- Efficient Market Hypothesis is just wrong
- A crash worse than 2008?
- A new, better, testable, economic model
Andrew Smithers: Look Out! Bad Models Equal Bad Outcomes
September 14, 2022
“But I must say I welcome any qualified economist who has the guts to say, “Smithers’ views are worth debating. I’m not going to say that Smithers is right and the consensus is wrong, but we do need a debate.” That will be the first step. I think that people are very frightened of debate, and the fear that they have is one of the reasons why we need it so much. They are frightened because what they have been teaching and writing papers on will look to have been badly wrong. And to face that is a very great challenge.” — Andrew Smithers
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
I’m looking forward to our guest today. Dave, you’ve interviewed him before. In fact, the last time you interviewed him was in Scotland. There was a harp in the background—one of my favorite backgrounds to one of your talks—but it’s always good to look back and say, “What have I learned in my life?” But this is a man who’s got five or six decades of not only asking himself what he’s learned, but testing it by model, and disqualifying a lot of the models that people are following right now that have just proven themselves to be wrong. I’m talking about Andrew Smithers.
David: He offers a model to complement or perhaps upset the neoclassical economic model which has been so popular in recent decades. And I find myself, after having gone through Valuing Wall Street, one of his earlier books, and now The Economics of The Stock Market, I find myself a man in debt. I’m in debt to Andrew Smithers at an intellectual level for his contribution, and feel the same way as I’ve read through [Giulio] Gallarotti and Harold James and Robert Higgs and Russell Napier and [Tomas] Sedlacek and Robert Jervis. Andrew Smithers is in that mix.
And from the standpoint of market dynamics and valuation and appreciating the long patterns that you see within the stock market, how do we explain them? How do we understand the behavior of the decision-makers within an economy? Whether it’s a household or corporation or a government. He puts many of these things into perspective. And so without further ado.
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I may be hopelessly nostalgic. I miss Alan Abelson’s articles in Barron’s. I miss the round table discussion from the same paper, including Felix Zulauf and Fred Hickey and Bill Gross. And I miss Andrew Smithers’ routine articles in the Financial Times. But I love it whenever retirement is more of a suggestion than a reality. Because here you are, once again, Andrew, writing another book. You just published The Economics of the Stock Market, and I’ve really enjoyed it.
I would argue your challenge to the consensus views is more important now than ever before. [Two weeks ago] in our commentary, we discussed how [Thomas] Kuhn describes a paradigm as broken, but still stubbornly adhered to. And so you’re in this situation where anomalies accumulate until a fresh set of ideas is finally welcomed. And I hope your ideas are part of the refreshed and rewritten economic consensus.
Thank you for joining us again. I think the last time we spoke in person was at the Balmoral in Edinburgh. I apologize today, we don’t have harps, and there’ll be no slipping away later for a single malt with Russell Napier, but welcome.
Andrew: Thank you very much, indeed. Very nice to be on the telephone with you.
David: We experienced a disconnect during the global financial crisis between professional economic forecasting and the realities of a financial sector and financial markets meltdown. While many lessons were learned, there still seems to be a detachment between finance and economics. And in your latest book, the economics of the stock market, you address this head on. To provide us an overview, what was or still is missing from the existing economic models?
Andrew: The major missing pieces in the economic model are a failure to have a financial sector involved, a failure to address the importance of money and banking. And to assume that you can model an economy by separating government from the private sector, but you don’t have to separate the business and household sectors. This is quite wrong. From that assumption follows the assumption that those who run companies ignore the stock market and seek to what is known as profit maximize, which is defined as worrying mostly about the net worth of their company. Frankly speaking, those of us who worked for many years in financial markets simply do not believe this assumption.
David: You quote [Hyman] Minsky saying that modern orthodox economics is not and cannot be a basis for a serious approach to economic policy. To what degree are economic policymakers aware of operating with flawed models?
Andrew: I think it takes the form of cognitive dissonance—very pronounced cognitive dissonance. Central bankers are I think really aware that having excess asset prices, run away money supply, and excessive leverage is going to lead them into financial crisis, but they can’t find a way to stop having them because they also believe, and this of course is the fundamental belief of the consensus theory, that if you’ve got the balance between supply and demand correct, you don’t have to worry about anything else. This is called a single equilibrium theory, and it’s that on which the consensus model conclusions arrive at, and it is radically wrong. There are several—at least two and probably more—equilibria which we have to preserve, which if we don’t we will have economic crisis and we will fail to preserve the aim, which is to have nice steady growth with low unemployment and low inflation.
David: So, two of the key elements you address are 1) how the stock market plays a role in financial decisions, which has significant economic implications. And 2) how the private sector is more appropriately divided between companies and households, each with a distinct set of priorities and motivations. And then there’s the further subdivision between publicly traded companies and privately held companies, which behave very differently. And you note that it’s roughly 82% which are publicly traded versus 18% privately held. So, a significant proportion who are behaving in a certain fashion, prioritizing certain things, and have a very clear footprint in the market, which goes unaccounted for according to this consensus model. Talk to us about these key elements.
Andrew: You summarized, if I may say, extremely accurately and correctly. The first point is division between dividing the private sector into the household sector and business sector. This is important because people who are running companies have a different set of priorities. They have a different utility function than the people investing in the stock market, but that can often apply, of course, one person having both worlds, but when they are doing one, they have to take one set of priorities. And when they do the other, they have another set of priorities. And it is that interaction that determines the way in which the economy behaves. So, that is the first point.
The second point is that there is a long history, going back to when I was in Cambridge in the 1950s, to a number of economists pointing out that this was a serious question and suggesting that the two sectors do need to be separated, and their views being ignored in spite of the fact that nobody has put forward any good explanation or reasons or supporting data to suggest that ignoring their points was valid. This is one of the reasons we’ve gotten to such a mess with current economic theory.
David: And of course the stock market plays a role in the financial decisions of the corporate and household sector as well. Perhaps you could speak to what is motivating your corporate executives and managers, which is such a distinction from the household sector.
Andrew: I’ve put forward a model, which I then test against the data, and is robust when tested. The model suggests that managers of companies have two main priorities. It doesn’t mean that they don’t worry about other things, but the driving forces for their decisions are twofold. One that they want to keep their jobs. And secondly, they want to have their best income they can while they’re keeping their jobs.
Now, this produces a number of interesting points. The first thing is, you will lose your job if your company is taken over. Now, that means that you must not underleverage your company, because if you do, companies which have gotten full leverage can buy you, paying partly in debt and partly in equity. And the result is, because debt is so much cheaper than equity, they can afford to pay more than the current market price. And I quote data which shows that leverage up to a point will increase share price. So, you have a requirement for holding your job, which is that you should not underleverage.
Another way, however, that people lose their jobs is if they suddenly have to go to the stock market to raise new equity. You can raise equity for a company in two ways. By profit retention, not paying out all your profits in dividends and share buybacks. Profit retention is one way. And since the stock market values companies, mostly on P multiples rather than dividend yield, it doesn’t make much difference to the value what your payout ratio is. But if you pay out too much, you cannot then afford to invest. And if you don’t invest, you run the great risk—in fact I would say, over time, the near certainty—that other companies who compete with you will invest and they will be using more modern equipment than you. Their cost of production will be lower, and they will drive you out of business.
And before that happens, what happens of course is the share price goes down because it’s looked upon as a badly managed company. And once that happens, you will get taken over or sacked by the existing shareholders. Or, if worse comes to worst, you’ll suddenly find your profit falls such that you run into problem with your debt levels. You are in default on your debt or threatened default of your debt. And you have to raise new equity in the stock market. If you go to the stock market to raise new equity, all of those who have worked in the stock market know that the stock market dislikes this intensely, when companies come for a rights issue, for example, the share prices suffer greatly.
So therefore you have this balance. And the result of this balance is that companies—and I showed this in the book—the companies in aggregate, they raise enough debt, but only up to the point where there is a regular steady relationship between the level of interest payment and profits before tax. So, you get that equilibrium. And that determines how corporate managers behave.
David: In past conversations with you, we’ve explored the importance of management remuneration. So, this is the bonus culture. And you continue this theme here, and attribute part of the weakness in contemporary economic theory to not accounting for the behavior of managers, which is rewarded for short-term planning and has dramatically reduced long-term investment.
This has reemerged in recent decades with a change in incentive to the C-suite. And you do actually quote, “This is an issue which has been present in the past.” You quote Adam Smith in 1776, who witnessed something similar. He says, “Being the manager is rather of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance.” To what degree do you think this is tied to a limited liability structure where managers and owners interests are not always aligned, or is this back to the issue of firms being publicly traded and needing to meet the expectations of investors’ short-term demands, fund managers’ short-term demands, on a quarter by quarter basis?
Andrew: The bonus culture has had an important impact on the motives of managers because they are now paid huge amounts for small differences in the profit they show in the near term, which are reflected of course in earnings per share and share prices. They have a bias they didn’t used to have, which is against investment and more for short-term profits per share. This is encouraged in the short run, and I think this will die over time, but in the short run—and I mean by that about 10, 15 years—that has encouraged a change in behavior. And that behavior has had a bad effect on economic growth.
Economic growth in the century so far has been very poor, and it has been matched by very poor business investments in fixed tangible assets, things that really produce advances. If you have a development of technology, it requires a new piece of equipment. Invention alone doesn’t produce growth. Invention plus investment produces growth. And it’s the lack of physical, tangible investment which has caused the lack of growth in the UK and the US in particular, and probably in the developed countries in general.
And that has been a major problem, I think, for liberal democracy because being in a very unhappy, disconcerted place where two things have happened: People managing companies had vast increases in their salary relative to the rest of us, and accompanied by their— while the rest of us have also had much slower growth in our incomes that we had before. This has naturally made for increased divisiveness in the political world, and is very dangerous and damaging.
Now, this change took place in the 1990s and I’ve shown in the book how dramatic it was in the 1990s. And it stayed. Then I do point out, however, that foreign-owned companies are less prone to this particular averse incentive than those of US owned companies. And you can see in the data that one thing that’s been happening in America is that the proportion of US domestic corporate output which is owned by foreign companies has risen very markedly this century. So, I think one of the things that you’re going to change in due course is the pressure from foreign competition in America. The pressure from competition from foreign-owned companies in America is going to become stronger and stronger. And people are going to realize, I think probably after or during the next bear market, how catastrophic the bonus culture has been. And I expect to see the bonus culture wither away after the next financial crisis.
David: Well, in that sense, there’s a bit of creative destruction. Something new and better emerging from a decline. If the corporate bonus culture has shifted the balance against investment, this comes back to the long-term equity investor. How should a long-term equity investor continue to view the opportunity and equities as it would appear that long-term profits and company survival are to a degree being compromised by a short-term improvement in return on equity? Or is that what you’re saying is resolved in the next bear market?
Andrew: No, I don’t. I think that, like every other thing, that is just not quite correct. What happens when investment falls is that it doesn’t hit the return on corporate equity. This isn’t the return you get in the stock market. This is the return that companies are getting on their own money. There’s a famous thing called the Gordon Growth Model, which says very simply and correctly that the return that you get from shares is dependent on the underlying return on equity of the company. And it doesn’t matter whether they distribute all of it in profits or in buybacks or they use retention, but what that difference makes is not in the return that shareholders get from companies, it is on the growth rate.
So, what happens when companies fall off and don’t invest as much as before is that the underlying returns of the corporate sector don’t go down, but the growth of the whole economy goes down. The problem of the stock market is a different one. It’s the problem of the Q ratio. As the return on equity is pretty constant over time—very, very constant over the long term, around 6½% in real terms – a very strongly mean-reverting series, as I show in the book—then what happens is that, from time to time, the stock market becomes seriously overvalued. And you can measure this because the stock market value becomes very much higher, sometimes a multiple of the underlying net worth of the companies in question.
That is the current situation in America. It’s happened before. It happened, for example, in 1929, and it was followed by a very large bear market. I of course do not know the future. None of us do, but I do think we can measure probabilities. Not certainty, it’s probabilities. And I am sad to tell you that I think the chances of a bear market, a major proportion in the relatively near future—let’s say the next 12 months, 18 months—I think the probability of such a major bear market is sadly very strong indeed. Not because the growth of the economy has slowed, though it has, badly, but because the stock market has become seriously overvalued,
David: Would you suggest that that kind of a bear market is on a par with what we had in 2008 or 2009, significantly lighter?
Andrew: The market was not as overvalued for the crisis of 2008 as it is now—nothing like it’s overvalued. Last time we’ve had poor markets of this proportion, ’29, 2000, and today. And 2000, we had a very different world, and the stock market came down quite a lot. It was definitely a sizeable bear market, but it was nothing like the one we had after ’29. It could be mild compared to what I fear we’re about to have, but I would emphasize that I am talking probabilities. I do not pretend to know the future.
David: There’s a new element in the market, at least for those who are participating in the market in just the last 10, 15, 20 years: inflation. Does persistent inflation potentially impact either household demand for equity, household demand for debt, or even a corporation’s interest in issuing one versus the other?
Andrew: The big thing that I think which— importance for inflation lies in money supply. Money supply as a result of, I think, a very foolish policy called quantitative easing. Money supply, first of all, didn’t move much while the first stages of quantitative easing were taking place, but then it pushed up the stock market in that phase. And then it’s produced a large dramatic increase in money supply, and now we’re seeing the result of that in high inflation.
Now to bring down inflation, you have to turn— get rid of some of the excess money that’s floating around, either by quantitative [tightening], which is being applied quite rigorously at the moment, or by raising interest rates, or both. When you do this, you take out the money from the economy. You are going to squeeze the ability of companies to buy back their shares. Now in recent years, the final buyer of the stock market has been companies. The level of buybacks has been so big where they have dominated the stock market.
And if—and I think it’s probable—we have sufficient tightening to eliminate inflation over, say, the next three years, then that process will require a very, very sharp reduction in excess money. The ratio of money supply to GDP will have to go back to what it was before. And in the process of going back, there will have to be a large contraction in the amount available relative to other uses. And when that happens, we are going to find that companies will simply not be buying back shares as much as they were before, and quite possibly, because they brought back so much, they will have to start making issues. Now, if you change the supply of demand and balance, you will change a stock market.
There is an old adage that you can teach a parrot to be an economist if you can teach him the two words supply and demand. My experience is that if a parrot who knew those words also understood their meaning, they would be an above average economist.
David: Well, there’s throughout your book reference to leverage and the importance of leverage, and you’ve got managers who— Raising debt, frankly, has been a hallmark of this past cycle, with increased leverage tending to push up share prices. We’ve perhaps seen some constraint to that. You can’t just pile on more and more debt infinitely. What does it look like? This issue of corporate leverage in the context of increasing long-term interest rates and a shift that we have not seen in some time, an adjustment, I should say, to enduring inflation.
Andrew: I think it’s very hard to put solid numbers on this. Obviously we don’t know how much long-term rates will go up, and how much it’ll go because the yield curve steepens or because short-term rates go up, and we don’t know exactly how people will react to this. We’re always talking about a world which ultimately depends on the behavior of people, and this is not totally forecastable.
But we can say, I think, with great clarity, conviction, that we will need to get a serious reduction in the availability of money. And that is likely to produce higher long-term bond yields. And with those higher long-term bond yields, this will reduce the leverage because I say companies, on average, only borrow so much that they can cover the interest payments by about five times their net profits before tax and have interest rates go up. Then they will have to cut back on their leverage, and they’ll have to do that by reducing buybacks or even cutting dividends, certainly. And possibly by adding to that by new equity issues.
And of course, the extent to which they have to do that will depend to some extent, not only on interest rates, but on profit. And here we have at least the help of inflation boosting profits, but profits are also likely to go down other than for inflation reasons when we go into a slower growth, which we’ll have to have if we are going to control inflation. So you’ve got a combination of very complicated things. You have some help from inflation, but inflation is also the cause of the problem. So you have to have profit suffering cause of the slowdown and you’ll also have interest rates going up. And I don’t think anybody could forecast the economy well enough to be able to put all those three through exact balance, other than to say, in combination, those three things point to a very unpleasant bear market.
David: You look at equities and discuss equities exhibiting strong negative serial correlations so that the risks of holding them fall as your time horizon lengthens. You also point out that the benefit of holding shares versus bonds also rises with that time horizon being stretched out. So, your numbers test that. Your numbers prove that. What would you say today concerning the average investor who’s holding period is shrinking dramatically, and where short-term trading has become more and more common?
Andrew: Right. This is very difficult because one of the things I know from my experience of life is that if you are going to time markets, if you are going to say, “We’re not going to be wholly invested in equities at the moment, we’re going to put some money into cash.” There’s no point, by the way, of holding bonds and equities together. That was a freak because we had both markets going up for a long time. Basically, bonds and equities are very much at risk to the same forces, which are particularly inflation. So, you’re not going to cover your risk by being in bonds and equities.
What you need to have is equities plus cash. How much do you put into cash or how much into equities? Well, equities give you the best long-term return. So, if you hold some cash, you have to be able to put it into the stock market when they get cheap. That means you have to make your decisions in advance. If you’re getting to go liquid now, which I think is a good thing to do, you must also say to yourself, “And I’m going to reinvest it when the market goes down.” And you will almost certainly invest too soon when you do that because the stock market goes down often, very much below its own equilibrium. Just as it goes up above equilibrium levels, it goes down below them.
Now my experience of people who are sitting on committees to make these decisions is that it’s astonishingly difficult to get people to carry out what they have previously agreed to do. I’ve had bad experience of not being able to persuade people to go back into the stock market when they did go liquid. So, I’m saying it’s a very difficult thing to say how much liquid should you have? The important thing I think at the moment is to at least have some. Let’s put it this way, if you are 30% liquid set, 70% in the stock market, and the stock market halves, your portfolio afterwards will be 65% cash, 35% equities. And you can then happily go back in the stock market assuming it’s not still overvalued.
You will almost certainly, as I say, go in too soon, but the thing you must avoid is failing to go in when it’s cheap because you might as well have stayed in the stock market otherwise. Over time, the stock market gives you a good return. Even today when the market is virtually the highest it has ever been, just a little down to its previous peak. The probability is that if you held the stock market for a very long period of time, not infinity, that’s too long. If you held the market for a very long time, say 60 years, you would get at least a 2, possibly a 3% real return on your money. And that is not negligible. So, there’s a good case of holding a proportion of your funds in equities come rain, come shine, if you are young enough. But at the moment you should not be 100% invested in the stock market. Am I clear?
David: Crystal clear.
Andrew: Thank you.
David: One of the things I wanted to return to, Wall Street operates with certain ideas that have through time been discredited, yet have not been discarded. And you just tossed out in a candid comment that bonds and equities are not necessary to be held together. And in one casual comment, throw out modern portfolio theory. Perhaps while we’re at it, I love how you describe the random walk hypothesis as reasonable, but not necessarily right. Can you quickly for us dismantle Malkiel’s idea, and then at the same time maybe take a quick moment and cut off the efficient market hypothesis at the knees as you’ve already leveled modern portfolio theory?
Andrew: Right. The efficient market hypothesis is often confused with other things, but what it says is that the financial markets will price correctly— efficiently, and therefore correctly. The relative prices of equities, bonds, and cash, they will go therefore up and down together. They will assume that you can have times where an interest rate should be low. Now the time when they should be high. And holders presumably assume that you are talking in real terms all the time. So, you can say when stock markets have say 3% real returns on cash, you will get something a lot less. If the market was sufficient on other assets, you get negative returns from it basically.
But as I show in this book, this doesn’t work. The bond market, the equity market, and the stock market do not go up and down together. Over sustained periods of time, 30, 50, 60 years, you get very different returns relative to the stock market from holding cash and bonds. And that there’s a chart in the book which shows this very clearly. Basically the problem is more a one of inflation than anything else. There are others. Stock markets, as I can say, can get overvalued without necessarily interest rates themselves being too low, but they do usually come and go together. So, what you’ve got is things which are independently variable.
Now, the efficient market hypothesis assumes that they are not independent variables, they are dependent variables. And it assumes therefore that the market is efficient. And we know that the market isn’t. The great proof of this lies in a thing called random walk hypothesis. When the idea of efficient markets was first put forward, it was put forward by Paul Samuelson. And he pointed out that if people were efficient in their choices, if they didn’t make silly mistakes, and they knew enough about the future, they would quite simply be efficient investors. And the returns on the stock market would then be random. You’d get some returns which were good because he assumed that everything went up and down with the interest rates, and you’d get good returns at some times and less good returns at other times, but none of that would be predictable and would get a random walk. The return on equities would be random over time.
Now I go into some considerable length in the book and show that that is nonsense. The return on equities is not random. Returns are strongly mean reverting. When the stock market is high, returns are low. And when the stock market is low, returns are high. And you can measure the stock market by Q and you can check the value of Q because when Q is high, I show that future returns on the stock market are low, and vice versa. It is a testable hypothesis, and the stock market does not follow a random walk.
After a while, and it took a long time, a lot of academics were at last prepared to believe that the stock market did not follow a random walk, but they felt unable to throw away the efficient market hypothesis. So, what they produced was a focused version of it. They said that the market is sufficient if you adjust it for variable risk, and they then sought to show that, but you couldn’t do this because you couldn’t test it. All that you ended up with was saying you could only measure the risk, according to them, by what then happened to the stock market. They’re saying that the stock market varied with the risk was shown by the stock market variation, that you couldn’t say anything about the stock market. This risk factor couldn’t be measured on its own account. It therefore fell the wrong side of Carl Popper’s famous demarcation between science and non-science. The random walk theory of the efficient market hypothesis is demonstrably wrong. We can show that because we can show that returns are mean reverting. The attempt to modify that by saying we can adjust it for risk meant the adjusted version was not testable, and therefore it was not science at all. It was non-science.
David: One of your charts on page 57 spoke to me. It was titled “The Long Term Stability of Volatility.” And this chart goes back to 1841. You have the mean and the standard deviation fluctuations above and below the mean. And I suppose for stability you could put in predictability, reliability, and the point would be similar. Mean reversion is real. Is this overlooked or undervalued because it stretches across years and decades while hedge funds and fund managers tend to focus on shorter-term dynamics?
Andrew: I don’t think one can blame fund managers. They have their own interests, as you were pointing out yourself earlier. And you can’t expect them not to be aware and concerned with their own interests.
Steven Wright, who’s my co-author of a book called Valuing Wall Street, Steven and I calculated roughly when we published our book Valuing Wall Street that the market was then at the highest level to have been since 1929 and was just about the same level as that. But the chances of it falling over the next 12 months were not more than 70%. And we said, well, if a fund manager goes liquid on behalf of his [unclear] and he’s wrong because the market doesn’t fall, if it stays still it gives you a positive return. If it goes up slightly, it gives you a better positive return. He will have seriously underperformed the competition in a year.
Now, if investors had a long-term view of their choices of fund manager, this would not matter. He would have a reasonable expectation of being able to tough it out. But in practice, unfortunately, money flows to fund managers on their short-term performance. They cannot therefore afford to risk their businesses and their jobs by going liquid very much, even though the stock market is extremely high.
The interests of plants and the interests of fund managers are separate. We therefore said to people, you must make your own decisions about the portfolio balance, the extent to which you hold equities or cash. You can then entrust your money, the equity money, to a portfolio manager and can expect risk performance to be judged against the stock market. And that I think is the long and the short of it. Fund managers have a conflict of interest, and it’s not their fault that they have a conflict of interest.
David: You wrote that book in the year 2000, and it is a classic. I’ve recommended it to people in our office as a must read. Valuing Wall Street: Protecting Wealth in Turbulent Markets. It’s interesting to me that one of the endorsements for the book came from Jeremy Grantham, who did in fact take, not necessarily your advice, but was aware of overvaluation, moved to cash, was punished greatly in the year 2000 with massive, massive client flight from his funds. And he was right.
David: As you were right. As you were right. And so sometimes it takes time for these trends to play out. And that’s what perhaps the investing public lacks is sufficient patience. So short-term versus long-term judgments, he was correct. And I think he regained much of the funds under management as the decade went forward, but Jeremy Grantham endorsed your book. Charles Goodhart, Charles Kindleberger, Barton Biggs. He said of you, “Andrew Smithers is one of the five best, most dispassionate, erudite analysts in the world. This is a book to read and chew on.” I don’t think he’s overstating it.
Andrew: Well, thank you. Can I tell you a story about Jeremy?
Andrew: Jeremy’s a good friend of mine, and he’s very kind. He’s coming over to England to help me celebrate my 85th birthday in September. After his going liquid in the peak of the 2000 market, getting it right, and rebuilding his business because a lot of people then departed, he said that he found that a lot of people wouldn’t forgive him for being right. Even though the clients who had left knew he’d been right, they didn’t want to come back. He said, “I could sell them something else, perhaps.” One of his funds for investing to save the global warming problems, trees and things.
But he said they’ve learned he had to get the money from new people on the whole. And one of the problems, I think, with timing stock markets is that people not only don’t forgive you if you are wrong, they often don’t forgive you even if you are right because their time horizon is simply too short for the time horizon for people who are going to try to be right. And although we can state that the stock market is extremely overpriced today, we cannot tell you how fast it’s going to fall, when it’s going to fall, how much it will go down. All these things are unknown.
David: I wonder if, in addition to Grantham’s reflections on a lot of people not forgiving him for being right, if there’s also a reflection of the frailty of most egos, unable to admit that they were wrong.
Andrew: Well, I think admitting you are wrong is tough for a lot of people, and you can say you are wrong and grit your teeth, but sometimes you don’t necessarily want to let the money follow where your teeth are gritting.
David: Well, I want to come back around to problematic theorems which are still used as a pillar of thought, in this case by our central bank community. In 2020, James Bullard referenced the Miller Modigliani theorem as a reason to be unconcerned about corporate choice to either raise equity or debt. And it would appear that many central bankers still underappreciate leverage in the financial system as a temptation for corporate managers, along with underappreciating the de-leveraging events which can occur and are real risks to the market, but also by extension with impact the broader economy. I’m hoping, of course I saw a write up of your current book, The Economics of The Stock Market from Andy Haldane and William White and Charles Goodhart. I’m wondering if you’re sending copies to Jerome Powell and Evans and Bullard, as Bullard still seems to be holding onto Miller Modigliani as if it’s the gospel truth.
Andrew: I haven’t the acquaintance of Jerome Powell or Mr. Bullard, but I do remember the quote from Bullard, and here I think you illustrate the point very well that I made before. Central bankers cannot really hold a different view of how the economy works than the consensus view of economists. The Miller Modigliani theorem which he was quoting is a corollary of the current consensus theory. And just as the current consensus theory is wrong, so is the Miller Modigliani theorem wrong. And I demonstrate that in the book.
The result, of course, is that you have people making quite reasonable statements in the sense of economic theory, which are totally wrong from the point of view of economic policy. And it is, I think, increasingly recognized that this must be a problem because I don’t think people really do believe in the Miller Modigliani theorem, which, as you know, says that you don’t add value to a company by leverage. This is nonsense. Debt is much cheaper than equity virtually all the time, even if it wasn’t subsidized by making debt allowable for corporation tax. Even if you had to pay interest out of post-tax income, you would still find that debt is cheaper than equity. And if you are raising money at a cheaper price than others, then you are adding value to your business.
So, it’s really very, very odd that the Miller Modigliani theorem should not have been exposed. And the reason I think it is not being exposed is because it is actually central to modern consensus theory. The problem is that if you accept the invalidity of the Miller Modigliani theorem, you have to accept the invalidity of current consensus mode of economics. And what happens if you do that? You have to put something in its place.
One of the many very strong claims I’m making is that I am suggesting something to put in its place. i.e., I am proposing in the book a thing called the stock market model of the economy. Now this is very important because there’s an old adage which says, it takes a theory to beat a theory. And this is not only psychologically correct, it’s actually scientifically correct. The way we assess one model in science compared to another model is by comparing them. What we do is we build a model because the world is too complicated to understand unless we start to cut out bits. We simplify to understand. And the success of science has been in getting the right simplification. And because of its success, it’s grown and grown in important stature.
At the moment, we’re looking at economics, which is I’m afraid to say is pursued largely unscientifically, and we’ve got to get it to be pursued scientifically. And to do that, we need a debate. And one of the things I’m so pleased to hear from you about for this interview, David, is because the key role of people like you is to make sure that academic economists do not hide away from the debate. If they’re going to continue to hold the consensus theory, they must defend it against it the, I think obvious, fault, and I don’t find them doing that. If they’re going to say that they prefer the consensus theory to the stock market model, they must show the errors in the stock market model, and they will not debate it.
So a very, very important role for people such as yourself is to make sure that we do get an open debate on the basic principles of economics. And if we can do that, we will have a first important step towards changing economic theory. And only if we change economic theory can we start to manage the economy better. And if we don’t manage it better, we are going to get a continuation of what we are seeing now, which is an ever growing threat of ever worse financial crises following increasingly quickly on each other’s heel. 2008 is now 14 years ago, but we don’t want another one—even to say we have another one immediately in the next year—and we don’t want another one thereafter, 14 years after that. We want to try and get people to change their view of what constitutes good theory and economics.
David: Well, you bring Popper into the conversation, and the need for economics to reflect a better robust approach to science and embrace of science. And as you say, it takes a theory to beat a theory. If the current consensus is inadequate, it does take something on offer to step into its place. This is what we spoke of earlier. Yes, the anomalies have accumulated with the current consensus. There are flaws, there are problems, and we continue to hold onto the consensus—what Kuhn describes as almost a textbook loyalty. No one lets go of the old until there’s something new to put into the textbook. And so I am hopeful that your stock market model of the economy is a part of that.
Yes, indeed this book is different than other books that you’ve written. This book is meant to advance and improve conversation amongst academics about their models and the flaws that have held over, despite experiences the past decades suggesting that they make those improvements. They have not, and they must. You’ve provided a compelling reason for them to adapt and to change, and so we appreciate your contribution.
One last question, just on a personal note because we do want to translate this into something perhaps pedestrian in nature. What would you say to the individual investor who’s very interested in mean reversion, loves the ideas of your first book, Valuing Wall Street, sees the importance of a return to that in your book The Economics of The Stock Market? How are you navigating these markets?
Andrew: Well, as I hope I said earlier, the key practical question for people obviously is how to manage one’s own affairs. And this is your duty to your family, as well as yourself, to manage it as well as you can. So, the first thing—you pre-suppose that your [unclear] qualifies here—the first thing you need to do is at least study the subject of how to invest. And I hope that Valuing Wall Street in particular will be a help for that. From that, you can take the view that you have to decide for yourself. How much you should be invested in the stock market? You can’t expect fund managers to do it for you, and you will have to try and judge [unclear] at what level you don’t wish to be invested a hundred percent in the stock market. And then you should go liquid. And then, as I said, if you do that, you then must decide at the same time what level you will go back into the stock market because you must lose your nerve and it happens because that gives you the risk of being double whammied, finding that you actually got out and then get back in at a higher level because you’ve missed the chance to get in at a lower level. So, the practical questions of how do we manage our family finances as well as we can, I say the first necessity is study. The second necessity is deciding that you’re going to stick to your own judgment when you take your judgment.
David: In the 15 years we’ve done this podcast each week, we’ve attempted to bring in that first element, study the subject. And I think one of the most critical books I’ve read is your book Valuing Wall Street. And so for anyone who’s interested in studying the subject, this is a place to start. I regret only discovering your book and reading it for the first time in 2013. I experience this on a routine basis. I discover a resource or an insight that I wish I had known years earlier. And so I continue to pursue and ask questions. And so we appreciate not only the work that you put into that book with Steven Wright 20 years ago—more than 20 years ago—but the most recent effort, The Economics of The Stock Market. I don’t know if this is you coming off the bench and coming out of retirement at coming up on 85—happy birthday, by the way.
Andrew: Thank you.
David: Perhaps that’s not the case. On the other hand, who is going to make the case? Who is going to argue and debate against the academics? I hope you’ve got some energy to take them to the mat, so to say.
Andrew: It’s a very good question. I hope I have the energy. I’m certainly trying to. I’ve been organizing seminars, podcasts, and everything else, including ones with academics at the National Institute here and the London School of Economics, and I’m trying to organize more of those, but I must say I welcome anybody who is qualified economist who has the guts to say, “Smithers’ views are worth debating.” I’m not going to stick my neck out and say that Smithers’ is right and the consensus is wrong, but we do need a debate. That will be the first step.
I think that people are very frightened of debate. And the fear that they have is one of the reasons why we need it so much. They are frightened because what they have been teaching and writing papers on will look with retrospect to have been badly wrong. And to face that is a very great challenge. As you know, there’s an old statement, science advances obituary by obituary. Unfortunately, in a serious paradigm shift, as you were referring to the great work of T. S. Kuhn already, in a serious paradigm shift, it’s quite a lot of the young as well who seem to have got stuck into it.
But I’m hoping that we will have—on your encouragement—we will stimulate the academics to at least say they have a duty to stand up and be counted. Either prove the consensus right, i.e., to show that the criticisms of it are real and founded, or to accept that we have to change the consensus, and likewise to stand up, be counted, and say, “Either the stock market is demonstrated wrong or we must accept it and use it as an improvement on consensus theory.” It’s a great challenge. I hope I have the energy, and I’m certainly trying to promulgate my views through every way I can.
Thank you very much indeed, David. It’s been a very stimulating conversation for me.
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Kevin: What an interesting interview. I love when he said science advances obituary by obituary. The modern classical model should be one of those obituaries because it’s proven itself to be wrong.
David: Yeah. Old ideas die hard. And here we have the neoclassical economic model, which has stood for many, many decades, and may need to die. But like Kuhn suggested, that usually happens only at the end of a revolution. Fortunately we have now something to substitute for it.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany and our guest today, Andrew Smithers, you can find McAlvany.com, and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.