Dow 36,000 – Fact or Fiction?

Thomas K. Philips, Chief Investment Officer, Paradigm Asset Management Company, L.L.C.

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.

  • 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.
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