Jody Clarke talks to Andrew Smithers about which markets are overvalued, and which look best for the long run.
Can you make money from buy and hold?
No. This is not a sensible idea. Markets are not 'random walks'. They revert to around a level of fair value. So, as you'd expect from that fact, when markets are high, they give poor returns. When they are low, they give good returns. Obviously, that means you shouldn't be investing when they're high, because you'll get battered.
So we should all be value investors?
Well, most value methods are thrown up by investment banks and brokers, whose purpose isn't to find value but to sell shares. The pursuit of commission and the pursuit of truth often conflict. I once read a large report from an investment bank that said there were 18 ways you could measure the value of a market. In a world that can write that sort of nonsense and be paid well for it, you're in danger of upsetting people if you take a more robust approach to these things.
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So are fund managers worth the money we pay them?
You've hit on a point where my business and intellectual interests do run against one another. My clients are fund managers. Fortunately, they don't seem to mind the honesty of my views too much.
Back in 2000 the stockmarket was, according to our calculations, more expensive than at any other time in history. Of course, we got a great deal of abuse for saying so. We pointed out that there was a 70% chance of the markets falling at some point over the next 12 months. A fund manager who understood this would then, if he was entirely self-interested, probably sell the shares in his own account and keep his clients' on the grounds that there was a 30% chance of losing business.
These conflicts that fund managers face mean that clients should stand back and learn themselves. That isn't an easy thing to ask anybody to do. I think there is a good case for buying index-tracker funds rather than managed funds. The problem isn't that some fund managers will do better than others. The trouble is identifying before the event which one will do better than the others: this seems to me to be extraordinarily hard to do. And you invariably pay for it. I really think that on the whole, the chances of success, compared with the expense you engage in while trying to succeed, make it scarcely worth while.
How do you value a market?
We came up with two, and only two, methods that were valid under testing. These were the 'q ratio' [defined on page 44] and the cyclically adjusted p/e (CAPE), which uses average inflation-adjusted earnings over ten-year periods. By those measures, the US market is now 40% overvalued. The long-term average CAPE is just over 15. It's about 21 today. UK house prices look expensive too. Fuelled by liquidity, everything has gone up. But there is a relationship between house prices and peoples' incomes, though people have been prepared to spend more of their income over time. But even allowing for this trend, house prices are still well above their equilibrium level and you'd expect them to undershoot in current conditions at some stage.
You're bullish on Japan
The reason I'm positive on Japan (not in the short term, I should say) is that profits look a lot more depressed than in America. Adjust for depreciation (a hit to profits reflecting asset wear and tear) and US profits are high while Japanese profits are low. Over the last 12 months, Japanese depreciation charges have eaten up more than two-thirds of Japanese non-financials' profits. The equivalent figure for US firms is 50%. But that's because Japanese companies have over-invested in the past (higher assets = more depreciation). As investment now falls, so in turn will depreciation charges. So even if profit margins stay still on both sides of the Pacific, you'd expect Japan to do better. Over time, I think we'll see Japanese profits go up, which in turn will be good for stockmarket valuations.
Who is Andrew Smithers?
Smithers studied economics at Cambridge. He doesn't go into detail, except to say: "My mother once remarked that university was the only holiday a boy got between his mother and his wife. So I enjoyed myself." He turned down an offer to do a PhD at Stanford and joined SG Warburg when "there were only 120 people in the place". He founded economics consultancy Smithers & Co in 1989. His book, Valuing Wall Street, with co-writer Stephen Wright, predicted the bursting of the tech bubble. His latest book, Wall Street Revalued, claims markets can be objectively valued and that central bankers should try to prevent bubbles.
Andrew Smithers' new book, Wall Street Revalued, is published by Wiley.
