Real Interest Rates


Throwing Cold Water On Dow 36,000 View
Wall Street Journal, September 21, 1999

The latest sensation among investment books is a bestseller called "Dow 36,000," which argues that the Dow Jones Industrial Average should be worth three times its current value.

Sound intriguing? Before you purchase the book - yet alone buy the argument - take a moment to listen to Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School.

"The Dow will reach 36,000 someday, but certainly not in the next decade," Mr. Siegel says. He considers "Dow 36,000" to be "well thought out" but "basically flawed."

Why care what Mr. Siegel thinks? For starters, he wrote a far better book, "Stocks for the Long Run," first published in 1994. Like "Dow 36,000," Mr. Siegel's book prodded investors to buy stocks, but without making outlandish forecasts about future returns.

But maybe more important, James Glassman and Kevin Hassett, authors of "Dow 36,000," draw on Mr. Siegel's book for a key part of their argument. Yet Mr. Siegel thinks his data are being misused.

The Glassman-Hassett thesis is simple enough. Citing Mr. Siegel's work, they note that if you hold stocks for 20 years, they appear to be no more risky than bonds. As a result, they reckon that stocks should be priced so that their expected return is the same as bonds.

In calculating what they call the "perfectly reasonable price" for stocks, the authors start with a 30-year Treasury bond yielding 5.5%. They note that the interest on the bond won't grow, while stock dividends rise over time.

Given that advantage, what should stocks initially yield to match the return on bonds? The solution lies in an elegant piece of mathematics. To match a bond yielding 5.5%, you need the initial dividend yield on stocks and the annual growth rate of that dividend to add up to the same number, 5.5%.

Dividend growth has varied over time, but a conservative estimate might put it at 5% a year. Thus, to match the future return on bonds, stocks initially need to yield just 0.5%, which would place the Dow at around 36,000.

But this mighty claim is built on the shakiest of assumptions, which is that stocks and bonds are equally risky.

"I don't believe that my data lead to their conclusion," Mr. Siegel says. "They're under the assumption that those people who have 20- or 30-year time horizons will totally dominate the equity markets and will continue to have faith in the long-run performance, despite poor and possibly disastrous intervening years."

Moreover, in the Glassman-Hassett model, it doesn't take much to radically change the Dow's forecasted value. Let's assume investors do indeed bid up the Dow industrials to 36,000, so that stocks offer the same expected return as a 5.5% Treasury bond.

But what if interest rates drifted up to 6.5%? Suddenly, to match that return, stocks need to yield 1.5%. To get to that level, share prices would have to plunge 67%. At that juncture, those who thought stocks and bonds were equally risky might be inclined to revise their views.

"What they have is a model that is extraordinarily sensitive to the inputs," says William Bernstein, an investment adviser in North Bend, Ore.

Messrs. Glassman and Hassett readily concede that their model is sensitive, and say the right value for the Dow industrials might be anywhere from 25,000 to 50,000. But they defend the notion that stocks and bonds are equally risky.

"People are learning the truth about stocks," Mr. Glassman says. "We think people are coming to their senses and bidding down the risk premium" on stocks.

True, investors are now much more comfortable with stock-market investing. But if anything, that suggests lower returns ahead, not higher ones. Which brings us back to Mr. Siegel.

In "Stocks for the Long Run," he used two centuries of market returns to point out that stocks had, with remarkable consistency, provided long-term investors with gains above inflation of around seven percentage points a year.

But Mr. Siegel suspects lower returns may lie ahead. In the past, he notes, investors might only have pocketed five or six percentage points above inflation, because trading costs were so high. Moreover, to earn those returns, investors took on a lot more risk, because the easy diversification offered by mutual funds wasn't available.

Now, trading is cheap and diversification is easy. That, combined with a remarkably robust economy, may explain why stock prices have been bid up in recent years. "People are putting their faith in the long run and buying stocks," Mr. Siegel says.

That faith, however, could be easily shaken. "If this rapid earnings growth and very stable economic growth ends, you'll get very disappointing returns," he warns. In that scenario, "I estimate long-term, after-inflation returns of 3% to 5%."

Faced with that possibility, the author of "Stocks for the Long Run" thinks it might be smart to keep some money in inflation-indexed bonds, which provide a guaranteed return above inflation.

"You can lock in 4% real returns in inflation-indexed bonds today," Mr. Siegel notes. "There will come a time when people will look around and say, 'That's a deal.' "

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