. 2022. Andrew Smithers. Oxford University Press.
Judging by the behavior of the stock market, we live in difficult times for mainstream finance. Under the hypothesis that markets are efficient and investors are rational, neoclassical theory addresses the issue of economic bubbles and the relationships between stock returns and the opposite macro variables. However, after a decade of unconventional monetary policies, massive budget deficits and the return of inflation, the behavior of stock markets in recent times has been downright confusing, leaving most practitioners struggling to grasp the vagaries of stock markets. Today, the neoclassical workhorse requires an intensive examination of its assumptions (and conclusions). More than ever, we urgently need a comprehensive alternative.
Andrew Smithers seeks to fill this gap together with his latest book, which offers an alternate theory of how stock markets work. The book builds on a small and obscure tradition of growth models, Developed by Nicholas Kaldor greater than 50 years ago, which handled distribution issues in a Harrod-Domar type scaffolding. One of those iterations showed that in a closed economy with two sectors (households and businesses) and no government activity, stock valuation multiples are determined exclusively by macroeconomic variables – primarily the balance between total savings and total investment. Kaldor’s framework was quite novel in that stock market valuations fit seamlessly into macroeconomics and were liable for the balance between savings and investment, in contrast to the Keynesian and neoclassical traditions wherein the equilibrium process occurs through quantities (unemployment rate) and costs, respectively.
Although Kaldor never intended his model to be a framework for understanding stock markets, Smithers draws on this structure to formulate a theoretical alternative. Smithers can be very “Kaldorian” in the way in which he constructs his framework for 2 reasons. Firstly, he is especially fascinated with the long-term behavior of the system or stationary solutions. Second, he bases his assumptions on several “stylized facts” in regards to the stock market. In particular, 4 variables have historically been reduced to a relentless, and any model should take these under consideration:
- Real stock returns
- The share of profits (after depreciation) and labor in total production
- The ratio of interest payments to profits
- The ratio of the worth of fixed capital to production (a Leontief-type production function)
The first stylized situation has particular significance for the mechanics of the general model. For Smithers, stock returns are (real) average-oriented and are inclined to be constant at around 6.7% per yr over the long run. According to the creator, this long-term constant arises from the chance aversion of capital owners reasonably than from the marginal productivity of capital or the consumption decisions of households. As we are going to see, these dynamics have profound implications for determining returns in other asset classes.
This novelty shouldn’t be the just one inside Smithers. His model deviates from the neoclassical framework in a minimum of three other ways. First, at the guts of Smithers’ proposal is the corporation as a separate entity from households. This distinction is vital because corporations behave significantly in another way than households. In corporations, decisions about investments, dividend policies, stock issuance, and leverage are made by managers whose motivation (keeping their jobs) differs significantly from that of the neoclassical utility-maximizing consumer. In Smithers’ framework, corporations don’t seek to maximise profits because in the event that they did, they might vary their investments in line with the associated fee of capital – as in Investment models based on the Q ratio. Random empirical observations seem to substantiate this point – as Smithers explains: “A rise in the stock market would be limited by a growing flood of new issues as stock prices rise, and their declines would be limited by their absence in weak markets.” Minor fluctuations within the stock market appear to be a natural consequence.”
In this context, any model also needs to take note of the contrasting behavior of listed and unlisted corporations. According to Smithers, one consequence of listing more corporations is that the company sector as a complete becomes less attentive to the associated fee of equity capital (Q models). This dynamic arises because management teams’ behavior when making investment decisions is constrained by the potential of a hostile takeover and job losses. In other words, “management cares about the price of its companies’ stocks, not the overall level of the stock market.” A macroeconomic implication of the dearth of connection between valuations and investments is that the stock market plays a crucial role in economic growth by it prevents fluctuations in the associated fee of capital from affecting investment levels – and ultimately production.
Second, the returns between asset classes are derived independently and aren’t co-determined. Smithers’ framework assumes that an organization’s balance sheet consists of short-term debt (which could be viewed as highly liquid instruments), long-term bonds, and equity. The returns of those instruments are derived independently and their influence on the system occurs through different mechanisms. Savings and investments are equated by movements within the short-term rate of interest. Corporate leverage is aligned with the preferences of economic asset owners through fluctuations in bond yields. Finally, as explained above, stock returns are stationary. Consequently, the difference in returns between asset classes – ie the equity risk premium – it shouldn’t be a reversion to the mean, there was no stable average previously and its level cannot provide details about future returns of stocks or bonds. For Smithers, the equity risk premium is a residual value and has little correlation what role it plays in mainstream finance.
Finally, for Smithers, the associated fee of capital varies with leverage on the macroeconomic level. This conclusion is diametrically against the 1958 Miller-Modigliani (M&M) theorem which states this The value of an organization is independent of its capital structure. According to M&M, an organization’s risk increases as its financial leverage increases, so the required return on equity also increases, while the entire cost of capital stays unchanged because debt is cheaper than equity. As discussed earlier, Smithers argues that long-term stock returns remained stationary, but at the identical time U.S. corporate debt increased dramatically within the post-World War II period. Such a change in the general capital structure must have had an impact on the associated fee of equity, but this shouldn’t be the case.
As the book progresses, readers will discover other vital and interesting insights. Smithers, for instance, postulates a connection between the typical lifespan of an economy’s capital stock and the yield curve. Since the typical lifespan of capital stock is about 20 years (corporate investments are typically shorter than investments in housing or public sector infrastructure), corporations have an incentive to borrow for this era (or shorter) with a view to “ To reduce risks due to fluctuations, profits and inflation rise, but there is no incentive to pay more for longer debt. So the yield curve is steep from one year to ten years, then flattens out and is flat beyond twenty years.”
The scope is ambitious and the tone quite provocative; Both practitioners and academics will find this book relevant and stimulating. However, some minor facets might have been improved.
First, the writing style is occasionally too succinct and provides little background knowledge – particularly for financial practitioners less accustomed to macroeconomics and growth theory. Readers might more easily understand the fundamental assumptions of the model if the complete apparatus had been formalized mathematically. In particular a Inventory flow modeling approach, which closely tracks all stocks and flows of the economy, would have enabled a scientific study of the dynamics and nature of the system’s long-term solutions. In this context, many chapters leave the reader wondering how certain facets (e.g. inventory, trade credit) fit into Smithers’ overall framework and why they’re relevant. Further references to other theoretical approaches would have been helpful. Although Smithers devotes Chapter 30 to comparing his own framework with other approaches, the reader would profit from a more detailed discussion of the strengths and weaknesses of every approach.
Second, the evidence Smithers provides to support his assumptions appears to be insufficient in some cases. For example, his claim that stock returns (in real terms) converge across countries in the long term is predicated more on theoretical principles (“[t]“He intended that the actual return on net assets for companies and shareholders would be the same worldwide for two reasons: arbitrage and our common humanity,” reasonably than based on empirical data. Several countries (notably the United Kingdom, the United States and the Nordic countries) have outperformed their competitors during the last century.
Finally, although the book is primarily concerned with stationary situations wherein the difference process is complete, Smithers sometimes seems to attract conclusions about short-term behavior from these equilibrium positions. For example, in several passages he discusses the impact of a short-term change in household portfolio behavior while considering long-term outcomes (that stock returns remain stationary in the long term).
However, these minor criticisms mustn’t deter readers from benefiting from the book’s novel approach. Policymakers, academics and practitioners will all find useful insights and a brand new perspective on the connection between macroeconomics and stock markets. Again, there couldn’t be a greater time to take an alternate approach.
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