Dow 36,000

Has the long-running bull market been a contemporary version of tulipmania? In explaining their new theory of stock valuation, the authors argue that in fact stock prices are much too low and are destined to rise dramatically in the coming years

Illustration by Christoph Niemann

THROUGHOUT the 1980s and 1990s, as the Dow Jones Industrial Average rose from below 800 to above 11,000, Wall Street analysts and financial journalists were warned that stocks were dangerously overvalued and that investors were caught up in an insane euphoria. They were wrong.

Stocks were undervalued in the 1980s and early 1990s, and they are undervalued now. Stock prices could double, triple, or even quadruple tomorrow and still not be too high.

Market analysts and media pundits have also persistently warned that stocks are extremely risky. About this they are wrong too. Over the long term stocks in the aggregate are actually less risky than Treasury bonds or even bank certificates of deposit. Although the experts may not be very good at predicting what the market will do, they are brilliant at scaring people—not out of malice but out of a profound misunderstanding of stock prices. Whatever their intentions, they have performed a terrible disservice to millions of investors by frightening them away from the market.

Stocks are now, we believe, in the midst of a one-time-only rise to much higher ground—to the neighborhood of 36,000 for the Dow Jones Industrial Average. After they complete this historic ascent, owning them will still be profitable but the returns will decline. You won't be able to make as much money from them each year. We believe that in the meantime, however, astounding profits will be made.

Many small investors are already catching on. They have ignored the dire warnings from professionals that have accompanied nearly every step of the Dow's rise from 777 on August 12, 1982. They are rejecting the outdated model that Wall Street has used to assess whether stocks are overvalued—a model based largely on historical price-to-earnings, or P/E, ratios. That rejection reflects not their nuttiness but their sanity. Contrary to the famous warning from Alan Greenspan, the chairman of the Federal Reserve Board—made on December 5, 1996, with the Dow at 6,437—many investors are rationally exuberant. They have bid up the prices of stocks because stocks are a great deal.

Still, even the most enthusiastic investors have doubts. They know vaguely that stocks are wonderful, but they have no real framework of analysis. They don't know why prices are going up and up. We believe that we do.

How did we come to hold our views? We began by wondering what on earth was going on in the market. Stocks had quintupled in price in the dozen years up to 1994. Then, in 1995, 1996, and 1997, the Standard & Poor's 500 composite index, generally considered a good proxy for U.S. stocks as a whole, scored returns of more than 20 percent. ("Returns" means dividends plus capital appreciation, which is a fancy name for the increase in a stock's price.) Never before in modern history had the market had three years this good in a row.

Why were prices rising so quickly and consistently? We weren't satisfied with the explanations we heard in the press and on Wall Street: that investors—reflecting what Charles Mackay called "Extraordinary Popular Delusions and the Madness of Crowds" (in the title of the second edition of his 1841 book)—were acting irrationally, or that Baby Boomers all of a sudden remembered they should invest for retirement and decided to dump huge sums into stocks as protection against a penurious future. There had to be better answers.

We decided to begin with the core question. If the issue was whether the market was overvalued, we wanted to know this: What is the right value—that is, price—for a stock? The experts did not have an answer. They typically focused on the P/E ratio and other "valuation indicators." Wall Street analysts figure that if P/Es are too high, stocks are overpriced.

But the term "too high" relates only to history, not to substance. We decided to look at substance—at dollars. How many dollars does a stock put in your pocket over time? As John Burr Williams, a brilliant economist with the ability to cut through the muck, wrote in 1938, "A stock is worth only what you can get out of it." So we developed a method for estimating the flow of cash from a stock, and then we determined what that cash flow is worth.

A house that throws off $1,000 a month in rental income might be worth, say, $200,000. A restaurant that generates $100,000 a year in profits might be worth $1 million. What, then, is a share of IBM worth? What is the "perfectly reasonable price"—or, as we put it, the PRP—for any share of stock?

In our research we were surprised at how high PRPs turned out to be. But after refining our analysis for a year, and listening to the criticisms and suggestions of people we trust, we are convinced that our theory is correct, and that it explains—as no other theory does—the rise in stock prices over the past two decades. More important, we concluded that the rise will continue, at least until Dow 36,000.

The History of Stocks: A New Interpretation

THE stock market is a money machine: put dollars in at one end, get those dollars and more back at the other end. The history of these remarkable returns is vivid and undeniable, yet few investors seem to be able to make it out in the fog of hourly jabber and the haze of constant fear, and many experts seem always to draw from the past the lesson that stocks are headed for a fall. Here, instead, are the lessons that we draw from history.

Lesson 1: Stocks have been steady winners through thick and thin.

Imagine that you bought $10,000 worth of stock on the very eve of the Great Crash, at the beginning of October, 1929. Over the next two months, if you held a portfolio similar to the modern S&P 500, you would have lost $3,000. It would get worse: after big losses in 1930, 1931, and 1932, your $10,000 stake would have been reduced to $2,800.

Naturally, you would have been tempted to sell as trouble brewed in Europe. But if you had decided to hang on, you would have been rewarded: from 1933 through 1936 stocks enjoyed their best four-year period in history, tripling in value. Remember that these were some of the darkest times on the planet, with fascism infecting Europe and Asia, Stalin ruling Russia, bread lines everywhere, and Franklin Delano Roosevelt forced to remind Americans that "the only thing we have to fear is fear itself." Yet stocks rose 200 percent.

As the decade wore on, Hitler marched into Czechoslovakia and Poland, and Japan invaded China. By the end of 1939 your account would have been up to $7,200. And because the 1930s were characterized by deflation, or falling prices, the buying power of that $7,200 would actually be $8,600.

As the 1940s began, the war broadened, and the United States was soon fighting both Japan and Germany. The market fell and rebounded, and by the end of 1944, fifteen years and three months after you invested your $10,000, you would have been ahead—by $400. Despite the worst-timed investment imaginable, the worst depression of the century, and the worst war in history, your initial investment would have grown by four percent.

Over the next sixteen years, through the hot war in Korea and the Cold War elsewhere, through nuclear threats and labor turmoil, the market continued to rise powerfully. By the time of John F. Kennedy's election as President, in 1960, your $10,000 would have become $92,900.

The Vietnam War began and seemed never to end. Protests disrupted U.S. campuses, and riots burned Detroit, Washington, Los Angeles, and other cities. Inflation loomed. Then came the Arab oil embargo, wage and price controls, the closing of the gold window, and the Watergate crisis. The years 1961 to 1975 were nasty and often depressing, and included the worst two back-to-back years (by far) for the market since 1930 and 1931; nevertheless, stock values more than doubled, and by 1975 your $10,000 would have been worth $261,800.

Inflation accelerated to nine percent in 1978 and to 13 percent in 1979. The rate on long-term Treasury bonds took off as well, breaking 15 percent in 1981. It was hardly an atmosphere accommodating to stocks. Who would want to own equities when Treasury bonds were paying significantly more than stocks had returned historically? Yet the market continued to climb, and by 1985 your $10,000 stake would have become $999,000.

Over the next thirteen years inflation declined, taxes were cut, the Berlin Wall fell, and U.S. businesses rejuvenated themselves. The stock market soared, and by the end of last year your investment would have been worth $8,414,000. It would have grown by a factor of 840—or, after accounting for inflation, by a factor of 90.

The calculations for this little history come from a series developed by Ibbotson Associates, a Chicago research firm. We tried to pick the worst possible scenario, and chose dates after the initial one at random, but stock-market returns are so steady that you can pick any lengthy period you want and the results will be roughly the same.

The consistency of returns in the stock market over long periods is an important lesson. In his book Stocks for the Long Run (1998), Jeremy J. Siegel, a professor of finance at the Wharton School of the University of Pennsylvania, divided U.S. market history into three periods: 1802-1870, when stocks returned 7.0 percent in real (inflation-adjusted) terms; 1871-1925, when they returned 6.6 percent; and 1926-1997, when they returned 7.2 percent.

That last figure is especially convenient, because it works well with the "Rule of 72." Divide the percentage rate of growth into 72 and you find the number of years it takes an initial investment to double. At 7.2 percent it takes ten years. This means that if stocks continue to behave as they have over the past seventy years, a woman twenty-five years old who invests $20,000 now will have $320,000 in today's buying power when she reaches sixty-five. She could use that money to buy an annuity that would pay her an income she could live on until she died.

Lesson 2: Stocks are not very risky in the long run.

So why doesn't everyone invest lots of money in stocks? The main reason is that people are naturally cautious, especially with their own money, and the return on stocks is highly volatile from day to day. This inclination toward caution is perfectly reasonable, reflecting an intuitive understanding of an important financial truth: the average return is not the only thing that matters when evaluating an investment. You must also consider the likelihood of profits and the chance of losses. In other words, remember risk.

Despite its inadequacies, history is the best source of information we have when analyzing risk, and the history of stocks is clear and consistent: in the short run they are very risky; in the long run they are not.

Let's turn again to Jeremy Siegel, who examined U.S. stock prices going all the way back to 1802, using his own research supplemented by that of G. William Schwert, of the University of Rochester; Robert Shiller, of Yale University; the Center for Research in Security Prices; and others. Siegel found that in the worst year he studied, the inflation-adjusted return on stocks was -38.6 percent. In other words, an investment of $100 became $61.40 in real terms, taking into account both declines in price and income from dividends. In the best year the return was 66.6 percent. A $100 stake became $166.60 in real terms.

That is an enormous range. No wonder stocks scare so many people. Over the past seventy-three years, Ibbotson data show, large-company stocks have produced positive returns fifty-three times. So according to history, the chances that you will lose money in a single year are greater than one in four—not a very cheerful prospect. Worse, the chances that your losses will be in double digits are one in nine.

But the research of Siegel and others shows something else about risk, and it is striking: the longer you hold on to stocks, the less volatile your returns will be and the more likely it is that you will make money. Stocks appear to obey a kind of reversion to the mean—whatever goes down must go up.

Let's assume that you hold a diversified portfolio of large-cap stocks—such as the S&P 500—for ten years instead of one year. Risk shrinks significantly. For the sixty-four overlapping ten-year periods from 1926 to 1998 (that is, 1926-1935, 1927-1936, and so on) the S&P stocks scored positive returns sixty-two times. For the fifty-nine periods of fifteen years they were positive every time. Over the worst twenty-year period, from 1929 to 1948, the total gain was 84 percent.

Siegel's research shows declining risk over time in another way. Whereas the worst single year since 1802 showed a loss of 38.6 percent after accounting for inflation, the worst five-year period in the past two centuries produced an average annual loss of only 11.0 percent, the worst ten-year period an average annual loss of 4.1 percent, the best ten-year period an average annual gain of 16.9 percent.

Now let's go out to a thirty-year period. The worst average annual return was 2.6 percent. In other words, an investment of $10,000 grew to $21,598 in inflation-adjusted dollars. Never in American history has a diversified basket of stocks failed to double in buying power over a generation. Never.

Here's another way to express the amazing decline in risk as time passes and you hold your stocks. Over a one-year period the standard deviation for stocks is 18 percent. This means that in two out of three years the return on a stock will vary by no more than 18 percentage points from the average—in either direction. Since the average real return is about seven percent, returns should vary two thirds of the time between 25 percent and -11 percent. That's very risky. But over ten-year holding periods the standard deviation drops to five percentage points. Over thirty-year periods it drops to about two percentage points—meaning that two thirds of the time the range is five to nine percent. That's not risky at all.

What is truly amazing about these long-term-risk figures is that they are lower than those for Treasury bonds and even Treasury bills, which mature in a year or less. If you keep your money at work for more than twenty years, stocks are actually safer than short-term T-bills rolled over annually.

Over a twenty-year period the worst inflation-adjusted return by stocks was an annual average of 1.0 percent. For bonds, however, the worst was -3.1 percent, and for T-bills -3.0 percent. Over one-year periods stocks have outperformed bonds only 61 percent of the time, but stocks beat bonds 92 percent of the time over twenty-year periods and 99 percent of the time over thirty-year periods.

Lesson 3: Traditional valuation methods have predicted catastrophe throughout the bull market of the 1990s.

The fact that stocks weren't risky in the past doesn't mean you can buy them now and be certain you will make lots of money. When you buy a stock, you are buying an asset, just like a house. If you buy in a particularly hot neighborhood, you might not feel reassured by the fact that prices there have doubled in the past three years. On the contrary, you might feel that you are in danger of buying at the top, just as a real-estate bubble is about to burst.

Is there any way to figure out what an asset—specifically, a stock—is worth? Traditionally, market analysts have used several different measures of what is called valuation, each based on hard data about a company. The most popular are the dividend yield and the stock's price-to-earnings ratio. In our view, these measures are limited, shortsighted, and anachronistic. Let's look at each.

Dividend yield. When you are thinking about whether to put your money in the bank or spend it on, say, a new television, one of the things you look at (besides the reception of your old television) is the interest rate the bank will give you. If the bank pays you 20 percent, you might be inclined to postpone buying the TV. If you put your money into a stock, you will get whatever dividends the firm pays, plus the increase in the price of the stock. Dividends are fairly predictable, whereas changes in price are not, so one calculation of value focuses on the current dividend. If a stock pays a $5.00 annual dividend and the price of a share is $100, analysts say that the stock yields five percent, just as a bank account that paid you $5.00 on a $100 deposit would be said to yield five percent.

Drawing on a long series of data on stocks put together by Robert Shiller, of Yale, we tracked the history of dividends back to the 1870s. From 1871 to 1885 dividend yields were typically around six percent. Buy $100 worth of stock and each year you would receive about $6.00 in dividends. Interest rates on long-term Treasury bonds were about the same at the time. From 1886 to 1930 dividend yields stayed fairly close to the interest rate, wandering no higher than 7.5 percent and not much lower than four percent—the level just before the crash of 1929.

After stock prices plummeted, dividend yields rose—at least among the companies that survived. That stands to reason. For example, if a stock that cost $100 before the crash paid a $4.00 dividend, it was yielding four percent. If after the crash the firm traded at only $50 and reduced its dividend to $3.00, the yield rose to six percent. For the market as a whole the yield stayed in the six percent range until the 1950s. Since then a long and fairly steady decline has brought yields, as of last spring, to 1.5 percent for the thirty stocks of the Dow Jones Industrial Average and 1.2 percent for the 500 stocks of the S&P. Those yields are by far the lowest in history.

Another reason that many people use dividend yields as an indicator of value is that actual dividend payouts—in dollars—are fairly steady for a corporation. They tend to rise as earnings rise. Remember that a dividend yield is the payout divided by the share price. So if the price rises at the same rate as the payout, the yield will stay the same.

If dividend yields drop when stock prices rise, many Wall Street pessimists conclude that stock prices are far too high—out of whack with dividends and earnings, the measures to which they should always be tied. But dividend yields have been falling for half a century, so if you believe that the dividend yield is the true measure of a stock's value, you would conclude that stocks have been too expensive for the better part of fifty years. Around 1950 a $100 investment bought annual dividends of $6.00, just as it did in the 1870s. But except for a blip in the inflation-wracked 1970s and early 1980s, when bond rates soared, that $100 has since bought less and less. In the early 1990s it bought only $3.00 in dividends. Now it buys less than $1.50.

Consider Boeing, which this year paid a dividend of 56 cents while trading at $37 a share—a yield of 1.5 percent (.56 divided by 37 = 0.015). If you believe that the appropriate yield for a stock is the historical six percent, and if Boeing's dividend remains at 56 cents, then its price should be $9.25 a share. To achieve a yield of three percent the price would have to drop to $18.75. Since Boeing's yield is roughly the same as the S&P's, the entire market would have to fall by either three quarters (from $37 to $9.25) or one half (from $37 to $18.75) to return to its old dividend-yield levels.

As we will see, dividends and dividend growth—as opposed to dividend yield—are essential to our 36,000 theory. But we think it's time for those who keep pointing to low dividend yields to reassess the usefulness of that indicator. Certainly, a high yield may be a signal that a particular stock is attractively underpriced. But a low yield tells us very little about whether the market is dangerously overpriced.

P/E ratio. Academic research has shown that shareholders appear to be indifferent to whether their companies pay dividends or retain earnings. If the firm you own earns $5.00, it is your $5.00 whether the firm formally hands you the money or not. One reason dividend yields are no longer a useful tool for valuing stocks is that companies now recognize their shareholders' indifference to quarterly payouts. In fact, owners may prefer to keep profits inside the company, because the tax liability is lower. So earnings may be even more important than dividends when it comes to valuing a company—which is why the P/E ratio has become such a closely followed indicator.

Just as you can calculate a dividend yield comparable to a bond interest rate, you can calculate an earnings yield that takes into account all the profits a company makes after taxes—whether those profits are distributed to shareholders or kept in the company. A stock that earns $5.00 per share and costs $100 has an earnings yield of five percent—the earnings per share divided by the current price of the share. That's the earnings-to-price, or E/P, ratio. Most analysts, however, like to talk about the inverse of the earnings yield, the P/E ratio.

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