seeNicholas Barberis, “Investing for the Long Run When Returns Are Predictable,” Journal of Finance,vol. 55 (2000), pp. 225–264. Paul Samuelson has shown that mean reversion will increase equityholdings if investors have a risk aversion coefficient greater than unity, which most researchers findis the case. See Paul Samuelson, “Long-Run Risk Tolerance When Equity Returns Are Mean Regressing: Pseudoparadoxes and Vindications of ‘Businessmen’s Risk’” in W. C. Brainard, W. D.Nordhaus, and H. W. Watts, eds., Money, Macroeconomics, and Public Policy, Cambridge: MIT Press,1991, pp. 181–200. See also Zvi Bodie, Robert Merton, and William Samuelson, “Labor Supply Flexibility and Portfolio Choice in a Lifecycle Model,” Journal of Economic Dynamics and Control, vol. 16,no. 3 (July–October 1992), pp. 427–450. Bodie, Merton, and Samuelson have shown that equity holdings can vary with age because stock returns can be correlated with labor income.
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CONCLUSIONNo one denies that in the short run stocks are riskier than fixed-incomeassets. But in the long run, history has shown that stocks are actually lessrisky investments than bonds. The inflation uncertainty that is inherentin the paper money standard that the United States and the rest of theworld have adopted indicates that “fixed income” does not mean “fixedpurchasing power.” Despite the dramatic gains in price stability seenover the past decade, there is still much uncertainty about what a dollarwill be worth two or three decades from now. Historical evidence indicates that we can be more certain of the purchasing power of a diversified portfolio of common stocks 30 years in the future than the principalon a 30-year U.S. government bond.
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STOCK INDEXESProxies for the MarketIt has been said that figures rule the world.JOHANN WOLFGANG GOETHE, 1830
MARKET AVERAGES“How’s the market doing?” one stock investor asks another.“It’s having a good day—it’s up over 70 points.”For most of the past century, no one would ask, “What’s up 70points?” Everyone knew the answer: the Dow Jones Industrial Average,the most quoted stock average in the world. This index, popularly calledthe Dow, was so renowned that the news media often called the Dow“the stock market.” No matter how imperfectly the index describes themovement of share prices—and virtually no money manager pegs his orher performance to it—the Dow was the way virtually all investorsthought of the stock market.But today the Dow does not go unchallenged as an indicator ofmarket prices. The S&P 500, first published by Standard & Poor’s, nowa division of The McGraw-Hill Companies, in March 1957, has becomethe uncontested benchmark index for large U.S. stocks. And the Nasdaq,37Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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PART 1 The Verdict of History
an automated electronic market that began in 1971, has become the exchange of choice for technology companies. The Nasdaq index measuresthe performance of such large technology firms as Microsoft, Intel, CiscoSystems, Google, and Apple.The rise of the Nasdaq did not go unnoticed at Dow Jones. In 1999,for the first time in over 100 years, Dow Jones ventured off the Big Board,as the New York exchange is called, and selected two Nasdaq stocks—Microsoft and Intel—to join its venerable list. Here’s the story of these threevery different indexes with three unique reflections of the stock market.
THE DOW JONES AVERAGESCharles Dow, one of the founders of Dow Jones & Co. that also publishesthe Wall Street Journal, created the Dow Jones averages in the late nineteenth century. On February 16, 1885, he began publishing a daily average of 12 stocks (10 railroads and 2 industrials) that represented activeand highly capitalized stocks. Four years later, Dow published a dailyaverage based on 20 stocks—18 railroads and 2 industrials.As industrial and manufacturing firms succeeded railroads in importance, the Dow Jones Industrial Average was created on May 26,1896, from the 12 stocks shown in Table 3-1. The old index created in1889 was reconstituted and renamed the Rail Average on October 26,1896. In 1916, the Industrial Average was increased to 20 stocks, and in1928 the number was expanded to 30. The Rail Average, whose namewas changed in 1970 to the Transportation Average, is composed of 20stocks, as it has been for over a century.The early Dow stocks were centered on commodities: cotton, sugar,tobacco, lead, leather, rubber, and so on. Six of the 12 companies havesurvived in much the same form, but only one—General Electric, whichin the summer of 2007 boasted the second-highest market value on U.S.exchanges—has retained both its membership in the Dow Industrialsand its original name.1Almost all of the original Dow stocks thrived as large and successful firms, even if they did not remain in the index (see the chapter appendix for details). The only exception was U.S. Leather Corp., whichwas liquidated in the 1950s. Shareholders received $1.50 plus one shareof Keta Oil & Gas, a firm acquired earlier. But in 1955, the president,Lowell Birrell, who later fled to Brazil to escape U.S. authorities, looted1Chicago Gas Company, an original member of the 12 Dow stocks, became Peoples Energy, Inc.,and was a member of the Dow Utilities Average until May 1997.
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TABLE
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3–1
Firms in the Dow Jones Industrial Average
Keta’s assets. Shares in U.S. Leather, which in 1909 was the seventhlargest corporation in the United States, became worthless.
Computation of the Dow IndexThe original Dow Jones averages were simply the sum of the prices ofthe component shares divided by the number of stocks in the index.However, this divisor had to be adjusted over time to prevent jumps inthe index when there were changes in the companies that constituted theaverage and stock splits. In December 2006, the divisor was about0.1248, so that a 1-point rise in any Dow stock caused the average to increase about 8 points.22The procedure for computing the Dow Jones averages when a new (or split) stock is substituted isas follows: the component stock prices are added up before and after the change, and a new divisoris determined that yields the same average as before the change. Because of stock splits, the divisorgenerally moves downward over time, but the divisor could increase if a higher-priced stock is substituted for a lower-priced one in the average.
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The Dow Industrials is a price-weighted index, which means that theprices of the component stocks are added together and then divided bythe number of firms in the index. As a result, proportional movements ofhigh-priced stocks in the Dow averages have a much greater impactthan movements of lower-priced stocks, regardless of the size of thecompany. A price-weighted index has the property that when a component stock splits, the split stock has a reduced impact on the average,and all the other stocks a slightly increased impact.3Price-weighted indexes are unusual since the impact of the firm’sprice on the index has nothing to do with the relative size of the company. This is in stark contrast to a capitalization-weighted index, such asStandard & Poor’s 500 Index, which is described later in the chapter. Asof December 2006, the 30 Dow stocks were valued at $4.2 trillion, whichis about 25 percent of the capitalization of the entire U.S. market. Out ofthe 10 largest U.S.-based capitalization stocks, all but Bank of Americaare in the Dow Industrials. But not all the Dow stocks are large. TwoDow stocks are not even in the top 100: Alcoa and General Motors. Andthe smallest, General Motors, is ranked below 200 and has about 4 percent of the market value of Exxon Mobil, which is the largest component.
Long-Term Trends in the Dow JonesFigure 3-1 plots the monthly high and low of the Dow Jones IndustrialAverage from its inception in 1885, corrected for changes in the costof living. The inset shows the Dow Industrial Average uncorrected forinflation.A trend line and a channel are created by statistically fitting the Dowon a time trend. The upper and lower bounds are 1 standard deviation,or 50 percent, above and below the trend. The slope of the trend line, 1.85percent per year, is the average compound rate at which the Dow stockshave appreciated, excluding inflation, since 1885. The Dow Jones average, like most other popular averages, does not include dividends, sothe change in the index greatly understates the total return on the Dowstocks. Since the average dividend yield on stocks was about 4.3 percentduring this time, the total annual real compound return on the Dowstocks was 6.2 percent over this period, a bit below the long-term realstock return reported in Chapter 1.3
Before 1914, the divisor was left unchanged when a stock split, and the stock price was multipliedby the split ratio when computing the index. This led to rising stocks having greater weight in theaverage, something akin to value-weighted stock indexes today.
CHAPTER 3 Stock Indexes
FIGURE
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3–1
The Real Dow Jones Industrial Average, February 1885 through December 2006 (in 2006 Dollars)
The inflation-corrected Dow has stayed within the channel aboutthree-quarters of the time. When the Dow broke out of the channel to theupside, as it did in 1929 and again in the mid-1960s, stocks subsequentlysuffered poor short-term returns. Likewise, when stocks penetrated thechannel on the downside, they subsequently experienced superiorshort-term returns.
BEWARE THE USE OF TREND LINES TO PREDICT FUTURE RETURNSUsing channels and trend lines to predict future returns, however tempting, can be misleading. Long-standing trends have been broken in thepast. Uncorrected for inflation, the Dow Industrials broke and stayedabove the trend line in the mid-1950s, as shown in the inset of Figure 3-1.This is because inflation, caused by the shift to a paper money standard,
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propelled nominal stock prices justifiably above their previous, noninflationary trend. Those who used trend-line analysis and who failed to analyze stock prices in real, instead of nominal, terms would have sold in1955 and never reentered the market.4But there is now another justification why the channel may be penetrated on the upside. Stock indexes record only capital appreciation, andthey therefore understate total returns, which must include dividends.But firms have been paying an ever-lower fraction of their earnings asdividends. More of the return is being pushed into capital gains throughstock buybacks and reinvestment of earnings. Since the average dividendyield on stocks has fallen 2.88 percentage points since 1980, a new channel has been drawn in Figure 3-1 with a 2.88 percentage point higherslope to represent increased capital gains. By that measure the Dow levelat the end of 2006, although at a peak, was within 1 standard deviation ofthe mean.
VALUE-WEIGHTED INDEXESStandard & Poor’s IndexAlthough the Dow Jones Industrial Average was published in 1885, itwas certainly not a comprehensive index of stock values, covering atmost 30 stocks. In 1906 the Standard Statistics Co. was formed, and in1918 it began publishing the first index of stock values based on eachstock’s performance weighted by its capitalization, or market value.This technique is now recognized as giving the best indication of theoverall market, and it is almost universally used in establishing marketbenchmarks. In 1939, Alfred Cowles, founder of the Cowles Commission for Economic Research, constructed indexes of stock values back to1871 that consisted of all stocks listed on the New York Stock Exchangeusing Standard & Poor’s market-weighting techniques.The Standard & Poor’s stock price index began in 1923, and in 1926it became the Standard & Poor’s Composite Index containing 90 stocks.The index was expanded to 500 stocks on March 4, 1957, and it becamethe S&P 500 Index. At that time, the value of the S&P 500 Index comprised about 90 percent of the value of all NYSE-listed stocks. The 500stocks contained exactly 425 industrial, 25 railroad, and 50 utility firms.Before 1988, the number of companies in each industry was restricted tothese guidelines.4
For a related situation in which a long-standing benchmark was broken because of inflation, seethe first section in Chapter 7, “An Evil Omen Returns.”
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A base value of 10 was chosen for the average value of the S&Pindex from 1941 to 1943 so that when the index was first published in1957, the average price of a share of stock (which stood between $45and $50) was approximately equal to the value of the index. An investor at that time could easily identify with the changes in the S&P500 Index since a 1-point change approximated the price change for anaverage stock.The S&P 500 Index does not contain the 500 largest stocks, nor areall the stocks in the index U.S.-based corporations. For example, WarrenBuffett’s Berkshire Hathaway, which S&P considers a holding company,is not in the S&P 500 Index. On the other hand, the S&P 500 Index has afew firms that are quite small, representing companies that have fallenin value and have yet to be replaced. As of March 2007, the total value ofall S&P 500 companies was about $12.7 trillion, but this constituted lessthan 75 percent of the value of all stocks traded in the United States, significantly less than 50 years ago when the index comprised almost 90percent of the market. A history of the S&P 500 Index and the insightsthat come from analyzing these stocks in this world-famous index is described in the next chapter.
Nasdaq IndexOn February 8, 1971, the method of trading stocks underwent a revolutionary change. On that date, an automated quotation system called theNasdaq (for National Association of Securities Dealers Automated Quotations) provided up-to-date bid and asked prices on 2,400 leading “overthe-counter” (OTC) stocks. Formerly, quotations for these unlisted stockswere submitted by the principal trader or by brokerage houses that carried an inventory. The Nasdaq linked the terminals of more than 500 market makers nationwide to a centralized computer system.In contrast to the Nasdaq, stocks traded on the New York or American Stock Exchanges are assigned to a single specialist, who is chargedwith maintaining an orderly market in that stock. The Nasdaq changedthe way quotes were disseminated and made trading these issues farmore attractive to both investors and traders.At the time that the Nasdaq was created, it was clearly more prestigious to be listed with an exchange (and preferably the New York StockExchange) than be traded on the Nasdaq. Nasdaq stocks tended to besmall or new firms that had recently gone public or did not meet the listing requirements of the larger exchanges. However, many young technology firms found the computerized Nasdaq system a natural home.
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Some, such as Intel and Microsoft, chose not to migrate to the Big Board,as the NYSE was termed, even when they qualified to do so.The Nasdaq Index, which is a capitalization-weighted index of allstocks traded on the Nasdaq, was set at 100 on the first day of trading in1971. It took almost 10 years to double to 200 and another 10 years toreach 500 in 1991. It reached its first major milestone of 1,000 in July 1995.As the interest in technology stocks grew, the rise in the NasdaqIndex accelerated, and it doubled its value to 2,000 in just three years. Inthe fall of 1999, the technology boom sent the Nasdaq into orbit. Theindex increased from 2,700 in October 1999 to its all-time peak of5,048.62 on March 10, 2000.The increase in popularity of Nasdaq stocks resulted in a tremendous increase in volume on the exchange. At the onset, the volume onthe Nasdaq was a small fraction of that on the New York Stock Exchange. By 1994 share volume on the Nasdaq exceeded that on theNYSE, and five years later dollar volume on the Nasdaq surpassed theNYSE as well.5No longer was the Nasdaq the home of small firms waiting to qualify for Big Board membership. By 1998 the capitalization of the Nasdaqhad already exceeded that of the Tokyo Stock Exchange. At the marketpeak in March 2000, the total market value of firms traded on the Nasdaq reached nearly $6 trillion, more than one-half that of the NYSE andmore than any other stock exchange in the world. At the peak, Nasdaq’sMicrosoft and Cisco had the two largest market values in the world, andNasdaq-listed Intel and Oracle were also among the top 10. By 2007 Microsoft was the only Nasdaq stock among U.S. stocks ranked in the top10 by market value.When the technology bubble burst, trading and prices on the Nasdaq sunk rapidly. The Nasdaq Index declined from over 5,000 in March2000 to 1,150 in October 2002 before rebounding to 2,400 at the end of2006. Trading also fell off from an average of over 2.5 billion shares whenprices peaked to approximately 2 billion shares in 2007. Despite the decline in the Nasdaq Index, the Nasdaq still trades in some of the world’smost active stocks.Although there is a lively rivalry between the Nasdaq and theNYSE, most investors should not be concerned about what exchange a5There is admittedly some double counting of volume in the Nasdaq dealer system due to the factthat the dealer buys the security rather than acting as an auctioneer. See Anne M. Anderson and Edward A. Dyl, “Trading Volume: NASDAQ and the NYSE,” Financial Analysts Journal, vol. 63, no. 3(May/June 2007), p. 79.
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stock is listed on. Small stocks may be better served by having a specialist provide liquidity, but the spread between the price a stock sells forand the price it can be bought for may be lower on active stocks underthe Nasdaq market maker system. There is now rapid consolidationamong exchanges, and cross-listing of issues is now becoming common.The importance of what exchange a stock is listed on will decline evenmore in the future.6
Other Stock Indexes: The Center for Research in Security Prices (CRSP)In 1959, Professor James Lorie of the Graduate School of Business of theUniversity of Chicago received a request from the brokerage house MerrillLynch, Pierce, Fenner & Smith. The firm wanted to investigate how wellpeople had done investing in common stock and could not find reliablehistorical data. Professor Lorie teamed up with colleague Lawrence Fisherto build a database of securities data that could answer that question.With computer technology in its infancy, Lorie and Fisher createdthe Center for Research in Security Prices (CRSP, pronounced “crisp”)that compiled the first machine-readable file of stock prices dating from1926 that was to become the accepted database for academic and professional research. The database currently contains all stocks traded on theNew York and American Stock Exchanges and the Nasdaq.At the end of 2006, the market value of the 6,744 stocks was $18trillion.The largest comprehensive index of U.S. firms, Figure 3-2 showsthe size breakdown and total market capitalization of the stocks in thisindex. The top 500 firms, which closely mirror the S&P 500 Index, constitute 74.6 percent of the market value of all stocks. The top 1,000 firmsin market value, which are virtually identical to the Russell 1000 andpublished by the Russell Investment Group, comprise 85.4 percent of thetotal value of equities. The Russell 2000 contains the next 2,000 largestcompanies, which adds an additional 11.7 percent to the market value ofthe total index. The Russell 3000, the sum of the Russell 1000 and 2000indexes, comprises 97.1 percent of all U.S. stocks. The remaining 3,744stocks constitute 2.9 percent of the value.Closely related to the CRSP Total Return indexes is the Dow JonesWilshire 5000 Index, which was founded in 1974 and contains approximately 5,000 firms.6Institutions have their own ways of dealing with big blocks of stock no matter what exchange thestock is listed on.
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PART 1 The Verdict of History
FIGURE
3–2
CRSP Total Market Index (Value at $18.12 trillion in September 2007)
RETURN BIASES IN STOCK INDEXESBecause stock indexes such as the S&P 500 Index constantly add newfirms and delete old ones, some investors believe that the return calculated from these indexes will be higher than the return that can beachieved by investors in the overall market.But this is not the case. It is true that the best-performing stocks willstay in the S&P 500 Index, but this index misses the powerful upsidemove of many small and mid-sized issues. For example, Microsoft wasnot added to the S&P 500 Index until June 1994, eight years after goingpublic. While small stock indexes are the incubators of some of the greatest growth stocks, they also contain those “fallen angels” that droppedout of the large-cap indexes and are headed downward.
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An index is not biased if its performance can be replicated ormatched by an investor. To replicate an index, the date of additions anddeletions to the index must be announced in advance so that new stockscan be bought and deleted stocks can be sold. This is particularly important for issues that enter into bankruptcy: the postbankrupt price (whichmight be zero) must be factored into the index. All the major stock indexes, such as Standard & Poor’s, Dow Jones, and the Nasdaq, can bereplicated by investors.7 Consequently, there is no statistical reason tobelieve that capitalization-based indexes give a biased representation ofthe return on the market.
APPENDIX: WHAT HAPPENED TO THEORIGINAL 12 DOW INDUSTRIALS?Two stocks (General Electric and Laclede) retained their original name(and industry); five (American Cotton, American Tobacco, Chicago Gas,National Lead, and North American) became large public companies intheir original industries; one (Tennessee Coal and Iron) was merged intothe giant U.S. Steel; and two (American Sugar and U.S. Rubber) wentprivate—both in the 1980s. Surprisingly, only one (Distilling and CattleFeeding) changed its product line (from alcoholic beverages to petrochemicals, although it still manufactures ethanol), and only one (U.S.Leather) liquidated. Here is a rundown of the original 12 stocks (marketcapitalizations as of March 2007):American Cotton Oil became Best Food in 1923, Corn Products Refining in 1958, and finally, CPC International in 1969—a majorfood company with operations in 58 countries. In 1997, CPCspun off its corn-refining business as Corn Products International and changed its name to Bestfoods. Bestfoods was acquired by Unilever in October 2000 for $20.3 billion. Unilever(UN), which is headquartered in the Netherlands, has a currentmarket value of $43.2 billion.American Sugar became Amstar in 1970 and went private in 1984. InSeptember 1991 the company changed its name to DominoFoods, Inc., to reflect its world-famous Domino line of sugarproducts.
7The original Value Line Index of 1,700 stocks, which was based on a geometric average of thechanges in the individual stocks, was biased downward. This eventually led Value Line to abandonthe geometric average in favor of the arithmetic one, which could be replicated.
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American Tobacco changed its name to American Brands (AMB) in1969 and to Fortune Brands (FO) in 1997, a global consumerproducts holding company with core business in liquor, officeproducts, golf equipment, and home improvements. AmericanBrands sold its American Tobacco subsidiary, including the PallMall and Lucky Strike brands, to one-time subsidiary B.A.T. Industries in 1994. The current market value is $12.1 billion.Chicago Gas became Peoples Gas Light & Coke Co. in 1897, and thenPeoples Energy Corp., a utility holding company, in 1980. Peoples Energy Corp. (PGL) was bought by WPS Resources andchanged its name in 2006 to Integrys Energy Group (TEG). It hasa market value of $4.1 billion. PGL was a member of the DowJones Utility Average until May 1997.Distilling and Cattle Feeding went through a long and complicatedhistory. It changed its name to American Spirits Manufacturingand then to Distiller’s Securities Corp. Two months after the passage of prohibition, the company changed its charter and became U.S. Food Products Corp. and then changed its name againto National Distillers and Chemical. The company becameQuantum Chemical Corp. in 1989, a leading producer of petrochemicals and propane. Nearing bankruptcy, it was purchasedfor $3.4 billion by Hanson PLC, an Anglo-American conglomerate. It was spun off as Millennium Chemicals (MCH) in October1996. Lyondell Chemical (LYO) bought Millennium Chemicalsin November 2004. The current market value of Lyondell is $7.7billion.General Electric (GE), founded in 1892, is the only original stock stillin the Dow Industrials. GE is a huge manufacturing and broadcasting conglomerate that owns NBC and CNBC. Its marketvalue of $359 billion is the second highest in the world.Laclede Gas (LG) changed its name to Laclede Group, Inc., and it is aretail distributor of natural gas in the St. Louis area. The marketvalue is $647 million.National Lead (NL) changed its name to NL Industries in 1971, and itmanufactures titanium dioxide and specialty chemicals. Themarket value is $4.96 billion.North American became Union Electric Co. (UEP) in 1956, providingelectricity in Missouri and Illinois. In January 1998, UEP mergedwith Cipsco (Central Illinois Public Service Co.) to form Ameren(AEE) Corp. The market value is $10.5 billion.
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Tennessee Coal and Iron was bought out by U.S. Steel in 1907, and itbecame USX-U.S. Steel Group (X) in May 1991. In January 2002,the company changed its name back to U.S. Steel Corp. U.S. Steelhas a market value of $10.2 billion.U.S. Leather, one of the largest makers of shoes in the early part ofthis century, liquidated in January 1952, paying its shareholders$1.50 plus stock in an oil and gas company that was to becomeworthless.U.S. Rubber became Uniroyal in 1961, and it was taken private inAugust 1985. In 1990 Uniroyal was purchased by the MichelinGroup, which has a market value of 13 billion.
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THE S&P 500 INDEXA Half Century of U.S. Corporate HistoryMost of the change we think we see in life is due to truths being in andout of favor.R O B E RT F R O S T, “ T H E B L A C K C O T TA G E , ” 1 9 1 4
Out of the three stock market indexes, the Dow, the Nasdaq, and the S&P500, only one became the world standard for measuring the performance for U.S. stocks. It was born on February 28, 1957, and it grew out ofStandard & Poor’s Composite Index, a capitalization-weighted indexbegun in 1926 that contained 90 large stocks. Ironically, the 1926 indexexcluded the largest stock in the world at that time, American Telephoneand Telegraph, because S&P did not want to let the performance of sucha large firm dominate the index. To correct this omission and to recognize the growth of new firms in the 1950s, Standard & Poor’s compiledan index of 500 of the largest industrial, rail, and utility firms that tradedon the New York Stock Exchange.The S&P 500 Index comprised about 85 percent of the total value offirms traded on the Big Board in 1957. It soon became the standardagainst which the performance of institutions and money managers in51Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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vesting in large U.S. stocks was compared. The S&P 500 Index originallycontained exactly 425 industrial, 25 rail, and 50 utility firms, but thesegroupings were abandoned in 1988 in order to maintain, as S&Pclaimed, an index that included “500 leading companies in leading industries of the economy.”Since its creation, the index has been continually updated byadding new firms that meet Standard & Poor’s criteria for market value,earnings, and liquidity while deleting an equal number that fall belowthese standards.1 The total number of new firms added to the S&P 500Index from its inception in 1957 through 2006 was 987, an average ofabout 20 per year. On average the new firms constitute about 5 percentof the market value of the index.The highest number of new firms added to the index in a singleyear occurred in 1976, when Standard & Poor’s added 60 firms including 15 banks and 