ynes, “An American Study of Shares versus Bonds as Permanent Investments,”The Nation & The Athenaeum, May 2, 1925, p. 157.12Quoted by Edgar Lawrence Smith in Common Stocks and Business Cycles, New York: William-Frederick Press, 1959, p. 20.13Edgar Lawrence Smith, “Market Value of Industrial Equities,” Review of Economic Statistics, vol. 9(January 1927), pp. 37–40, and “Tests Applied to an Index of the Price Level for Industrial Stocks,”Journal of the American Statistical Association, Supplement (March 1931), pp. 127–135.14Siegfried Stern, Fourteen Years of European Investments, 1914–1928, London: Bankers’ PublishingCo., 1929.
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Common Stock Theory of InvestmentThe research demonstrating the superiority of stocks became known asthe “common stock theory of investment.”15 Smith himself was carefulto not overstate his findings. He wrote:Over a period of years the principal value of a well-diversified holding of common stocks of representative corporations in essential industries tends toincrease in accordance with the operation of compound interest. . . . Suchstock holding may be relied upon over a term of years to pay an average income return on such increasing values of something more than the average current rate on commercial paper.16
Yet Chelcie C. Bosland, a professor of economics at Brown University in the 1930s, claimed that the common stock theory was often misused to justify any investment in stocks no matter what the price.Bosland stated:The purchase of common stocks after 1922 was more likely to result inprofit than in loss. Even though this was largely a cyclical up-swing, manybelieved that it was a vindication of the theory that common stocks aregood long-term investments. Participation in this profit-making procedure became widespread. The “boom psychology” was everywhere in evidence. No doubt the “common stock theory” gave even to the downrightspeculator the feeling that his actions were based upon the solid rock ofscientific finding.17
A RADICAL SHIFT IN SENTIMENTBut the glorious days for common stocks did not last. The crash pushedthe image of stocks as safe and fundamentally sound investments intothe doghouse and with it Smith’s contention that stocks were the bestlong-term investments. Lawrence Chamberlain, an author and wellknown investment banker, stated, “Common stocks, as such, are not superior to bonds as long-term investments, because primarily they are notinvestments at all. They are speculations.”18The common stock theory of investment was attacked from all angles. In 1934, Benjamin Graham, an investment fund manager, and15
Chelcie C. Bosland, The Common Stock Theory of Investment, Its Development and Significance, NewYork: Ronald Press, 1937.16Smith, Common Stocks as Long-Term Investments, p. 79, emphasis added.17Bosland, The Common Stock Theory of Investment, p. 4.18Lawrence Chamberlain and William W. Hay, Investment and Speculations, New York: Henry Holt &Co., 1931, p. 55, emphasis his.
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David Dodd, a finance professor at Columbia University, wrote SecurityAnalysis, which became the bible of the value-oriented approach to analyzing stocks and bonds. Through its many editions, the book has had alasting impact on students and market professionals alike.Graham and Dodd clearly blamed Smith’s book for feeding the bullmarket mania of the 1920s by proposing plausible-sounding but fallacious theories to justify the purchase of stocks. They wrote:The self-deception of the mass speculator must, however, have its elementof justification. . . . In the new-era bull market, the “rational” basis was therecord of long-term improvement shown by diversified common-stockholdings. [There is] a small and rather sketchy volume from which thenew-era theory may be said to have sprung. The book is entitled CommonStocks as Long-Term Investments by Edgar Lawrence Smith, published in1924.19
THE POSTCRASH VIEW OF STOCK RETURNSAs the news spread about all the people who lost their life savings in themarket, the notion that stocks could still beat other financial assetssounded ludicrous.In the late 1930s, Alfred Cowles III, founder of the Cowles Commission for Economic Research, constructed capitalization-weightedstock indexes back to 1871 of all stocks traded on the New York Stock Exchange. Cowles examined stock returns including reinvested dividendsand concluded:During that period [1871–1926] there is considerable evidence to supportthe conclusion that stocks in general sold at about three-quarters of theirtrue value as measured by the return to the investor.20
Yet Cowles placed the blame for the crash of 1929 squarely on theshoulder of the government, claiming that increased taxation and government controls drove stock prices downward.As stocks slowly recovered from the Depression, their returnsseemed to warrant a new look. In 1953, two professors from the University of Michigan, Wilford J. Eiteman and Frank P. Smith, published astudy of the investment returns on all industrial companies with trading19
Benjamin Graham and David Dodd, Security Analysis, 2d ed., New York: McGraw-Hill, 1940, p.357.20Alfred Cowles III and associates, Common Stock Indexes 1871–1937, Bloomington, Ind.: PricipiaPress, 1938, p. 50.
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volume over 1 million shares in 1936. By regularly purchasing these 92stocks without any regard to the stock market cycle (a strategy called dollar cost averaging), they found that the returns over the next 14 years, at12.2 percent per year, far exceeded those in fixed-income investments.Twelve years later they repeated the study, using the same stocks theyhad used in their previous study. This time the returns were even higherdespite the fact that they made no adjustment for any of the new firmsor new industries that had surfaced in the interim. They wrote:If a portfolio of common stocks selected by such obviously foolish methods as were employed in this study will show an annual compound rateof return as high as 14.2 percent, then a small investor with limited knowledge of market conditions can place his savings in a diversified list ofcommon stocks with some assurance that, given time, his holding willprovide him with safety of principal and an adequate annual yield.21
Many dismissed the Eiteman and Smith study because it did not include the Great Crash of 1929 to 1932. But in 1964, two professors fromthe University of Chicago, Lawrence Fisher and James H. Lorie, examined stock returns through the stock crash of 1929, the Great Depression,and World War II.22 Fisher and Lorie concluded that stocks offered significantly higher returns (which they reported at 9.0 percent per year)than any other investment media during the entire 35-year period, 1926through 1960. They even factored taxes and transaction costs into theirreturn calculations and concluded:It will perhaps be surprising to many that the returns have consistently beenso high. . . . The fact that many persons choose investments with a substantially lower average rate of return than that available on common stockssuggests the essentially conservative nature of those investors and the extent of their concern about the risk of loss inherent in common stocks.23
Ten years later, Roger Ibbotson and Rex Sinquefield published aneven more extensive review of returns in an article entitled “Stocks,Bonds, Bills, and Inflation: Year-by-Year Historical Returns (1926–74).”24They acknowledged their indebtedness to the Lorie and Fisher studyand confirmed the superiority of stocks as long-term investments. Theirsummary statistics, which are published annually in yearbooks, are fre21
Wilford J. Eiteman and Frank P. Smith, Common Stock Values and Yields, Ann Arbor: University ofMichigan Press, 1962, p. 40.22“Rates of Return on Investment in Common Stocks,” Journal of Business, vol. 37 (January 1964), pp.1–21.23Ibid., p. 20.24Journal of Business, vol. 49 (January 1976), pp. 11–43.
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quently quoted and have often served as the return benchmarks for thesecurities industry.25
THE BEGINNING OF THE GREAT BULL MARKETThe Ibbotson and Sinquefield findings were first published in the teethof the worst bear market since the Great Depression. Because of the Vietnam War, surging inflation, and the OPEC oil embargo, real stock returns were negative from the end of 1966 through the summer of 1982.But as the Fed successfully squeezed out inflation and interest rates fellsharply, the stock market began its greatest bull market run in August1982. From a level of 790 the Dow began to shoot skyward, surging past1,000 to a new record by the end of year.Amid much skepticism, some analysts took the correct view of themarkets. Robert Foman, president and chairman of E.F. Hutton, proclaimed in October 1983 that we are “in the dawning of a new age of equities” and boldly predicted the Dow Jones average could hit 2,000 ormore by the end of the decade.But even Foman was too pessimistic, as the Dow Industrials broke2,000 in January 1987. Except for the great stock crash that occurred thatOctober, which is documented in Chapter 16, stocks marched steadilyupward, and the Dow broke 3,000 just before Saddam Hussein invadedKuwait in August 1990. The Gulf War and a real estate recession precipitated a second bear market, but this one, like the crash in 1987, wasshort-lived.Iraq’s defeat in the Gulf War ushered in one of the most fabulousdecades in stock market history. The world witnessed the collapse of communism and diminished threat of global conflict. The transfer of resourcesfrom military expenditures to domestic consumption enabled the UnitedStates to experience increased economic growth and low inflation. The interests of Americans turned inward, and the postwar baby boomers became preoccupied with career enhancement and retirement security.The Dow Industrials quickly scaled 3,000 in March 1991. Fewthought the trend would last. In 1992, Forbes warned investors in a coverstory “The Crazy Things People Say to Rationalize Stock Prices” thatstocks were in the “midst of a speculative buying panic” and citedRaskob’s foolish advice to invest at the market peak in 1929.2625
Stocks, Bonds, Bills, and Inflation Yearbooks, 1983–1997, Chicago: Ibbotson and Associates.William Baldwin, “The Crazy Things People Say to Rationalize Stock Prices,” Forbes, April 27,1992, pp. 140–150.26
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But such caution was ill advised. After a successful battle againstinflation in 1994, the Fed eased interest rates and the Dow subsequentlymoved above 4,000 in early 1995. When the Dow was at 4,300, BusinessWeek defended the durability of the bull market in an article on May 15,1995, entitled “Dow 5000? Don’t Laugh.” The Dow quickly crossed thatbarrier by November and then reached 6,000 eleven months later.By late 1995, the persistent rise in stock prices caused many moreanalysts to sound the alarm. Michael Metz of Oppenheimer, CharlesClough of Merrill Lynch, and Byron Wein of Morgan Stanley expressedstrong doubts about the underpinnings of the rally. In September 1995,David Shulman, chief equity strategist for Salomon Brothers, wrote anarticle entitled “Fear and Greed,” which compared the current marketclimate to that of similar stock market peaks in 1929 and 1961. Shulman claimed intellectual support was an important ingredient in sustaining bull markets, noting Edgar Smith’s and Irving Fisher’s work inthe 1920s, the Fisher-Lorie studies in the 1960s, and my Stocks for theLong Run, published in 1994. Shulman’s own long-term studies, basedon dividend growth, reinforced his long-term bearish views onstocks.27
WARNINGS OF OVERSPECULATIONBy 1996 price-earnings ratios on the S&P 500 Index reached 20, considerably above its average postwar level. More warnings were issued.Roger Lowenstein, a well-known author and financial writer, asserted inthe Wall Street Journal:Investing in stocks has become a national hobby and a national obsession.People may denigrate their government, their schools, their spoiled sportsstars. But belief in the market is almost universal. To update Marx, it is thereligion of the masses.28
Floyd Norris, lead financial writer for the New York Times, echoedLowenstein’s comments by penning an article in January 1997 “In theMarket We Trust.”29 Henry Kaufman, the Salomon Brothers guru whosepronouncements on the fixed-income market had frequently rockedbonds in the 1980s, declared that “the exaggerated financial euphoria is27Three months later, in December 1995, Shulman capitulated to the bullish side, claiming his longtime emphasis on dividend yields was incorrect.28Roger Lowenstein, “A Common Market: The Public’s Zeal to Invest,” Wall Street Journal, September 9, 1996, p. A1.29Floyd Norris, “In the Market We Trust,” New York Times, January 12, 1997.
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increasingly conspicuous,” and he cited assurances offered by optimistsequivalent to Irving Fisher’s utterance that stocks had reached a permanently high plateau.30Warnings of the end of the bull market did not emanate just fromWall Street. Academicians were increasingly investigating this unprecedented rise in stock values. Robert Shiller of Yale University and JohnCampbell of Harvard wrote a scholarly paper showing that the marketwas significantly overvalued and presented this research to the board ofgovernors of the Federal Reserve System in early December 1996.31With the Dow surging past 6,400, Alan Greenspan, chairman of theFederal Reserve, issued a warning in a speech before the annual dinnerfor the American Enterprise Institute (AEI) in Washington on December5, 1996. He asked, “How do we know when irrational exuberance hasunduly escalated asset values, which then become subject to unexpectedand prolonged contractions as they have in Japan over the past decade?And how do we factor that assessment into monetary policy?”His words had an electrifying effect, and the phrase “irrational exuberance” became the most celebrated utterance of Greenspan’s tenureas Fed chairman. Asian and European markets fell dramatically as hiswords were flashed across computer monitors. The next morning WallStreet opened dramatically lower. But investors quickly regained theirbalance, and stocks closed in New York with only moderate losses.From there it was onward and upward, with the Dow breaking7,000 in February 1997 and 8,000 in July. Even Newsweek’s cautious coverstory “Married to the Market,” depicting a Wall Street wedding betweenAmerica and a bull, did nothing to quell investor optimism.32The market became an ever-increasing preoccupation of middleand upper-income Americans. Business books and magazines proliferated, and the all-business cable news stations, particularly CNBC, drewhuge audiences. Television sets in bars, airports, and other public placeswere invariably tuned to an all-business network. Electronic tickers andall-business TV stations were broadcast in lunchrooms, bars, and evenlounges of the major business schools throughout the country. Cruise30Henry Kaufman, “Today’s Financial Euphoria Can’t Last,” Wall Street Journal, November 25, 1996,p. A18.31Robert Shiller and John Campbell, “Valuation Ratios and the Long-Run Stock Market Outlook,”Journal of Portfolio Management, vol. 24 (Winter 1997).32Newsweek, April 27, 1998. Cover stories about the stock market in major newsweeklies have oftenbeen poorly timed. BusinessWeek’s cover article “The Death of Equities” on August 13, 1979, occurred 14 years after the market had peaked and 3 years before the beginning of the greatest bullmarket in stocks.
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ships and resorts in some of the world’s most isolated locations weresure to carry all-financial stations. Air travelers could view up-to-theminute Dow and Nasdaq averages flying 35,000 feet above the sea asthey were flashed from monitors on phones anchored to the back of theseat in front of them.Adding impetus to the already surging market was the explosion ofcommunications technology. Internet service providers such as AOL allowed investors to stay in touch with markets and their portfolio fromanywhere in the world. Whether it was from Internet “chat rooms,” financial Web sites, or e-mail newsletters, investors found access to aplethora of information at their fingertips. CNBC became so popularthat major investment houses made sure that all their brokers watchedthe station on television or their desktop computers so that they could beone step ahead of clients calling in with breaking business news.The bull market psychology appeared impervious to financial andeconomic shocks. The first wave of the Asian crisis, discussed further inChapter 10, sent the market down a record 554 points on October 27,1997, and closed trading temporarily. But this did little to dent investors’enthusiasm for stocks.The following year, the Russian government defaulted on itsbonds, and Long-Term Capital Management, considered the world’spremier hedge fund, found itself entangled in speculative positionsmeasured in the trillions of dollars that it could not trade. Markets temporarily seized up, and the Federal Reserve facilitated a rescue of thefund in order to resuscitate financial markets. These events sent the DowIndustrials down almost 2,000 points, but three quick Fed rate cuts sentthe market soaring again. On March 29, 1999, the Dow closed above10,000, and it then went on to a record close of 11,722.98 on January 14,2000.
THE TOP OF THE BUBBLEAs always, the bull market gave birth to those who envisioned muchhigher stock prices. In 1999, two economists, James Glassman and KevinHassett, published a book entitled Dow 36,000. They claimed that theDow Jones Industrial Average, despite its meteoric rise, was still grosslyundervalued, and its true valuation was nearly three times higher at36,000. They incorrectly asserted that the theoretical underpinning fortheir analysis came from my book Stocks for the Long Run! Since I showedthat nominal (nonindexed) bonds were as risky as stocks over long horizons, they improperly claimed that stock prices should rise sufficiently
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to reduce their returns to those of bonds, which implied an astronomicallevel for stock prices.33Despite the pundits’ preoccupation with the Dow Industrials, thereal action in the market was in the Nasdaq. The once sleepy over-thecounter market in unlisted stocks soared to preeminence as the public’sfascination with computers, the Internet, mobile communications, andnetworking firms blossomed. Volume on the Nasdaq eclipsed the NewYork Stock Exchange, as investors feverishly traded shares in Cisco, SunMicrosystems, Oracle, JDS Uniphase, and other companies that werescarcely in existence a decade earlier. The most heated pace of tradingcentered on the Internet stocks, where a dot-com index of 24 online firmssoared from 142 in November 1997 to a high of 1,350 on March 10, 2000.
THE BEAR MARKET AND ITS AFTERMATHThe date March 10, 2000, marked the peak not only of the Nasdaq butalso of many Internet and technology stock indexes. When capital expenditures in technology unexpectedly slowed, the bubble burst and asevere bear market began. Measured by the S&P 500 Index, the marketdeclined by 49.15 percent between March 10 and October 9, 2000, eclipsing the 48.2 percent decline in the 1972 to 1974 bear market and the worstsince the Great Depression. There were some redeeming features to thedevastation. Since inflation had been far lower during the recent bearmarket, the after-inflation decline was considerably more moderate, andsmall stocks did not fall nearly as much in the 2002 bear market as theydid in the 1970s.Still, the decline in stock values exceeded $9 trillion, by far thegreatest loss in history. The bear market came in two waves. The firstwas the popping of the technology bubble, which sent the Nasdaq indexplummeting by nearly 70 percent by the summer of 2001. Nontechstocks held up very well until the second wave of the bear market, whichwas sparked by the spectacular crash of Enron and allegations of accounting irregularities at many firms, including such blue chips as General Electric.Just as the bull market brought out the optimists, the collapsingstock prices brought out the bears in droves. In September 2002, Bill33
I immediately wrote a rebuttal in the Wall Street Journal (“Are Internet Stocks Overvalued? AreThey Ever,” April 19, 1999, p. A22) stating that their analysis was faulty and that stocks must havereturns exceeding those on U.S. Treasury inflation-protected bonds, whose yield had reached 4 percent at that time.
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Gross, the legendary head of the PIMCO bond trading department andhead of at that time the largest mutual fund in existence, came out withan piece entitled “Dow 5,000” in which he said that despite the market’sawful decline, stocks were still nowhere near as low as they should be onthe basis of economic fundamentals. As will be discussed in the nextchapter, this analysis was wrong since it concentrated on historicalgrowth of earnings, failing to take into account changes in dividend andinvestment policies that impacted future growth. Here, within a periodof a couple years, you had economists claiming the right value for theDow was as high as 36,000 and as low as 5,000.The bear market squelched the public’s fascination with stocks.Televisions in public venues were no longer tuned to CNBC but insteadswitched on sports and Hollywood gossip. As one bar owner colorfullyput it, “People are licking their wounds and they don’t want to talk aboutstocks anymore. It’s back to sports, women, and who won the game.”34The bear market also left many professionals skeptical of stocks. Yetbonds did not seem an attractive alternative, as their yields had declinedbelow 4 percent. Many looked to other, nontraditional assets that mightlead the way.David Swensen, chief investment officer at Yale University since1985, seemed to provide that answer. At the peak of the bull market, hewrote a book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, that espoused the qualities of “nontraditional” (and often illiquid) assets, such as private equity, venturecapital, real estate, timber, and hedge funds. Hedge funds—pools of investment money that can be invested in any way the fund managers seefit, often in the nonconventional assets Swensen advocated—enjoyed aboom.35 From a mere $100 billion in 1990, assets of hedge funds grew toover $1.5 trillion by 2007.But the surge of assets into hedge funds drove the prices of manyunconventional assets to levels never before seen. Jeremy Grantham, asuccessful money manager at GMO and a one-time big booster of unconventional investing, stated in April 2007, “After these moves, mostdiversifying and exotic assets are badly overpriced.”36 In comparison, in
34
Paul Sloan, “The Craze Collapses,” US News and World Report Online, November 30, 2000.The word hedge means “to offset,” as someone making an investment in a foreign market maywant to hedge, or offset, adverse currency movements with a transaction in the forward market.Hedge funds often, but not always, took positions that were contrary to the stock market.36Jeremy Grantham, “A Global Bubble Warns against the Stampede to Diversify,” Financial Times,April 24, 2007, p. 38.35
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early 2007 the valuation of stocks, particularly large-capitalization equities, was near its historical average, and many hedge funds were bidding well above the market for large, publicly traded companies.Despite the bursting of the bubble and the success of nontraditionalinvestors, many individual investors ignored these bears and retainedtheir long-term faith in stocks as the best long-term investments. Datacollected by Robert Shiller of Yale University confirmed that despite thesevere bear market of 2001 to 2002, as of January 2007, three-quarters ofinvestors believed that stocks were the best long-term investment.37And with good reason. Stocks have returned a very healthy 15 percent per year measured from the market lows reached in October 2002through the end of 2006. By 2007, stocks as measured by the popularcapitalization-weighted indexes were at or near all-time highs, havingrecovered all their losses sustained in the bear market.The bull and bear markets of the last decade were no different fromthe bull and bear markets that preceded them. As stocks rose, the bullscame out of the woodwork, and at the top they fabricated theories thatwould support even higher prices. In the subsequent down markets, thebears would pounce with justifications for even lower prices. Nearly allwould discard the long-term historical evidence that supports the casefor equities. How can investors avoid these fickle prognosticators andaccurately assess the future returns on the market? This is the topic ofour next chapter.
37
Robert Shiller, Yale School of Management Stock Market Confidence Indexes, http://icf.som.yale.edu/confidence.index.
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VALUATION, STYLEINVESTING, ANDGLOBAL MARKETS
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STOCKS: SOURCES AND MEASURESOF MARKET VALUEEven when the underlying motive of purchase [of common stocks] ismere speculative greed, human nature desires to conceal this unlovelyimpulse behind a screen of apparent logic and good sense.B E N J A M I N G R A H A M A N D D AV I D D O D D , 1 9 4 0 1
AN EVIL OMEN RETURNSIn the summer of 1958, an event of great significance took place for thosewho followed long-standing indicators of stock market value. For thefirst time in history, the interest rate on long-term government bondsrose above the dividend yield on common stocks.BusinessWeek noted this event in an August 1958 article entitled“An Evil Omen Returns,” warning investors that when yields on stocksapproached those on bonds, a major market decline was in the offing.2The stock market crash of 1929 occurred in a year when stock dividend1“The Theory of Common-Stock Investment,” Security Analysis, 2d ed., New York: McGraw-Hill,1940, p. 343.2BusinessWeek, August 9, 1958, p. 81.
95Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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yields fell to the level of bond yields. The stock crashes of 1891 and 1907also followed episodes when the yield on bonds came within 1 percentof the dividend yield on stocks.Until 1958, as Figure 7-1 indicates, the yearly dividend yield onstocks had always been higher than long-term interest rates, and financial analysts thought that this was the way it was supposed to be. Stockswere riskier than bonds and therefore should yield more in the marketplace. Under this reasoning, whenever stock prices went too high andsent dividend yields below the yields on bonds, it was time to sell.But things did not work that way in 1958. Stocks returned over 30percent in the 12 months after dividend yields fell below bond yields,and stocks continued to soar into the early 1960s.It is now understood that there were good economic reasons whythis well-respected valuation indicator fell by the wayside. Inflation increased the yield on bonds to compensate lenders for rising prices, whileinvestors bought stocks against the eroding value of money. As early asSeptember 1958, BusinessWeek noted, “The relationship between stockFIGURE
7–1
Dividend and Nominal Bond Yields, 1871 through December 2006
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and bond yields was clearly posting a warning signal, but investors stillbelieve inflation is inevitable and stocks are the only hedge against it.”3Yet many on Wall Street were puzzled by the “great yield reversal.”Nicholas Molodovsky, vice president of White, Weld & Co. and editor ofthe Financial Analysts Journal, observed:Some financial analysts called [the reversal of bond and stock yields] a financial revolution brought about by many complex causes. Others, onthe contrary, made no attempt to explain the unexplainable. They showedreadiness to accept it as a manifestation of providence in the financialuniverse.4
Imagine the investor who followed this well-regarded indicatorand pulled all his or her money out of the stock market in August 1958and put it into bonds, vowing never to buy stocks again unlessdividend yields rose above bond yields. Such an investor, if he or shewere still alive, would still be waiting to get back into stocks. After 1958,stock dividend yields never again exceeded those of bonds. Yet overthe last half century, stock returns overwhelmed the returns on fixedincome securities