The Stock Market Without Tears: What we said in Dow 36,000; why the critics are wrong - Column - Industry Overview

National Review, Sept 2, 2002 by Kevin A. Hassett

The publication of Dow 36,000 has caused such a stir that it has at times seemed as if co-author James Glassman and I had written another Bell Curve. Yet Dow 36,000 merely seeks to describe why stocks are highly volatile in the short run but highly profitable in the long run. How could such a message be inflammatory?

The question of this upset is hardly new. In February 2000, Investors Business Daily ran an editorial asking why the Left was obsessed with Dow 36,000. The piece upbraided Paul Krugman and online magazine Slate for their "ludicrous" accusations that our theory contained a mathematical error, adding that "even by the loose journalistic standards of op-ed page columns, this falls short." Confronted with the facts, Krugman publicly backed down.

The hubbub, however, went on. In recent weeks, columnist Michael Kinsley has called us "lunatics" in the Washington Post, and Slate has referred to us as "geniuses." (Somehow, we think Slate meant that snidely.) To say these people are obsessed is actually an understatement: Between June 9, 1999, and July 23, 2002, Paul Krugman wrote about Dow 36,000 in eight separate articles.

But if the book is so wrong, why not sweep it into the dustbin of history? The answer is that it is not wrong and the Left knows it. Though not an overtly political book, Dow 36,000 attacks their anti- capitalist religion at its core. Here's why.

On January 2, 1991, the Dow stood at 2,610. By 1996, with the Dow at around 5,000, perpetual bears were announcing yet again that a bubble was forming and a sharp correction imminent. Individual investors, in their view, were acting irrationally, getting swept up in a mania.

At this point, Mr. Glassman and I entered the fray. We contended that investors were not acting stupidly at all. Between 1926 and 2001, after all, the average annual return -- after inflation -- of the large-cap stocks of the Standard & Poor 500 was 7.6 percent, compared with a return of just 2.2 percent for Treasury bonds. Stocks have thus returned more than three times as much as bonds. They are highly risky in the short run, but much less so in the long run. A vast academic literature has found that as stocks are held over long periods, risk declines. Jeremy Siegel of the Wharton School, for example, examined nearly 200 years' worth of data and found that during their worst 20- year period, stocks still rose by more than 20 percent. For bonds, by contrast, the worst 20 years produced a loss of 60 percent.

Why the puzzling decline in risk long-term? Since the economy grows over time, and corporations generally keep up with it, earnings and dividend news can only get so bad in the aggregate. Even if the U.S. economy grows nominally at 6 percent per year for the next 20 years, it will triple in size -- as will corporate profits.

Dow 36,000 argued that as many small investors began to realize that stocks were a solid long-run investment, they became more willing to purchase them. This increase in the demand for stocks helped to bid up both the price and the price/earnings (P/E) ratio, without a sign of a bubble.

But had the "correction" been completed? Mr. Glassman and I argued no - - at least not for old-economy firms of the Dow. Using a widely accepted financial valuation model, we demonstrated that the Dow (not Nasdaq) would have to be roughly four times higher than it was in March 1998 for all excessive fear of stocks to be priced out of the market.

Was that a forecast that the Dow would immediately quadruple? Of course not. In 1998, we issued a warning, which we went on to emphasize repeatedly: "We wouldn't bet the ranch on such an enormous and immediate increase. After all, subtle variations in parameters we cannot possibly predict, such as the growth rate or inflation rate, lead to big changes in conclusions."

We issued these cautions for an important reason: Our calculations were based on the assumption that the economy would grow in the future at about the same rate as in the past. But so pleasant an outcome is no sure thing. Political and economic developments can easily undermine the upward trajectory. And the economy may not bounce back in the long run if a recession leads to troubling social change. This point was driven home forcefully as Mr. Glassman and I prepared for the launch of the French translation of our book. In anticipation of a likely question, we decided to calculate the equivalent "break-even" level for the French market. Our calculations suggested that the French market was then significantly overvalued.

Brit Hume recently summed it all up: "[Dow 36,000] didn't predict the Dow was going to 36,000 next week or tomorrow or next year. But [the authors] basically said that stocks had been undervalued for a long time, and they were a better proposition than bonds, and that if it ever equalized and they were priced based on their return equal to bonds, the Dow would eventually get to 36,000." Those with a political axe to grind have unfortunately chosen to distort this message.