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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.

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

• Wells Fargo, now merging with Norwest Bank, has been growing dividends at 16.5%/year for the past five years. Suppose that we assume this growth rate continues another five years.
• After five years, assume the company abruptly matures and their growth is 1/2% less than the economy as a whole, i.e., 5% - 0.5% = 4.5%/year.
• Assume that the long-term Treasury bond rate is 5.5%. [These rates assume and include 2.5% inflation.]
• "If, in May 1999, the market smartened up and correctly price the stock immediately, the share price would have to rise from $40 to $128. The P/E ratio, which at the time was 33, would jump to 105."

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.

• Overall, corporate earnings cannot grow faster than GDP (Gross Domestic Product). For an explanation, I recommend "Mr. Buffet on the Stock Market," by Carol Loomis, Fortune, Nov. 22, 1999, pp. 212-220.
• As of this writing, Wells Fargo's stock (WFC) has dropped to about $31 on interest rate fears.

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.