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TCS Five years ago, economist Kevin Hassett and I wrote a book called Dow 36, 000. The book made the bestseller lists and won accolades from, among others, the current chairman of the president' s Council of Economic Advisors. For some, however, the book became an ob ject of derision because -- just in case you haven't noticed -- the Dow hasn't actually risen to 36,000 yet. The Risk Anomaly This is a good time to review the case we made in the book -- a case in w hich Kevin and I still strongly believe. Sure, the Dow will hit 36,000 and probably, eventually, 360,000. But I don't know exactly when, and I don't believe investing is a game o f forecasting what's going to happen tomorrow or next year. Instead, the book tried to explain how stocks are (and should be) valued by investors. They had produ ced so much cash in the past and were likely to produce so much cash in the future, that their prices deserved to be considerably higher. We argued that investors, starting roughly in August 1982, when the Dow s tood at just 777, had begun to wake up to the true worth of stocks and w ould bid prices considerably higher, as they should. Our analysis showed that stocks would be fairly priced when the Dow Jones industrial averag e hit roughly 36,000 (at the time we published our initial article in th e Wall Street Journal explaining our theory, on March 30, 1998, it was 8 ,782; But Kevin and I believed t hen (and continue to believe now) that a dispassionate analysis leads to only one result: Stocks are a far better place than bonds and cash to p ut the vast majority of your money for the long run. Over the long run, a diversified portfolio of stocks has returned a great deal more than a similar portfolio of bonds. If history is a guide, $10,000 invested in stocks will become $20,000, i n terms of today's purchasing power (which is what counts), in about 10 years; A basic rule in finance is that if an asset produces a high return, it ca rries a high risk. When you bet on a big favorite at the race track and the horse wins, the profit on your investment will be small, say, $3 on a $2 bet. But if a long-shot wins, your returns can be $100 for every $2 . But, with stocks, economists long ago discovered an anomaly. Stocks re turn more than bonds, but, in the long term, stocks don't carry much mor e risk. When you invest in a Treasury bond, it's a virtual certainty tha t the US government will return your principal at maturity, but, along the way, the purchasing power of that money will decline because of inf lation, and the interest checks might not make up for the loss. Jeremy Siegel, an economist at the Wharton School of the University of Pe nnsylvania, looked at vast amounts of data on US stocks and bonds goin g back to 1802. He wrote, in his groundbreaking 1995 book, Stocks for th e Long Run, that "the safest long-term investment has clearly been stock s and not bonds." He found, for example, that there has never been a per iod of 17 years or longer in history in which stocks did not produce a p ositive return after inflation. Lookin g at every overlapping 20-year period (that is, 1802-21, 1803-22, up to the present), Siegel discovered that the worst period for stocks produce d a total return of more than 20% after inflation. Even in the short and medium term, bonds have proven quite risky. Long-te rm Treasuries suffered losses in three of the past ten years (the same r ecord as stocks), and research by Ibbotson Associates has found that for 10-year periods between 1926 and 2003, a portfolio composed 90% of stoc ks and 10% of long-term Treasury bonds has never lost money, while 100% bond portfolio has. Siegel's work highlighted what economists call the "equity premium puzzle ." Stocks return more than bonds (that is, a premium), but stocks are no more risky over the long term. In Dow 36,000, we off ered a possible answer: Investors were irrationally fearful of stocks. T hey saw the wild volatility of stocks in the short term and, with faulty logic, extrapolated that risk out into the long term. It was like sayin g that because it had rained for three days straight, it would rain the whole year. In fact, stock investing gets less and less risky the longer you hold on. Shaking Off Fear But in the early 1980s, something changed. Investors began to wake up to the true risk of stocks and began bidding up prices. Kevin and I said th at this process was "perfectly rational" and was likely continue. We war ned that "a cyclical downturn, after nearly two decades of growth, could shock investors who have become used to good times" and that "political unrest around the world could boost the risk premium," especially since "aggressive, unpredictable nations like Iraq and Iran now have greater access to weapons of mass destruction." Why did investors become properly less risk-averse starting in the 1980s? They learned the truth about stocks from the work of economists like Siegel, from responsible financial journalists and from mutual fund companies, which did a good job educating their clients. Investors were encouraged by the advent of tax-de ferred retirement accounts -- IRAs and 401 plans -- to keep their mon ey at work for the long term. Suddenly, the idea of jumping in and out t he market, with a short-term perspective, became unattractive. Because investors were not demanding such high returns from stocks, price s (and price-to-earnings ratios) rose. Americans no longer required a gi gantic equity risk premium to get into the market. Using an established financial formula, we calculated that, if the risk p remium fell to its proper level -- around the same as bonds -- the stock market, as represented by the Dow, would go to about 36,000. While Dow 36,000 was often criticized for puffing up the tech bubble, the stocks we highlighted in our book were mainly boring, value-oriented se curities. Our reasoning was that, if the entire market is cheap for long -term investors, why take the extra risk of speculating in a go-go firm without any earnings? The Keepers In the book, we cited 15 specific stocks as good investments. Our prefere nce was for businesses that had a strong, defensible market niche and a history of generating lots of cash. Kevin and I have monitored an imagin ary, equally weighted portfolio of these 15 stocks, and throughout the p ast five years, it has consistently beaten the S&P 500 benchmark. From O ctober 29, 1999, when Dow 36,000 was published, through September 30 of this year, the portfolio rose a total of 17%, compared with a loss of 12 % for the S&P 500. The list includes such superb companies as Cintas, which rents and sells work uniforms; There were only two tech companies, Microsoft and Cisco; the ir prices have declined in the past five years, of course, but I still l ike them. In fact, there is not a single stock among the 15 that I would drop from the portfolio. A good example of a Dow 36,000 stock is RPM International, which makes pr otective coatings like Rust-Oleum. Since then, including dividends, the stock has returned 78% -- our second-biggest winner after Landauer, a maker of ra diation detectors. RPM still appears a bargain, with a dividend yield of 32% and a price-to-earnings ratio of 14. From 777 in August 1982, the Dow rose to 5117 in 1995 and 10,000-plus in 1999. Mainly because earnings fell, thanks to the tech bubble, the recession, the attacks of 9/11 and the o verzealous political reaction to corporate accounting scandals. The fact that risk premiums have staye d relatively low and P/E ratios have been robust is evidence that the Do w 36,000 theory remains intact. As the economy continues its recovery, s tock prices should get back on their upward track. Kevin, a dist inguished economist who had served with the Federal Reserve, suggested t hat we should have called it A Treatise on the Declining Equity Risk Pre mium.
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