September 22, 1999

Bookshelf

How Much Higher
Can the Market Go

By BURTON G. MALKIEL

With the arresting title "Dow 36,000," (Times Books, 294 pages, $25) James K. Glassman and Kevin A. Hassett tell us, in the memorable words of Jimmy Durante, "You ain't seen nothing yet."

Mr. Glassman, formerly a columnist for the Washington Post, and Mr. Hassett, a resident economist at the American Enterprise Institute, put forth a controversial thesis: Stocks today are not overpriced as a result of irrational exuberance; rather they are enormously underpriced by a factor of three or four. A "perfectly reasonable price" for the Dow Jones Industrial Average is 36,000 -- not 10 years from now but today. Investors who failed to take advantage of recent gains should jump in now -- the best is yet to come, and it will happen soon.

The Glassman-Hassett thesis is easily described. Over the past 75 years, common stocks have provided investors with average annual returns of about 11% a year, including dividends and capital gains. Government bonds have returned only about 5.5% a year. The extra 5.5 percentage points of returns from owning stocks over bonds (referred to as the equity risk premium) is unjustified.

Over the long run, the authors argue, the riskiness of stocks (as measured by the dispersion of long-run, say 20-year, returns) is no greater than the riskiness of bonds or Treasury bills similarly measured. Hence stocks must rise to reduce their future returns and thereby eliminate unwarranted risk premiums. Some of the recent rise in the stock market reflects the beginning of that adjustment. But the adjustment will only be complete -- Messrs. Glassman and Hassett believe -- when stocks and bonds are priced to offer equivalent returns, and that implies a level of 36,000 for the Dow today with a price-earnings multiple of 100.

Messrs. Glassman and Hassett first tried out their ideas as an op-ed piece in this newspaper in 1998. Not surprisingly, they elicited a storm of criticism. A dialogue ensued over the Internet in Slate magazine between Mr. Glassman and Clive Cook of the London Economist, which has long claimed that U.S. stock prices are "vastly overvalued." Mr. Cook claimed that the Dow 36K Duo had made a fundamental conceptual mistake by equating corporate earnings with the cash flow that could be distributed to shareowners.

The economist Paul Krugman echoed such criticisms, writing that the theory was based "on a simple misunderstanding of corporate accounting" that assumed that "businesses can eat their seed corn and plant it too." Messrs. Glassman and Hassett are responsible in part for such misunderstandings, since in both the article and the book they often talk in terms of earnings rather than dividends and share buy-backs, and they make excessive claims to have a "new and useful model for determining the true value of stocks."

In my view, however, such criticisms are beside the point. It is possible to come to a Dow 36,000 valuation using a standard dividend discount model, where the return from a share is taken to be the sum of the initial dividend yield at which the stock is bought plus the long-term growth rate of dividends. Indeed, in chapter four of "Dow 36,000" the authors do make such a standard calculation under the assumption that stock and bond returns should be the same.

The problem that many critics miss is that there is a fundamental indeterminacy in estimating the proper value of any stock or of the stock market as a whole. Given an assumption of one's required equity rate of return in excess of the government bond rate (which the authors claim should be a premium of zero), there is some growth rate that could justify any level of share prices. With a 6.5% required equity rate of return and an assumed 5% growth rate of dividends, the Dow could be priced to yield 1.5%. (This calculation would suggest that the equity risk premium has already been driven down to zero.) If, instead, a (perpetual) 6% dividend growth rate was assumed, the Dow could reasonably be priced three times as high to produce a yield of 0.5%. As I have often argued: Even the Almighty cannot determine a single correct value for the market as a whole.

But we can and should ask whether the Glassman-Hassett thesis is reasonable and whether the authors are correct in their assessment of investment risk. Have they discovered a new paradigm where investors should be comfortable with stock returns no greater than bond yields? One can sympathize with the argument that historical equity risk premiums appear to have been "too high." Indeed, economists have often called such high excess equity returns "the equity risk premium puzzle." But I find it hard to accept that even over the long run equities are no riskier than government bonds.

Suppose you have a goal of retiring in 20 years with a fixed dollar amount. Today you could buy a 20-year, zero-coupon Treasury bond to yield 6.65%. The dollar amount you will collect in 20 years is absolutely guaranteed. Alternatively, suppose you could invest in a diversified portfolio of equities with an expected total return of 6.65%. While the authors are correct that the range of actual percentage returns from equities over any 20-year period may be relatively narrow, the variance in the final dollar amount of an equity portfolio will be enormous. In my judgment, therefore, it is illogical to assume that risky equities will be priced to offer an expected return of only the 6.65% available from the risk-free zero-coupon bond.

To be sure, the zero-coupon bond is riskless only in terms of its nominal value. After inflation, its return is uncertain. But it is possible to buy 20-year Treasury inflation-protection bonds (TIPS) with a real yield of just over 4% guaranteed. Equities provide no such assurance. Messrs. Glassman and Hassett do have nice things to say about TIPS in a generally sensible and well-written set of "advice" chapters at the end of the book. But they fail to acknowledge how the availability of such instruments affects their argument.

In sum, "Dow 36,000" is a provocative and well-written treatise that cannot be dismissed as easily as many of its critics have suggested. But what is at stake here is much more important than a debate among economists. This is a book with the goal of giving investment advice. For this reason I believe "Dow 36,000" is a dangerous book that may lead some investors who can ill afford the significant risks of equity investments to throw caution to the wind.

To be sure, the end of the Cold War, the spread of free markets, the containment of inflation and our more stable economic performance does justify lower risk premiums today compared with the early 1980s, when we suffered from simultaneous double-digit inflation and unemployment. But the world is still a very unstable place, and economic events are always surprising us.

Only a decade ago we were told that Japanese management techniques were the best in the world, and Japanese stocks soared to unprecedented levels, with the Nikkei index near the 40,000 level. The U.S. was widely believed to have lost its manufacturing edge, and risk premiums in our market were high. Today the Nikkei index stands at 18,000, and Japan's economy languishes. By contrast, we are described as a supertanker economy that can sail through troubled waters undisturbed. We were not in such bad shape in the 1980s as was supposed, and we may not be so good today. Unfavorable economic shocks could create problems for us in the future and with them risk premiums could increase -- not fall further. Books like "Dow 36,000" reveal a degree of optimism and complacency that can be, for some, truly perilous.

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