Dimensions: 8.75'' x 6'' 294 pages Times Books Publication Date: September 1999 Paperback ISBN: 0-609-80699-8 Hardcover ISBN: 0812931459

In the first half of this book, the authors present their case for a new method of assessing the proper value of stocks and conclude that U.S. stocks, on average, are worth approximately three times their current prices. They elaborate that theory primarily by looking at historical rates of return for stocks and comparing them with the rates generated by other types of investment. In the latter half of the book, the authors explain how to profit from their theory and cite specific stocks and mutual funds that are well poised to benefit from the trends they foresee.

James K. Glassman is a financial columnist for Reader’s Digest and a resident fellow at the American Enterprise Institute. Kevin A. Hassett is a resident scholar at AEI.

Since 1982, the Dow Jones Industrial Average has climbed from 777 to above 10,000. Recently, in fact, the gains for stocks have accelerated. Returns (that is, price increases plus dividends) for the Standard & Poor’s 500-Stock Index, a popular proxy for the stock market as a whole, have exceeded 20 percent for an unprecedented four years in a row. But throughout the spectacular rise of the past two decades, a considerable number of financial experts on Wall Street, in the media, and in academe have continually warned that stocks were dangerously overvalued.

This book argues that the conventional model for valuing stocks has been rendered obsolete--like Ptolemy’s model of the heavens--and that the inaccurate warnings of the financial establishment have kept millions of Americans from enjoying the fruits of the equity boom.

The conventional model cannot explain the bull market of the past two decades except as an anomaly, an episode of what nineteenth-century writer Charles MacKay called "the madness of crowds." Glassman and Hassett offer a new model that not only explains what has happened in the 1980s and 1990s but also asserts that the proper level for the stock market--right now--would be three to four times its current level.

The authors arrive at that conclusion by using assumptions that most analysts would call modest, including real (that is, inflation-adjusted) economic growth of 2.5 percent annually. For the past three years, by contrast, real gross domestic product has increased at 4 percent annually. In other words, the theory is based not on a "new economy" but on a fundamental analysis of the intrinsic value of stocks.

The authors begin, simply enough, by treating stocks like any other asset and calculating the dollars that will flow into the pockets of stockholders over time. As Alan Greenspan, chairman of the Federal Reserve Board, said in August, "The value ascribed to any asset is the discounted value of future expected returns, even if no market participant makes that calculation." In the case of stocks, those returns--the actual dollars--mount spectacularly, thanks to the growth of earnings, dividends, and cash flow in general.

Stocks are a fabulous deal--so fabulous that they can fairly be said to have been underpriced for much of market history. Why? Because of widespread misperception by investors of the true risks of stocks. Economists have written dozens of papers on what they call "the equity premium puzzle"--the question of why stocks return so much more than bonds when data from nearly 200 years of market history show that the two types of asset are equally risky over the long term. The scholars’ best explanation is that investors are "irrational" about the riskiness of stocks. They watch the short-term ups and downs and myopically lose sight of the fact that, in the long run, the positive returns have been remarkably consistent. That fear has directly affected share prices: since many potential buyers have shied away from stocks over the years, stock prices have been too low.

Now, in the view of Glassman and Hassett, investors are becoming more rational. They are bidding up the prices of stocks and will continue to do so until shares reach an equilibrium, or "perfectly reasonable price" (PRP, as the authors call it), and the Dow Jones Industrial Average stands at about 36,000.

For decades, financial experts have measured stock prices against particular yardsticks of the past--especially price-to-earnings (P/E) ratios and dividend yields--that suggest that current prices are far too high. The Glassman-Hassett model, to the contrary, indicates that prices remain far too low.

How low? Their analysis finds that the proper current value for the Dow is 36,000. Based on their model, P/E ratios of 100--three to four times current levels--are justified for the market as a whole. In March 1998, Glassman, who, at the time, was also a financial columnist for the Washington Post, and Hassett, who had previously taught at Columbia University and had served as a senior economist at the Federal Reserve Board, laid out their theory in an article in the Wall Street Journal headlined "Are Stocks Overvalued? Not a Chance." The Dow at the time was at 8,782. Then, in the summer of 1998, with the Dow at 7,500, they began writing Dow 36,000. By the summer of 1999, the Dow had breached 11,000.

The authors looked at the two simple components of any investment--risk and return. Historically, stocks have provided a much higher return than alternative investments--an annual average of 11 percent, compared with about 5.5 percent for Treasury bonds.

Normally, one asset delivers a higher return than another because it is riskier. For example, in early 1999, relatively secure AT&T bonds were paying interest of 6.7 percent, while the bonds of Chesapeake Energy, a shakier company, were paying 12.3 percent. The riskier company was forced by the market to pay that extra return--called a "risk premium"--in order to attract lenders.

But understanding the relationship between risk and return of stocks has always been more complicated. Although the returns of stocks fluctuate from year to year, that volatility is canceled out over longer periods. In comparison, bonds, which can drop precipitously in value if inflation increases, have proven to be a riskier long-term investment. In his book Stocks for the Long Run, Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, presented copious evidence on this subject and concluded that "although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true: the safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds."

Siegel looked at every twenty-year period from 1802 to 1997 and found that the worst such stretch for stocks produced average real returns of 1 percent annually; Treasury bonds, in their worst comparable period, returned minus 3.1 percent per year. Siegel noted that, in contrast to bonds and Treasury bills, stocks have never generated negative real returns over a holding-period of seventeen years or more.

Glassman and Hassett believe that the key to understanding the bull market of the past seventeen years and, especially, the current run-up in stock prices is that people are catching on to the true nature of stocks--to their relative lack of risk over time and to their fantastic returns. The accompanying surge in demand has driven stock prices higher and higher.

When will it end? Though there is some uncertainty about the exact level, the model developed in the book indicates that irrational fear would b e completely priced out of the market today if the Dow rose immediately to 36,000. To put it another way--with the Dow currently at about 11,000--people are still too reluctant to own stocks, and the effect of the lower demand is to depress prices to about one-third their true fundamental value.

Glassman and Hassett believe that the risk premium--that extra return investors demand for holding stocks instead of bonds--will fall from about 3 percent to roughly zero, which is where it should be, according to the historical analysis of risk. Moreover, the authors list nine other reasons why risk levels are falling, including the renovation of American industry, more benign fiscal policies, better monetary management, and the reduction of national security threats.

In the second half of the book, the authors present detailed investment strategies for taking advantage of their theory. They give advice about how to choose stocks and mutual funds, how to allocate one’s assets among stocks, bonds, and cash, and how to think about one’s investments in a way that is likely to maximize returns. In the final chapter, the authors discuss the profound political and social consequences of the stock market’s tripling in a short time.

The authors’ theory has already provoked heated controversy, but they believe that their views will prevail. After all, to argue that stocks are overvalued today, traditional analysts are saying either that earnings growth will slow, that real interest rates will soar, or that the risk premium will return to its higher levels of the past. Most analysts citing stock "mania" lean on the third explanation. In other words, they believe that the attitudes of investors toward risk, which have become more rational over the past two decades (and especially over the past five years), must become less rational. Could that happen? Well, yes, say the authors. Such a reversion to an irrational mean is a possibility. But Glassman and Hassett firmly believe that people have the capacity to learn and will avoid falling back into delusion.

And while it makes sense to be skeptical when you hear someone (like the authors) claim that "this time it’s different," the truth is that, sometimes, it is different. Things change. For example, for three decades after the Crash of 1929, stocks had dividend yields that were greater than Treasury bond yields. Those high dividends were necessary, analysts believed, to compensate investors for the extra risk in stocks. Then, in 1958, something changed. Dividend yields dipped below bond yields. As Jeffrey M. Applegate of Lehman Brothers writes, "Financial commentators of the time bemoaned the astronomical valuation of the equity market, predicting an imminent decline in the stock market as the dividend yield climbed back above the bond yield." Among those commentators, by the way, was Greenspan, then a consulting economist, who in 1959 warned in Fortune of investors’ "over-exuberance"--a phrase with a familiar ring.

But the dividend yield kept falling, and never again exceeded the bond yield. Despite the admonitions of the experts, investors in the late 1950s came to realize, almost in a blinding flash, that stocks were not as risky as they had thought and that a dividend that grew as profits grew was far better than the static yearly payout from a bond. As a result, investors did not need the extra enticement from high dividends. That new realization caused them to bid up stock prices sharply to a new level that has endured. From 1940 to 1957, the P/E ratio never exceeded 15 in any single year. Since then, it has exceeded 15 in a majority of years.

In the 1980s and 1990s, a similar process of rethinking began as investors started looking at stocks through a different lens. The authors believe that the process will continue and that, as it does, the old view of valuations based on a specific historical vantage point will be rejected.

When observers say that "history" dictates certain results, they really mean a particular perspective on history. Karl Marx, for example, viewed history as class struggle, picking and choosing events and nations to make his case. By focusing on such indicators as P/Es and dividend yields, the current generation of observers sees only part of the picture, and the consequence is a badly distorted view--as the soaring market of recent years confirms. The theory offered in Dow 36,000 provides an explanation for the bull market built on a different and far more plausible paradigm.