In April 1998, Lawrence Lindsey, the economist and former Federal Reserve governor who is now a principal adviser to Governor George W. Bush, pulled his savings out of the stock market. He's been out ever since. At the time, the Dow Jones Industrial Average had climbed above 9,000, more than tripling in the previous eight years. Wall Street had never seen a run like it, and Lindsey was far from alone in believing it could not continue. Sixteen months earlier, Federal Reserve Chairman Alan Greenspan had issued his famous warning against the "irrational exuberance" of a market then hovering around the 6,500 mark.
Given Greenspan's influence, you almost have to give Lindsey credit for staying in the market as long as he did. And by getting out when he did, he missed the nasty downturn that sent the Dow down nearly 20 percent last summer and early fall. But he also missed the dramatic rally in the final months of 1998 and well into 1999, which saw the average rise 25 percent above the level where Lindsey had bailed out.
Many market sages have attempted to explain the extraordinary strength and duration of this bull market, but it has defied explanation by the traditional yardsticks used in the traditional ways. The most widely used of these measures is a comparison of a stock's price to its current earnings, the P/E ratio. Since ownership of a share of company's stock is defined as a claim on the company's future earnings, this is a handy number. Historically stocks have traded at an average P/E of about 14. Today they are trading at more than twice that.
Now come the veteran journalist James Glassman and economist Kevin Hassett with Dow 36,000. You would never know it from the indignant reaction the book generated well before its September publication date, but Dow 36,000 advances a reasonable argument based on data that are widely known and not seriously disputed. Indeed, what is most striking about the book, despite its radical-sounding title, is how radical it isn't.
Glassman and Hassett draw upon data assembled by Jeremy Siegel, a professor at the University of Pennsylvania, which formed the basis of Siegel's much-praised 1994 book Stocks for the Long Run. Siegel concluded, as do Glassman and Hassett, that a diversified portfolio of common stocks held for the long term (at least five years, preferably longer) is no more risky than a comparable investment in bonds.
The reason is that common stocks have averaged a yearly return (dividends plus the increase in the price of stocks) of 11 percent since 1926, about 7 percent, they estimate, better than the average return on bonds. Of course, some years the return has been much higher than 11 percent, and some years it has been much lower or even negative -- which is why stocks must be held for a long-enough period to ensure obtaining stocks' superior returns.
When the effect of compound interest is included, the difference between the return on stocks and the return on bonds (as both are currently priced) becomes truly staggering. So why have stock prices not been much, much higher relative to the prices of bonds? The answer lies in the perception, persistent through much of this century, that stocks are much more risky than bonds. The effect of this perception is a discount called the "risk premium," and Glassman and Hassett believe it has resulted in the severe and continuing undervaluation of stocks.
After all, if stocks, held for the long term, produce higher returns with no greater risk, there shouldn't be a risk premium at all. Glassman and Hassett argue that most investors have come to reject the notion of a risk premium -- which they express by buying stocks and mutual funds and holding on through thick and thin, propelling the bull market that has mystified so many in Wall Street.
These ordinary investors witnessed the frightening downturn of 1987, when the Dow Jones plunged 25 percent in a single day, and a series of other stalls and hiccups that have prompted gloom-and-doom forecasts from one end of Wall Street to the other. Each time the market has recovered smartly and soared to new highs. There has not been such a protracted bull market for a quarter century.
Glassman and Hassett believe a fortuitous set of events has created our current investment atmosphere. They cite the proliferation of 401(K) and other company-sponsored investment programs, which helped give more Americans a stake in the stock market. Estimates now are that half the nation's adult population owns stock. The Cold War is over, and market economies practicing free trade are spreading. The budget deficit, once regarded as a mortal threat to the U.S. economy, is gone. Inflation, the scourge of stocks and bonds alike, has slowed dramatically amid a wave of growth in productivity occasioned by the revolution in information technology -- a revolution whose benefits are only now beginning to be felt. Even Alan Greenspan seems now to believe that this technology-driven, technology-assisted economy is something new and lasting.
By the calculations of Glassman and Hassett, stock prices will reach parity with bond prices only after tripling beyond current levels, which would lift the Dow Jones Average to 36,000. At that level, stocks would achieve what the authors call their "PRP," their "perfectly reasonable price." Once this occurs, they predict, the growth of stock prices will level off, and stocks and bonds with comparable returns will remain comparably priced. Glassman and Hassett believe this will happen relatively soon, but they don't pretend to know exactly how long it will take.
Siegel, on whose data the book is based, has been quoted as disagreeing with Glassman and Hassett, and that may seem a damning indictment. But it's not.
In the end, stocks, like everything else traded in a true market, are worth what people are willing to pay for them. All the supposedly hard data used for market projections rest on soft assumptions about human attitudes.
The average P/E ratio, for example, is regarded by many as a solid benchmark of value, but it is nothing more than a measure of what people have been willing to pay for stocks in the past. Glassman and Hassett think people are learning through experience that stocks are worth much more than that. Could they be wrong? Of course. But their explanation of the current bull market is certainly more compelling than the arguments of those whose predictions have been consistently wrong and whose current market analysis amounts to little more than repetition of the word "bubble."
Brit Hume is a contributing editor to THE WEEKLY STANDARD.