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Authors argue that the market is vastly under-valued

'Dow 36,000'
By James K. Glassman and Kevin A. Hassett

September 14, 1999
Web posted at: 2:41 p.m. EDT (1841 GMT)

(CNN) -- Like many people, Jim Glassman and Kevin Hassett heard the constant message that the stock market was going too high and was too risky. But, they wondered, why did the prices of stocks keep rising? Was financial gravity being defied, or were other forces at work? Were investors being frightened away from a market that might continue to grow?

"Dow 36,000" is the result of the investigation by Glassman, a former columnist for "The Washington Post" and host of the PBS show Techno-Politics, and Hassett, a former senior economist at the Federal Reserve Board. They predict continued growth in the market, and suggest an analysis and program for profiting from it.



Introduction: Why Stocks Are Such a Good Buy

I have steadily endeavored to keep my mind free so as to give up any hypothesis, however much beloved (and I cannot resist forming one on every subject), as soon as facts are shown to be opposed to it. -Charles Darwin (1809-1882)

Never before have so many people owned so much stock. They depend on their shares not just to enjoy a comfortable retirement, but also to pay tuition, to buy a house or a car, to help their children, to take a long vacation, or simply to lead a good life.

Today, half of America's adults are shareholders -- up from one-fifth in 1990 and just one-tenth in 1965. Stocks are the largest single asset that families own, topping even the net value of their homes.

But investors -- many of them novices -- are as frightened as they are enthusiastic. The market has been a great boon, but it remains a great and ominous mystery.

It should not be. This book will give you a completely different perspective on stocks. It will tell you what they are really worth -- and give you the confidence to buy, hold, and profit from your investments. It will convince you of the single most important fact about stocks at the dawn of the twenty-first century: They are cheap.

A one-time only rise

Throughout the 1980s and 1990s, as the Dow Jones industrial average rose from below 8800 to above 11,000, Wall Street analysts and financial journalists warned that stocks were dangerously overvalued and that investors had been caught up in an insane euphoria.

They were wrong.

Stocks were undervalued then, and they are undervalued now. Tomorrow, stock prices could immediately double, triple, or even quadruple and still not be too expensive.

Market analysts and media pundits have also persistently warned that stocks are extremely risky. About this, they were wrong too. Over the long term, stocks, in the aggregate, are actually less risky than Treasury bonds or even certificates of deposits at a bank.

While 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 about stock prices. Whatever their intentions, they have performed a disservice to millions of investors by frightening them away from the market,.

If you own stocks or mutual funds, this book will remove the fear.

If you are worried about missing the market's big move upward, you will discover that it is not too late.

Stocks are now in the midst of a one-time-only rise to much higher ground -- to the neighborhood of 36,000 on the Dow Jones industrial average. After stocks complete this historic ascent, they will still be profitable, but their returns will decline. You won't be able to make as much money from them each year. In the meantime, however, astounding profits will be made. This book will show you how easy it is to participate.

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 been using 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. After all, the stock market itself long ago repudiated the model. Contrary to the famous warning of Federal Reserve Board Chairman Alan Greenspan -- made on December 5, 1996, with the Dow at 6437 -- investors are not irrationally exuberant, but 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 for analysis. They don't have an explanation for why prices are going up and up.

We do.

How did we come to hold our views? We began nearly three years ago 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-stock index, generally considered a good proxy for all U.S. stocks, 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 were acting irrationally reflecting what Charles MacKay called, in the title of his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds 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.

No. There had to be better answers.

The right price

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 price for a stock?

The experts did not have an answer. Their model -- or view of the financial world -- typically focused on what are called "valuation indicators," such as the P/E ratio. 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, first of all, to look at substance. At dollars. At how many dollars a stock puts in your pocket over time.

As John Burr Williams, a brilliant young economist with the ability to cut through the muck, wrote in 1938, "In short, a stock is worth only what you can get out of it [his italics]."

So, first, we developed a method for estimating the flow of cash an investor can get from a stock. Next, we determined what that cash flow was worth.

A house that throws off $1,000 in rental income a month might be worth, say, $150,000. A restaurant that generates $100,000 in profits a year 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 shocked at how high PRPs turned out to be. Could it be possible? After refining our analysis for a year, listening to the criticisms and suggestions of people we trust, we became convinced that our theory 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.

You will find, after reading this book, that you can determine the right price for any stock. But if analyzing individual companies is too time-consuming or unappealing, we will show you how to construct a portfolio of mutual funds that will accomplish much the same purpose.

But picking the right stocks and funds does not guarantee success. More important than your selections is what you do after you make them. We will show you how to build a personal relationship with your investments so that you are less likely to act rashly and unprofitably in a volatile market.

The reason to invest in stocks immediately is that changes are afoot that will cause shares to rise powerfully toward their true value, their PRP Stocks, of course, will not go straight up. They never do. There will be dips, possibly even brief bear markets, along the way. Those declines will provide great buying opportunities -- but only for investors who know what stocks are really worth.

The power of dividends

For too long, the value of stocks has been seriously underrated.

Consider dividends, which are the part of a company's earnings that it gives out in cash, usually in the form of quarterly checks, to its shareholders. Most stocks today pay what the experts say are paltry dividends. But the truth about dividends is that they increase as earnings increase-and over time, these increases compound so that even tiny dividends today will provide shareholders with loads of cash in the long term.

Take General Electric Co., a giant diversified corporation with interests ranging from lightbulbs to broadcasting to jet engines to plastics to consumer finance. GE is superbly managed but hardly the sort of fresh, go-go business associated with parabolic growth. After all, it is more than a century old. In Chapter 13, we will closely examine GE, but here are the highlights on the company's dividends.

First, we took the price of GE in 1989 and adjusted it for splits that occurred later. (When a company splits its stock, it issues new shares to current owners, but the value of their total holdings does not change. For instance, if you own 100 shares with a market price of $100 each, and the stock splits two-for-one, you will own 200 shares with a market price of about $50 each.)

In 1989, you could have bought a share of GE for $11, after accounting for splits. At the time, the stock was paying an annual dividend of 41 cents, or 3.7 percent of the share price. The dividend rose each year, so that, by the start of 1999, it was $1.40 -- or more than three times the annual dividend ten years earlier. In other words, in 1999, your GE stock was paying you a dividend return -- in that year alone -- of 12.7 percent on your original investment, or well over twice the rate of a ten-year Treasury bond, and rising. At this pace, in another twenty years, GE will be paying an annual dividend that represents a 50 percent return on your initial investment!

GE is a profitable company that passes on its gains to shareholders, but it is not exceptional. In the year 1999 alone, dividends on a share of Philip Morris exceed the stock's 1980 purchase price.

This is the difference between what bonds and stocks put into your pockets: Bonds may make higher interest payments to start, but over time stocks outstrip them because the profits of healthy firms increase, and so do their dividends.

For example, over the twenty years starting in 1977, a $1,000 investment in American Brands, a modest consumer products company that later sold some divisions and changed its name to Fortune Brands, put five times as much money (in dividends alone) into the pockets of its shareholders as a $1,000 investment at the same time in a long-term Treasury bond.

Our research found that, since 1946, dividends have risen, on average, more than 6 percent a year. The after-tax earnings that companies report to shareholders have risen more than 7 percent. Something growing that fast doubles about every ten years through the miracle of compounding.

Those growth rates are at the heart of our theory about rising stock prices. They have largely been ignored by analysts, who prefer to judge stocks by backward-looking valuation techniques that, much of the time, have argued against investing in stocks at all.

The measures you see in the stock tables and hear mentioned on television have been so wrong for so long that it is hard to see why anyone continues to pay attention to them. But old ideas die hard.

The empire strikes back

New ideas, on the other hand, disturb.

On March 30, 1998, we unveiled our theory in The Wall Street Journal under the headline, "Are Stocks Overvalued? Not a Chance." At the time, the Dow stood at 8782, and we said we were comfortable then, as now, with the index rising to 36,000 or even higher.

The article provoked criticism because it challenged the cherished assumptions of the financial establishment -- for example, that dividend yields of 2 percent are too low and that P/E ratios of 25 are too high. But the truth is that clinging to the conventional wisdom can be very costly to investors.

(Don't worry. We'll explain all the jargon. For example, a "price-to-earnings ratio" indicates how many dollars an investor has to pay today for one dollar's worth of a company's profits. The average P/E since 1872 has been 14. A high P/E indicates that a stock is popular -- some would say too popular -- with investors.)

At the same time, our views have led some professionals to begin reconsidering the old rules of the stock market. After our Wall Street Journal piece, Byron Wien, the respected Morgan Stanley strategist, wrote a letter to his clients laying out our arguments -- for example, that "the fair-market P/E multiple of the market could reach 100." The article, he said, did start me thinking."

It's smart to be skeptical when someone (like us) claims that "this time it's different" -- that something new is happening in the stock market. But, as Wien points out, there have been times "when recognizing that something was, in fact, different paid off significantly."

Still, a more common response to our ideas by the financial establishment was anger and resentment. Following our second piece in The Wall Street Journal -- on March 17, 1999, just after the Dow passed 10,000 -- Bob Brusca, then chief economist at Nikko Securities, was quoted in the New York Post as saying "This stupid article does not make any sense."

He's right. It doesn't make sense if you are stuck with the model that has dominated Wall Street, the media, and academia for the past half-century or so. But that model clearly has not worked. Even its supporters are shaking their heads in disbelief. "We're at an unusual point in history," said Robert Shiller, the Yale economist, at the start of 1999. "Historically, after a period of success on the stock market, the price goes back down. Currently, it's a little uncomfortable because it has never gotten this out of whack." Back in 1996, Shiller told the governors of the Fed -- the Federal Reserve Board -- that stocks were dangerously high and headed for a fall. But, in the next three years, share prices continued to rise at a record pace. The problem is not the insanity of investors but the inadequacy of the old models. Today's professionals measure stock prices against particular yardsticks of history and say they are far too high. But there is another way to value stocks -- and it indicates clearly that prices are far too low.

Copyright © 1999 James K. Glassman and Kevin A. Hassett

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