Smithers 2009 November

reprints

http://welling.weedenco.com



VOLUME 11

ISSUE 22

listeningin

NOVEMBER 25, 2009





INSIDE

Moderation, Now

Andrew Smithers See Asset Prices Again Signaling For Bank Caution

Listening In Andrew Smithers, propri- body, kind, thoughtful —

It’s All About etor of the eponymous except, of course, to

research shop Smithers & central bankers and

Value, Says Author Co., based in London but fund managers, stock-

Of Wall Street with clients in all the brokers and investment

Revalued world’s major markets, bankers. But, other-

PA G E 1

has the mind of a first- wise, I think, of ordi-

rank research scientist, nary people, I was quite

Guest Perspectives several lives’ worth of considerate.

Michael Belkin experience in the finan-

cial markets and the Yes, quite so. But it

Bubble Phobia: soul of a firebrand. All is a mite unusual for

Be Calm, Markets of which combined to the language that a

Not Near Topping produce his combustible publisher splashes on

new book, Wall Street a book’s cover to be

Albert Edwards

Revalued, Imperfect more temperate than

2010 Forebodings: what’s inside.

Markets and Inept Central

Trade War, Cheaper Bankers. In it, Andrew (Laughs) You mean our

Yuan Could Appear manages not merely to subtitle — Imperfect

Arthur Kroeber demolish the last surviv- Markets and Inept

Obama In China: ing vestiges of the Central Bankers?

Real Progress Efficient Market

Seen On Currency Hypothesis and to evis- You leave no doubt

cerate central bankers about either. Not that

Chart Sightings

who rely on it to excuse you don’t have

Mark Lapolla: ignoring the role their grounds for venting

Belief Hospice excessive monetary ease plays in inflating asset frustration. After all, it was back in 2000

Ron Griess: bubbles, he lays out precisely how — and how not that you and Stephen Wright wrote, Valuing

— to value markets. And why it is exceedingly Wall Street: Protecting Wealth in Turbulent

Golden

important that central bankers, as well as Markets, which laid out just how exceedingly

Perspectives investors, pay attention to market valuation. overvalued the internet bubble was.

Ron Griess: Listen in and be educated. Yes, and we got a lot of abuse at the time. It was

Think You’re KMW quite funny. But that’s the way it happens.

Diversified?

Your typical British reserve seems to have Was the problem that people just did not

Acute Observations gone missing when you sat down to write understand the Q ratio, which is what you

Comic Skews your latest book, Andrew — based your valuations on?

ALL ON WEBSITE Was I not calm and considerate? Polite to every- Well, no. I mean, if people didn’t have a lot of





RESEARCH

Reprinted with permission from

DISCLOSURES PAGE 12 welling@weeden NOVEMBER 25, 2009 PAGE 1

interest in having these things get ridiculous, they Because?

wouldn’t get ridiculous. People have to believe. Because it would be so difficult to get still more

They just get more and more excitable, I suppose, fiscal stimulus, yet more monetary expansion. So

Kathryn M. Welling as things go up. And there we are. We’re seeing a it seems to me that a major aim of policy today

Editor and Publisher mini example of it at the moment, I’m afraid. should be to ensure that we don’t get a third leg of

welling@weedenco.com the asset collapse on our hands. Probably the best

Published exclusively Your 2010 outlook piece just came across way of ensuring that is by making sure that asset

for clients of my desk. In it, you say that quantitative prices simply don’t go up much more.

Weeden & Co. LP easing has been helpful so far, boosting

asset prices and stabilizing the system — You’re really trying to kill the Christmas

Lance Lonergan

but warn that now we are risking driving goose, aren’t you?

National Sales Manager

(800) 843-9333 or asset prices into dangerous territory again? Not really. Rising asset prices so far have done, as

(203) 861-7670 Yes, and I am intrigued to find other people shar- I said, a useful job in helping the economy.

lance@weedenco.com ing the view, including Spencer Dale, who’s the Obviously, rising asset prices tend to get Keynes’

Thomas Orr Chief Economist at the entrepreneurial animal

Director of Research Bank of England. Dale spirits up. They help

(800) 843-9333

tom_orr@weedenco.com

was quoted in the

Financial Times today as

“We now want a investment; they con-

strain firms from cut-

Noreen Cadigan

Director of Research Sales

saying that substantial period basically of slow ting investment and

(203) 861-7644 further injections of liq- employment as much as

ncadigan@weedenco.com uidity could result in contained growth they otherwise would if

unwarranted increases everybody was feeling

Jean M. Galvin

Business Manager/Webmaster in some asset prices. He in which we can get less cheerful. And obvi-

was against any further ously they also have a

(203) 861-9814

jean_galvin@weedenco.com increase in quantitative a lot of deleveraging beneficial effect on sav-

Karin-Marie Fitzpatrick

Editorial Assistant

easing. I think that you

will find that several

going on without it ings, in the short run

that is; in other words,

fitz@weedenco.com



Subscriptions:

economists over the

next few weeks and

having to burden rising asset prices deter

people from increasing

Pat Quill

(203) 861-9317

months will be express- the public sector debt savings too fast. But

pquill@weedenco.com ing concern about quan- that is not a long-term

Deirdre Sheehan titative easing. by too much.” solution.

(203) 861-7636

dsheehan@weedenco.com

Why is that? What is a long-term

Published biweekly Because, clearly, the most damaging thing that solution?

on Friday mornings, could happen to the world economy would be a

by welling@weeden,

What we need over time is a rebalancing of the

a research division of third asset bubble collapse. Asset bubbles, as I economy in which we get deleveraging going on.

Weeden & Co. LP. explain in Wall Street Revalued, when they col-

145 Mason Street

And there are only two ways to delever: One is by

Greenwich, CT 06830. lapse, make it extremely difficult to manage generating cash flow and the other is by replacing

Telephone: (203 ) 861-9814 economies. In the normal process, whereby a cen-

Fax: (203) 618-1752

debt with equity, either through bankruptcy, via

tral bank’s lowering of interest rates has a stimula- the banking system, or directly, through the cor-

Copyright Warning and Notice: It tive effect, a large transmission element of that

is a violation of

porate sector. Now if you have deleveraging as the

federal copyright law to repro- process comes through asset prices. But when main driving force, you can only achieve that

duce all or part of this publica- asset prices get too high and too far out of line —

tion or its contents

goal, really, if you switch the debt from the private

by any means. The Copyright and they then fall — normal central banking, as we sector to the public sector. Otherwise, you get the

Act imposes liability have seen recently, ceases to be very effective.

of up to $150,000 per issue for

attempt for everybody to save more and everybody

such infringement. However, with huge increases in budget deficits to invest less and you fall clearly into one of those

welling@weeden does not and quite extraordinary measures of quantitative

license or authorize

problems that Keynes identified, where the

redistribution in any form by easing, both fiscal and monetary policy have adjustment process, rational on the individual

clients or anyone else. turned extremely stimulative following the second

However, clients may print one

level, just digs the economy, as a whole, deeper

personal copy and limited of these two asset bubbles, the one that peaked at into a recession. At the moment, I think, the right

reprint/republication permis- the end of 2007. So if we were to get the markets

sion may be made available

steps have been taken, given the errors of the cen-

upon specific request. going up a bit more, say during 2010 into a third tral bankers in the past. Governments have

Copyright 2009, K.M. Welling. asset bubble, and if they were then to fall again, it

All rights reserved.

thrown a great deal of money at the situation.

would be frightfully difficult to see how the result Central bankers are throwing money at the situa-

Victor Juhasz wouldn’t be very severe, in terms of recession.

Page 1 Illustration

tion and this was necessary. They have responded

correctly to the recession, with massive fiscal





Reprinted with permission from

welling@weeden NOVEMBER 25, 2009 PAGE 2

stimuli, near zero inter-

est rates and unconven-

tional monetary poli-

cies. Without this

response, the recession

would have been many

times worse — and with

them, the recovery

seems at last to be

underway.



I hear a “but” coming

—

But we now want a peri-

od basically of slow con-

tained growth, in which

we can get a lot of

deleveraging going on —

without it having to bur-

den the public sector

debt by too much. For

that, you need time and

helpful markets. The

sort of ideal market is

one that goes down a bit

— that has periodic

bounces. So people can

take advantage of the bounces to issue a great undoubtedly inflationary expectations and it’s

deal of equity, which also, of course, means that very important now that the central banks of the

the market is more likely to go down thereafter. world don’t allow inflationary expectations to

pick up. If they aren’t kept in check, stagflation,

And you’re calling that ideal? with its twin evils of inflation and recession will

Yes, with a bit of luck — and we will need luck. return. And it is going to be quite difficult to pre-

Because that would allow for deleveraging with- vent that because of the likely rises in food and oil

out just endlessly increasing the debt ratios of the and raw material prices. That means we really

public sector. Sooner or later, of course, another don’t want a rapid recovery. So I think the two

recession is virtually certain. The aim of policy things that we don’t want are, first, another dip, a

makers must be to make sure that it is mild, does- straightforward falloff in the economy back into

n’t come too soon and will respond well to con- recession — because that would be difficult to deal

ventional monetary stimulus. In other words, with. Second, we equally do not want a rapid

they can’t tighten to early, or too late, when infla- recovery because that would rapidly put us in the

tionary expectations have picked up. position of expecting fairly soon another reces-

sion. To subscribe to

Their track record on that score isn’t exact- I think it’s obvious to everybody, or it should be, Welling@Weeden

ly confidence-inspiring — that recessions are as near enough to being or to hear about

Exactly. Past experience suggests that the central inevitable as anything you can have. What we the other

bankers moving too late is the greater risk, espe- don’t want is one that comes too soon, and we research products

cially since there’s a widespread and worrying don’t want one that comes with collapse of asset Weeden offers, please

view that there is a huge amount of excess capaci- prices. Too soon simply doesn’t give you enough contact:

ty in the world that will keep inflation down. As I time to do what I call good deleveraging. The col-

point out in a recent report, it’s hard to look at lapse of asset prices, we don’t want — simply Pat Quill

history — with the long upward rise in both infla- because it means that it becomes almost impossi- (203) 861-9317

tion and unemployment from the ’50s to the ’80s, ble for central banks and governments to restimu- pquill@weedenco.com

and the opposite, going from the ’80s to more late the economy without a great deal of pain and

recently — and say that there is this lovely connec- anguish. Deirdre Sheehan

tion between inflation and output gaps, at least as (203) 861-7636

conventionally thought of. The key here is Now, when talking about inflation/deflation dsheehan@weedenco.com





Reprinted with permission from

welling@weeden NOVEMBER 25, 2009 PAGE 3

Yes, the scope for the economy to set up problems

in itself is huge. In all dynamic systems, you

would tend to get this. You need dampeners in

cars and shock absorbers. Likewise, in

economies. You don’t want them to stall and you

don’t want them to suddenly shoot off. You want

them to go at a steady pace. Clearly, since part of

the transmission mechanism is interest rates’

impact on asset prices, you do have asset price

fluctuations as part of the normal stimulus. But,

as I said, the good news so far is that the stock

market got down to pretty much fair value or

even, possibly, a tickle below it, at its March bot-

tom. But now it has gone up. Which is why I said

earlier that this rally was probably a good help for

the economy. I certainly wouldn’t criticize quanti-

tative easing for having pushed up asset prices, so

far. But now they have gotten up to levels where

“Stock markets are notoriously volatile. we probably have a market which is, roughly, 40%

Research into this volatility has shown you make a distinction between expecta-

overpriced. It isn’t at a level which, in the past,

that markets do not follow a random tions for asset prices and consumer prices?

walk. If they did, their behavior would necessarily has been followed by a collapse. But

Yes, there’s a feeling around that deflation, falling

have no influence on their future and should it go up another 10%-15%, you’re looking

the analysis of volatility shows that this

consumer prices are bad. I don’t know that

a bit nervy.

is unlikely to be the case. If markets fol- there’s a great deal of evidence for that.

low a random walk, and their past has

no influence on their future, then this Would you mind running through how you

I rather like them when I’m shopping.

would be true of their volatility; and if arrive at that 40% overpriced valuation?

this were measured over relatively long

You are not alone. Certainly, in economies where

Certainly. The EPS on the S&P 500 for the 12

periods of 20 or 30 years, the volatility you want the stimulus to come from the con-

months to June 20, 2009 were $7.51, making the

when measured over these long periods sumer sector, the old-fashioned theory was that

could be forecast from their volatility P/E. with the index at 1073 (when I ran the num-

wages were stickier than prices. So if you had

over short periods, such as one year. bers on Oct. 13) 143, which was 10 times the

But this is not how volatility actually

wages being sticky, they would not fall as fast as

long-term average P/E, using data which start in

behaves. Markets are less volatile over prices when prices went down. That, of course,

1871.

longer periods than they would be if the was good for consumption. It would raise peo-

RWH held. The variance, which is a mea- ple’s real incomes. Deflation is dangerous if it

sure of volatility, has fallen by more Which superficially sounds like a lot more

happens too fast, because then people can easily

over time than it would have done had than 40% overvalued —

stock prices followed a random walk. It wait: “I’m not going to buy tomatoes today

Yes, but that doesn’t mean the market is horribly

can be shown mathematically that this because they are going to be cheaper tomorrow.”

‘variance compression’ means that expensive, because profits have recently been

But with slow inflation or slow deflation, the

stock market returns exhibit ‘negative quite depressed. Equally of course, though this

serial correlation’, i.e. that high returns

actual speed of events doesn’t seem to have much

point is often ignored, claims that the market is

will be followed by lower ones and vice impact on people’s behavior patterns. Certainly

selling at some low future multiple would not

versa. As the observed behavior of mar- we’ve had long periods of disinflation or deflation

kets exhibits ‘variance compression’, show that the market today is cheap. In order to

in history; After the Napoleonic wars, we had

with returns varying less over longer assess value, it is necessary either to calculate the

periods than they do over short ones, it

about 100 years of falling inflation in the U.K. and

level at which the EPS would be if profits were

is less risky for investors to hold equi- a rather good economy. I think that was also true

neither depressed nor elevated, or to use a metric

ties if they expect to invest for, say, 30 in the recovery from the post-’73 problems in

years than it is for those who are saving of value which does not depend on profits. The

America. So it looks to me as if there’s quite a lot

for their next year’s holiday or who have cyclically adjusted P/E (CAPE) normalizes EPS by

short-term time horizons.

of evidence that what you want to be scared of is

averaging them over 10 years. It thus follows the

Chart 13 illustrates the variance com- not a relatively minor downward trend of defla-

first of those two possible methods. Using even

pression that has been observed in the tion, downward trend of prices. What you should

U.S. stock market, using data from 1801. longer time periods has advantages, particularly

be scared of, instead, is deflation in asset prices,

“ The red and purple lines show the as EPS have been exceptionally volatile in recent

actual variance and variance ratio for

when they fall sharply — that tends to cause the

years — and using longer time periods raises the

the U.S. market, while the blue and real disruptions in the economy.

current measured degree of overvaluation. The

green lines are indications of what the

variance “should have been” according other methodology we use measures stock market

Of course, one of the major points in your

to random walk theorists. value without reference to profits: the q ratio. It

book is that asset prices also create huge

compares the market capitalization of companies

problems in the economy when they run

All charts from Wall Street Revalued: Imperfect Markets and with their net worth, also adjusted to current

Inept Central Bankers, Copyright Smithers & Co Ltd, with permis- away to the upside —

sion from John Wiley & Sons, Ltd prices. The validity of both of these approaches





Reprinted with permission from

welling@weeden NOVEMBER 25, 2009 PAGE 4

can be tested and is robust under testing — and ble was relatively benign because leveraged “The Fed Model

they produce results that agree. Currently, both q bank balance sheets weren’t caught up in a

and CAPE are saying that the U.S. stock market is feedback loop of contagion. is nonsense

about 40% overvalued. The stock market bubble which peaked in 2000 in practice as

was not just “a tech-stock bubble”. The U.S. mar-

You heap a lot of scorn on central bankers in ket became in aggregate more overvalued in that

well as in

your book, for refusing to listen to what bubble than at any time before, including at its theory and

asset prices were trying to tell them. previous peak in 1929. What is more, when the simply

Yes, although I was hopeful, I must say, as I was bubble finally broke in 2000, recovery from the

writing the book that central bankers finally subsequent devastation required a large fiscal represents a

seemed to be prepared to learn the lessons of the stimulus and an excessively easy monetary policy. triumph of what

past. There were quite a lot of press comments The consequences were the asset bubbles in

saying that Ben Bernanke felt that perhaps he did shares, houses and credit that ultimately burst in

is known as

have to look after asset prices in the future. But 2007 and produced our current problems. data mining.

more recently there seems to have been perhaps a This is the use

little bit of back-tracking there in the Fed, which So you’re saying that the cure was over-

makes me nervous. Talk that asset prices don’t done, ultimately a killer — and that it is in of carefully

matter again; complaints that it’s very difficult to danger of being overdone again? selected data to

value assets. It’s not. It’s easy. I was hoping that Well, as bonds, shares and gold have all risen in

they’d realized that asset prices do matter. But the price, it seems likely that quantitative easing is

support a story

old Fed attitude basically seems to be re-emerging responsible for the current rise in asset prices. If which has no

in some recent comments that it is “impossible” it is, this has justified the policy, as the boost to real justification.

to value assets but easy to measure an output gap. demand from a rise in asset prices was clearly

desirable and — because of past policy errors — It has been

Which is exactly the opposite of reality — was not possible through the more orthodox remarked that

That is my view. I think they were wrong on both approach of lowering interest rates. At this junc-

counts, and I was pleased when they seemed, ture, it may well still be premature to tighten

‘If data are

while I was writing my latest book, to be moving monetary policy, but the situation is nonetheless tortured hard

in the direction of the view that it is most difficult dangerous. Economic recovery from the reces- enough, they

to measure output gaps and quite easy to measure sion following the next bubble collapse will be

asset values. But now there seems to have been a even more difficult than this one has proved. will always

tenor change and I’m a little worried that there confess’. When

are voices in the Fed that seem to take an oppo- Which is why you are so keen that central

site view. bankers accept the notion that asset prices

seeking to test

should not be permitted to run wild; that we a theory it is

I assume one of the things you’re referring need a true “great moderation” here. important to

to is former Fed governor Frederic Mishkin’s Now we need it, exactly, that’s right. I know you

defense of “irrational exuberance” asset have to be very careful about putting irony in use all the

bubbles in an FT piece earlier this month — headlines because people take you seriously but, available data

Well, if people can write things like that and they “Is this the time for moderation?” might be a

hold, or held, important roles in the Fed and may suitable headline for this interview.

rather than just

still have influence on the Fed today, it is a little some of it.

alarming. Once again, as I demonstrate in my I was leaning more towards “Paradigm When this is not

book, asset prices are a key transmission mecha- Lost,” in reference to the way Wall Street

nism whereby changes in interest rates affect the Revalued demolishes the last vestiges of done, it often

real economy. Rising asset prices encourage the Efficient Market Hypothesis in finance provides a use-

investment and discourage savings, so they boost and economics and replaces it with a call for

demand. Asset prices tend to rise when interest central bankers to accept responsibility for

ful warning that

rates fall, but the effect is ephemeral, as there is — and be given adequate tools to — contain data may be

no long-term relationship between asset prices asset prices on the rare occasions when being mined

and interest rates. What’s more, this transmission they run far ahead of value. Though from

mechanism is weakened and can even break down what we’ve been hearing lately, you might rather than

— as we have seen recently — if asset prices rise to have to write a few more books before they properly

bubble levels. Because then asset prices can fall finally “get it!”

despite interest rate cutting by the central banks. Well, writing this one book took 10 years of

employed.”

research so I don’t think I shall be rushing to do Andrew Smithers

Mishkin tried to argue that the internet bub- this sort of book again. A lot of very hard work Wall Street Revalued





Reprinted with permission from

welling@weeden NOVEMBER 25, 2009 PAGE 5

“Invalid approaches to value went into Wall Street Revalued.



typically belong to the world of It shows, though you were kind enough to banish the algebra and

stockbrokers and investment such to the appendix! Why do you suppose educated people clung

to the Efficient Market Hypothesis for so long, even though markets

bankers whose aim is the pursuit of plainly aren’t efficient?

commission rather than the pursuit Well, I think that the support that the Efficient Market Hypothesis (EMH)

of truth. The more they achieve received, when it appeared to accord with the evidence, was perfectly reason-

able. What was unreasonable was the reluctance to discard it once contrary

their aim the greater is their evidence appeared. But that sort of reluctance is all too common, I’m

success at creating confusion afraid, when assumptions that underlie our understanding of the world are

challenged. The process was famously set out by T.S. Kuhn, in his book, The

rather than helping our understand- Structure of Scientific Revolutions, back in 1962, in which he described the

ing. I have already touched on the importance of paradigms in science and the difficulty in shifting them, mak-

egregious Fed Model, which ing them both a help and a hindrance. A commonly agreed basis for new

research is a help when a subject is progressing well, but it stifles develop-

purports to value the stock market ment when the assumptions behind it need to be replaced by a new vision.

by comparing its current PE with It’s my view that EMH became an obstacle, in just that fashion, to progress

in financial economics.

the yield on bonds. The other most

common and ill-considered view is But no more —

to refer to value by comparing the Well, there are always mini-swings within the broader swings in intellectual

movements like this, but my impression is that events are always more pow-

current PE with its average. The erful than arguments and that events have really driven the final nails into

reason why current PEs provide no the coffin of the Efficient Market Hypothesis. Of course, a lot of people

have to adjust to that and it’s going to be uncomfortable for those who have

guide to value is that profits are a great deal of career money invested in views which now appear to be

highly volatile and rotate around untenable.

their equilibrium level. If profits

It’s pretty hard to argue, in the wake of two massive asset price

are at their equilibrium level, and bubbles, that share prices are always correctly priced. Yet as you

only if they are, then the ratio of point out, people still cling to notions about things like the equity

risk premium that are based on the EMH.

the current to average PE will Yes, indeed. The equity of risk premium. When I am teaching, I challenge

provide a valid estimate of the the class. I say, “If you can find an article in the newspaper which does two

market’s value. Profits can move things: Mentions the equity risk premium and is sensible, I will award you a

prize.” I’m yet to find one.

far from equilibrium and have on

occasion been negative, as they And your problem with journalistic discussions of the equity risk

premium is?

were for the U.S. corporate sector It is because, basically, I think the assumption around the equity risk premi-

as a whole in 1932, and as was also um, when it’s usually used, is that the equity risk premium must be stable

the case for all quoted Japanese because it would be stable in an efficient market, therefore, it can be used.

Then, of course, it tends to be used to justify something, like saying some-

companies on several occasions in thing is fair-valued. Well, obviously, everything must be fair valued if the

the 1990s. Those who seek to value Efficient Market Hypothesis holds. Now, if the EMH doesn’t hold, then the

size of the equity risk premium, if you can measure it, which is of course

the corporate sector, whether highly dubious anyway, can obviously mean not just that the equities market

quoted or in total, by reference to is reasonably priced, for example, against bonds, but that the bond market is

current profits would therefore unreasonably priced. So it takes you nowhere. It tends almost invariably to

be a circular argument in which you assume that markets are efficient in

have concluded that from time to bonds and inefficient in equities and then you assume that the equity risk

time the sector was worthless.” premium has some stability, which appears to me to mean that you’re basi-

Andrew Smithers cally assuming view inconsistent with the belief that the market itself is effi-

cient. I don’t think it’s possible to make use of the equity risk premium to

Wall Street Revalued tell you anything about markets, unless you assume that there’s nothing to

be told about markets because they must be correctly priced all the time any-





Reprinted with permission from

welling@weeden NOVEMBER 25, 2009 PAGE 6

way.



Yet it’s an article of faith and a part of every

broker’s tool bag.

Indeed. There have been articles in the papers

recently by various professors arguing that the

market was selling at some low future multiple,

which of course, nobody knows, and was, there-

fore, reasonably priced against current bonds.

The assumption there is that when the market

gets this future low multiple because everything

is wonderful and profits are up, interest rates will

nonetheless still be where they are today.



How likely is that?

Exactly, exactly. There we are. If I could put my

finger on the two big risks we run at the moment,

I think they are, 1) the belief that a rapid recovery

is a good thing. This is quite understandable but I “Many claims have been made about

Scotsman, as Samuel Johnson unkindly said, or a how the stock market can be valued.

think is very dangerous. And 2) is that asset

new idea into the head of a banker, but I think Such claims have been made a various

prices really mustn’t be thought to matter again, times by all sort of people, including

that this idea is basically around in banking cir-

because getting them up is the way we are going economists and investment bankers. To

cles. The result, of course, has been that they

to get the rapid recovery. It is a sort of round see whether any models that claimed to

don’t want to increase their asset bases because measure value were valid, Stephen

robin problem and it is probably quite common in

that merely means they will need to do even more Wright and I considered the criteria with

the central banking world. But it shouldn’t be, which they would have to comply...in

equity raising in the future.

and I hope it won’t affect the decisions. summary we showed that the following

tests were those which a valid criterion

And the upshot is that we have bankers of value would need to pass.

Isn’t that a symptom of short-term thinking

refusing to lend — 1. There needs to be a fundamental

by central bankers — who should be thinking against which price can be compared

Which seems a lovely answer to them. This is how

long term? Rising asset prices do relieve and this fundamental must be reason-

wonderful this is for bankers: If banks stop lend-

their immediate problem, which is that bank ably stable.

ing, their margins go up, so they start making a 2. The ratio of price to value must not

“assets” aren’t worth the paper they’re

lot of money. The banks have found out that this wander all over the place. It must rotate

printed on. around its average and must be shown

business of not expanding their balance sheets is

Yes. But, in fact, I think there’s a stroke of good to revert to this average, i.e. to be

actually rather nice and that adds another encour-

luck in the reality that politicians throughout the “mean reverting”.

agement for them to not do anything. Ironically, I 3. It must be understandable in terms

world seem quite incapable of getting together

think, at the moment, by a stroke of good acci- of economic theory.

and agreeing to deal with the banking problem. 4. It must have a moderate, but limit-

dent, that lack of action may be just what the

It’s very, very clear that even bankers know that ed, ability to forecast future returns.

economy needs.

the banks haven’t got enough equity. There’s a ...Only two of the various metrics we

wonderful paper out by Andy Haldane at the Bank considered successfully passed these

In other words, a force for moderation, at tests. The successful ones were q, which

of England, called “Why Banks Failed The Stress is the ratio of the market value of equi-

this juncture, would be a good thing?

Test,” which has some wonderful pieces of data, ties to the net worth of the companies

If banks don’t lend, nobody can be certain what

fascinating. Things like after being fairly stable and the cyclically adjusted price/earn-

will happen. It may be possible to have a sharp ings ratio (CAPE)....Having found two

for something like a couple of hundred years, the

recovery in spite of credit constraints. But it valid metrics it was important that they

relationship of bank assets to GDP went up by 10 should prove compatible...and they

seems to me that the probability is that this lack

times in the last 20 years. And bank equity ratios agree with each other, as illustrated in

of bank equity or that the inadequacy of bank

have come down to roughly a fifth of their previ- chart 15.”

equity in the short term leads to credit constraint,

ous levels. So I think it’s quite clear — I wouldn’t

which may lead to slow growth in the economy,

say it’s universal, but I would say that there would

which may be exactly what we all need. So I’m

be a consensus among economists who are con-

more optimistic, you might say, about the econo-

cerned with these things, in England, at any rate

my than about the stock market, though I do

— that bank equity ratios have to be increased, not

think there are plenty of risks around for both.

just 10%-15% but by a multiple of what they are

today. And that point — although perhaps not the

So meanwhile, the stock market could be a

scale of it — has to some extent even gotten

wrecking ball if the bulls get carried away

through into the psychology of bankers. As we

here again?

know, it’s not easy to get a joke into the head of a





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welling@weeden NOVEMBER 25, 2009 PAGE 7

prices have gone up are not unconnected.



It’s not very mysterious, is it?

No.



We talked earlier how the EMH has come a

cropper without talking about the theory

your book suggests should take its place,

what you call the “imperfectly efficient mar-

ket hypothesis.” Which is not at all the

same as saying that the markets are casi-

nos.

I think the evidence against the markets being

casinos is very strong. If, as I said, markets were

perfectly efficient, price and value would be the

same thing, and if markets were casinos, there

would be no meaning to the concept of value at

all. But the evidence is that prices rotate around

“Another invalid way of seeking to value value, and that evidence is robust and strong and

equities is to try to derive the cyclically Indeed, and bond markets, too. I mean, the bond

adjusted PE from an assumed trend in

testable, while the EMH falls apart on testing.

market looks vulnerable. If you chart, as I do, the

real earnings per share. This naturally And it seems to me that the casino argument is

expansion of the Fed’s balance sheet and yields on

depends on the assumption that there is equally crazy — or “crazy” may be overstating it,

a stable trend, but this falls foul of both 20-year government bonds, they form a very nice

perhaps. But the casino argument is equally lack-

theory and observed data... pattern, so much so that the causal relationship

“As the real return on equity has been

ing in robustness. Yet I fear that there is a danger

between central bank buying and yields falling

stable, but payout ratios have not, there people will swing from a view that markets are

looks very strong. Of course, that is not too sur-

is unlikely to be a stable trend in real perfectly efficient to saying that the markets are

EPS and, as chart 23 shows, there hasn’t prising; if the central bank comes in and buys

merely casinos. Because it seems to me to be clear

been. I have simply split the period for things, you’d expect the price to go up. Anyway,

which we have EPS data in half and the

from the evidence that they are not casinos.

that has gotten bonds into rather dangerous-look-

trends for the first and second halves ing territory. Now, I wouldn’t think that we’re yet

are markedly different. What evidence?

“Without a stable trend in EPS, it is in the territory where bond market yields going

It’s awfully difficult, using the historical data, to

not sensible to try to derive the current up by 1% or more would be disastrous for the

equilibrium level of EPS by assuming

construct economic models in which value has no

economy. But that, again, could help slow things

that such a trend exists. Some of those meaning. Because, unless you throw away the

down a bit.

who seek to use this method do not idea that in a reasonably competitive economy,

assume that there is stable growth in the value of something is what it costs to produce

EPS over the long term, but assume I wouldn’t bet against it.

such a trend over shorter periods. This

it, you’re bound to have value existing in markets

And it would probably have a negative effect on

has all the advantages and disadvan- with companies that consist of physical assets.

the stock market — but one doesn’t know. It

tages of data mining. As the choice of True enough. I just wonder if the market

time periods is at the discretion of the would obviously mean people who have a choice

might not be tilting more towards a casino

user, it has no logical validity and is between raising money in equities markets and in

thus useless for those in pursuit of

today, than it was in the past for which

bond markets will have a greater preference for

truth; on the other hand, the starting you’ve compiled so much historical data.

equities markets than they otherwise would. I’m

date can be chosen to produce any Simply because the market has been domi-

answer desired, which can be helpful to sure you’ve heard me tell the story of the parrot

nated in the last decade or so — like never

those in pursuit of commission.” who wanted to become an economist.

before — by short-term trading and by deriv-

ative instruments. Perhaps as trading has

Yes, but I can’t recall the punch line.

become more unhinged from the market’s

There’s no real punch line. It’s just one of those

capital raising function, prices have become

stories that help us all on our road through life.

more unhinged from value?

Now, the parrot was asked why he wanted to

You can always say that history teaches us noth-

become an economist and he said, well, he did

ing. Unfortunately, though, we don’t have an

find language quite difficult and if you’re an econ-

alternative to trying to learn from experience.

omist, you only have to know two words in

There is a certain element of, I suppose, trust, in

English: Supply and demand.

any attempt to interpret the world. It seems to me

I often think that if the parrot really understood

that the only thing to do is to look at history in a

the joke’s meaning, he probably became an

critical way, and draw what conclusions you can

above-average economist. The facts that central

from it. And then, when you do draw conclusions

banks have been buying assets and that asset

from it, make sure that they are testable conclu-





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sions — and that you then test them. That doesn’t,

of course, mean that somebody can’t come along

and improve matters by finding something that

works even better. But something that works and

can be demonstrated to work is better, I think,

than a view in which you throw up the hands and

say, “Oh well, not that it matters; it’s all chaotic

and it’ll go away; let’s go on the beach and play

volleyball.”



That might be fun in the moment, but would

not advance society, you’re suggesting?

It’s a counsel of intellectual despair, it seems to

me, and probably it is a moral issue, whether you

rush down that route or keep trying.



Okay, but doesn’t it strike you that bank

asset/equity ratios got so out of whack at

the same time that complex derivative “...houses are not only an expense, they

finance came to dominate the credit mar- Europe had no choice but to follow policies of are also an asset; as their prices rise,

kets? excessive monetary ease so that domestic savings owners are pleased, and those who

Well, this isn’t the first crisis we’ve had of this would fall to offset the high levels of intended sav- don’t own them are increasingly anxious

to do so. This dual character of houses,

sort, and attempts to explain the recent troubles, ings elsewhere. which are both forms of consumption

either in terms of derivatives or in terms of “it’s- and very important capital assets,

all-the-fault-of-the-Chinese” seem to me to be You’re saying we didn’t have to cooperate in makes it likely that they will respond to

lacking in historical perspective. We’ve had these China’s vendor financing operations? two different forces. In the short run,

expectations regarding future house

crises before. There’s this one. There was the Certainly not on the scale that occurred. prices will, as appears to happen in

Japanese one after 1990. There was the one back Accommodating the policies of China and others, share markets, often rise when prices

in the ’30s. There was apparently a very nasty which involved the export of their excess savings, rise, making them volatile in the short

one around 1907. was not sustainable and was not therefore sensi- to medium term. Over the longer run,

however, such expectations ebb and

ble unless it was accompanied by international flow and house prices will be related to

You blame the systemic crisis from which negotiations which would have allowed it to be incomes, While shares fluctuate around

the world is now trying to recover on inept very short-lived. And I don’t recall any of those. their fair value, house prices are likely

central bankers, but they themselves have to fluctuate around their affordability,

As Chart 31 shows, this model whereby

pointed the finger at “excess savings” in the But people liked buying cheap goods – and house prices rotate around some level

developing world — which, of course, they low interest rates. Times were good. of affordability fits with observed

chose to help China recycle in a massive I do not doubt that a less expansive monetary pol- behavior...”

global vendor financing scheme that was fun icy might well have produced an earlier recession

while it lasted. than the one we’re recovering from today, but

I don’t really find those accounts mutually exclu- that might not have occurred, and if it had, it

sive. The central bankers allowed asset prices to would almost have certainly been less deep, easier

reach absurd levels, which would not have been to solve, and have raised far fewer unpleasant

possible without monetary policies whose exces- long-term problems. In fact, it is erroneous to

sive ease was demonstrated by the low level of risk believe that avoiding recessions should be a major

aversion, shown by the vanishingly low price of objective for central banks. Their objective

liquidity and the exceptionally high prices of should be to avoid major recessions. Periodic

shares and houses. The “savings glut” argument minor recessions may well be a necessary condi-

says that it was necessary to encourage over-con- tion for achieving this, as mild shocks provide

sumption here to offset an excess of savings in necessary reminders to lenders and investors of

Asia and oil exporting countries and thereby keep the risks they run and help to restrain excesses.

the global economy from falling into a recession,

albeit only at the price of creating massive global In fact, doesn’t your research show that

current account imbalances. As an account of the major recessions are quite rare events?

way events transpired, I find this very reasonable. They are rare events but beyond that, what histo-

It connects the imbalances in savings flows with ry shows is that what they can be attributed to, in

those in asset markets. My quarrel is with the each case, is the bursting of an asset bubble.

assumption that central banks in the U.S. and Whereas, to explain each one in terms of what





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who said, “Oh, grab it, and grab it and grab it.”

You probably get a deterioration in the quality of

bank managements during periods of bubbles.



Not just bank managements —

Indeed, it’s a broad problem. That is another rea-

son we want to make sure that central bankers

don’t allow another asset bubble to develop. The

consequences for all economic management

thereafter would be pretty awful, I think. We’ve

managed to survive this crisis without a general

cry to throw away the baby with the bath water

and blame it all on capitalism. and, to some

extent, particularly in continental Europe, there

have been those who have been surprised and dis-

appointed by this. We certainly don’t want yet

another asset bubble implosion and the conse-

quences of that. I think you’d see a marked turn-

“Chart 35 compares the return which ing away to irrationalism regarding the way in

can be attributed to the loss of liquidity was happening at the time, you’d have to go all which economies can and should work, if that

to investors on U.S. investment grade over the map. You might explain the 1907 crisis happens.

corporate bonds from 1997 to 2008 with in terms of the San Francisco earthquake, for

their average level. On this measure,

credit conditions would appear to have

instance, but I think it had wider antecedents There already is a considerable backlash in

been too lax from 1997 to 2000 and from than that, just as trying to explain the recent trou- this country, lots of populist anger and

2003 to 2007. The first period coincided bles as being all the fault of irresponsible bankers rhetoric directed at bankers, politicians,

with the stock market bubble and the is inadequate. I think that bankers always hang regulators — journalists, even.

second with both an overvalued and ris-

ing stock market and with house prices

themselves if given enough rope — and if we give Yes, I hope that that gets channeled in the right

which were above and moving further them too much rope, they hang us, as well. We’ve direction. There is a great deal of change that is

above their trend level.” seen that throughout history and — needed in banking; we do need a lot of bank

reform. And I am nervous that banks do have a

As a matter of fact, for all the sharp barbs lot of influence in political circles. They have

you aim at bankers, you actually have some made a lot of money in recent years, and they have

— dare I say? — kind words for the breed contributed a lot to political parties — which gives

towards the end of your book. them a lot of access. You don’t have to take an

Yes, well, you can blame burglars for burglaries unpleasant sort of bribery view of the world to

but attributing a sudden sharp rise in burglaries think that the amount of influence that bankers

to a marked recent deterioration in the moral atti- have has become a serious impediment to serious

tudes of burglars seems to me a little on the bank reform.

absurd side. They do what they do, regardless,

and if you increase the opportunities for bankers No, you’d have to be blind, deaf and very,

to be silly, they will take them. While the inven- very dumb to miss it. Yet as you’ve also

tion of new and complex financial instruments — observed, most of the attention has so far

and the incentives to management folly given by been squandered on headline-grabbing micro

their absurd bonuses and remuneration — may issues, like bonuses, instead of focused on

have added zest to the flames, the fuel on which macro reforms that might really make a dif-

the fire relied was excessive liquidity provided by ference.

central banks and the asymmetric management of Absolutely, there’s a tendency to confuse the

interest rates, which was known as the micro and the macro very much. Bankers’ bonus-

“Greenspan Put” because the Fed had given the es and pay are very good examples of this. There

impression that it would slash rates in response to is a strong case that bank size has been driven

falling asset prices, while doing nothing about partly by a natural oligopoly in market making. I

rises. So unfortunately, we gave the bankers lots wrote a paper on this, which was called, “Bank

and lots of rope. I also think we got a sort of weed- Requirements Must Rise Sharply With Size,”

ing out of the good going on during the bubble. pointing out that the combination of the law of

The people who were more concerned and more large numbers and order flow had tended to drive

sensible thought this was a bit dangerous. So they the number of market makers down throughout

didn’t tend to last as long as bankers as the people recent history, or anyway, post-war history. I





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quoted the example of stock jobbers in the U.K., banks are driven to split themselves up into small-

which from my own personal experience was a er units, because then, they won’t need so much

good example. My great-grandfather, Alfred capital. That would be a very positive way for-

Smithers, started a very large one, called Ackroyd & ward, and as far as I can see, just about the only

Smithers, with a man named Alfred Ackroyd, and practical way of dealing with the “too big to fail”

during my working life, the number of major play- problem.

ers in the jobbing market came down narrower

and narrower and narrower all the time. The What about resuscitating Glass-Steagall?

same thing happened after May Day in America. I don’t myself think that reinventing Glass-

And we’re seeing the same law of large numbers Steagall is the solution, not only because it’s so

applied in this instance. The law of large numbers difficult to make that dividing line between nar-

— or this branch of it — says that if a group of peo- row banking and the rest, but also because I don’t

ple of similar skills should sit down at a table, say, think it deals with the whole problem. I think

at a game of poker, which has a short-term risk we’ve gotten to a situation in which market mak-

volatility element — it’s got a chance element, ing is also too big to fail. Now, I have been told

obviously, in the cards you’re dealt — but where that E. Gerald Corrigan, who is now at Goldman

skill is important, if the players are of equal skill, Sachs, of course, has recently made a strong case

the person most likely to go bust is the person in favor of large banks being needed to handle

with the least money. In addition, jobbers get market making. I haven’t checked it out myself,

inside information from order flow. If you talk to so I can’t really comment. All I can say is that this

any jobber, he will tell you that order flow is very is an area in which big banks will seek very

helpful. That’s because people see the effect of strongly to resist reform, and that will be very

order flow in prices, but that is only after the per- dangerous for the economy.

son who gets the order flow will have that infor-

mation. So the jobber has a natural inside infor- I’m shocked, shocked, I tell you, that they’d

mation stream. Now, the larger you are, the less fight the hardest to protect their most prof-

likely it is that this flow of information will mis- itable preserves.

lead. You get less random misinformation. So the Indeed. It is natural for managements to be rent-

tendency, I think, both theoretically and, clearly, seeking and to protect rents and, therefore, it will

in practice is for market making to be a natural be very, very important, for those who have got a

oligopoly, which concentrates over time. public interest element in their thinking to resist

bankers on those issues as hard as they can.

Not a good thing, except for the oligarchs.

Right. The trouble with that process is, of course, Capital requirements that get more onerous

that whenever somebody goes bust, the scale of with size would be enough, you imagine, to

the remaining players gets bigger and bigger, and inspire banks to break themselves up?

the “too big to fail” starts to cover everybody who Yes, I’m sure they would. I don’t know how esca-

is left making markets. So you got minor market lated the capital requirements would have to be,

makers going bankrupt a few years ago, but this and I don’t know the form things would ultimate-

time you got Lehman Brothers, and everyone is say- ly take. But that’s one of the advantages of

ing, “Oh, Lehman Brothers should never have addressing “too big to fail” this way. You don’t

gone bust.” But with this process, the next time have to rush to judgment overnight; you just start

we get a crisis of this sort, it will be somebody big- at a figure and if you don’t find companies are

ger than Lehman Brothers that goes bust. So I breaking themselves up, then you raise the ante.

think that “too big to fail” is part of rent acquisi- If you find that things aren’t working, because the

tion by management in these firms. I don’t think way they break themselves up doesn’t work and it

that the high returns that bankers receive are due isn’t what you want, well, then you’ve got to think

simply to their wonderful banking skill; that they of a new answer. But you’re never going to

are all so much cleverer than the rest of us that answer all the problems of life in one go.

they deserve these wonderful salaries.

No, really?

Then how do you explain them? I’m sorry about that. I’m a natural optimist so

I think it’s rent gouging to a significant extent, perhaps I shouldn’t have said anything like that.

and the solution to that is not to say, “You must But it seems to me that an incremental approach

not rent gouge; you must not be paid well.” That has a great deal going for it when the uncertain-

sort of thing won’t work. I think we need to have ties of anything that you do are quite high.

escalating capital requirements with size so that





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One of the arguments the big banks make Right. So one clearly does not want to subsidize

against being broken up is that they need industries. Yet what the explosion of the banking Weeden & Co. LP’s

scale to provide liquidity to the market. industry clearly suggests is that the increasingly Research Disclosures

Yes. The argument is likely to run along the fol- well-believed (it’s not only explicit but implicit) In keeping with Weeden & Co. LP’s

reputation for absolute integrity in its

lowing lines: If you don’t have large market mak- guarantee that the government and taxpayers dealings with its institutional clients,

ers, you will reduce the liquidity of the market. It give to depositors in banks means that they have w@w believes that its own reputation

seems to me perfectly valid. And if you reduce the had a huge subsidy — so the industry has over- for independence and integrity are

essential to its mission. Our readers

liquidity of the market, you will probably get expanded. One of the things you constantly hear must be able to assume that we have

increased short-term volatility. But to then argue from bankers is, “Ah, you shouldn’t increase bank no hidden agendas; that our facts are

that it would be a bad thing, seems to me to be capital because that will increase the cost of the thoroughly researched and fairly pre-

sented and that when published our

very dubious. As far as I can see, if you look at the provision of finance for bank intermediation — analyses reflect our best judgments,

pattern of volatility going back to 1871, it has had but that, of course, is just the purpose of doing it. not vested pocketbook interests of

large jumps over crises, obviously, but once You’ve got an industry which is subsidized. After our sources, colleagues or ourselves.

Neither Weeden & Co. LP nor w@w

you’re over looking at monthly or annual volatili- all, if you guarantee an industry’s debts, its bor- engage in investment banking; w@w’s

ties, the market volatility seems to have remained rowings, it doesn’t need any equity in the first mission is strictly research.

much the same over the last 140 years or some- place. In a guaranteed industry, equity has to be This material is based on data from

thing. So I can’t believe that the size of market there only by regulation; it can’t be there for any sources we consider to be accurate

and reliable, but it is not guaranteed

makers would, therefore, be important, and I other reason. And if you get an industry which as to accuracy and does not purport

think there’s rather a case to be made that it’s the has grown from 50% of GDP to five times GDP, as to be complete. Opinions and projec-

other way around. the U.K. banking sector has done in the space of tions found in this report reflect

either our opinion (or that of the

10 years, you can be absolutely as nearly certain named analyst interviewed) as of the

Do you suppose the size of market makers as you can be in this difficult world that it is an report date and are subject to change

contributed to the mispricing of risk that industry which is over-subsidized. One of the without notice. When an unaffiliated

interviewee’s opinions and projec-

became so ubiquitous in the last bubble? great reasons for increasing capital isn’t just to tions are reported, Weeden & Co. is

I’m not sure on that. As I say, I’m against size, A) protect the taxpayers, although that itself is an relying on the accuracy and com-

because it permits rent creation and that’s bad excellent one, it is to offset the subsidy which pleteness of that individual/firm’s

own research disclosures and

for economies. You don’t want monopolies; you these effective guarantees give to the banking sys- assumes no liability for same, beyond

want to avoid rent creation; B) because it con- tem. reprinting them in an adjacent box.

tributes to the instability of the financial system This report is neither intended nor

should it be construed as an offer to

when you have large organizations which are “too Good luck. sell or solicitation or basis for any

big to fail.” Even if it were the case that the con- We have a long way to go. Without blaming contract, for the purchase of any

sequence of breaking up the big banks would be bankers for this sudden increase in burglary, I do security or financial product. Nor has

any determination been made that

greater short-term volatility in market, I think think that the need for a great deal of reform in any particular security is suitable for

that is something which sensible people should the banking industry is with us and that reform any client. Nothing contained herein

readily accept. should include a very large, multiple expansion of is intended to be, nor should it be

considered, investment advice. This

Another argument I hear all the time is that equity ratios and an escalation of equity ratios in report does not provide sufficient

breaking up the big banks or tightening reg- size. I don’t expect those views to be popular with information upon which to base an

ulation will stifle financial innovation — bankers. investment decision. You are advised

to consult with your broker or other

Actually, there is a case that not just financial, but financial advisors or professionals as

all, innovation tends to involve a lot of rent cap- Here’s hoping you won’t be disappointed. appropriate to verify pricing and

ture by the people who are working in the busi- Thanks, Andrew. other information. Weeden & Co. LP ,

its affiliates, directors, officers and

ness that innovates. Several good research papers And Happy Thanksgiving to all. associates do not assume any liabili-

have been published on that recently. Now this ty for losses that may result from the

may simply be the price we pay for innovation. reliance by any person upon any such

information or opinions. Past perfor-

But it also does make another case for not subsi- mance of securities or any financial

dizing industries, because if you subsidize indus- instruments is not indicative of future

try, you’re going to get the rent extraction from performance. From time to time, this

firm, its affiliates, and/or its individ-

innovation and the oversizing of the industry due ual officers and/or members of their

to the subsidy working together. So you’ll get families may have a position in the

super rent extraction where you have innovation. subject securities which may be con-

sistent with or contrary to the rec-

ommendations contained herein; and

Imagine if we subsidized Google or Apple— may make purchases and/or sales of

W@W Interviewee Research Disclosure: Andrew Smithers is founder and head of Smithers & Co., London, which provides economic and asset allocation advice to institutional clients based those securities in the open market

mainly in London, New York, Boston and Tokyo. Smithers & Co. focuses mainly on stocks, bonds and currencies in the 5 largest economies (U.S., U.K., France, Germany and Japan), but it also or otherwise. Weeden & Co. LP is a

analyzes abnormalities that crop up on the micro level, as the need arises. This interview was initiated by Welling@Weeden and contains the current opinions of the interviewee but not nec- member of FINRA, Nasdaq, and SIPC.

essarily those of his firm. Such opinions are subject to change without notice. This interview and all information and opinions discussed herein are being distributed for informational purpos-

es only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained

from sources believed to be reliable, but is not guaranteed. In addition, forecasts, estimates and certain information contained herein are based upon proprietary research and should not be

interpreted as investment advice, or as an offer or solicitation for the purchase or sale of any financial instrument. No part of this interview may be reproduced in any form, or referred to in

any other publication, without express written permission of Welling@Weeden. Past performance is no guarantee of future results.









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