Thursday, August 01, 2002
Time for some serious damage control.
James K. Glassman and Kevin A. Hassett, writing in today’s Wall Street Journal (“Dow 36000 Revisited”), virtually negate whatever value their book, Dow 36000, might ever have had as economic prognostication or even as an intellectual exercise.
Glassman and Hassett today say:
“When our book, Dow 36,000, was published in September 1999, the Dow Jones Industrial Average stood at 10318. The Dow closed yesterday at 8736. What went wrong? Actually, nothing. Despite its flamboyant title, Dow 36,000 was a book of sober explanation, not of wild prognostication. We calculated that 36000 was the point at which the 30 stocks that comprise the Dow Industrials would be fully valued, and we warned that ‘it is impossible to predict how long it will take.’”
We admit to having only skimmed a review copy of Dow 36000 prior to its publication three years ago, dismissing the book as yet another attempt to cash in on an overvalued equity market. But if the above paragraph constitutes an accurate summary of the Glassman-Hassett thesis, anyone who bought the book deserves a full refund because the explanation offered here includes nothing of any value whatsoever.
Apparently we are to believe it was the publisher’s fault, or perhaps the marketing department of the publishing company. A catchy title was needed to sell the book, and Glassman and Hassett here seem to imply they wouldn’t have chosen such an aggressive title. This doesn’t quite get them off the hook, but it is a very convenient argument.
Determining “full value” -- Is it worth it?
Glassman and Hassett, resident fellow and resident scholar, respectively, at the American Enterprise Institute, fail to explain what they mean by “full value.” That’s unfortunate, because as anyone who has valued equity securities knows, the calculation of a stock’s fair value to a particular investor (and they are not all alike) includes numerous factors, the most quantifiable of which are, among other things, the expected rate of return, the equity risk premium, the investment horizon (or time period the stock is expected to be held), and the discount rate (needed to calculate present value).
When will the 30 stocks in the Dow Industrials become “fully valued”? Who knows and who cares? What difference could that possibly make to an investor? The phrase “fully valued” seems to imply that there is a terminal point at which individual stocks achieve their full value, their complete potential as it were. The odds of this happening to all 30 Dow stocks at the same time are virtually nil.
And irrelevant. The investor cares only about the “fair” or “intrinsic” value of the security in light of current and anticipated economic conditions, interest rates, inflation, desired rate of return, and, to be blunt about it, his “cash out” date.
Stating the obvious . . .
According to today’s article, Glassman and Hassett argued that an investor with a “long-term” horizon (“at least five years and, better, 10 or more”) should invest primarily in stocks and equity mutual funds and avoid bonds. In addition, investors should “buy and hold, and not try to time the market.” Why? Because “[s]tocks will not go straight up, we warned.” And third, they argued, “stocks are undervalued relative to their long-run trend.”
The first two points are conventional wisdom. The third point sounds the most impressive but it is also the most obvious. Except during periods of mania such as we experienced roughly from 1998 to early 2000, the stocks of quality companies are almost always undervalued relative to the long-term trends of the stocks’ prices, i.e., to their long-term value.
After all, if an investor believes a share of Gillette Co. will be worth $150 in 20 years or so, why would he pay $150 to own a share of Gillette right now, particularly when a share can be had for $33? He wouldn’t, for the simple reason of what is called “the time value of money.” The investor, if he’s smart, would be willing to pay the present value of the stock 20 years out, factoring in his expectations of growth, interest rates, the equity risk premium, the value of dividends, the manner in which he invested his dividends, and so forth. Naturally that figure will be lower than the “long-run trend” of the stock’s price.
. . . And a weak conclusion
Sadly, Glassman and Hassett end their essay with a resounding thud: “No, the Dow is not at 36000 right now, and we didn’t say it would be. But there is little doubt that, as long as the U.S. economy remains sound, stock prices will rise to 36000 and beyond.”
Do they mean that if an investor buys the Dow 30 now and then holds these stocks for some unspecified period of time he will be handsomely rewarded because the index will eventually reach 36000?
No kidding! Really? Amazing!
This is a no-brainer. We just created -- in less than 10 minutes -- an Excel spreadsheet demonstrating that the Dow could reach 36000 in about 16 years assuming a 10 percent annual return, and in nearly 20 years assuming the S&P 500’s historical annual rate of return of 7.6 percent. And if we accept the 15.2 percent annual rate of return Glassman and Hassett refer to with respect to the 20 years ending in 2001 (and we shouldn’t), the Dow would reach 36000 in just over 10 years.
All Glassman and Hassett are saying is the same thing every two-bit broker says over a few cocktails: “In the long run, stocks always go up.” Every element of that seemingly profound statement is true. Pick almost any “long run” -- 10-, 20-, and certainly 30-year period -- and you will find that the major stock indexes (i.e., “stocks” as a group, rather than a particular stock) appreciated, usually substantially.
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