But let’s return to the question of where equity markets ought to be. Robert Shiller, the un-Ponzi-ish economist who produced the housing index reviewed in the previous chapter, has produced a wonderful tool for examining fundamental value in the equity markets. We’ll look at that in a moment, but first a brief refresher on equity valuation. When you buy stock in a company, you become a part-owner of the firm, entitled to a share of its profits. Some firms will return a large proportion of those profits to shareholders by way of dividends (or share buybacks). Other firms, particularly those needing capital to fund investment activity, will retain all or most of their profits. Because shareholders benefit either way—they get either dividends in their pockets today or a promise of expanded profits tomorrow—it is profits or earnings which form the basis of equity valuation. Naturally, a firm is worth substantially more than its current year profits, as it’ll expect to generate further profit and further dividends into the future. The million-dollar question, then, has to do with the correct ratio between stock price and company earnings. Is a firm worth five times its profit? Ten times? Twenty times? Forty?
That’s one critical question to answer, but there’s another almost equally important one. Company profits, after all, are by their nature unstable. They’ll be high during boom years, lower during lean ones. If you’re seeking a measure of fundamental valuation, the instability of annual company profits gives you an uncertain foundation on which to build. The second question, then, is: how can you remove the instability from company profits without losing the crucial insight they give you into company value?
Shiller’s work provides partial answers to both questions. His work involves two steps. The first is to generate a profit measure which averages a firm’s earnings over ten years. That ten-year period will include good years and bad ones, exceptional losses and exceptional profits. The average figure, unlike any annual one, supplies an unvarnished estimate of its true trading position. Instead of looking at a regular price/earnings ratio, Shiller therefore prefers to use a ‘cyclically adjusted price earnings’ (CAPE) ratio—the same fundamental concept, but adjusted to remove temporary noise.
His second step was, quite simply, to do the math. He calculated his CAPE ratio for the entire S&P index for every month of every year from 1881 to the present. His results are shown in figure 13.2.
Figure 13.2: Long-term value in the US equity market, 1881–2011
Source: Data available at www.irrationalexuberance.com.
Those results are wonderfully illuminating. From 1880 to 1940, the ratio averaged 14.9. From 1940 to 1979, the ratio also averaged 14.9. Then, over the three decades of Planet Ponzi, from 1980 to 2010, the ratio has averaged 21.2, an average 42% overvaluation against historic norms. Since January 2000 it has averaged 25.9, an overvaluation of 74%. Just to be clear, there is no reason why this ratio should tend to increase over time. On the contrary: it should provide the most fundamental conceivable measure of value, and the ratio’s stability over the century running from 1880 to 1980 should lay to rest any idea of long-term structural shift.
Such truths, of course, had little chance of taking hold on Planet Ponzi. In the last month of the twentieth century, the S&P 500 reached its highest ever CAPE ratio: a gravity-defying (and lunatic) ratio of 44.2. The extent of that bubble, its obvious absurdity, is clear from the graph above and is worth bearing in mind when you think about questions like ‘When will the S&P return to 1500?’ The question makes no more sense than trying to guess the number of African countries in the UN by watching the spin of a wheel. In fact, it makes considerably less sense. At least the spin of a wheel is random and unbiased. The level of 1500, on the other hand, was achieved when the equity market was in the grip of a once-in-a-century bubble. We might as well ask when the cheese mines on the moon will finally start to deliver. (The answer is probably around the time the government finally pays off its debt.)
In December 2010, the month in which Goldman was predicting a swift return to 1450, Shiller’s CAPE ratio stood at 22.4, almost 40% above its historic average. The S&P has fallen back a little since then, but it still stands at just shy of twenty times cyclically adjusted profits, which is still more than 20% above the long-term average. These reflections suggest that the ‘right’ level for the S&P is around 900, a level which would be regarded by most well-known commentators as a ludicrously pessimistic prediction.
I’m not about to volunteer a prediction of my own. Equity markets have such a remarkable gift for self-deceit that, for all I know, stock prices will race back to 1500 before reality finally catches up. What I would say, however, is just what I said in relation to the housing markets. Why should we expect equity prices to normalize when we are living in extraordinarily abnormal times? The period in recent economic history which bears the greatest resemblance to our own is the troubled decade of the 1970s. The 1970s saw oil shocks, inflation, weak growth, high unemployment, and the breakdown of global currency systems. Between the oil shock of 1973 and the start of recovery a decade later, Shiller’s CAPE ratio averaged just 10.2. If the S&P were to return to those bargain basement levels, it would need to fall by some 50% to around 600 or 700. If you think that a fall on that scale is impossible, you might want to take this book back to the place you bought it and ask for a refund. You can honestly say you’ve derived no benefit from it.
Meanwhile, if you’d be interested to know how you’d have done if you’d bought gold—the classic way to hedge against uncertainty and turmoil—you might want to study figure 13.3. You’ll study it with relish if (like me) you bought gold way back in the early years of the millennium. You’ll study it with mixed feelings if you didn’t. And, of course, if you’re the former British Chancellor of the Exchequer (and later Prime Minister) Gordon Brown, who sold around 400 tonnes of gold in 1999–2001, when the gold price was at a twenty-year low, you will probably review the chart with a little embarrassment. Equity returns over that period have been more or less flat. Gold is up over 500%.5
Figure 13.3: The price of gold, 2000–2011
Source: ThomsonReuters.
We’re just about done on equity markets. The simple truth, once again, is that the assets promised by a Ponzi scheme are worth vastly less than they purport to be. Your house is worth less than the Ponzi-sellers suggested. Your equities and pension are worth less too. They were always worth less. It’s just that for a long time there were enough Ponzi-ish buyers to keep the whole merry-go-round moving.
If you own any shares, either directly or via a pension fund, the thoughts contained in this chapter have probably done little to brighten your day. It wasn’t you who led us into this mess, but you seem to be among those of us asked to pay for it all. Yet I wouldn’t want these personal woes to conceal some of the policy implications that will follow from further falls in the equity market.
The most obvious issue is that people will feel poorer. People who feel poor tend to cut their spending. So firms will find it tougher to sell their goods. Profits will be under pressure, employees will be laid off. There’s a vicious circle building there, emphasis on the word ‘vicious.’
Secondly, of course, every decline in the equity market means a bigger hole in government and private pension funds. Those holes need to be filled. Corporations, which account honestly and openly for their pension funds, will need to dig into profits to find the necessary cash. Governments, which prefer to manipulate their figures, will simply find that their ever-swelling pool of commitments has just gotten deeper.
Thirdly, though, almost everything in Planet Ponzi traces back to the banks. If the banks were sound and strong, the economy could start to get going again. If the banks are little better than zombies, the economy is years from recovery. Japan’s economy is still on intravenous support twenty years on from its crisis. And though banks operate through the markets for credit rather than equity, the equity markets are crucial to them nevertheless. We’ll look closely at the financial sector i
n a future chapter, but for now you can just take it for granted that banks are hemmed in between their mountains of crappy assets and their oceans of excessive debt. Those mountains and those oceans aren’t about to disappear.
In some crisis situations, governments have simply relieved banks of their bad debts. In others, banks have gone to the equity markets and raised capital. Either way, their balance sheets become freed up and capable of working once again.
Today, however, neither option looks at all easy. Governments simply aren’t in a position to incur any more debts, to take on any more problems. Equally, however, declining equity markets make it fearsomely hard (and expensive) to seek capital. In September 2011, Bank of America announced a $5 billion investment by Warren Buffett. The market greeted the news with a surge of relief—which, however, faded rather quickly once the terms of the deal sank in. Buffett bought preferred stock, which paid an annual dividend of 6% (at a moment when the yield on ten-year Treasuries was just 2.02%). That stock will still be repayable even if the common equity sinks to zero. In addition, he was given no fewer than 700 million warrants, which gave him the right (but not the obligation) to acquire BoA stock at crisis levels. Those warrants are valid for an extraordinary ten years. At one point, following announcement of the transaction, Buffett’s paper profits amounted to almost $4 billion. The scale of those profits indicates Buffett’s genius—and BoA’s desperation. In ordinary times, the bank would have rejected Buffett’s offer as derisory or even exploitative. In the times we’re in now, it seized the moment so greedily that the deal was agreed within twenty-four hours of its having been proposed.6 As time goes by, and if equity markets stay under pressure, such deals will become ever harder to do. Banks will find it ever harder to prop up their balance sheets. The bad assets will remain frozen. The excessive debts will remain hard to clear. These aren’t cheering thoughts, I know, but I’m in the truth business not the cheerleading one. As I said before, I did try to warn you.
Sorry. Again.
14
Planet Ponzi comes to London
I started Part Two of this book by pointing out the improbably large profits recorded by the financial sector in the US. Those profits alone would provide compelling evidence of a giant financial sector Ponzi scheme. The huge destruction of value that has taken place since 2008 (and which still has some way to run) comprises the inevitable corollary of those bogus profits. When I moved to London from New York in late 1999 I was motivated in large part by a strong desire to get away from what I was coming to see as a financial system out of control.
Unfortunately, Planet Ponzi followed me here. In the UK, the growth in the financial sector has been equally wild—and even more recent. A 2011 study for the Bank of England looked at value added in the financial sector and value added in the economy at large. The respective average real growth rates since the start of World War One are as shown in table 14.1.
Table 14.1: Growth in UK value added since 1914 (average annual %)
Source: Stephen Burgess, ‘Measuring financial sector output and its contribution to UK GDP,’ Bank of England Quarterly Bulletin, Q3 2011.
For over half a century, the financial sector actually grew less fast than the economy as a whole. For the quarter-century after 1971, the financial sector grew a little faster than the economy as a whole, but not all that much. Given the growth in capital markets and the greater availability of consumer finance, you can argue that the financial sector was due a little catch-up time. But that’s all. The rapid acceleration of the financial sector from 1997 essentially represents the sudden turbo-boost of Planet Ponzi. In 1996, the UK boasted a sophisticated, competitive and fully functional financial system. It didn’t need to catch up any more. What happened in the period after 1996 was historically unprecedented—and inherently implausible.
And remember that value added is a measure of output, not profit. If you examine profits, rather than value added, Planet Ponzi’s London division appears even more distended. Between 1948 and 1978, financial intermediation (a subsection of the financial services sector) accounted for around 1.5% of profits in the total economy. By 2008, that ratio had risen tenfold to 15%. That’s such an extreme change as to be effectively impossible. Banks weren’t making those profits, they were simply pretending that they did: manipulating their books to show profits that weren’t, in truth, ever there. The financial bust of 2008–9 showed what happens when some of those wheels started to come off the wagon. The financial disasters we are starting to experience now show what happens when all the rest fall off too.1
If Britain copied America in the pell-mell Ponzification of its economy, London arguably exceeded New York in the grossness of its rewards for the new banking elite. A 2007 report in the Washington Post—that is, a report from that that distant pre-crash era before bankers started to become PR-savvy about moderating their displays of wealth—made it clear just how gross those rewards could be.
They call themselves ‘the haves and the have yachts’: rich London bankers and traders who drop tens of thousands of dollars for an evening of cocktails and hire ‘personal concierges’ to get their girlfriends dresses like those worn by movie stars.
Long a hub for the world’s ultra-rich, London has just welcomed an unprecedented number of newcomers into those ranks. Analysts here estimate that London’s financial stars were paid a total of $17 billion in annual bonuses in recent weeks—including more than 4,200 people who received bonuses of at least $2 million each, on top of salaries already sagging under the weight of zeros.2
So gross were those rewards that Mayor Bloomberg of New York commissioned a report which argued that the light touch of regulation in London was making the city more attractive than New York as a hub for international talent.3 Back in those happy pre-crash days, the waiting list for a custom-built Ferrari was three years. Auction houses were notching up records. Property prices were going crazy. Bankers were racking up cocktail bills of $36,000 in a single evening.4 And it’s all happening again today. There’s a little more discretion, perhaps, but the money is the same, and in some cases property prices in central London are actually higher than in New York.
These things corrode a society. When talking about the financial industry in the US, I complained about weak regulation and the absence of consequences for bankers. When talking about regulators, I listed just some of the big-money lawsuits and settlements which have riddled the US financial industry in recent years. My own view is that neither the fines nor the lawsuits have been proportional or sufficient: people needed to go to jail. Yet at least the US is awash with such lawsuits. Where are their equivalents in Britain? Why are banks and bankers being allowed to ruin the country and then left to continue their Ponzi-ish activities with impunity? In an ideal world, any business leader who inflicts multi-billion losses on ordinary taxpayers should be deemed to have committed a crime, the only appropriate punishment for which would involve staring out of a barred window for a decade or two. If that’s not possible, there should at least be a profound financial cost for the individuals involved. And if that’s not possible, their firms should be fined huge sums of money.
There’s nothing particularly vengeful in this logic. A kid who smashes a window once would expect to suffer. A kid who repeatedly smashes windows would ultimately expect to be locked up. Quite right too. Yet, in Britain, the firms and individuals which collectively caused damage amounting to tens and hundreds of billions of pounds have suffered almost not at all. That’s crazy. If it’s because the laws are too slack, the laws should be changed. If the laws are fine but are not being enforced, they should be enforced immediately. Indeed, lawsuits and criminal charges should be mounted even if the prosecution case is less than watertight. A judge can decide whether a charge is justified or not; the regulators should be seeking whatever penalties they can.
One of the striking differences between the financial cultures of London and New York is that, in America, at lea
st regulators attempt to act with rigor. Those attempts often fail, because of weak laws or insufficient resources, but the will is there. In London, the opposite is true. Regulators are underpaid and often come from an academic background. Because economic theory tends (idiotically) to suggest that the financial world offers the most perfect possible example of markets in action, those theorist-regulators are woefully unsuited to tackle the grim realities of the financial sector. The situation will only change when regulators are better paid, have more real-world experience, and show real willingness to press for huge fines and, where possible, jail terms. At the moment, there’s not the slightest hint of such a change.
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