The Stock Market Without Tears

The publication of Dow 36,000 has caused such a stir that it has at times seemed as if co-author James Glassman and I had written another Bell Curve. Yet Dow 36,000 merely seeks to describe why stocks are highly volatile in the short run but highly profitable in the long run. How could such a message be inflammatory?

The question of this upset is hardly new. In February 2000, Investors Business Daily ran an editorial asking why the Left was obsessed with Dow 36,000. The piece upbraided Paul Krugman and online magazine Slate for their "ludicrous" accusations that our theory contained a mathematical error, adding that "even by the loose journalistic standards of op-ed page columns, this falls short." Confronted with the facts, Krugman publicly backed down.

The hubbub, however, went on. In recent weeks, columnist Michael Kinsley has called us "lunatics" in the Washington Post, and Slate has referred to us as "geniuses." (Somehow, we think Slate meant that snidely.) To say these people are obsessed is actually an understatement: Between June 9, 1999, and July 23, 2002, Paul Krugman wrote about Dow 36,000 in eight separate articles. But if the book is so wrong, why not sweep it into the dustbin of history? The answer is that it is not wrong and the Left knows it. Though not an overtly political book, Dow 36,000 attacks their anti-capitalist religion at its core. Here's why.

On January 2, 1991, the Dow stood at 2,610. By 1996, with the Dow at around 5,000, perpetual bears were announcing yet again that a bubble was forming and a sharp correction imminent. Individual investors, in their view, were acting irrationally, getting swept up in a mania.

At this point, Mr. Glassman and I entered the fray. We contended that investors were not acting stupidly at all. Between 1926 and 2001, after all, the average annual return--after inflation--of the large-cap stocks of the Standard & Poor 500 was 7.6 percent, compared with a return of just 2.2 percent for Treasury bonds. Stocks have thus returned more than three times as much as bonds. They are highly risky in the short run, but much less so in the long run. A vast academic literature has found that as stocks are held over long periods, risk declines. Jeremy Siegel of the Wharton School, for example, examined nearly 200 years' worth of data and found that during their worst 20-year period, stocks still rose by more than 20 percent. For bonds, by contrast, the worst 20 years produced a loss of 60 percent.

Why the puzzling decline in risk long-term? Since the economy grows over time, and corporations generally keep up with it, earnings and dividend news can only get so bad in the aggregate. Even if the U.S. economy grows nominally at 6 percent per year for the next 20 years, it will triple in size--as will corporate profits.

Dow 36,000 argued that as many small investors began to realize that stocks were a solid long-run investment, they became more willing to purchase them. This increase in the demand for stocks helped to bid up both the price and the price/earnings (P/E) ratio, without a sign of a bubble.

But had the "correction" been completed? Mr. Glassman and I argued no--at least not for old-economy firms of the Dow. Using a widely accepted financial valuation model, we demonstrated that the Dow (not Nasdaq) would have to be roughly four times higher than it was in March 1998 for all excessive fear of stocks to be priced out of the market.

Was that a forecast that the Dow would immediately quadruple? Of course not. In 1998, we issued a warning, which we went on to emphasize repeatedly: "We wouldn't bet the ranch on such an enormous and immediate increase. After all, subtle variations in parameters we cannot possibly predict, such as the growth rate or inflation rate, lead to big changes in conclusions."

We issued these cautions for an important reason: Our calculations were based on the assumption that the economy would grow in the future at about the same rate as in the past. But so pleasant an outcome is no sure thing. Political and economic developments can easily undermine the upward trajectory. And the economy may not bounce back in the long run if a recession leads to troubling social change. This point was driven home forcefully as Mr. Glassman and I prepared for the launch of the French translation of our book. In anticipation of a likely question, we decided to calculate the equivalent "break-even" level for the French market. Our calculations suggested that the French market was then significantly overvalued.

Brit Hume recently summed it all up: "[Dow 36,000] didn't predict the Dow was going to 36,000 next week or tomorrow or next year. But [the authors] basically said that stocks had been undervalued for a long time, and they were a better proposition than bonds, and that if it ever equalized and they were priced based on their return equal to bonds, the Dow would eventually get to 36,000." Those with a political axe to grind have unfortunately chosen to distort this message.

Dow 36,000 rests upon solid conservative foundations: Its premise is that free markets promise to deliver prosperity over time. While fluctuations are inevitable, they are spurred principally by the hard economic news that rationally should affect prices. (The recent decline in the Dow, for example, is about the same size as the drop in corporate earnings.) Over time, bear markets are reversed not because the free market is always perfect, but rather because it corrects itself when it makes mistakes.

The Left proposes an alternative view. Markets--especially financial markets--are prone to manias. The wild swings that occur drive economies into deep depressions, and a large and intrusive government is therefore necessary to protect us.

Historically, the stock market has played a key role in helping the Left to make this case. The economy itself has only rarely posted years of negative growth, but it is quite common for the stock market to drop. And whenever it does, we hear yet again about the dangers of unfettered capitalism. The naysaying continues to this day: Consider the recent statement of journalist Robert Kuttner that "the stock-market plunge is more than a crisis of confidence. It's a belated appreciation of economic reality." The plunge, he writes, is attributable to capitalism run amok, and the fact that Democrats' "own romance with the free market is not entirely over."

Complaints like Kuttner's can be ignored, however, if capitalism always bounces back. If the stock market can recover from world wars and a Great Depression, perhaps one should not panic when it drops for a lesser reason.

The second premise of Dow 36,000 is that citizens are rational beings, fully capable of making their own choices. This, too, contrasts sharply with the motherly attitude the elite take toward the common man. Princeton professor Burton Malkiel, for example, has warned that Dow 36,000 "may lead some investors who can ill afford the significant risks of equity investments to throw caution to the wind." In other words, it's not the message of the book--it's that ordinary folks are so darn stupid, they're bound to misunderstand it.

This basic contrast in philosophy is at the core of many current debates. We must not adopt a school voucher program, the Left argues, because parents should not be trusted to choose schools. We cannot privatize Social Security, because individuals are too inept to plan for retirement. These--and other--positions rest on a mythology of the common man that itself arose, in part, from the observation that individuals are stock-market lemmings. The "madness of crowds" justifies the employment of government orderlies.

Philosophical differences like these have important tactical implications as well. In Crisis and Leviathan, Robert Higgs documents how liberals have taken political advantage of periods of high stress, using them to significantly expand the reach of government. Higgs attributes the steady growth of Leviathan over time to a "ratchet effect": Government expands sharply if a panic can be orchestrated, and it then stays larger once the panic has subsided.

Once the stock market's short-run volatility became widely accepted, this pattern would be short-circuited. Downward market swings would no longer be attended by a swelling Leviathan. This would challenge the Left's distributional objective as well. As more and more individuals participate in stock ownership, a cease-fire is declared in the war between capital and labor.

But those times are not yet here, and that seriously affects policy. Because both corporate and personal taxes apply to corporate income, for example, U.S. dividends are among the highest-taxed in the world. At a time when the reliability of corporate-earnings reports is a concern, a change in tax policy that reduces the burden on dividends would simultaneously increase the attractiveness of U.S. equities and increase the visibility of cash flows. With a majority investor class, such a policy could be possible; today it is not.

The liberals' hysteria over the market also has a more immediate effect on the wealth of their audience. Dalbar, Inc., a Boston research firm, studied the behavior of actual investors in U.S. equity mutual funds between 1984 and 1997. They found that the typical investor earned an average return of 6.7 percent per year over that period--more than 10 percentage points lower than the average return of the S&P 500 index (17.2 percent). Why the big difference? Simple: Many investors would sell in panic after market declines (sound familiar?), jumping back in only after market advances.

The result is even more shocking than it may first appear. Dalbar did not distinguish between the growing number of investors taking the rational long view, and those selling after declines. Hypothetically, then, let's assume 50 percent of stocks were owned by individuals who took the long view, and received the 17.2 percent annual return. For the averages to work out, the other 50 percent must then have gotten a return of -3.8 percent. Market timers probably lost money, then--even during the best bull market of all time! Of course, this would be neither the first nor the last time the liberals' motherly concern for the average Joe has proved to be his worst nightmare.

One reason for the amazing success of equity investment is that the U.S. has always been fortunate. Terrible things that could have happened, did not. Our cities were not destroyed by the Nazis; our government was not seized by the socialists. As we move forward, however, there are no guarantees--which suggests that faith in markets is not enough. Action is required as well. History shows that if our citizens collectively decide to defend capitalism, as they have in the past, we can recover as a nation from whatever is thrown our way. But if we don't, all bets are off. Faith in financial markets requires faith in capitalism, and vice versa.

There are undoubtedly dark times lurking. A necessary war with Iraq is likely, and the terrorists have yet to be defeated. Economic history suggests that the turmoil of war and terrorism often leads to recessions, which result in declining profits and equity prices. As the work of Robert Higgs suggests, it is in these darkest moments that free-market principles face their most serious political challenge.

How will it turn out? Will our economy finally fall into a hole from which there is no escape? As Jim Glassman and I wrote in Dow 36,000, "Unlike other animals, human beings have the capacity to take the long view." Being optimists, we think our citizens--despite the palpable fear and short-term enthusiasms that markets and political opportunists generate--will put that capacity to profitable use with increasing frequency. If they do, their actions will buttress the freedom and prosperity of our nation, which will be the sweetest dividend of all.

Kevin A. Hassett is a resident scholar at AEI.

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