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Leithner Letter No. 27
26 March 2002

Markets do work. They work so obviously well that our scientific curiosity is aroused to seek understanding of the counter-intuitive phenomenon of this success. What we have argued here is that the achievement of a deepened appreciation for the nature and implications of subjectivism ... can here, as elsewhere, offer a most illuminating contribution towards enhanced economic understanding.

Israel Kirzner
Subjectivism, Freedom and Economic Law
Inaugural Ludwig Lachmann Memorial Lecture
University of the Witwatersrand
19 August 1991

Austriae Est Imperare Orbi Universo

“As the twentieth century draws to a close,” wrote Israel Kirzner in The Driving Force of the Market: Essays in Austrian Economics (Routledge, 2000, ISBN: 0415228239), “ the Austrian tradition in economics has, it appears, begun to attract a significantly increased volume of attention. Long thought to be a relic of a once-prominent school that had been swept from the professional stage soon after the end of the first third of the century, Austrian economics has recently enjoyed something of a renaissance.”

“Renaissance” is far too strong a word to describe the profile of Austrian School economics among, and the influence of its principles and methods upon, financial market participants. At the same time, however (perhaps because its insights are as considerable as they are applicable), its profile and influence are not completely negligible. James Grant, author of The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust and Speculation (Random House ppbk. ed., 1998, ISBN: 0812929918) and other books, Forbes columnist and editor of Grant’s Interest Rate Observer, is the most eminent of the very few market participants who view economic activity, financial markets and investment decisions through Austrian lenses.

Mr Grant justified this juxtaposition of framework and application in the Austrian Economics Newsletter (Vol. 16, No. 4, Winter 1996). “What we do is look for extremes in markets: very undervalued or very overvalued. Austrian theory has certainly given us an edge. When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and nightstands. At least you can begin to visualise in the dark, which is where we all work. The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while. So I’d like to put in a plug, not just for the theory itself – as elegant as it is – but for the application of the theory for calling the turn of cycles in the workaday world.”

Mr Grant concluded his interview with the observation that “in a false prosperity, good economic ideas are marginalised [elsewhere he has stated that the more intense the craze, the deeper the intellect that succumbs to it]. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe we’ll find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”

For the most practical and entrepreneurial of reasons, then, the axioms, methods and conclusions of Austrian School economists matter. They matter because (as, for example, during the booms of the 1920s and 1960s, the busts of the 1930s and 1970s and busts-and-booms of the 1980s and 1990s) they have helped to explain crucial financial and economic developments that have been difficult to explain from a contemporary mainstream point of view. It is significant, then, that an Austrian inspired, accessible and engaging example of the application of theory to present reality in financial markets was held on 18-19 January 2002. In addition to presenters from academic institutions, Boom, Bust, and the Future: A Private Retreat with Austrian Economists included talks from Sean Corrigan (Capital Insight), Coping in a Bear Market; Gene Epstein (Barron’s); and Frank Shostak (Mann Financial).

Hayek Versus Keynes Redux?

Friedrich von Hayek, the twentieth century’s second most influential Austrian School economist (and who, like the most important, Ludwig von Mises, suffered severe professional ostracism during much of his career), was awarded the Nobel Prize in Economic Science – the pinnacle of orthodox prestige – in 1974. The Seventies, it will be recalled, was a decade during which financial markets slowly, erratically and painfully purged the excesses of the “Go-Go” years of the late 1960s and early 1970s. It was also a decade when “stagflation” (warned by Austrians but dismissed as a theoretical impossibility by orthodox Keynesians) stalked the land. It was therefore a time of disquiet and introspection within the economics profession.

A generation later, parallels may be beginning to reappear. During the past two years financial markets have begun to purge the vast “malinvestments” accumulated during the boom. Yet this process (i.e., bust) has been tentative and incomplete; further, over the past year governments, central banks and market participants – cheered all the while by most economists, journalists and market participants – have moved heaven and earth in order to abort the purging and maintain and indeed extend the boom’s misallocations and excesses. Accordingly, individuals acting in markets and governments intervening in markets have generated sets of seemingly incompatible reactions; and a few mainstream observers (much more in The Financial Times than The Wall Street Journal) have puzzled and worried about the simultaneous appearance of these reactions.

On the one hand there are weaknesses and imbalances in the structure of production. These include artificially-low prices of credit and consequent record indebtedness, minuscule savings and chronic overcapacity; heavy and growing reliance upon credit and foreigners’ savings; high and rising government expenditure; an unprecedented binge of private consumption and a steep and sustained drop in the quality of corporate credit; and obfuscation of corporate earnings and meagre profit margins. At the same time, however, there are also ubiquitously sunny and relentlessly repeated expectations about the future – and high and rising (frequently to unprecedented levels) price multiples in equity and real estate markets.

In Australia, for example, the Reserve Bank noted in its most recent Statement on Monetary Policy (11 February 2002) that “share valuations relative to the latest profits (i.e., P/E ratios) have risen again in recent months, taking them further above their long-run average. The current aggregate P/E ratio for the Australian market is 26, up from 23 in October. The long-run average is about 15. The ratio is being supported by bullish profit expectations in the period ahead; in the current year, analysts expect industrial companies’ profits to increase by 14 per cent, a very strong rate of increase.”

In America the picture is even more foreboding. Using earnings compiled under Generally Accepted Accounting Principles (GAAP), the P/E ratio for the S&P 500 has surpassed 40. This, to put it delicately, is somewhat higher than its historical average of 14. Indeed, the average price paid voluntarily by “investors” for earnings appears to be higher now than it has been at any other time during the past century. Using projections of earnings (which assume that notoriously over-optimistic analysts and their implied projected rate of earnings growth, 36%, will be within a bull’s roar of the actual figure) the American multiple is a hefty 25 times. Rounding out the dour picture, earnings relative to the size of the economy have fallen to their lowest level since the funk of the 1970s; and real profitability may have regressed to levels last seen during the late 1930s.

In this broad context, where an obstinate reality is generating unease among a small and reprobate minority of market participants, it is perhaps more than a co-incidence that Austrian principles, which from the 1870s until the 1930s were regarded as orthodox, are beginning to receive a respectful hearing within quarters that for decades have either ignored or dismissed them. (On several occasions similar scientific discoveries have been made simultaneously and independently in different countries. Solutions to the “paradox of value,” for example, a paradox from the point of view of Ricardian and other classical economists, appeared independently and in three distinct forms in 1871. In that year, modern – i.e., “marginalist” or “neo-classical” – economics was born. Honours for its birth can be apportioned among the first neo-classicists: William Stanley Jevons at Cambridge, Leon Walras at Lausanne and Carl Menger at Vienna. Menger founded the modern Austrian School).

Two documents, each a must-read (as well as an enjoyable read) for value investors, are most notable in this respect. The first, The Austrian Theory of Business Cycles: Old Lessons for Modern Economic Policy? was published as a Working Paper by the International Monetary Fund in January 2002. The second, a speech entitled Economic Concerns, was delivered by former U.S. Congressman Ron Paul (Republican-Texas) on 7 February. Both emphasise a quintessentially “Austrian” point: aggressive fiscal and monetary policies do little good and (because they postpone necessary adjustments to the structure of production, making the eventual correction more prolonged and severe) potentially much harm.

Further, although they are not Austrian-inspired the Double-Dip Alert issued on 7 January and The Smoking Gun issued on 27 February by Stephen Roach of Morgan Stanley are consistent, by and large, with what Austrian theory tells us attempts to delay and deny busts will produce. So is Paul Kasriel’s report dated 22 February and entitled The “New Economy” Leverage Chickens Are Coming Home To Roost.

Robert Gottliebsen (The Australian 5 March), drawing upon Mr Roach, concludes “the case for the double-dip remains quite compelling. When the headlines scream ‘Recession Is Over!’ it’s a sign of a false dawn. Someone is going to be wrong big time.” It is entirely possible that Leithner & Co. is wrong. If so, then it will commit a modest sin of omission; it will, in other words, forego whatever modest results can be generated by the purchase of quality businesses at today’s high prices.

In contrast, if the increasingly confident vast majority of market participants are wrong, then they will commit a grievous sin of commission; i.e., they will suffer the much more severe and long-lived consequences generated by the purchase of businesses (whatever their quality) at inflated prices. If so, then they will belatedly realise (as Benjamin Graham admonished in the 1934 edition of Security Analysis) “that this concept of an indefinitely favourable future is dangerous, even if it is true; because even if it is true you can easily overvalue the security, since you make it worth anything you want it to be worth. Beyond this, it is particularly dangerous too, because sometimes your ideas of the future turn out to be wrong. Then you have paid an awful lot for a future that isn’t there. Your position then is pretty bad.” In 1998, Warren Buffett described what happens under these circumstances: “investors making purchases in an overheated market need to recognise that it may often take an extended period for the value of even an outstanding company to catch up with what they paid.” The hundreds of thousands of Australians who purchased Telstra II Instalment Receipts in 1999 know precisely what he means.

When Mr Market is in an ebullient mood, as he is at the moment, it thus seems to me that a premium attaches to scepticism, caution and independent thinking from first principles. The conclusion of Mr Paul’s speech quotes from Horace (“adversity has the effect of eliciting talents which in times of prosperity would have lain dormant”) and Leonard Read (“in every society there are persons who have the intelligence to figure out the requirements of liberty and the character to walk in its ways. This is a scattered fellowship of individuals – mostly unknown to you or me – bound together by a love of ideas and a hunger to know the plain truth of things”). These thoughts unintentionally but nonetheless aptly summarise the character and relevance to businessmen and investors of Austrian School scholars such as Mises, Hayek and Murray Rothbard.

All Roads Lead to New York

These attributes also epitomise the twentieth century’s most outstanding value investors such as Benjamin Graham, Warren Buffett, Walter Schloss and Thomas Knapp. It is interesting that at one time or another, and particularly during the 1940s and 1950s, disproportionate numbers of Grahamite value investors and Misesian economists worked, taught and studied in New York City. Most notably, until 1956 Mr Graham commuted between his home in 91st Street and Central Park West, Graham-Newman Corp. and his securities analysis class at Columbia University; and Prof Mises trekked from his flat in West End Avenue to the National Association of Manufacturers, New York Public Library, Foundation for Economic Education in Irvington-on-Hudson and (beginning in 1949) his economics seminar at NYU’s Graduate School of Business.

Although Murray Rothbard and Howard H. Buffett (broker, Congressman and father of Warren Buffett) corresponded throughout the 1950s, no publicly-available information suggests that Grahamite value investors and Misesian economists crossed paths and exchanged ideas. Had they met or corresponded, it is reasonable to suppose that they would have disagreed about a range of economic and political matters. It is doubtful, for example, that Graham’s advocacy of a commodity-based reserve currency would have commanded Mises’ assent; and Graham’s support of the Employment Act of 1946 would have been even less likely to impress. Yet on one fundamental point adherents to these two schools of thought would surely have agreed emphatically (and disagreed with most of their counterparts in Wall Street and academia). The price and the value of a financial asset are distinct things that tend eventually towards one another; but at any given moment they may well differ from one another and from one moment to the next may diverge rather than converge.

Show Me the Money! Value Investing and Dividends

This point is characteristically “Austrian.” So too is Graham’s thesis (in the 1934 edition of Security Analysis) that “the typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself.” But as Grahamites’ consistently profitable exploitation of value, price and time preference demonstrates, these points are hardly exclusively Austrian.

This underlying compatibility of views concludes that the assumptions and reasoning underlying established (in America) and emerging (in Australia) views about dividends do not emerge unscathed from critical scrutiny. Indeed, a case can be made that a diametrically opposite (i.e., Grahamite) view and appreciation of dividends may be closer to the mark. Companies, in other words, should retain and re-invest only those earnings which (using suitably cautious and sometimes dour assumptions) are very likely to generate demonstrably better results than can reasonably be expected if invested elsewhere by shareholders. Accordingly, if a company cannot demonstrate a superior ability to re-invest capital, either at a given point in time or over intervals of time, then it should return capital to its owners.

Starting from first principles, the series reasons towards several counter-intuitive conclusions. First, companies returning a large percentage of their earnings to shareholders as dividends will tend to achieve better operating results than those which retain (and hence often squander) earnings. Second, although there are notable exceptions – Berkshire Hathaway comes immediately to mind – shareholders’ wealth will derive disproportionately from such companies (and only incidentally from companies that retain a large percentage of their earnings). Finally, dividends and their re-investment provide the bedrock of an investor’s accumulation of wealth.

Given these conclusions, the last word goes to Benjamin Graham. “Basically price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Chris Leithner


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