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September 2002

Dow 5,000

Okay, so what’s a bond guy doing phony earnings. Dividends and

talking about the stock market again? dividend increases have been miserly
Shouldn’t he stick to his “knitting?” to say the least for several decades
Isn’t he really just an equity transves- now and you’ve been hoodwinked
tite in disguise? A frustrated stock into believing the CORPORATION
wannabe who couldn’t get a job in the should hold on to them for you so that
early 1970s and took the best thing he they can convert them into capital
could find – A Bond Manager? Yeah, gains and save you taxes. Companies
well maybe, but then again maybe you have been diluting your equity via
owners and managers of stocks could stock options claiming that manage-
benefit from a different perspective. ment needs incentives of millions of
We already “know” bonds are going dollars just to get up in the morning
to yield/return 5% or so over the next and come in to work. Then they pick
umptyump years. How about asking you off by trading on insider informa-
the same question for stocks? Afraid tion, selling shares before the bad
of the answer? news hits and you have a chance to
get out. If you try to get a hot IPO you
My message is as follows: stocks stink find all the shares are taken – by
and will continue to do so until Bernie Ebbers. Come on stockholders
they’re priced appropriately, probably of America, are you naïve, stupid,
somewhere around Dow 5,000, S&P masochistic, or better yet, in this for
650, or NASDAQ God knows where. the “long run?” Ah, that’s it, you own
Now I guess I’m on somewhat of a stocks for the “long run.” We bond
rant here but come on people get a managers may have had a few good
hold of yourselves. Earnings have relative years but who can deny
been phonied up for years and the Stocks for the Long Run? Not Jeremy
market still sells at high multiples of Siegel, not Peter Lynch, maybe not
Investment Outlook

even Bill Gross if you stretch the time Many of you readers may be familiar
period long enough – 20, 30, 40 years. with Peter Bernstein via his books on
But short of that, stocks can be, and risk or even gold, but recently he
often have been poor investments. teamed up with common sense and
The return on them depends signifi- actuarial wizard Rob Arnott to pro-
cantly on their beginning valuation duce a brilliant piece of research
and right now valuation remains poor. entitled What Risk Premium is Nor-
Dow 5,000 is more reasonable. Let’s mal? In addition, the trio of Elroy
see why. Dimson, Paul Marsh, and Mike
Staunton have written a book that
To present my case I resort to a panel may have equaled or perhaps sur-
of expert witnesses, academicians and passed Siegel’s, as well as Ibbotson
financial theorists with a lot more and Sinquefields’ study of world
brainpower than I have. Over the past wealth, with their Triumph of the
several years, in contrast to the more Optimists, a 101-year survey of invest-
bullish and optimistic Jeremy Siegel, ment returns. I shall refer to both sets
or Jim Glassman of Dow 36,000 fame, of authors frequently over the next
there have been several more realistic few pages.
and down to earth experts that speak
to low, not high, equity returns over Let me say first of all that it is difficult
the foreseeable future. Their primary to keep this simple. I’ve read, reread
thesis is not that the U.S. economy is and near-memorized both of these
headed for a depression or that the research gems. Their contents seem
economic sky is falling but that even simple to me now but they were not at
under near normal economic growth the beginning, so I must assume the
rates, the U.S. stock market is priced same for most of you. Besides, you
at current levels to return less than have minutes not months to get my
has been historically “required.” drift, and if I am to help you I must
Grow those earnings they say (al- inform you quickly and yet simply,
though let’s be sure what they are) at even leaving some critical think pieces
near historic rates and you’ll still need out, in order to do so. Forward. The
much lower prices in order to offer crux of the valuation argument is this:
stock investors a chance at returns Stocks historically return more than
that exceed corporate bonds or even almost all other alternative invest-
inflation protected Treasuries – TIPS. ments but only when priced right

September 2002
when the race begins. If you start Staunton), as well as “B&A”
from day one with P/E’s too high or (Bernstein and Arnott) all pretty much
importantly, dividends too low, you agree that over the past 100 years U.S.
will not obtain equity returns in stocks have provided a real return
excess of bonds. Seems simple (after inflation) of about 6.7%. While
enough. People know that if they pay that return has been higher than for
twice the market price for their house, most other countries shown in the
that it will take years and years to get “DMS” chart below, in none of the
their money or their equity out. Some- countries did stocks fail to outperform
how though when it comes to stocks bonds over the past century and that
they forget. includes several stock markets, which
virtually disappeared during WWI
Maybe they forget because it’s hard to and WWII. The average real return for
know at any point what a stock or a the 16 countries shown was 5.1%.
stock market should be worth. Here’s Remember that these returns are ex-
some help. Jeremy Siegel, “DMS” inflation, so that arguments for higher
(author’s Dimson, Marsh and nominal returns in inflationary periods

Real Return on Equities Versus Bonds Internationally, 1900-2000

Annualized percent return


Equities 7.6
8 7.5
Bonds 6.8
5.8 5.8
4.8 5.0
4.5 4.6
4 3.6 3.6
2.5 2.7 2.8
2.5 2.4
1.8 1.6
2 1.2 1.5 1.3 1.4
1.1 1.1

-2 -1.0
-2.2 -2.2
Bel Ita Ger Spa Fra Jap Den Ire Swi UK Neth Can US SAf Aus Swe

Reprinted from Triumph of the Optimists, Copyright 2002 Elroy Dimson, Paul Marsh, and Mike Staunton
with permission from Princeton University Press.
Investment Outlook

and lower nominal returns during over the next century, turns out it was
times of low inflation are neutralized. because of some reasons that you
probably wouldn’t think of right off
Using the commonsensical approach the top of your noggin. Most investors
that “100 years of the past” is “100 would say it was because earnings
years of prologue” an investor might grew that much, so stock prices just
reasonably expect to have future real naturally followed like a little puppy
returns come close to 6.7% in the U.S. dog at the heels of its master. Wrong.
and 5.1% globally. Remember though, The two primary components of this
to get those same returns with similar 6.7% real return were 1) a beginning
economic growth you have to start at dividend yield of 4.2% and 2) rising
the same valuation point as an inves- valuation (P/E’s going up). Real
tor did in 1900. Maybe the market was earnings growth, or its twin, real
super cheap then and very expensive dividend growth, comes in a poor
now. Makes a difference, and as third. Over those same 100 years, real
you’re about to find out, that was dividends managed to grow at only .6%
exactly the case. Although 1900’s as seen in the “DMS” chart below.
stock market would provide 6.7% real

Real Dividend Growth Rates Around the World: 1900-2000

Annualized real dividend growth rate (%)


4 2.3

2 1.5
0.6 0.9
0.3 0.4

-1.1 -0.8 -0.8
-2 -1.3
-1.9 -1.7

-4 -3.3

Growth: first half-century

-6 Growth: second half-century
Dividend growth: 1900–2000

Jap Ita Den Bel Ger Fra Spa Ire Neth Swi Can UK US Aus SAf Swe

Reprinted from Triumph of the Optimists, Copyright 2002 Elroy Dimson, Paul Marsh, and Mike Staunton
with permission from Princeton University Press.

September 2002
Ninety percent of the market’s real 8-9 percent – and the faster portion it
return then came from factors other turns out – has come from newly
than earnings growth. Most of it came created companies that are not even
from the initial dividend yield. listed and available for purchase by
outside investors. The balance after
And so dear reader, in an attempt to subtracting 4 percent inflation… has
keep this simple and help you to been near the .6% real growth of the
plough through what can get most past 100 years or the .8% of the past
complicated, the primary element in 50 years. You are being hoodwinked
determining how a stock market is America. You pays your money and
priced – whether it’s cheap or expen- you gets…you gets…a dividend yield
sive – is its yield. At 4.2% in 1900, the and a little bit of dividend growth:
market needed an additional 2.0% .6% real over the last 100 years.
annual push from a tripling of P/E
ratios over the century to get near that Where does that leave us (you – not
6.7% real return. Earnings growth me – I’m out of the market) today?
was a pathetically small factor. How Well, most large market indices
could that be? As Peter Lynch said in a (NYSE, Wilshire 5000) yield some-
recent CNBC interview when asked where in the area of 1.7%. Whoa now,
about the future of the stock market, did I say 1.7%? Yes siree. And despite
“Well, since WWII corporate profits the claims for higher implied yields
have grown about 8 or 9 percent a due to stock buybacks (mostly falla-
year…I don’t see why that won’t cious) even if we grant an “implied”
be different the next 50 years,” imply- yield of 2.0% to the market, it’s hard
ing that stock prices would do the to see how we can get to our 6.7% real
same or more. The problem is, as return target. Say real dividends grow
Peter Bernstein points out in an at 2.0% for the next 100 years instead
August 2002 research piece entitled of .6%. Not sure why that would be
The Trouble With Earnings, at least but let’s just say that to be more than
50% of the earnings growth over the fair. If so, then a 2% implied dividend
past 40 years has been earnings of the yield, plus 2% real dividend growth,
“mystical” kind – pro forma, operat- only equals 4% - far short of our
ing, phonied up. Those “earnings” hoped for or perhaps required 6.7% of
didn’t flow through to dividends. In the past 100 years. How to get there?
addition a goodly portion of Lynch’s Well, absent faster economic growth
Investment Outlook

which would lead to even higher risk premium” to get to an appropriate

dividend growth than I’ve already starting point valuation. This equity
generously granted, the only way to risk premium is really the excess
make that happen is to start with a return that investors require over and
yield of 4.7% and the only way to do above real Treasury yields (best
that would be to cut the market aver- measured by TIPS yielding nearly
ages in half or more. Dow 4,000 would 3.0%) to compensate them for the
do it as would S&P 400. increased volatility and increased risk
of owning stocks. Both B&A and DMS
Now to be fair and truthful to B&A calculate that risk premium should be
and DMS, both assert that the 6.7% roughly 2.4% when measured against
real return over the past 100 years 30-year TIPS. Let me though, intro-
should never have been the “ex- duce my final chart that you can play
pected” return anyway. After all, 2.0% with yourself. This chart’s horizontal
of that 6.7% came from a tripling of P/E axis tracks the equity risk premium
ratios which is really not rational to that you, the investor, would be
expect again over the next
century. A rather unscien- Gordon Model Valuation of the Dow ( r-g )

tific adjustment, which

Index level of the Dow (assumes dividend = $185
neither DMS nor B&A and 2% real dividend growth)

employ, would be to use 15,000 15,000

the 100-year real return 14,000 14,000

13,000 13,000
from equities without the
12,000 12,000
tripling effect, or 4.7%. If 11,000 11,000
so, with 2% real dividend 10,000 10,000
9,000 9,000
growth, stock markets
8,000 8,000
need to yield 2.7% and 7,000 7,000
B&A, DMS Estimate
would fall by 20% in order 6,000 6,000

to get there. At Dow 7,000 5,000 5,000

4,000 4,000
or so we would be fairly 3,000 3,000
priced. 2,000 2,000
1,000 1,000

B&A and DMS approach it 0% 1% 2% 3% 4%

a little differently though, Equity Risk Premium
The real return you need to earn over and above 30 year TIPS (3.0%)
using an historical “equity by purchasing the Dow and assuming stock market risk.

September 2002
satisfied with. Ask yourself this: How will be losers too. As Warren Buffett
much more real return over and above 30- has said, in the short run the stock
year Government guaranteed TIPS do market is a voting machine but in the
you need to compensate you for owning long run it’s a weighing machine.
stocks? If you say nothing, then the Despite being down nearly 50% from
sky’s the limit – Glassman theorized its highs, this market remains over-
just this when writing Dow 36,000. If weight. Forget about “Stocks for the
however, you have some common Long Run” until they slim down to the
sense and know that even over the point from which even yours truly can
long term there’s a decent chance of admit that they will outperform the
something going haywire – war, bond market. And if some of this is
depressions, deflation, etc. – then confusing, just remember this: the
you’ll need something more than the market needs to yield close to 3.5%
government guaranteed TIPS rate of before it approaches fair value, and
3.0% to buy stocks. B&A and DMS say that means DOW 5,000. While stocks
it has been and should be an extra are the best bet over the very long
2.4% in which case the DOW is worth term, they will not be, nor will they
5,000 on this chart. But put in your own beat bond returns until they begin the
number and see what value you get. race from a fair valuation. Since in the
short-term the stock market is a
If you’ve got even half of your marbles voting machine/popularity contest,
left, I’ll bet you your number is no- it’s impossible to say exactly when, if
where near today’s level of 8,500. That ever, this fair valuation mark of ap-
means that in order to get a real return proximately Dow 5,000 will be
sufficiently higher than 3.0% to meet reached. If it doesn’t get there how-
your “risk premium” requirements the ever, future real equity returns will be
market has to go down before it can go lower than 5%, and a diversified
up again. And when it starts to go up portfolio of government, mortgage,
again, it’s only going to produce and corporate bonds will be the best
inflation adjusted, real returns of 5% performing asset class for years to
over the long run if it mimics what the come. And oh, one large caveat. If the
market has returned over the past 100 bond market continues to rally and
years (absent a tripling of P/E ratios). the Fed can successfully engineer a
Until then, stocks are losers and 2% long-term TIPS rate instead of 3%,
anyone who owns too many of them then stock markets are actually within
10% of fair valuation. That, however,
would continue to support the case
for bonds as the better performing
asset class. Sounds like an opening
for a bond geek to write Bonds for the
Long Run. Count me out – one book’s
enough for me.

William H. Gross
Managing Director

840 Newport Center Drive

P.O. Box 6430
Newport Beach, CA
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