January 25, 2022
In November of last year, a popular U.S. stock index passed a noteworthy milestone. The milestone is noteworthy not for what it says about last year’s market performance but rather because of a proclamation made about it more than two decades ago.
In 2000, just after the peak of the technology boom that brought U.S. stocks to sky-high valuation levels never seen before, James Glassman and Kevin Hassett published Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market. At the time of publication, the Dow Jones Industrial Average (DJIA) level was approximately 10,000. Late last year, the Dow crossed 36,000 for the first time.
The authors argued that over the long-term, stocks offered a higher return than bonds without substantially higher risk. Therefore, stocks deserved to trade at much higher prices. The following passage provides a summary of their thesis:
“Stocks should be priced two to four times higher—today. But it is impossible to predict how long it will take for the market to recognize that Dow 36,000 is perfectly reasonable. It could take 10 years or 10 weeks. Our own guess is somewhere between three and five years, which means that returns will continue to average about 25 percent per year…In the meantime, you can hold a diversified portfolio of stocks in comfort, knowing that for a solid company with good earnings growth, a P/E (price-to-earnings ratio) below 100 is not a cause for concern.”
Years after the book’s publication, I recall Roger Gibson on stage at speaking engagements pulling out of his bag a copy of Dow 36,000 as well as one more book titled Irrational Exuberance (by Robert Shiller, also published in early 2000). Shiller would later win a Nobel Prize in Economics. Shiller’s premise was very different from that of Dow 36,000. He argued that price matters in investing and that the very high stock market valuations of that era were a recipe for disappointing future returns.
Here you have two books with nearly identical copyright dates and completely opposing assertions. A glance at the book jackets conveys much about their popular receptions at the time. Dow 36,000 was “rock solid investment advice”, “scholarly”, “one of the hottest business books around”, “well-written”, and “wonderfully clear”. Irrational Exuberance was “controversial” and “unconventional”. Glassman and Hassett had received jacket endorsements from prominent academics and journalists. Shiller had just one jacket endorsement.
In the decade that followed the publication of these books, U.S. stocks experienced two separate price declines of approximately 50 percent and finished the decade with a negative return. Shiller was right, and even though the Dow eventually did cross 36,000 last year, Glassman and Hassett’s forecast was way off the mark.
The Origin of Irrational Exuberance
On the surface, the lesson provided by Shiller’s book is straightforward. Price does matter in investing. The very high U.S. stock valuations of the late 1990s did result in a decade of disappointing returns for investors. However, digging just a little deeper yields an additional observation that is important and relevant today.
The origin story of Shiller’s book title goes back a few years before the book’s publication. On December 3rd, 1996, Robert Shiller and fellow economist John Campbell testified in front of Alan Greenspan and the Board of Governors of the Federal Reserve. Shiller and Campbell presented data showing that stock price movements were not always random. High valuations tended to foreshadow low future long-term returns and low valuations tended to result in relatively high future long-term returns. They concluded that at the valuation level of late 1996, U.S. stock investors should expect very little in return over the coming decade.
Two days later, Chairman Greenspan used the term “irrational exuberance” to describe the behavior of stock market investors. Stock markets around the world quickly declined by between two percent and four percent. Greenspan’s speeches, much like those of today’s Fed Chairman Jerome Powell, had the power to move markets.
Note that the year of this meeting was 1996—three full years before the publication of Dow 36,000 and Irrational Exuberance. And what happened in those three years? U.S. stocks returned 33 percent in 1997, 29 percent in 1998, and 21 percent in 1999. In the three years after Shiller’s testimony, U.S. stock investors doubled their money!
The legendary investor Jeremy Grantham has said that stock valuations are like gravity—a weak but persistent force relentlessly pushing markets toward fair value. Eventually, high valuations tend to come back down to earth and, in doing so, can take a big bite out of long-term returns. Short-term returns, such as over just a few years, tend to be driven more by changes in investor sentiment, which are nearly impossible to forecast. The data that Shiller presented at his testimony in 1996 are the same data that appear in his book three years later. Stock prices were high in 1996 and even higher in 1999. Shiller was right eventually, but the apparent prescience of his book masks the fact that valuations are not a useful tool for timing the market.
Decision-Making at Market Extremes
One observation that I have had over the years is that your decisions during relatively extreme moments in financial markets have an inordinate impact on your long-term investment results. Extreme financial market conditions also tend to invite extreme decisions. Those who bought into the Dow 36,000 theory would have no purpose for diversification. Why have bonds in your portfolio if stocks are about to triple in value? Shiller, while more careful than the Dow 36,000 authors, shared the following sentiment in the paper accompanying his 1996 testimony: “it is hard to come away without a feeling that the market is quite likely to decline substantially in value over the succeeding ten years; it appears that long run investors should stay out of the market for the next decade.” What is the likely fate of an investor who followed this course? Would he still have been waiting patiently for his opportunity to invest at lower prices more than three years later after the U.S. stock market doubled in value from 1997 through 1999? I doubt it.
Market extremes invite radical decisions because emotion can overtake reasoning. It follows that these moments are precisely when following a sound strategy with discipline is most important. Consider a broadly diversified investor who was worried about the extremely high valuation level of the U.S. stock market in 2000. The table below compares returns for the S&P 500 index with those of a portfolio allocated equally to four different asset classes and rebalanced once per year.
Compound Annualized Return by Period
Index data from Morningstar.
The broadly diversified portfolio avoided the lost decade for U.S. stocks and finished the combined period with higher overall returns. No market timing required.
Today’s environment is reminiscent of the late 90s in some respects. Modern day versions of Dow 36,000 speculation include SPACs, meme stocks, some cryptocurrencies, and scores of very highly valued but unprofitable technology companies. As in the 90s, U.S. stocks have performed very well for more than a decade, both in absolute terms and relative to other asset classes. Echoes of Shiller’s warnings also resonate, as the U.S. stock market entered 2022 at the second highest valuation level in history (behind the late 90s).
Our guidance to clients in the late 90s applies equally well to today: maintain broad asset class diversification, avoid trying to time markets, and reduce expectations for future returns. Also, be careful about what winds up on your reading list.
As always, we look forward to our next conversation.
- By valuation, I am referring to stock prices in relation to fundamental measures of corporate net worth, such as sales, earnings, cash flow, dividends, and book value.
- The Dow Jones Industrial Average is a price-weighted index of 30 large U.S. companies.