Wall Street Journal - August 1, 2002
In Today's Paper COMMENTARY Dow 36000 Revisited
By JAMES K. GLASSMAN and KEVIN A. HASSETT
When our book, "Dow 36,000," was published in September 1999, the Dow Jones Industrial Average stood at 10318. The Dow closed yesterday at 8736. What went wrong? Actually, nothing. Despite its flamboyant title, "Dow 36,000" was a book of sober explanation, not of wild prognostication. We calculated that 36000 was the point at which the 30 stocks that comprise the Dow Industrials would be fully valued, and we warned that "it is impossible to predict how long it will take."
But picking target prices was not what our book was about -- nor is it what investing is about. The book had three themes -- and they apply even more forcefully today than they did three years ago.
Long Term
First, investors who can put away money for the long term (at least five years and, better, 10 or more) should invest mainly in stocks and stock mutual funds rather than in bonds.
Second, while stocks are risky in the short term, investors should buy and hold, and not try to time the market. Stocks will not go straight up, we warned. But bear markets are unpredictable, and trying to guess the ups and downs of stocks is a fool's errand.
Third, stocks are undervalued relative to their long-run trend. We don't guarantee that the price of Tootsie Roll or Johnson & Johnson -- two of the 15 stocks we highlighted in the book -- will not decline over the next month or year. But based on our analysis of return and risk, a diversified portfolio of shares in good businesses is an excellent long-term investment.
The theory that shaped our book comes from some powerful data. Ibbotson Associates, the Chicago research firm, found that from 1926 to 2001, the average annual return, after inflation, of the large-cap stocks of the Standard & Poor's 500 was 7.6%, compared with just 2.2% for Treasury bonds. In other words, stocks return more than three times as much as bonds. Thanks to compounding, after 30 years, an investment of $10,000 in stocks will rise, on average, to more than $90,000, while a similar investment in bonds will rise to less than $20,000.
Higher returns are normally correlated with higher risk, but work by Jeremy Siegel of the Wharton School and others has found that if stocks are held over long periods, risk declines dramatically. Mr. Siegel looked at nearly 200 years, and found that during their worst 20-year period ever, stocks rose more than 20%. But for bonds, the worst 20 years produced a loss of 60%. Mr. Siegel concluded that "the safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds."
How can bonds be risky? Nearly all bonds are exposed to inflation, which erodes principal. In an inflationary time, businesses can respond by raising prices, so stocks tend to suffer less than bonds. Stocks also increase their earnings fairly consistently from year to year, while bonds pay a fixed rate of interest, which is practically guaranteed to decline in purchasing power with inflation. Sure, there will be recessions and accompanying bad profit news from time to time. But in the end, the growing economy will pull firms' profits, and share prices, back upward.
For students of modern finance, the real mystery is how to reconcile these two facts: Over the long term, stocks return much more than bonds, but stocks are no more risky than bonds. This paradox is called the "equity premium puzzle" -- the premium being the extra return that stocks provide over benchmark bonds. For decades, economists were at a loss to explain the puzzle. A 1997 paper by Mr. Siegel and Richard Thaler of the University of Chicago concluded that the answer was "myopic risk aversion." In other words, investors are so frightened of short-term losses in the stock market that they can't see beyond their noses.
We argued, to the contrary, that investors were finally solving the equity premium puzzle. Starting about 20 years ago, irrational risk aversion to stocks began to decline, thanks mainly to the spread of new research, better financial education, the rise of defined-contribution retirement plans, and increased world stability.
On Aug. 13, 1982, the Dow closed at 777. Even today, after the second-worst bear market of the post-World War II era, it has risen 11-fold without counting dividends. For the 20 years ending Dec. 31, 2001, large-cap stocks returned an annual average of 15.2%. These valuations are a rational response to the truth about stocks -- that they provide high returns at risk levels about equal to bonds. Another way to say this is that investors have been bidding down the equity risk premium -- the extra return that they demanded in the past because they believed (irrationally) that stocks were riskier than Treasuries.
But has something changed since our book came out? Certainly, "Dow 36,000" has been put to a severe test. The U.S. has been through a lot in three years: the impeachment of a president, a disputed election for the first time in a century, the first attack on the U.S. mainland since the War of 1812, the first recession in 10 years, corporate scandals and a zealous political response that could create unintended consequences. What's remarkable is that, in spite of this, price/earnings ratios have remained higher than historic averages -- exactly what we expected.
But what about this 36000 business? If the Dow were there today, one could say that the upward pressure from the demystification of stock ownership had subsided. Since it is not, and there is no convincing evidence that the earnings history of the past 200 years is suddenly irrelevant, stocks are still a very good buy. The best way to partake in a rising market is through buying and holding diversified stock portfolios. But some people are impatient.
If anything has changed since our book appeared, it is increasing respect for the debunked strategy of market timing. Robert Shiller, the economist whose book "Irrational Exuberance" appeared in 2000, has been celebrated as a Timer Saint. But Mr. Shiller was bearish while the market was setting new records. His theory was laid out with fanfare in 1996, when, with the Dow at 5427, he said his data "implied an expected decline in the real Standard and Poor Index over the next 10 years of 38.07 percent." But six years later, despite a long bear market, the Dow is up about 60%; the S&P, 40%.
Critics
Our noisiest critics, Paul Krugman in the New York Times and various Slate.com scribblers, willfully distort our arguments. And no wonder. If Americans continue to embrace long-term stock investing, the role of the state as dispenser of retirement benefits will shrink or disappear. And the "war" between capital and labor will be over. Unfortunately, many politicians and journalists have a vested interest in spreading fear and chasing people out of stocks -- even though stock investing is the most reliable route to accumulating wealth.
No, the Dow is not at 36000 right now, and we didn't say it would be. But there is little doubt that, as long as the U.S. economy remains sound, stock prices will rise to 36000 and beyond.
Messrs. Glassman and Hassett are scholars at the American Enterprise Institute. Mr. Glassman's latest book is "The Secret Code of the Superior Investor" (Crown); Mr. Hassett's, just published this week, is "Bubbleology" (Crown).