Dow 36,000-Fact or Fiction?

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.

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