Stocks Still Look Good.(Brief Article)(Statistical Data Included)

Two years ago my AEI colleague Kevin Hassett and I wrote Dow 36,000. Despite its flamboyant title, the book was a serious attempt at formulating a new model for valuing stocks, one that would explain the incredible rise in prices from a Dow Jones average of 777 in August 1982, to 9,324 in March 1999.

But something happened on our way to the Nobel Prize: The stock market fell sharply right after the book was finished. It recovered impressively in the fourth quarter of 1999 and kept flying through March of last year. Then the technology-heavy NASDAQ Composite index collapsed, losing half its value by December. Also in 2000, the broader S&P 500 fell 9 percent, and the Dow, after accounting for dividends, dropped 5 percent--its first loss in 10 years. (As I write, the Dow is up a bit.)

So, has the stock market changed? Have Kevin and I changed our minds?

The answer to both questions is "no."

Our book generated controversy because it challenged the conventional wisdom on how to value stocks--the notion that there are "ceilings" and "floors" beyond which market prices can't go for long. That challenge stands. The old model can't explain what has happened over the past two decades; ours can, and still does.

The best-known valuation ceiling is the price-to-earnings (or P/E) ratio: the number of dollars it costs to buy a dollar's worth of a company's annual after-tax profits. Analysts have long believed the P/E ceiling was about 15, but Kevin and I paid little attention to P/Es. We were concerned with something more important: the cash investors can put in their pockets, either immediately through dividends or in the future through the piling up of a company's "undistributed operating earnings"--the phrase super-investor Warren Buffett uses for a firm's free cash, available to shareholders rather than required to run the business.

Economists have long puzzled: Why do stocks return so much more than other investments (an average of 12 percent a year) when research clearly shows that stocks, if held for the long term, are no more risky than Treasury bonds, with average returns far lower? Stocks somehow carry a hefty "risk premium"--that is, a higher return to investors to compensate for their perceived riskiness.