the Institute & Faculty of Actuaries
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Book review: Wall Street Revalued

Smithers’ central hypothesis is that asset prices, stock markets and houses do not wander randomly but rather rotate about a fundamental value. Two methods of fundamental valuation use Tobin’s q and Shiller’s cyclically adjusted price-earnings ratio (CAPE). These two methods are seen to give similar valuations in the UK and US markets for the last hundred years or so. The resulting theory, the imperfectly effi cient market hypothesis (IEMH), states that market prices rotate about fundamental value rather than being equal to it.

He argues for a central bank policy objective to prevent assets diverging too far from their fundamental level, using not only the current levers of interest rates and money supply but also flexing minimum capital ratios in banks’ solvency supervision. Such actions would have pricked historic bubbles and prevented the subsequent recessionary adjustments, to the benefit of society as a whole.

Most of the book focuses on empirical evidence in market prices for IEMH in contrast to EMH. Several forms of evidence are offered:
>> Volatility compression, that return standard deviation as a function of holding period grows less quickly than would be expected if returns were independent
>> Charts showing volatile market prices and their relation to more stable measures of fundamental value
>> Demonstrating the ability of q and CAPE to predict stock market returns, in defiance of EMH assertions that such prediction is impossible.

However, I would prefer to see these tests in a more formal statistical setting. It is often unclear what hypothesis is being tested, what the alternative hypothesis is and how significantly the data supports the conclusion. Many of the charts can be summarised as saying that investment returns are relatively higher if you start from a point in time when prices were historically low. The problem Smithers fails to address is that this arithmetic observation holds whether markets are efficient or not. Deprived of a rigorous statistical trail from data to the conclusions, the reader can only take on trust many of the book’s key hypotheses. I would also liked to have seen more development of Smithers’ proposals for central bank operation. It is naive to think that the use of bank capital ratios as a policy instrument could prevent asset bubbles with no other consequences.

Alongside the successes of IEMH, there are also some failures. According to Smithers, the average value of q should be 1, but the calculated average turns out to be 0.63. The explanation, naturally enough, is not a shortcoming of the theory itself. Instead, the fault lies with mischievous accountants whose fi nancial mis-statements mislead the casual reader into questioning Smithers’ view of the world.

Thomas Kuhn famously characterised scientific development in terms of paradigm shifts: revolutionary transitions from one accepted theory to another. Smithers repeatedly quotes Kuhn, taking the egocentric perspective that progress in finance consists of everyone else shifting their paradigms in favour of Smithers’ own views. Smithers does not publish his research in peer-reviewed journals. His book reveals this not to be a deliberate choice, but rather a conspiracy in which a secret inner circle of academics maintain an irrational creed of market efficiency and block the publication of any paper questioning it.

This is an interesting book with many challenges to conventional thought. Andrew Smithers is optimistic that his proposals for central bank reform could consign asset bubbles and their painful corrections to history. Stability would be a nice thing and, at a time when mainstream economics seems unable to deliver it, readers may be persuaded that his hour has come.

Andrew Smith is a partner at Deloitte.

Wall Street Revalued is published by John Wiley & Sons. RRP £16.99