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How to Think About the Stock Market

Against the Gods: The Remarkable Story of Risk

by Peter L. Bernstein
Wiley, 383 pp., $27.95

It Was a Very Good Year: Extraordinary Moments in Stock Market History

by Martin S. Fridson
Wiley, 244 pp., $29.95

Security Analysis: The Classic 1934 Edition

by Benjamin Graham, by David Dodd
McGraw-Hill, 725 pp., $50.00

A Random Walk Down Wall Street

by Burton G. Malkiel. sixth edition
Norton, 522 pp., $15.95 (paper)

What Works on Wall Street

by James P. O’Shaughnessy. revised edition
McGraw-Hill, 366 pp., $29.95

Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies

by Jeremy J. Siegel
McGraw-Hill, 301 pp., $29.95

Advances in Behavioral Finance

edited by Richard H. Thaler
Russell Sage Foundation, 597 pp., $19.95 (paper)

The Intelligent Investor

by Benjamin Graham, with introduction and appendix by Warren Buffett. fourth revised edition
Harper Business, 340 pp., $30.00

Are stocks overvalued? Federal Reserve Board Chairman Alan Greenspan raised the issue most famously in December 1996 when he said he was worried about “irrational exuberance” in the stock market.1 At that time, the Dow Jones Industrial Average,2 the oldest and most popular index of stock prices, was about 6500. It is now over 9000, and Greenspan has backed off from making comments while other government officials have chimed in. Treasury Secretary Robert Rubin suggested in early May that investors use more “rigor” in evaluating their investments. A day later, Alice Rivlin, vice-chairwoman of the Fed, said that she saw “cause for concern about the values in the stock market,” but added, “That doesn’t necessarily mean it’s a bubble.” Between the comments by Greenspan and Rivlin, the financial press has kept the question of overvaluation alive, particularly as stock prices have reached new heights—7000, 8000, 9000.

It is hardly surprising that people are worried about stock prices because they have been rising so rapidly for such a long time. Despite setbacks in 1987 and 1990, stock prices have increased more than ninefold since 1982, when the Dow was less than 1000. Just the current phase of the upswing, which began in October 1990 with the index slightly above 2000, is considered the longest “bull market” in history (see Figure 1 on page 24, which also shows that when the long-term record of the Dow is drawn on a ratio scale which gives the same weight to equal proportional changes in the index, then the current rise in stock prices is less dramatic when it is compared to the pattern during several earlier periods). As a result of the sustained run-up in stock prices, total returns (i.e., dividends plus capital gains) on the stocks in the S&P 500, a more representative market index than the Dow, have averaged about 18 percent a year in the 1980s and 1990s, compared to about 11 percent between 1926 and 1980.

The rise in stock prices has been driven largely by improvements in the economy, principally rising corporate profits, falling inflation, and falling interest rates. Profits of the companies in the S&P 500 index more than doubled between 1982 and 1996, growing more than 6 percent a year on average. But because share prices rose even more rapidly, the price of stocks relative to a dollar of earnings (the price/ earnings, or P/E, ratio) also rose, from about 8 times earnings to more than 20; it is now about 24, roughly 50 percent above its long-term average of approximately 16 (see Figure 2 on page 24). Earnings growth and the rise of the P/E ratio to only its average level account for about two thirds of the rise in stock prices from 1982 to 1996. Investors have bid up stock prices even further because they anticipate growth in earnings to continue, and because interest rates have fallen sharply since the early 1980s, making investments in stocks even more attractive than in bonds.3

So far investors have been rewarded for assuming that corporate profits will continue to grow and that interest rates and inflation will remain low. The worry is that their expectations have become so high that when the economy slows down, or inflation accelerates, they will be disappointed and will dump shares, possibly producing a market crash. And because Americans now have about 28 percent of their assets in stocks, more than in any other asset, and more than at any other time in the last fifty years, there is a further fear that any sizabledecline in stock prices will have a much greater effect on the economy than in the past, creating a vicious cycle. When the market crashed in October 1987, for example, stocks accounted for only 13 percent of assets. The crash had little effect on the economy and was relatively short-lived.4

Anxiety about stock prices is thus to a great extent concern over whether the economy can continue to grow at a steady pace without a rise in inflation. But neither the path of the economy nor changes in stock prices can be predicted with much confidence. Seventy years ago, not long before the great stock market crash of 1929, the Federal Reserve wrote: “There is no way of knowing beyond question how far this recent rise in stock prices represents excessive speculation and how far a readjustment of values to increased industrial efficiency…and larger profits.”5 Because that observation is still true, and always will be true, we can’t really know whether stocks are overvalued. But other things are known about financial markets that can guide investors.

Perhaps the most important fact about investing in the stock market is that, over the long term, stocks in general have been a vastly superior investment. Nobody develops this theme more convincingly than Jeremy Siegel, a professor at the Wharton School of the University of Pennsylvania. As can be seen in Figure 3 (on page 25), which is reproduced from his book Stocks for the Long Run, a dollar invested in a representative group of stocks in 1802 would have grown to $559,000 in 1997 after adjustment for inflation, which reduced the value of the dollar to seven cents over this period. By comparison, in the same period a dollar invested in long-term government bonds, short-term bills, or gold, would have grown, after inflation, only to $803, $275, and $0.84, respectively. In other words, the real return on stocks over almost two hundred years was 7 percent a year, compounded, compared to 3.5 percent for bonds and 2.9 percent for bills.6

Moreover, the superiority of stocks grows, and their riskiness falls, the longer they are held. For example, stocks outperform bonds and bills about 60 percent of the time over any single year, but about 70 percent of the time if they are held for five years, 80 percent over ten years, and more than 90 percent of the time if held for twenty years. Unlike bonds or bills, stocks as a group have not had losses over any twenty-year period since 1802. It is true that it would have taken about fifteen years for stocks bought just before the 1929 crash to recover their value. Since World War II, however, the longest it has taken for an investment in a representative sample of stocks to show a profit has been three and a half years, between December 1972 and June 1976.

Of course, the long-run superiority of stocks as a group doesn’t guarantee results in any particular period, or for any particular stock. It is naturally tempting, at a time like this, to believe one can avoid a possible downturn in the market. But the second important thing we know about the stock market is that it is difficult to predict short-term changes in stock prices, and the consequences of mistiming the movements of the stock market as a whole can be so severe that it doesn’t make much sense to try. In general, an investor who tried to predict short-term changes in share prices would have to be right about 70 percent of the time to beat the market. During the 1980s, for example, the average real return on the S&P 500 index was about 12.5 percent a year. But an investor in that index who missed just the ten best days of the decade would have realized only 7.5 percent after inflation, about the same as on ten-year government bonds. Similarly, New York University’s endowment has reportedly languished because the trustees have been leery of stocks for most of the last two decades. It appears that the fund would be at least one third larger had they invested an additional $100 million in the stock market in 1982.7

The third thing we know about investing in the stock market is that it is possible, without taking bigger risks, to do better than the market averages through strategies such as “value investing,” the approach associated most closely with Warren Buffett and his teacher, the investor and former Columbia professor Benjamin Graham. Buffett says his huge success in picking stocks is owing to his ability to find companies whose shares are undervalued. Most economists, however, don’t believe that there can be such bargains in the stock market. To them, the stock market is “efficient”; that is, stock prices are set by a straightforward process in which self-interested choices by competing investors will almost automatically price shares correctly. The Nobel laureate economist Paul Samuelson explained to Congress thirty years ago that large numbers of highly motivated investors, constantly “selling those stocks they think will turn out to be overvalued and buying those they expect are now undervalued,” drive share prices to their true values. In this view, undervalued (or overvalued) shares simply cannot exist for more than a brief moment; if they did, investors would almost instantaneously rush to buy (or sell) them and their prices would rise (or fall) until they were valued correctly.

Buffett disagrees. He has described value investing as a “search for discrepancies between the value of a business and the price of small pieces of that business in the market.” There clearly would not be bargains of that kind if share prices reflected companies’ values. But at least as practiced by him and other like-minded investors, value investing has produced spectacular results. Ten thousand dollars invested with Buffett in 1956 would be worth about $200 million today, a return of about 27 percent a year compounded, more than double the annual return on the shares in the S&P 500 over the same period.

Buffett attributes his success to the fact that “market prices are frequently nonsensical.” Sometimes this is obvious: “The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, News-week, plus several television stations in major markets.” Buffet perceived what most other investors did not. He invested about $10 million in the company, an investment that is worth approximately $930 million today.

In most cases, the relationship between price and value is less clear. In part this is because more easily measured assets such as plant and equipment have declined in importance, while less tangible assets such as brand names, technology, software, and the skills and commitment of the work force have become more important. But it is also because making even general judgments about the “intrinsic value” of a business is very difficult. Like many other investors, Buffett defines this as the value today of “the cash that can be taken out of the business during its remaining life.” Thus he is not concerned simply with a company’s growth or even with its annual earnings, but with how much money will be available for shareholders—over and above the amount the company must invest in the business—over a considerable period of years.8 Because making even rough estimates of these future cash flows is not easy to do, Buffett writes, “you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million.”

  1. 1

    The Fed has questioned stock prices only twice before. In both cases the markets continued rising for about eight months before collapsing (1929) or stagnating (1965). Floyd Norris, “All Hail the Great Greenspan Bull Market,” The New York Times, July 6, 1997.

  2. 2

    The Dow also is not very representative. The thirty companies in the index account for only about one fifth of the market value of the US stock market. By contrast, the Standard & Poor’s 500 Index (S&P 500) accounts for about 78 percent of the value of these large companies, and about 75 percent of the value of all publicly traded shares. See Jeremy Siegel, Stocks for the Long Run, pp. 55-61.

  3. 3

    See Richard W. Kopcke, “Are Stocks Overvalued?” New England Economic Review, September/October 1997, especially pp. 22-25. In fact, interest rates on bonds have fallen more rapidly since 1982 than either the dividend yield on stocks (the dividend-price ratio) or the earnings yield (the earnings-price ratio).

  4. 4

    Edward Wyatt, “Share of Wealth in Stock Holdings Hits 50-Year High,” The New York Times, February 11, 1998.

  5. 5

    Quoted in “America’s Bubble Economy,” The Economist, April 18, 1998. See also note 1.

  6. 6

    These relationships hold in foreign markets as well. In fact, the real returns on British and German stocks from 1926 to 1997, 6.2 and 6.6 percent a year, respectively, are very similar. See Siegel, Stocks for the Long Run, pp. 18-20.

  7. 7

    See Malkiel, A Random Walk Down Wall Street, pp. 188, 162; Roger Lowenstein, “How Tisch and NYU Missed Bull Run,” Wall Street Journal, October 16, 1997; and Richard Wilner, “Tsk, tsk, Tisch: NYU loses out on millions with Larry as leader,” New York Daily News, October 17, 1997.

  8. 8

    A company’s “free” cash flow can be calculated from information in its annual report. It consists of essentially three elements: (1) net profit adjusted for any non-cash charges such as depreciation, or nonrecurring charges such as write-offs of obsolete assets; minus (2) cash needed to pay for growth in working capital, which consists of inventories plus accounts receivable, minus accounts payable; and also minus (3) capital spending. The company’s record provides the basis for estimating future growth in cash flow. In calculating intrinsic value, anticipated future cash flows also must be “discounted” to the present, a process that depends on interest rates. For example, if interest rates are 5 percent, then a dollar that will be received in one year is worth about 95å¢ (since 95å¢ invested in a one-year government bond would grow to $1 in one year). In general, the lower the interest rates, the smaller the discount.

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