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March 14, 2000. Whither the Dow? was the question of the hour at the Bank
Securities Association meeting at high noon in Tucson today. In a financial
version of the fabled gunfight at the OK Corral, James K. Glassman, co-author of
"Dow 36,000" and David L. Smith, author of the "Cyclical
Investing" newsletter squared off with radically opposing views of the
future of the Dow.
Glassman (for many years a columnist for the Washington Post, who
currently writes a financial column for the Reader¹s Digest) argued for
a leap in the Dow to 36,000 over the next 3 to 5 years, basing his case on two
critical assumptions:
1) The present value of the projected stream of dividends from Dow stocks
typically adds up to far more than the present value of interest payments on the
Treasury¹s bellwether 30-year bond. Even though the Dow¹s dividend yield is
hovering at near record lows around 1.5%, by Glassman¹s calculation the
compounded growth of these dividends will produce a stream of distributions that
far outweigh the present value of interest payments from the same amount
invested in Treasury bonds.
2) Statistically, according studies by Ibbotson and Associates, stocks are no
more risky in the aggregate than bonds over long holding periods.
If the risks are equal, Glassman reasoned, then the present value of
distributions ought to be equal. The only reason they aren’t, according to
Glassman, is that investors cling to "outdated perceptions" of stocks
as more risky than bonds. As that "irrational fear" dissipates
(presumably thanks in no small measure to his best-selling book), enlightened
market forces will equalize the present value of distributions from stocks and
bonds, eliminating the "irrationally low perennial undervaluation" of
stocks. In fact, Glassman attributes the phenomenal rise in stocks over the last
18 years to just such a realization by a growing number of investors .
Assuming constant long-term Treasury bond yields around mid-1999 rates of 5.5%,
Glassman calculates it will take a rise in the Dow to around 36,000 over the
next 3-5 years, to reduce dividends as a percentage of stock investments to the
point where equal investments in stocks and bonds will pay investors
distributions of equal present value. Once parity of long-term returns is
established between stocks and bonds, Glassman foresees either tranquil
"meadowlands" or a volatile "jungle" for stocks. In the
meantime, Glassman believes investors can "buy and hold" stocks
without fear as the Dow climbs toward a "perfectly reasonable price"
of 36,000 by 2003 to 2005.
Smith, a 30-year investment veteran, newsletter writer and lecturer, using an
analogy from craps, countered that Glassman was "making his point the hard
way," observing that "a lot of weird things" have to happen in
order for the Dow 36,000 scenario to unfold as Glassman projected. By Glassman¹s
own calculations, price-earnings ratios of 100 for Dow stocks would not be
uncommon. Such ratios would be unprecedented, compared to a historically
"normal" ratio of 14, and today’s extraordinarily high P/E ratios
for the Dow of 22 and the S&P 500 of 32. Likewise, the Dow would begin to
pay out initial dividends at the unprecedentedly low rate averaging around 0.5%,
compared to the historical norm around 3%. In addition, by reaching 36,000
somewhere between 2003 and 2005, the Dow would have grown at a compound rate of
more than 17% for a 21-to-23-year stretch, something that has never happened.
Glassman was unperturbed by these variations from historical norms, claiming in
his book and lecture that such norms were too low, reflecting perennial
undervaluation of stocks due to the "outmoded misperception" of stocks
as more risky than bonds.
"The fatal flaw in Glassman’s argument," Smith observed, "is
that he assumes there is only one way to equalize the projected streams of cash
distributions from stocks and bonds -- namely, for stock prices to rise. He
doesn’t consider the alternative, namely for interest rates to rise, so
as to increase the present value of the future interest payment stream until it
is equal the dividend stream for stocks."
"By increasing the value of the stream of interest payments through higher
interest rates," Smith pointed out, "you get to the same place --
parity in the present value of distributions of stocks and bonds -- without the
weirdness of P/E multiples of 100, current dividend yields of only 0.5% and
three-to-five more years of 25% appreciation piled on top of the 18 years of
15%-plus compound gains we have seen in stocks since 1982." Using
Glassman’s own arithmetic, Smith showed how the Treasury long bond interest
rate would have to rise from the constant 5.5% assumed in "Dow 36,000"
to only 6.4% in order to equalize the present value of distributions from stocks
and bonds. At this point, according to Glassman’s logic, it is either
"meadowlands" or "the jungle." Above 6.4%, Smith showed that
the present value of the revenue stream from bonds exceeds that of stocks,
prompting investors to bail out of stocks in favor of bonds. "That has
already happened," Smith pointed out, "when the long-bond yield topped
6.7% in January, not surprisingly, the Dow has been falling ever since
establishing what may well prove to be the bull market peak. Welcome to the
jungle."
"For stocks to rise to Dow 36,000 you have to believe things will happen
that have never happened before," Smith summarized, "whereas long-bond
interest rates rising above 6.4% would be a routine event, reflecting the usual
cyclical pattern of rising interest rates late in an economic expansion that
causes stock prices to peak and then decline, as recent events in the stock
market appear to be confirming. Applying ‘Occam’s Razor,’ when forced to
choose between two competing hypotheses, the simpler of the two is more likely
to be true, which should lay the fantasy of the Dow 36,000 Theory to rest,"
Smith concluded.
Smith went on to build his case for Dow 3,600, citing numerous "clouds in
the silver lining" of today’s "Goldilocks economy," that could
derail the stock market, including:
·
Soaring U.S. trade deficits that
could cause international investors to dump dollars and dollar-denominated
investments, as occurred in Mexico, Asia and South America in recent years
·
Increasing dependency on
imported oil in a tight global oil market that could prompt a reprise of higher
oil prices, inflation and crashing stock prices seen in the 1970’s
·
Heavy consumer debt burdens that
could force consumers to trim spending, dragging the economy into recession
·
A self-aggravating panic in an
overvalued stock market that could drag down the economy through the
"loss-of-wealth-effect"
"Regression to the mean" and a
return to more normal levels of valuation in terms of stock prices relative to
earnings and dividends would place the Dow around 5,000, according to Smith.
"Excesses to the upside are usually compensated for by excesses to the
downside as greed turns to fear, producing panic, " Smith observed,
"consequently a 3,600 Dow seems like a perfectly reasonable
proposition."
"All of the usual warning signs are in place," Smith said, listing his
"Top Ten Signs of a Bull Market Peak" in David Letterman
fashion.
10. High stock market volatility
9. High margin debt
8. Mergers and IPO frenzy
7. "New chips" outperform "blue chips"
6. Greed rampant, overvaluation ignored
5. "Newbies" entering the market
4. Parabolic surge in stocks after a long climb
3. Thriving economy and optimistic expectations
2. Technical breakdown prompted by rising interest rates
1. "This time it¹s different" rationalization
"It is for good reason that Sir John Templeton called ‘This time it’s
different’ ‘The four most expensive words in the English language,"
Smith added. "People fall back on ‘This time it’s different’ to
rationalize their desire for continued gains in the stock market, even at
irrationally high levels of valuation, at which point, the party is about
over."
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