Dow 36,000? It's Still a Good Bet

CIAO DATE: 8/01

Dow 36,000? It's Still a Good Bet

On The Issues

May 2001

American Enterprise Institute for Public Policy Research

Although turbulence in the U.S. stock market over the past year has unnerved many investors, stocks remain by far the best long-term form of investment for most people.

Amid all the blather about how the "bull market has ended" and the "bubble has burst," it's useful to step back and put the recent swings in perspective.

On December 5, 1996, with the Dow at 6,437 and the S&P 500 index at 744, Fed chairman Alan Greenspan issued his famous warning about "irrational exuberance"—shortly after he had heard an admonition from Robert Shiller of Yale that stocks were on the verge of falling by half or more. It's easy to see why concerns about a market bubble were prevalent. The S&P 500 had risen more than 60 percent since the end of 1994, and confident individual investors were pouring money into equity mutual funds.

The analysis, which called for a crash or a severe correction, was based on what was then a widely accepted view of stock valuation—the notion that there are specific ceilings to price/earnings ratios (the consensus was around 15) and floors to dividend yields (around 3 percent). Beyond those limits, stocks were supposed to correct sharply. This view did not prove useful over the subsequent four years. The P/E of the Dow never fell below 15 after 1991. The dividend yield went below 3 percent in 1993 and never looked back.

Far from crashing or even declining, the market continued to surge after 1996. If you had put money in the S&P 500 index the morning after the speech and kept it there until today, your account would have increased at an annual rate of 13 percent, nicely above the historical average.

But the increase was not steady. It never is. For example, after posting gains of more than 20 percent in 1998 and 1999, the Dow fell 6 percent last year. So far in 2001, it has risen 1 percent, but the S&P 500 has fallen 5 percent this year and the Nasdaq, 16 percent. While the bears were wrong in their 1996 forecast, a reasonable question is whether stocks will continue to fall from here on out. Or, to put it in more personal terms, will our own bullish analysis, first expressed in a Wall Street Journal article on March 31, 1998, and then in our 1999 book Dow 36,000, prove inaccurate?

The way to approach this question is to ask: What's changed? This is the same question any investor should ask about his portfolio after a sharp decline in stock prices. If nothing has changed, then stick to the strategy. Specifically, we believe rising prices depend on two factors: the fundamentals of U.S. corporations and the U.S. economy, and the continued desire of investors to hold stocks. Let's look at each.

Prospects for Growth

Business earnings and cash flow are closely correlated with the economy. When Mr. Greenspan first gave his warning about exuberance, government agencies thought that the speed limit for the economy was about 2 percent annual growth in gross domestic product. Growth beyond that level, it was widely believed, would ignite inflation and a quick Fed response. This speed limit also applied to corporate earnings, since average earnings, in the long run, could not be expected to grow faster than the economy.

But since 1996, government agencies have consistently revised those projections upward. On January 31, the Congressional Budget Office forecast for the decade ahead was 3 percent annual growth—below the consensus of most business economists, at 3.3 percent, but half-again as high as the CBO's long-term projection in 1996.

Of course, the recent forecasts are just that. But, with the rise in productivity over the past five years—and its persistence even as the economy slowed in the fourth quarter of 2000—there are strong reasons to believe long-term economic prospects have improved. Moreover, the good news about growth affected the bottom line. Corporate profits between 1996 and the end of 2000 rose at about double the historical average. Thus, a healthy upward movement in stock prices from the level of 1996 seems warranted—as do increases from today's level.

This is not to say that there are no threats. For example, the tripling of oil prices and the Fed's misjudgment in delaying rate cuts last fall have slowed the economy sharply, and profits have gone along for the ride. But even here, the news is not so dire as it seems. Wall Street firms are currently projecting that profits will fall by 3 percent in 2001. By comparison, in 1982 profits fell 8 percent—and buying stocks in 1982, with the Dow in the 700s, was not such a bad idea.

Stocks nearly always drop when the economy slows and corporate profits fall, and the decline has nothing to do with bubbles. Volatility is the very nature of the equity market in the short term—which is the reason that pessimists, like stopped clocks, will occasionally seem right. The key is the long-run ability of the economy to grow. If anything, these prospects are better now than they were in 1996 and than they were in 1998, when we used an annual GDP growth rate of 2.5 percent as our assumption for Dow 36,000.

The second key factor behind rising equity prices is that investor sentiment not turn sharply against stocks and stay there. This notion has clearly been put to the test lately. Certainly, investors will act on their fears in the short term, but in the long term we believe the facts will prevail.

Recall that for most investors the choice is between stocks and fixed-income assets. Will investors increase their demand for bonds at the expense of stocks? The data suggest that such a move would be highly unprofitable, and investors know it. The broadly diversified market, with the S&P 500 as the recent proxy, has returned an annual average of 12 percent since 1926. Investors, then, can reasonably expect to double their money every six years, quadruple it every twelve, octuple it every eighteen. No guarantees, of course, but there's a powerful body of data and logic behind such a forecast.

As for the alternative, bonds, they have a fairly abysmal long-term record and less-than-stellar short-term record as well. Last year, the yield for a typical short-term bond fund was about 6 percent. A taxpayer in the top bracket kept about 3 percent of that after taxes. Inflation was 3.4 percent last year, so the after-tax real return last year was, for many investors, negative. Over the past five years, the typical intermediate bond fund gave investors a similar performance. Sound enticing?

Timing the Market

Still, there's little doubt that many investors and institutions are attracted to an alternative investment strategy proposed by bears—moving back and forth between stocks and bonds depending on the level of the market. Adherents of this view often point to a chart that shows that the market generally underperforms when the P/E ratio is high. Investors, the story goes, are foolish if they purchase stocks today because they are ignoring the long-run relationship between P/E ratios and future returns.

Another phrase for such activity is market timing, and in real life, it doesn't work, period. As John Bogle, the founder of Vanguard mutual funds, put it: "After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I do not even know anybody who knows anybody who has done it successfully and consistently." As we highlighted earlier, the P/E alarm that sounded in 1996 (and, in fact, began ringing in 1991) did not correctly signal lower future returns. Even after the decline of the past year, a simple S&P index fund would have returned 88 percent during the past five years.

What about the longer term? Using S&P data, we compared a simple buy-and-hold strategy with one of buying stocks only when the P/E of the market is under the historical average and shifting to bonds when the P/E rises above that figure. For example, in 1946 our hypothetical investor would compare the P/E to the average through 1945 (14) and then decide whether to own stocks or bonds.

The result? The buy-and-hold strategy beat the P/E market-timing strategy, after taxes, by about 1,000 percent between 1946 and 2000. Will investors collectively accept a view that is obviously false? Not for long.

Of course, professional bears, helped by a media with the long-term memory of a fruit fly, have a talent for scaring the investing public. But after the scare, even bears would have to admit that the expected return of stocks should be about the same that it always has been.

So let's look at history one more time. If you put $2,000 in the market in 1950 and let it sit, then today those same stocks would be worth $1.2 million. If you put $2,000 in bonds in 1950, then today you would have $25,000. With such a difference, does what happened in 1949 matter?

When criticized for revising his position, John Maynard Keynes once replied, "When the facts change, I change my mind. And what do you do, sir?" That's a rare philosophy these days, and one we admire. So we checked the facts. Stocks are still a good buy. Our position hasn't changed.

James K. Glassman is a resident fellow at AEI, and Kevin A. Hassett is a resident scholar at AEI. A previous version of this article appeared in the Wall Street Journal on March 20, 2001.