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| Dow 36,000 –
Fact or Fiction?
By Thomas K. Philips
1999 |
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In a sequence of op-eds in the Wall Street Journal, an article
in the Atlantic Monthly, and a book, James Glassman and Kevin
Hassett of the American Enterprise Institute argue that the
stock market is undervalued, possibly by a factor of three or
more. Their case is predicated on the assumption that the expected
return of equities should equal that of treasury bonds, or equivalently,
that equity risk premium is undeserved.
As evidence in support of this view, they borrow from Jeremy
Siegel's superb study of the history of U.S. capital markets,
which shows that stocks have outperformed bonds over every single
20 year period from 1802 to the present time. Unfortunately,
the logic that underlies their argument contains a number of
flaws, and it behooves us to explore these flaws in some detail.
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Messrs. Glassman and Hasset assert that
stocks do not deserve a risk premium, as they have outperformed
bonds over every single 20 year period.
Surely, stocks have outperformed bonds precisely because
of their higher expected return – if the expected returns
of stocks and bonds were identical, we would expect bonds
to outperform stocks in half of all such periods. Furthermore,
if stocks deserve no risk premium, we must conclude that
investors have acted irrationally in demanding a risk premium
for two centuries. Given our faith in the efficiency of
capital markets, this appears to be an implausibly long
lived inefficiency.
In addition, the fact that stocks have outperformed bonds
in the U.S. over every 20 year period in the past does not
necessarily guarantee that they will outperform bonds over
every 20 year period in the future. In Australia and Japan,
for example, stocks have underperformed bonds for the past
decade. Was this a random occurrence, or a failure on the
part of investors to comprehend the long haul advantage
of equities? Are stocks in these countries guaranteed to
outperform bonds if we wait a full twenty years instead
of stopping the timer at ten?
The following analogy illustrates the Glassman/Hasset error
in a more familiar setting. Consider a race between a Ferrari
(stocks) and a Yugo (bonds). The Ferrari consistently wins,
thanks to its more powerful engine (or higher expected return).
Now replace the engine of the Ferrari with one from a Yugo
(equalize their expected return) and rerun the race. Is
the Ferrari still sure to win? I think not! This is the
primary flaw in the Glassman/Hasset logic. They assume,
incorrectly, that because stocks have consistently outperformed
bonds when their expected return was higher, they will continue
to do so even if the two expected returns are equalized
The Glassman/Hasset logic
implies that the expected return of corporate
bonds ought to be lower than that of treasury
bonds.
Look at the stocks vs. bonds question from
the viewpoint of a corporate treasurer. If
the expected return of equities ought to be
same as that of treasury bonds, what ought
the expected return of corporate bonds to
be? Corporate bonds are riskier than treasury
bonds – unlike the government, corporations
cannot print money to pay off bondholders.
Rational investors will demand some compensation
in the form of higher expected return for
the added risk they assume.
It follows that the expected return of corporate
bonds should be higher than that of treasury
bonds, and a quick look at bond yields will
show this to be true. If, as Messrs. Glassman
and Hasset suggest, the appropriate expected
return for stocks is the same as that of treasury
bonds, the expected return of corporate bonds
must be higher than that of stocks. But this
logic is flawed. Equities are junior claimants
to corporate earnings, and consequently, stocks
are riskier than corporate bonds. It follows
that the expected return of stocks must be
higher than the expected return of corporate
bonds, which in turn must exceed that of government
bonds.
- A fair value for the U.S. equity
market is between 3 and 4 times its
current level.
Spectacular if true, but unlikely
to be so. In the long run, corporate
earnings cannot grow faster than revenues,
which in turn cannot grow faster than
the economy. Earnings in excess of
that needed to finance growth will
be returned to shareholders via dividends
or stock buybacks.
From these elementary
principles, with the further assumptions
that profitability is both time invariant
and high enough to finance growthwithout
requiring infusions of new capital,
it can be shown that the long run
expected return of the stock market
is Nominal GDP Growth + (ROE –
Nominal GDP Growth)xB/P, where B/P
is its book to price ratio (the reciprocal
of its price to book ratio), and ROE
is its prospective long run return
on equity (earnings divided by book
value).
Currently, the book to price ratio
of the S&P 500 is 0.2. Assume
that the ROE of the S&P 500 averages
14% in the future, in between its
long term average of 11% and its current
value of 18%. Nominal GDP can be expected
to grow at about 5% per annum –
3% real growth with 2% inflation.
Substituting these figures into the
equation gives an expected return
of 6.8%, and a risk premium of 0.5%,
a far cry from the 3% risk premium
that Messrs. Glassman and Hassett
posit. If, as they suggest, the risk
premium collapses to 0, stock prices
will rise at most by 50%. Furthermore,
the fair value of the market is exquisitely
sensitive to changes in interest rates.
A 50 basis point increase in the risk
premium can reduce fair value by 25%.
For a different perspective, view
stock prices through the eyes of American
CEO's. If they thought their equity
was enormously undervalued, would
they pay for acquisitions with stock?
Would entrepreneurs allow investment
bankers to take their companies public
for a third of their true worth? I
believe that the answer to both questions
is a resounding no.
- A P/E of 100 equalizes the cash
flows of stocks and bonds
I assume that this computation is based
on the classic Gordon growth model in
which dividends grow in perpetuity at
a fixed rate. This model has an important
limitation that one must be aware of,
especially when the expected return
is only slightly larger than the growth
rate of dividends. A substantial portion
of the net present value is derived
from dividends paid is the very distant
(i.e. many centuries) future. For example,
if we discount future dividends at 5.5%,
as do Messrs. Hasset and Glassman, only
37% of the value of the stock market
can be attributed to dividends paid
from now till the year 2100.
I would be wary of making so rosy a
prediction for so long a period. The
old saying – the father wealthy,
the son noble, the grandson a pauper
– applies both to families and
to economies! In a competitive economy
and capital market, it is far more reasonable
to assume that the expected return of
equities will be a little (about 2%)
less than the ROE of corporations, and
that valuation levels will adapt accordingly.
Both the historical return and valuation
level of equities can be derived from
first principles under this assumption
. The answers accord well with history.
In conclusion, given our faith in
the general efficiency of markets,
a very strong case must be made to
support the assertion that markets
are underpricing stocks by a factor
of 3 or more. I do not believe that
Messrs. Glassman and Hassett's present
such a case. However, I hesitate to
come to the opposite conclusion –
that the market is substantially overvalued.
To determine whether or not the market
is overvalued requires knowledge of
two quantities – the expected
return embedded in the current price
of equities, and the rate of return
that investors require from their
investments.
If the second quantity is greater
than the first, the market is overvalued.
If the second quantity is less than
the first, the market is undervalued.
Unfortunately, it is not possible
to precisely determine investors'
expectations independently of market
prices, and as a result it is not
possible to determine if equities
are overvalued or undervalued.
However, one can determine the expected
return of both equities and bonds
and compare them to each other and
to one's own required rate of return.
Currently, the expected return of
equities is about 7%, while that of
bonds is about 6.5%. In real (i.e.
inflation adjusted) terms, the expected
return of stocks is 5%, a not insubstantial
figure. Investors must decide for
themselves if this real return and
this expected return differential
are sufficient to induce them to hold
equities.
1Siegel, Jeremy, ?The
Shrinking Equity Premium?, The Journal
of Portfolio Management, Winter 1999,
pp. 10-17.
2Philips, Thomas K., ?Why
Do Valuation Ratios Forecast Long-Run
Equity Returns?, The Journal of Portfolio
Management, Spring 1999, pp. 39-44.
©1999 IndexFunds.com
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