Thursday, August 01, 2002

Dow 36,000

James Glassman and Kevin Hassett, both of the American Enterprise Institute, are co-authors of a book published in 1999 arguing that the fair value of the Dow Jones Industrial Average is approximately 36,000 (as compared to the roughly 11,000 or so it was valued at when the book appeared). [Note: around the time of the book’s publication a precis of sorts was published in the Atlantic Monthly, still available online, here.]

It seemed silly even back then, but Glassman and Hassett are defending their thesis in today’s Wall Street Journal (available free on, here).

It may seem courageous that these guys are willing to even bring this stuff up at this point, rather than just letting everyone forget about it, but it’s not exactly clear that Glassman and Hassett are sticking to their guns. The full title of their book is Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. “Profiting”?…”Coming Rise”?… Sounds like the idea at the time was that if a 36,000 Dow wasn’t eminent then 11,000 was a hell of an investment opportunity. Now the authors are saying that Dow 36,000 is a long-term prognostication. The last sentence of their piece: “…there is little doubt that, as long as the U.S. economy remains sound, stock prices will rise to 36,000 and beyond.”

And what exactly does “as long as the U.S. economy remains sound” mean? As long as everybody wants to buy stocks? As long as corporate profits continually rise? As long as there’s no serious threat of catastrophic terrorist attacks against the U.S? Are Glassman and Hassett saying simply that as long as everything is peachy, stocks will – someday – reach the price levels they’re projecting? Isn’t that kind of like predicting that if the world never comes to an end – someday, God knows when, but someday – monkeys will type the complete works of Shakespeare?

The self-serving obfuscation of the piece aside, the Dow 36,000 prediction is just plain stupid. The logic behind it is that historically stocks have provided a better long-term return than bonds, thus the risk premium equity investors demand (and by and large receive) from the market doesn’t make sense, i.e., it’s economically irrational and therefore shouldn’t be sustainable in a reasonably efficient market. In fact, Glassman and Hassett argue that the historical data prove that stocks are generally a safer investment than bonds, and so there should be a negative risk premium. In other words, since stocks are safer than bonds they should provide a lower expected return than bonds. The way this will happen, according to Glassman and Hassett, is through a dramatic increase in the price of stocks, making them sufficiently expensive as to lower expected returns. Through this logic and some number crunching the authors arrive at a “fairly valued” market that puts the Dow at 36,000.

Think about what this means – these guys are not saying that stocks are undervalued because future earnings are being underestimated, they’re saying that stock prices will go up because the current risk/reward ratio offered by the stock market is unsustainable. According to them, Dow 36,000 is the current fair value.

The Dow closed today at 8,506.62, with a P/E of 23.23. That means that earnings are approximately 4.3% of the value of the Dow - for every $100 invested in a Dow stock, an average of $4.30 in earnings was produced. If the Dow were valued at 36,000, with earnings unchanged, that would mean an earnings yield of 1%! And if the market was in fact “fairly valued” at 36,000, the chances of making any kind of speculative profit would be just about nil. In other words, earnings would be pretty much the only criterion for judging the value of a stock, and buying a Dow stock with the Dow at 36,000 at current earnings would mean buying an asset that on average generates $1 for every $100 invested – less than half the profit to be realized by putting money into a federally insured savings account! If investors are rational -- and the Glassman/Hassett thesis rests on the idea of rational markets -- no one would ever take on the risks of owning stock when they could get a better expected return in a protected savings account.

And if no one is buying stocks, they won’t be very expensive.


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