My problem with “Dow 36,000” has nothing to do with the fact that the Dow has fallen more than 1,000 points from its all-time high on Aug. 25. Stomach-churning, but for long-term investors, a mere blip. My problem is that even if you accept the thesis that U.S. stocks are no riskier over the long term than Treasury bonds–which I don’t–you have to torture the numbers to justify 36,000 as a reasonable price for the Dow today.
Here is their argument: Step 1: Long-term U.S. Treasury bonds are riskless because Uncle Sam can always print dollars to pay interest and principal when due. Step 2: U.S. stocks, as represented by the Standard & Poor’s 500 Index, have outperformed Treasury bonds over any 20-year period you pick. Thus, for long-term investors, stocks are as safe as Treasury bonds. Step 3: Therefore, according to the authors, stocks should produce the same return as bonds rather than outperforming them, as they have historically done. A big leap, to be sure, but we’ll give it to them for the sake of argument.
Still following? Good. Now, one more piece of financial theory. The return on stocks equals their dividend yield (dividends divided by the stock price) plus the rate at which dividends are increasing. Now, brace yourself for some serious math. Assuming stocks should produce the same return as bonds because they’re equally safe, the authors lay out the following equation: Treasury bond interest rate = Dow dividend yield + dividend growth rate. Then, the authors plug in these numbers: 5.5 percent Treasury yield = Dow dividend yield + 5 percent growth. Thus, the Dow yield should be 0.5 percent. But the current yield is actually 1.5 percent. To get down to 0.5, you have to triple the Dow from its current 10,000 to around 36,000. Isn’t math fun?
But there’s a big problem here. The dividend growth rate isn’t 5 percent; it’s really 6.1 percent. But plug 6.1 into the equation and here’s what you get: 5.5 = Dow dividend yield + 6.1. Oops. The Dow yield would have to be negative, which is impossible unless stockholders start mailing dividend checks to companies. Not too likely.
Glassman says he wasn’t fudging figures. He says he took the interest rate from Congressional Budget Office projections, and used CBO’s 5 percent growth projection for the economy rather than the 6.1 percent dividend growth rate, the logic being that dividends and the economy will grow at roughly the same rate. “You have to use some sort of assumptions,” he said. “We used what we consider a wimpy assumption about rates of growth.”
Fine. But if he can pick numbers, so can anyone. Call the Treasury rate 6.25 percent, not far from today’s level. Subtract the 6.10 percent growth rate and you get 0.15 for the Dow’s yield. That’s a tenth of today’s rate. Hence, the Dow should be 100,000. There’s no end to the possible games.
An important aside: since most of the history and analysis in the book involve the S&P 500, not the Dow, “S&P 4,500” would have been a more accurate title than “Dow 36,000.” But “Dow 36,000” is so much sexier. “S&P 4,500?” Borrrrrring.
I happen to think the authors are right about investors’ need to rethink risk, and that they may be right about today’s historically high prices showing such rethinking is already underway. As a long-term investor myself, I sure hope stocks are a can’t-miss investment, as Glassman and Hassett contend. But 36,000 as a reasonable price for today’s Dow? Put that down as one of those too-good-to-be-true things that really is too good to be true.
