The Dow at 36,000? Indeed, that’s what the authors foresee as a consequence of looking at the valuation of stocks differently, by what they term as their “perfectly reasonable price” concept.
The authors unveiled this theory with an article in the Wall Street Journal in 1998 when the Dow stood at 8782, and followed it up with a second piece in 1999 when the Dow had just passed 10000. Predictably, the response was anything but receptive. But it did start some people thinking. And it led to this book.
Who are these irrationally exuberant guys anyway?
James K. Glassman, for many years a columnist for The Washington Post and host of the PBS show Techno-Politics, is currently financial columnist for the Reader’s Digest and a fellow at the American Enterprise Institute. Earlier in his career he was the publisher of The New Republic and president of The Atlantic Monthly.
Kevin A. Hassett is a resident scholar at the American Enterprise Institute who formerly served as a senior economist at the Federal Reserve Board. He received his Ph.D. in economics from the University of Pennsylvania. He is co-author with R. Glenn Hubbard, of The Magic Mountain: Defining and Using a Budget Surplus.
The gist of their theory is that Treasuries are the historical benchmark for stock valuation and by comparison there is a premium expected from stocks because stocks are perceived as a more risky investment. This may once have been so; however, the authors contend that this traditional mode of thinking does not take into consideration the evolution in the management of the businesses that typically comprise the Dow, and the positive regulatory changes of the last few decades. This risk premium is approximately seven percentage points more than the return on bonds that stocks have traditionally paid to shareholders in the form of dividends and price appreciation. The case is made that, with the passage of time, portfolios of companies that make up the Dow have been shown to be no more risky than bonds. Therefore an upward valuation of stocks is perfectly reasonable. In fact, the investing public intuitively knows this and is bidding up the prices of stocks regardless of the cautions thrown up by the traditionalists. This bidding up process has eroded the seven percent premium down to between two and three percent, the authors contend, and will continue until the differential has been eliminated. It will lead to triple digit price-to-earnings ratios for some stocks.
At the heart of the theory are the rising growth rates of dividends and stock prices. Using General Electric as an example, its stock was worth $11 in 1989 (after adjusting for stock splits) and paid an annual dividend of 41 cents, or 3.7% of the share price. By 1999 the dividend had more than tripled to $1.40 a share, or 12.7% of the price 10 years earlier, if you had stayed invested. By contrast, an investment in a ten-year Treasury bond would still be yielding the original 5.5%. GE is just one example of many, the lesson being that bonds may make higher interest payments to start, but over time stocks outstrip them because of this growth factor in price and dividend.
Are the authors following their own advice and therefore invested to the hilt? No, they are quite open about it and think that would be reckless because no theory is 100 percent foolproof. But they are following the basic concepts and claim to be doing quite well, thank you. And they have a whole chapter devoted to the jungle that stocks live in that is the market; the lesson being that no one knows for sure what the market will do tomorrow or the next day. Look no further than the disruption caused by the recent Clinton/Blair statement about the human genome project. Be prudent when investing!
What comes through clearly is that this is theory works best for the value investor, not the day-trader looking for a quick speculative gain. For the short-term investor the market is indeed dogged by rapid fluctuations, and fully justifies a risk premium; however, in this respect bonds also fluctuate in value, unless held until maturity or for the longer term.
The authors are long on advice about mutual fund investments for the beginner
but scant on specific stock recommendations, but they make up for it with
plenty of advice about what to look for and where. A sampler of questions
to ask before you buy (and much more advice under these captions):
The authors have put the book together in two parts. Part 1 deals with the idea, leading the reader through current concepts with the jargon stripped away, and examining the PRP (perfectly reasonable price) theory from every conceivable angle. Readers may recognize concepts such as return on investment; discounted cash flow; sources and uses of funds, and Buffett’s ‘intrinsic value’ method of valuation, although the terms as such are carefully avoided and made palatable with plenty of anecdotes and examples.
Part 2 deals with the practical application of the theory to investments, showing the reader how to get started, what to invest in; how to allocate assets, and re-allocate as the PRP effect unlocks the wealth of various categories of stocks. A final paragraph speculates on the political changes that could come about if the Dow soars to 36000 tomorrow, or in a few years’ time, and consequent social changes.
Critics of the book continue to claim that there is a double-counting of dividends and earnings, although the authors go to great lengths to refute this with fact. Critics have a bad habit of reading other critics to avoid working through a book!
So……will the Dow really go to 36000? This or a similar number in the near or longer term possibly, although this reader for one is not about to hold his breath. Investor behavior in the market is not always rational, and the Fed may take away the punch bowl to stop the party getting too boisterous. Maybe this title just symbolizes something else: a shift in the way we now look at and place a value on stocks. As such, Glassman and Hassett’s theory takes Warren Buffett’s ‘intrinsic value’ concept one big step further, and serves the equally worthwhile purpose of challenging the conventional wisdom about stock valuation.
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