TCS Daily

DOW 36,000 Lives!

By James K. Glassman - December 6, 2004 12:00 AM

Five years ago, economist Kevin Hassett and I wrote a book called Dow 36,000. Maybe you have heard of it. The book made the bestseller lists and won accolades from, among others, the current chairman of the president's Council of Economic Advisors. For some, however, the book became an object of derision because -- just in case you haven't noticed -- the Dow hasn't actually risen to 36,000 yet.

The Risk Anomaly

This is a good time to review the case we made in the book -- a case in which Kevin and I still strongly believe. Dow 36,000 was not a prognostication. Sure, the Dow will hit 36,000 and probably, eventually, 360,000. But I don't know exactly when, and I don't believe investing is a game of forecasting what's going to happen tomorrow or next year.

Instead, the book tried to explain how stocks are (and should be) valued by investors. Our conclusion was blunt: Stocks are cheap. They had produced so much cash in the past and were likely to produce so much cash in the future, that their prices deserved to be considerably higher.

We argued that investors, starting roughly in August 1982, when the Dow stood at just 777, had begun to wake up to the true worth of stocks and would bid prices considerably higher, as they should. Our analysis showed that stocks would be fairly priced when the Dow Jones industrial average hit roughly 36,000 (at the time we published our initial article in the Wall Street Journal explaining our theory, on March 30, 1998, it was 8,782; when our book came out, it was 10,730).

How long would all this take? "It is impossible to predict," we wrote. Stocks never go straight up. There are detours. But Kevin and I believed then (and continue to believe now) that a dispassionate analysis leads to only one result: Stocks are a far better place than bonds and cash to put the vast majority of your money for the long run. That was the unequivocal message of the book.

Let me walk you through our reasoning....

Over the long run, a diversified portfolio of stocks has returned a great deal more than a similar portfolio of bonds. After inflation, Standard & Poor's 500-stock index, a good proxy for the market as a whole, produced between 1926 and 2003 an annualized return, including dividends, of 7.4%; long-term U.S. Treasury bonds, 2.4%. That's a gigantic difference. If history is a guide, $10,000 invested in stocks will become $20,000, in terms of today's purchasing power (which is what counts), in about 10 years; bonds, by contrast, will require 30 years.

A basic rule in finance is that if an asset produces a high return, it carries a high risk. When you bet on a big favorite at the race track and the horse wins, the profit on your investment will be small, say, $3 on a $2 bet. But if a long-shot wins, your returns can be $100 for every $2. But, with stocks, economists long ago discovered an anomaly. Stocks return more than bonds, but, in the long term, stocks don't carry much more risk. When you invest in a Treasury bond, it's a virtual certainty that the U.S. government will return your principal at maturity, but, along the way, the purchasing power of that money will decline because of inflation, and the interest checks might not make up for the loss.

Jeremy Siegel, an economist at the Wharton School of the University of Pennsylvania, looked at vast amounts of data on U.S. stocks and bonds going back to 1802. He wrote, in his groundbreaking 1995 book, Stocks for the Long Run, that "the safest long-term investment has clearly been stocks and not bonds." He found, for example, that there has never been a period of 17 years or longer in history in which stocks did not produce a positive return after inflation. Bonds are another story entirely. Looking at every overlapping 20-year period (that is, 1802-21, 1803-22, up to the present), Siegel discovered that the worst period for stocks produced a total return of more than 20% after inflation. Bonds? Minus 60%!

Even in the short and medium term, bonds have proven quite risky. Long-term Treasuries suffered losses in three of the past ten years (the same record as stocks), and research by Ibbotson Associates has found that for 10-year periods between 1926 and 2003, a portfolio composed 90% of stocks and 10% of long-term Treasury bonds has never lost money, while 100% bond portfolio has.

Siegel's work highlighted what economists call the "equity premium puzzle." Stocks return more than bonds (that is, a premium), but stocks are no more risky over the long term. What's the explanation?

Academics have fretted over the question for years. In Dow 36,000, we offered a possible answer: Investors were irrationally fearful of stocks. They saw the wild volatility of stocks in the short term and, with faulty logic, extrapolated that risk out into the long term. It was like saying that because it had rained for three days straight, it would rain the whole year. In fact, stock investing gets less and less risky the longer you hold on. Investors' irrational fears kept prices low.

Shaking Off Fear

But in the early 1980s, something changed. Investors began to wake up to the true risk of stocks and began bidding up prices. Kevin and I said that this process was "perfectly rational" and was likely continue. We warned that "a cyclical downturn, after nearly two decades of growth, could shock investors who have become used to good times" and that "political unrest around the world could boost the risk premium," especially since "aggressive, unpredictable nations like Iraq and Iran now have greater access to weapons of mass destruction." But we believed such setbacks would be temporary.

Why did investors become properly less risk-averse starting in the 1980s? First, education. They learned the truth about stocks from the work of economists like Siegel, from responsible financial journalists and from mutual fund companies, which did a good job educating their clients. Second, new institutions. Investors were encouraged by the advent of tax-deferred retirement accounts -- IRAs and 401(k) plans -- to keep their money at work for the long term. Suddenly, the idea of jumping in and out the market, with a short-term perspective, became unattractive.

Because investors were not demanding such high returns from stocks, prices (and price-to-earnings ratios) rose. Americans no longer required a gigantic equity risk premium to get into the market.

Using an established financial formula, we calculated that, if the risk premium fell to its proper level -- around the same as bonds -- the stock market, as represented by the Dow, would go to about 36,000.

While Dow 36,000 was often criticized for puffing up the tech bubble, the stocks we highlighted in our book were mainly boring, value-oriented securities. Our reasoning was that, if the entire market is cheap for long-term investors, why take the extra risk of speculating in a go-go firm without any earnings?

The Keepers

In the book, we cited 15 specific stocks as good investments. Our preference was for businesses that had a strong, defensible market niche and a history of generating lots of cash. Kevin and I have monitored an imaginary, equally weighted portfolio of these 15 stocks, and throughout the past five years, it has consistently beaten the S&P 500 benchmark. From October 29, 1999, when Dow 36,000 was published, through September 30 of this year, the portfolio rose a total of 17%, compared with a loss of 12% for the S&P 500.

The list includes such superb companies as Cintas, which rents and sells work uniforms; Johnson & Johnson, health products; Wells Fargo, finance; Tootsie Roll Industries, candy; and Gillette, shaving, batteries and toothbrushes. There were only two tech companies, Microsoft and Cisco; their prices have declined in the past five years, of course, but I still like them. In fact, there is not a single stock among the 15 that I would drop from the portfolio.

A good example of a Dow 36,000 stock is RPM International, which makes protective coatings like Rust-Oleum. It's a boring business, but very profitable. "Has the market rewarded RPM for consistent growth? Not nearly enough," we wrote in 1999. Since then, including dividends, the stock has returned 78% -- our second-biggest winner after Landauer, a maker of radiation detectors. RPM still appears a bargain, with a dividend yield of 3.2% and a price-to-earnings ratio of 14.

From 777 in August 1982, the Dow rose to 5117 in 1995 and 10,000-plus in 1999. There, however, it has stalled. Why? Mainly because earnings fell, thanks to the tech bubble, the recession, the attacks of 9/11 and the overzealous political reaction to corporate accounting scandals. Again, I think this setback is temporary. The fact that risk premiums have stayed relatively low and P/E ratios have been robust is evidence that the Dow 36,000 theory remains intact. As the economy continues its recovery, stock prices should get back on their upward track.

Do I have any regrets about the book? Well, yes. The title. Kevin, a distinguished economist who had served with the Federal Reserve, suggested that we should have called it A Treatise on the Declining Equity Risk Premium. Maybe something in between.

A version of this article appeared in Kiplinger's


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