Tuesday, December 07, 2004


Glassman unrepentant

I must admit I like James Glassman. Usually, he has lots of interesting things to say about Wall Street and investing. But you would think that he would be the last person to admit that 5 years ago he co-authored a little tract called Dow 36,000, which was published right at the high of the NASDAQ bubble. But no… he comes out swinging, claiming he was right all along and that he really didn’t mean the DOW would climb to 36,000 like, you know, the very next day.

True enough, but isn’t it amusing that his column doesn’t refer to the subtitle of the book, The New Strategy for Profiting from the Coming Rise in the Stock Market or that they write in the book that a “conservative estimate” is that the Dow will hit 36000 in 3 to 5 years – that is, by the end of 2002 or 2004. By my count, they have 4 more week to get it right.

And where did the figure of 36000 come from, anyway? As Glassman explained in a Slate dialogue with Economist Deputy Editor Clive Crook,

A good way to express values is by price-to-earnings ratios. Currently, the average stock sells at a P/E of about 25, meaning that it costs $25 to buy $1 worth of profits. Or, as a reciprocal, the stock's return in the first year is $1/$25 or 4 percent.
That doesn't seem like much, especially compared with a 30 year Treasury bond, paying 5.9 percent. If stocks and bonds have equal risk, shouldn't the P/E for stocks be 1/.059, or about 17?
No. There's a big difference between a stock and a bond. A stock increases its profits year after year, while a bond simply pays the same return.
Hassett and I assumed that earnings would rise annually at the same rate as nominal GDP (in fact, they have been rising far faster lately), or 4.9 percent, according to the Congressional Budget Office. Then we applied a simple finance formula: value = 1/(r-g), where r is the interest rate on 30 year bonds (5.9 percent right now) and g is that 4.9 percent growth rate. The result: 1/.01, or a P/E of 100.

But wait a second! What’s that simple finance formula again? It’s not what Glassman says it is. A stock’s fundamental value is it equal to the present value of future dividends, not earnings. After all, companies need to invest in order to grow. A typical company will pay out only a dollar or so in dividends for every 3 or 4 dollars in earnings. As Crook points out, once you make the correct adjustment, the value of the DOW ends up being.. drum roll please.. 10,000 or so. Oops.

Very insightful post!
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