The Dow Jones Industrial Average set a record last week, but it’s still far from
the mark that economist Kevin Hassett and I forecast in our 1999 book, Dow
We wrote in the introduction that “it is impossible to predict
how long it will take” to get to 36,000. Then, in the same paragraph, we rashly
made a guess anyway: “between three and five years.”
Today, the far edge
of that time frame is clearly in reach.
From its low of 6,547 on March 9,
2009, the Dow has risen 117 percent. Another 117% in four years would put it at
31,022, just 16 percentage points shy of the magic number.
When we wrote
our book, we expected that the stock market, as represented by the 30 blue chips
of the Dow, would rise to 36,000 for two reasons.
First, investors had
mistakenly judged the risk in stocks to be greater than it really was. Here, we
drew from the work of Jeremy Siegel of the Wharton School of the University of
He showed that, over long periods, stocks were no more
volatile, or risky, than bonds.
We saw indications that the risk aversion
of investors was declining – as we believed it should. Lower perceived risk
would mean higher stock valuation measures: rising price-toearnings ratios, for
Second, we assumed that real US gross domestic product, the
main driver of corporate profit growth, would rise at 2.5% a year – a bit below
the historic post-World War II rate, but still a decent clip. We warned,
however, that small changes in growth rates could have big effects on stock
What’s happened since 1999? First, investors have
become more frightened of stocks, not less – as reflected in a higher equity
risk premium, the excess return that investors demand from stocks over
These fears may be perfectly reasonable. We wrote our book before
the September 11 attacks, the dot-com debacle, the 38% decline in stocks in
2008, the “flash crash” of 2010 that sent the Dow down 1,000 points in minutes,
the Japanese tsunami and the euro crisis. There’s a good case to be made that,
because of the instant interconnections wrought by new technology, unprecedented
“black swan” events are increasing and markets are becoming more volatile as a
The heightened fears of investors are reflected in lower
Currently, for example, the forward P/E ratio (based on
estimated earnings for the next 12 months) of the Standard & Poor’s 500
Index is about 14. In other words, the earnings yield for a stock investment
averages 7% (1/14), but the yield on a 10-year Treasury bond is only 1.9% – a
Judging from history, you would have to conclude that bonds are
vastly overpriced, that stocks are exceptionally cheap or that investors are
scared to death for a good reason.
Maybe all three.
One way stocks
could jump to 36,000 quickly would be for fears to subside and P/E ratios to
rise. Assume that earnings yields fall to 5%. That would mean P/E ratios would
go to 20, a boost of 50% in stock prices, assuming constant earnings.
second thing that’s been unexpected since our book came out is that US growth
has drastically slowed. Instead of the historic rate of 3%, or our projected
rate of 2.5%, actual annual real GDP increases from the end of 1999 to the end
of 2012 averaged just 1.8%. Inflation was lower than normal, too, so the nominal
rate of growth was only about 4%, instead of about 6%.Growth matters
you knock two percentage points off nominal growth a year – and assume that this
lower growth continues – then the value of a business, which is determined by
the present value of all the profits it will ever earn, will be dramatically
Let’s set investor fears aside for a moment. For investment
gains over the long term, there is absolutely no substitute for faster economic
To get it, we need policy changes that will create a better
environment for businesses to increase revenue, profits and jobs: a rational tax
system that keeps rates low and eliminates special deductions and credits;
immigration laws that encourage the best and the brightest to move here and
stay; entitlement reform to bring down costs and provide incentives for
productive seniors to keep working; sensible environmental, workplace and
financial regulation that allows entrepreneurship to thrive; a K-12 education
system that boosts student achievement and holds teachers, administrators and
Chime in and make your own list, because it’s
time to focus on what counts in an economy: growth. Even with relatively high
risk aversion (let’s say, what we have now), faster growth would significantly
increase stock prices.How fast can the US grow?
Four percent is
attainable, but I’d settle for 3%. Get there quickly, and we’ll get to Dow
36,000 quickly, too. (Bloomberg) James K. Glassman is executive director of the
George W. Bush Institute.