To all - text of 3/17/99 WSJ piece on Dow Jones 36,000 (soon) by James Glassman and Kevin Hassett.
March 17, 1999
Commentary
Stock Prices Are
Still Far Too Low
By James K. Glassman and Kevin A. Hassett. Mr. Glassman is a fellow and
Mr. Hassett a resident scholar at the American Enterprise Institute.
Almost exactly a year ago, with the Dow Jones Industrial Average at 8782, we
published an article in this space headlined "Are Stocks Overvalued? Not a
Chance." The piece drew criticism from a financial establishment that had been
preaching imminent disaster, pointing to high price-earnings ratios and low
dividend yields and predicting that stock prices would fall when this zany
euphoria wore off. They were dead wrong. Yesterday the Dow broke 10000
before closing at 9930. Including dividends, the 30 stocks of the industrial
average have returned 15% since our piece appeared, while the stocks of the
Standard & Poor's 500 have returned 21%.
Dire warnings from professionals have accompanied nearly every step of the
Dow's rise from 777 on Aug. 12, 1982. Could it be that the model that Wall
Street has been using to assess whether stocks are overvalued--a model based
largely on historic price-earnings ratios--is deeply flawed? We think so.
Investors are ignoring the old shibboleths and pricing companies like Gillette at
a P/E of 64 or Microsoft at a P/E of 66. This reflects not their nuttiness but
their sanity.
Contrary to Alan Greenspan's famous warning--made on Dec. 5, 1996, with
the Dow at 6437--investors today are rationally exuberant. They are bidding up
the prices of stocks because stocks are a great deal. Dow 10000 is just for
starters. How high will the market go? We'll give you a hint: The title of our
book, to be published this fall by Times Books, is "Dow 36,000." Using
sensible assumptions, we are comfortable with prices rising to three or four
times their current levels. Our calculations show that with earnings growing in
the long term at the same rate as the gross domestic product and Treasury
bonds below 6%, a perfectly reasonable level for the Dow would be
36000--tomorrow, not 10 or 20 years from now.
What do we mean by a "perfectly reasonable price"? If traditional P/E ratios or
dividend yields no longer apply, then what does? Our model looks at how
much money a stock will put in your pockets through the profits generated by
the company that issued it. Then, using those returns, we put a price on a
stock that is in line with the price of another asset that carries roughly the
same risk.
That other asset, believe it or not, is a government bond. Extensive research by
Jeremy Siegel of the University of Pennsylvania's Wharton School has found
that over 20 years and more, stocks are no more risky than Treasury bonds or
even bills. "The safest long-term investment for the preservation of purchasing
power has clearly been stocks, not bonds," he has written.
Stocks and bonds should offer similar returns at the very least. But according
to Ibbotson Associates, large-company stocks have since 1926 been producing
average annual returns of 11%, while long-term Treasury bonds have returned
just 5.2%.
Why do stocks return so much more? That question has vexed economists for
decades. Their best answer is that investors are irrationally fearful of the
volatility of stocks, and therefore demand an extra return to compensate for
their fears. What has happened since 1982, and especially during the past four
years, is that investors have become calmer and smarter. They are requiring a
much smaller extra return, or "risk premium," from stocks to compensate for
their fear. That premium, which has averaged about 7% in modern history, is
now around 3%. We believe it is headed for its proper level: zero. That means
stock prices should rise accordingly.
It is this declining risk premium--not higher earnings or lower interest
rates--that is the true explanation for the ascension of stocks. The increase in
the number of buyers has naturally pushed up the price. To argue today that
stocks are overvalued, you must believe that the risk premium, once so
irrationally large and becoming rationally small, will move back to that
irrationally large state again.
The bears' view of the world is a contradiction. When the equity risk premium
was high, it was a "puzzle," and economists like Richard Thaler of the
University of Chicago came up with complicated explanations for why
investors were behaving in such a screwy fashion. Now that investors have
smartened up and begun to buy stocks, economists are accusing them of being
screwy again. Our colleague Lawrence Lindsey said recently: "We have all the
signs of a bubble. . . . People get greedy, and they think nothing can go
wrong."
Will stock prices rise forever? No, they'll rise until they reach a level where
stock returns (the money stocks put in your pockets over a long period) equal
bond returns. We are not there yet, but we're on the way--as four straight
years of 20%-plus returns attest.
Assume Treasuries yield 6%. To equalize that cash flow, stocks can yield
much less than 6%, because, unlike bonds, stocks increase their earnings and
dividends each year. In inflation-adjusted terms, earnings per share have been
rising by an average of 3.3% annually since World War II.
Our conservative calculations show that an earnings return of about 1%--or a
P/E of 100--is adequate to match cash returns from bonds over long periods.
Since the P/E of the Dow is currently about 26, stocks could nearly quadruple
before becoming overpriced.
But 36000 or 40000 is not so much a precise target as the outer limits of a
comfort zone for long-term investors. Certainly, stocks could fall sharply in
the short term--as they did last summer after the Russian default--but,
ultimately, prices reflect three things: interest rates, earnings and the risk
premium. As long as rates stay reasonable, earnings rise with GDP and the risk
premium keeps falling, stocks will remain the investment of choice.
Why is the risk premium dropping? First, investors have become better
educated about stocks, thanks in large part to mutual funds and the media.
They have learned to hold for the long term and to see price declines as
transitory--and as buying opportunities. Look at 1998, a year in which, by
some indicators, the stock market registered its highest volatility in history.
Investors did not cut and run; they added $151 billion to equity mutual funds.
A study by the Investment Company Institute found that during the market's
19.3% decline over six weeks last summer, investors redeemed only 0.3% of
their stock-fund holdings. And a study by the Boston firm Dalbar Inc.,
concluded: "In a dramatic reversal of the behavior first identified in Dalbar's
1993 report on investor behavior . . ., the 1998 investors see the down market
as a buying opportunity."
Second, partly because of new laws, 31 million Americans (an increase of
48% in less than a decade) keep stocks in tax-deferred retirement accounts,
which force long-term holding. Third, businesses themselves have restructured
and become more efficient, thanks to shareholder pressure, global competition
and computer technology. They are less likely to suffer devastating reversals in
a recession. Fourth, government monetary and fiscal management have greatly
improved. Fifth, the regulatory and tax environment--while far from perfect--is
more benign. Sixth, foreign threats have diminished.
In short, investors' enthusiasm is well founded. The risks of stock
investing--never so great as imagined--really have declined. In 1952, a New
York Stock Exchange survey found that only 4% of Americans owned
equities; today, the figure is nearing 50%. It is this broad ownership of stocks
that is the most profound evidence that investors have become more rational
and that Dow 10000 is only the beginning.
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