The much discussed Dow 36000 prediction relies on discounted cashflow valuation - OK- and the assumption that investors will soon rate stocks no riskier than long term treasuries - not OK.

In a pair of Wall Street Journal editorials (March 30, 1998 and March 17, 1999) and a book to be published this Fall, James Glassman and Kevin Hassett argue that the Dow Jones Industrial Average is currently undervalued and should, in fact, be at 36,000. This is a rather breathtaking claim given that the Dow (as of the end of July 1999) is at around 11,000. From 1982 to 1999, the Dow generated annual returns of about 16.6 %, rising from around 800 to the aforementioned 11,000. Given that historical annual returns for the Dow have averaged around 12%, it’s been a great 17 years for the Dow.

Many pundits argue that the stock market is overvalued and point to such measures as dividend yields and price-earnings ratios as proof. The current dividend yield (dividends/price) for the stocks comprising the Dow is 1.51%, dramatically lower than the historical dividend yield of 3-4%. The current P/E ratio for the Dow is around 26, much higher than the historical P/E of 12. In both cases, the conclusion is that the prices for the stocks comprising the Dow must be very high and are certainly much higher than their historical norms. For example, if the current P/E ratio should be 12, then this implies that the Dow should be at 5,000, not the actual 11,000 we observe in the market. Given this historical information, how can we reconcile Glassman and Hassett’s view that the Dow is undervalued?

Needless to say, Glassman and Hassett’s view has generated much controversy. Much of the debate has centered on whether earnings are a good measure of the cash generated by firms. Glassman and Hassett initially used earnings as a measure of cash flow, which involved some double counting because some fraction of earnings are typically reinvested in the firm. Those arguing that Glassman and Hassett double-counted include Clive Crook in the Economist and Bruce Gottlieb and Paul Krugman in the online magazine Slate. For those interested in the double-counting debate, I refer you to those sources and Glassman and Hassett’s responses in Slate. While the double-counting issue is real, I don’t think that it’s central to the argument. Instead, I would like to focus on what I think is the most speculative piece of the argument for the Dow being undervalued—that stocks are essentially risk-free.

First, let’s see how Glassman and Hassett arrive at the conclusion that the Dow is undervalued. They use a constant growth, discounted cash flow model to arrive at a theoretical value for the Dow: V_Dow = CF/(r-g). In this model, cash flows (CF) are the cash generated by the firms comprising the Dow. Glassman and Hassett use earnings as a proxy for cash flow. At the time they first wrote about the Dow, the Dow was at 9,000 and the P/E ratio for the Dow was 25, which implies that earnings for the Dow were $360. The growth rate for cash flows is g. Glassman and Hassett assume that cash flows will grow at the projected rate of growth for the U.S. economy as a whole, or around 5%, in dollar value of output. The discount rate for cash flows is r. This typically is the equity cost of capital.

For the purposes of this discussion, we’ll treat the firms that comprise the Dow as being all-equity financed (this assumption is immaterial for the discussion that follows, but does simplify the math). In this case, the discount rate is the cost of equity which we can compute using the capital asset pricing model: r = r_f + b(r_m – r_f ). Here, r_f is the risk-free (Treasury) rate of about 6%, r_m is the expected return on the market as a whole, and b measures the covariance of the returns on the Dow with the returns on the market as a whole. Historically, the return on the market has been about 12% and b for the Dow has been about 1.  If we use these historical numbers, the discount rate  r = 6% + (1 )(12% - 6%) = 12%.  Combined with the current level of earnings for the Dow and the growth rate of 5%, the theoretical value for the Dow is: V_Dow = 360/(12% - 5%) = 5,143. This theoretical value is consistent with historical price-earnings ratios.

What Glassman and Hassett argue is that the expected return for the market is not 12%, but is instead the risk-free rate of 6%. They cite research by Jeremy Siegel of Wharton that shows that well-diversified portfolios of stocks held for twenty years or more are no riskier than Treasuries held for the same period. As the market recognizes this fact, they argue that the expected return on the market will shrink to the risk-free rate. If so, then the discount rate in our calculations will be r = 6% + 1 (6% - 6%) = 6% and the theoretical value for the Dow will be: V_Dow = 360/(6% - 5%) = 36,000.

The key component of the argument for Dow 36,000 is the assumption that the expected return on the market will shrink to the risk-free rate. Glassman and Hassett argue that the current level of the Dow (about 11,000) can be justified by noting that the expected return on the market has already shrunk to around 9%. I find the argument that the expected return on the market has shrunk to 9% to be plausible. Through time, Americans have become much more likely to invest in equities, primarily through retirement accounts. This is consistent with investors either becoming less risk averse or recognizing that equities are not as risky as they were once believed to be.

What I find less plausible is that the expected return on the market will shrink all the way to the risk-free rate. First, this argument relies on the average investor holding a well-diversified portfolio for at least twenty years. My best guess is that the average investor is nowhere close to behaving this way, in large part because the average investor is likely to be a money manager with strong incentives to take risks to outperform the market.

Second, the claim that well-diversified portfolios are no more risky than Treasuries is based on historical outcomes. Historical outcomes do not reflect the ex ante uncertainties faced by investors. In 1950, the outcome of the Cold War could not have been predicted (with any degree of certainty) to be as positive for the U.S. and U.S. equities as it was. The U.S. is one nation that has had a particularly good set of outcomes for a very long period of time. When evaluating equity investments, I wouldn’t necessarily project that past into the future.

Where does that leave the Glassman and Hassett argument? I believe that their claim that the Dow should be at 36,000 is much too strong. The Dow at 11,000 may be undervalued, but not by a factor of three. Even the claim that the Dow is undervalued at 11,000 is somewhat tenuous. Instead, what I view as their contribution is focusing attention on the idea that Americans’ attitudes towards the riskiness of equities has changed. This in itself could generate the enormous returns we have seen in the stock market over the past few years. But if this is the reason why we have seen large returns in the past, we are also quite unlikely to see such large returns in the near future.