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DOW 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market

by James K. Glassman and Kevin A. Hassett, 1999, Times Business/Random House, 294 pages, hardcover, ISBN 0-8129-3145-9.

"Every stock owner should read this book."
—Allan H. Meltzer, Carnegie Mellon University

On my book shelf are several depressing books, including these titles: Bankruptcy 1995: The Coming Collapse of America and How to Stop It, Crisis Investing: Opportunities and Profits in the Coming Great Depression, and When the Bottom Drops: How Any Business Can Survive and Thrive in the Coming Hard Times. There are lots of risks to the world's financial structure and our way of life. Buy gold and keep lots of cash.

DOW 36,000 offers quite a different perspective. Optimism. Authors James Glassman, a business writer, and Kevin Hassett, a PhD economist, offer evidence that stocks are greatly underpriced. What they call "perfectly reasonable prices," PRPs, place a reasonable Dow Jones Industrial Average at about 36,000.  This is about four times the level when the book was written. ("The Dow" index is the most widely referenced stock market benchmark in the U.S.) This is a very encouraging investment philosophy if they can make their case. The authors predict that we're in a once-in-a-lifetime revaluation of stock prices and that now is the time to invest.

The method of stock valuation in DOW 36,000 is reasonably consistent with my approach to valuing capital investments (see the box below).   Here is a summary of the rationale:

  1. History shows that investing in a diversified portfolio of stocks is, over the long term, no more risky than investing in government bonds. The premium demanded by investors for investing in stocks has been historically about 7% greater than government bonds. Thus if government bonds yield 5%, on average, investors in average stocks traditionally expect a total return of about 12%. [This relationship is captured in the Capital Asset Pricing Model.] Evidence suggests that "investors are catching on" to the new reality. The risk premium for stocks is dropping as people perceive that stock market investing has low risk over long investment horizons.
  2. If there is no difference in risk, then stocks and government bonds should provide an equivalent cash flow to investors, on average.
  3. "... the correct valuation for stocks—the perfectly reasonable price—is one that equalizes the total flow from stocks and bonds in the long run." (p. 18)
  4. Since 1946, dividends in the U.S. have been increasing an average of 6% per year. After-tax corporate earnings have risen about 7% per year. What counts is cash flow into the pockets of investors.
  5. Assuming conservative estimates for average dividend growth and yield of government bonds, the authors place a reasonable average price/earnings ratio at 100.
For several years I've been advocating that corporations should use a nearly risk-free discount rate when evaluating capital investment projects (see the reference, "Rational is Practical," for details). This presumes that we're using probabilities in the evaluation model to represent and adjust for risk.

Applying present value discounting to corporate cashflow (or profits) yields a curious result. The present value of a company generating, say, $1/year per share of free cash flow is:
      PV ~= $1 / (i - g)
where g is the annual growth rate, and i is the annual discount rate (typically a cost of capital). [This formula isn't quite correct, but it is a common approximation and the one used in the book.]

What happens to PV if a company's cash flow is growing faster than the discount rate? PV is infinite! A reasonable value for i, before taxes, might be about 7%/year, assuming inflation is about 3%/year.  Lots of companies have recent lengthy histories of growing dividends (or earnings, or free cash flow) at greater than 7% per year. This value is even better if we assume a buy-and-hold strategy and a corporation that reinvests in its business or repurchases shares rather than paying dividends. While a corporation's earnings cannot outpace Gross Domestic Product growth across the long term, a company with healthy growth will have a high present value.

Here is an example valuation from the book (p. 62):

I haven't been able to duplicate the calculations in the book (I've written separately to both authors about that; no answer yet).  I assumed 100 years as a more-than-adequate investment horizon and sale of the appreciated stock after this holding period. Using Wells Fargo's $0.79/share 1999 dividends, I calculate a PRP (perfectly reasonable price) of $256.86 (twice the book's level). My higher value may be due to a much longer investment horizon.

Few investors can access capital at long-term government bond rates. Investors are also risk averse.  Using what I perceive as a more reasonable discount rate of 7%, the PRP falls to $60.42. This is still a 50% increase over the then-current price of $40 per share.  The P/E ratio is 76 at the $60.42 PRP.

Discount Rate

7% per year

Adolescence

5 years

Growth through Adolescence

16.5% per year

GDP Growth Rate

5% per year

Maturity Underperformance below GDP

0.5% per year

Current (1999) Dividend (reported in Value Line Investment Survey, p. 2130)

$0.79 per share

Today's Price (when the book example was written)

$40 per share

 
Perfectly Reasonable Price (PRP)
Value that makes NPV=0

$60.42 per share

P/E Ratio at PRP

76

Year Cashflow NPV
0 -60.42 -60.42
1 .85 .82
2 .99 .90
3 1.16 .98
4 1.35 1.06
5 1.57 1.16
6 1.73 1.19
7 1.81 1.17
8 1.89 1.14
     
99 103.9 0.13
100 108.58 0.13
End 8,489.16 9.78
Totals 10,917.60 0.00

The example calculation used dividends, which were about 35% of 1999's $2.25 earnings per share. If there is cash flow beyond what can be prudently reinvested in growing the business, then the excess cash flow can be used to increase dividends or repurchase shares. This would make the PRP higher.

I recommend that stock investors study this book. In 20 years, the DOW 36,000 theory be recognized as a landmark publication. By then, it will be too late to participate in what the author's predict is this one-time price runup. The last half of the book provides many prudent investment tips that are worthwhile reading, even if you do not accept their valuation theory

I hope they're right. Their approach is similar on an investment ranking approach that I developed about 5 years ago. I'm betting about 1/3 of my portfolio on this type of "value investing."

Check out the book authors' Web site at http://www.dow36000.com.


—John Schuyler, March 2000  Revised March 9, 2000.

Copyright 2000 by John R. Schuyler. All rights reserved. Permission to copy with reproduction of this notice.