Valuing Wall Street
Protecting Wealth in Turbulent Markets

Andrew Smithers & Stephen Wright

Originally written in 1999 to warn investors to get out of the stock market totally because prices were way too high compared to the underlying securities’ net worth, Andrew Smithers and Stephen Wright were proven correct during the next three years as prices spiraled downward. The authors’ measuring stick was “q,” the Nobel prize-winning economist James Tobin’s 1969 invention to value stocks. It is the simple formula of stock price divided by corporate net worth (replacement cost). Essentially, it works over time like an oscillator. They take considerable amount of space to prove it is a more reliable indicator of stock market value than dividends or P/E. And it foretold harrowing events when it was computed and published in early 2000 with NASDAQ at 5000. Now the bigger question: So, what use is it going forward from today?

Their method of argument is to chart 100 years of historical stock prices against historical q, then create “normal,” “overvalued,” and “undervalued” zones with which you should make investment decisions. A reversion to the mean (in this case downward) is what drives their prediction for an extended period of stock market “under performance” during the foreseeable future. Stocks were and still are overvalued, they say, and therefore should be avoided until values return to more “normal” levels.

By the end of 1999, there were no shortages of bears calling for a crash of monstrous proportions based on any number of indicators, P/E and dividend yield included. As it turned out, all were correct. But as with all “fundamental” analysis, timing was lacking. Some bears had prowled the investment landscape for most of the decade and had come up empty until the turning of the millennium. Smithers and Wright, however, hit the market’s nail on the head.

Early on in their presentation, they admit that q is not very important most of the time because most of the time markets are not obviously overvalued or undervalued. And the authors do get sidetracked on whether you should pick stocks individually or go with index funds (they give 3 reasons why individual stock picking doesn’t work). They do come through loud and clear that stocks are for buying AND selling, and although stocks are good for the long term, when they get too expensive, they should be avoided like the plague.

The worth of the work is the powerful argument, intelligently presented and documented, as to why stock prices were sure to fall at the time the work was published. And fall they did. For awhile, anyway.

Now, the question for you is not whether or not their data and logic make sense; it’s whether you want to base your investment decisions on whether other people think it makes sense. And whether we like it or not, since there is no universal arbiter of stock market value except other people’s money, investing comes down to Keynes’ beauty contest (General Theory pages 154 - 156). If you want to be on the winning side, you don’t vote for who you think is the prettiest; you vote for who you think others will consider the prettiest. Translated here, it means you should value stocks the way stocks have been valued over the past century by previous investors. The idea of q is based on what other people throughout history eventually decided were the limits of value. And yes, q says the market is still dangerously overvalued and very might well continue it's way downward.. But as the past 14 months and 3000 Dow points (40% gain) prove, a lot of money can be left laying on the table by simply abandoning the investment environment completely until stocks once again become “cheap.”  Another Keynesism: “The market can stay irrational (overvalued/undervalued) longer than you can stay solvent.”

An update to the situation can be found at their website: http://www.valuingwallstreet.com/updates.shtml