Tip of the Week #91                    Tip Index

Go to the Prior Tip Career advice
Go to the Next Tip  More Warren Buffet books by Robert Hagstrom
Return to MaxValue Home Page

Toward Rational Exuberance:
The evolution of the Modern Stock Market

by B. Mark Smith, 2001, Farrar, Straus and Giroux, New York, 342 pages, hardcover, list US$25.00

This is a great book.  Mark Smith traces the 20th century history of the stock market. During that time, the market evolved from a mysterious and corrupt "gambling hell" into the sophisticated system we recognize and rely upon today.   Smith lights up the history with abundant stories about the personalities and events.  For persons new to stock investing, he gently explains origins and terminology such as: margin, retained earnings, options, and the Fed.

The author's only biography is on the dustjacket's back flap:  "B. MARK SMITH was a professional stock trader for nearly two decades, first with CS/First Boston Corporation, where he became a director, then as a vice president of Goldman, Sachs & Co."  This lack of self-aggrandizement is rare. Nonetheless, Smith exhibits deep insights into stock market behavior, putting history into context.  Dozens of market-movers and theoreticians are profiled with their influences on the market.

• P/E ratios early in the 20th century were about 10.  A typical company was expected to pay out 50-60% of its earnings in dividends, and these were about 5-6% of the stock price.  P/E ratios were always calculated from past earnings.  Anything looking forward was "speculation" and distrusted accordingly.
• At the beginning of the 20th century and before, "intrinsic worth" was the book value of a company, i.e., assets minus liabilities.  Investors didn't start recognizing growth in stock valuations until about mid-century, and that was mainly due to investors' seeing stocks as an inflation hedge.  Also, it became accepted that companies would often want to retain more of their earnings to fund growth; dividends gradually diminished in importance.
• Smith frequently describes people who sought to predict stock prices, and their almost universal failure at this. Smith seems firmly in the camp of "efficient market" theory, though he admits that this works only because there are people who believe otherwise and are doing analysis.  Market-beating systems that worked in the past have been discovered by others and no longer work well.

The explanations of stock market booms and busts are especially intriguing.   Sometimes there are several causes or competing explanations, and Smith seems to offer balanced treatments.

Smith describes technical and fundamental analysis methods and the basics of portfolio theory.  In addition to discussing history, he is careful to offer his own conclusions about what works best for the individual investor: being mostly in stocks, diversification, avoiding trying to time the market, and keeping a long-term perspective.

Beware the dividend discount formula on page 282.  This is a common and incorrect formula, and the error is about 8% (too low) using his example parameters.   The correct formula (assuming continuous dividends and discounting) is:

    PV = D / (ln(1+R)-ln(1+G))

where D is the current dividend yield per year, R is the annual PV discount rate, and G is the annual dividend growth rate. "ln" is the natural logarithm function.   R and G both should be either real (not inflated) or nominal (inflated).

—John Schuyler, January 2002.

Copyright © 2002 by John R. Schuyler. All rights reserved. Permission to copy with reproduction of this notice.