Interpretation of Returns

Table 1-1 summarizes the annual returns on U.S. stocks over the past two centuries.13 The shaded column represents the real after-inflation, compound annual rate of return on stocks. The real return on equities has averaged 7.0 percent per year over the past 195 years. This means that purchasing power has, on average, doubled in the stock market every 10 years. With an inflation of 3 percent per year, a 7.0 percent real return translates into a 10.2 percent average annual money return in...

Financial Market Returns From 1802

This chapter analyzes the returns on stocks and bonds over long periods of time in both the United States and other countries. This two-century history is divided into three subperiods. In the first subperiod, from 1802 through 1871, the U.S. made a transition from an agrarian to an industrialized economy, much like the emerging markets of Latin America and Asia today.5 In the second subperiod, from 1871 through 1925, the U.S. was transformed into the foremost political and economic power in...

Historical Yardsticks for Valuing the Market

Many yardsticks have been used to evaluate whether stock prices are either overvalued or undervalued. These include price-to-earnings ratios, dividend yields, book-to-market ratios, and the total value of equity relative to some aggregate, such as gross domestic produce (GDP) or total replacement cost of the capital stock. To imply that these historical yardsticks constitute the right or fair value for stocks also implies that the historical returns to equity have also been right or fair to the...

Historical Series On Bonds

Bonds are the most important financial assets competing with stocks. Bonds promise a fixed monetary payment over time. In contrast to equity, the cash flows from bonds have a maximum monetary value set by the terms of the contract and, except in the case of default, do not vary with the profitability of the firm. The bond series shown in Figure 1-1 are based on long- and short-term government bonds, when available if not, similar highly rated securities were used. Default premiums were removed...

Post Crash View of Stock Returns

The crash left the impression that stocks could not be worthy long-term investments. So much had been written about so many who had been wiped out by the market that the notion that stocks could still beat other financial assets was regarded as ludicrous. In the late 1930s, Alfred Cowles III, founder of the Cowles Commission for economic research, constructed capitalization-weighted stock indexes back to 1871 of all stocks traded on the New 19 Lawrence Chamberlain and William W. H& yyestment...

Dow 10 Strategy

The Dow 10 strategy, which calls for investors to buy the ten highest-yielding stocks in the Dow-Jones Industrial Average, has been regarded as one of the most successful investment strategies of all time. James Glassman of the Washington Post claimed that John Slatter, a Cleveland investment adviser and writer, invented the Dow 10 system in the 1980s.9 Harvey C. Knowles III and Damon H. Petty analyzed and praised the system in their book, the Dividend Investor, written in 1992, as did Michael...

Solution to the Age Wave Crisis

Is there a resolution to this Age Wave Crisis Yes, but it cannot be resolved by the United States, or for that matter by any country acting alone. A solution must involve the world economy. As Figure 2-9 indicates, the age wave is strictly a phenomenon of the developed world. The developing world, such as China, India, Indonesia, and Latin America has experienced ever-increasing population growth. Over the next half-century workers aged 20-65 will decline from 60 of the population to 54 in the...

How Costs Affect Returns

Trading and managerial costs of 2 or 3 percent a year might seem small compared to the year-to-year volatility of the market and for investors who are gunning for 20 or 30 percent annual returns. But such costs are extremely detrimental to long-term wealth accumulation. One thousand dollars invested at a compound return of 11 percent per year, the average nominal return on stocks since World War II, will accumulate 23,000 over 30 years. A 1 percent annual fee will reduce the final accumulation...

The Economics of Market Volatility

Many of the complaints about market volatility are grounded in the belief that the market reacts excessively to changes in news. But how news should impact the market is so difficult to determine that few can quantify the proper impact of an event on the price of a stock. As a result, traders often follow the crowd and try to predict how other traders will react when news strikes. Over half a century ago, Keynes illustrated the problem of investors who tries to value stock by economic...

Performance of Equity Mutual Funds

Many claim that striving for average market performance is not the best strategy. If there are enough poorly informed traders who consistently underperform the market, then it might be possible, by researching stocks or finding professionals who research stocks and actively manage funds, to outperform the market. Unfortunately, the past record of the vast majority of such actively managed funds does not support this contention. Table 19-1 shows that, from January 1971 through June 1997, the...

Price Earnings Ratios and the Rule of

Figure 5-2 displays the inverse correlation between the price-to-earnings ratios and inflation rates over the past 40 years. High inflation rates are associated with low P-E ratios, and low inflation rates with higher P-E ratios. There is good reason for this correlation. Higher inflation lowers the quality of reported earnings. This refers to the ability of reported earnings to accurately reflect the true economic earnings of a firm. Because accounting is based on historical costs, periods of...

An Evil Omen Returns

In the summer of 1958, an event of great significance took place for those who followed long-standing indicators of stock market value. For the first time in history, the interest rate on long-term government bonds exceeded the dividend yield on common stocks. Business Week noted this event in an August 1958 article entitled An Evil Omen Returns, warning investors that when yields on stocks approached those on bonds, a major market decline was in the offing.3 The stock market crash of 1929...

Valuation Fundamentals Or Sentiment

Some investors believe that they can beat the market by basing their strategy on investor ''sentiment instead of fundamentals such as earnings and dividends. They contend that most investors are unduly optimistic when stock prices are high and unduly pessimistic when they are low. It is difficult for even sophisticated investors to remain aloof of the prevailing sentiment. Rising prices breed excitement and those who have committed the most to the market realize the highest profits. When the...

What Moves the Market

Although you might think that economic and political news should be the major source of market movements, it is surprising how much volatility occurs in the absence of any clearly defined news event. Since 1885, when Dow Jones averages were first formulated, there have been 123 days when the Industrial average has changed by 5 percent or more. Of these, only 28 or less than one in four can be identified with a specific world political or economic event, such as war, political changes, or...

What is the Right PE Ratio to Pay for a Growth Stock

If you could have presented long-term investors with a crystal ball in 1972 that revealed the 25 subsequent years of dividends, earnings, and 1997 prices of the Nifty Fifty stocks, what price would investors have paid for these stocks in December 1972 The answer is a price high or low enough so that, given their subsequent dividends and June 1997 price, their total returns over the past 25 years would match the overall market.7 Table 7-1 reports these prices relative to their 1972 earnings....

Value Criteria

Market capitalization is not the only factor influencing returns. In the late 1970s, Sanjoy Basu, building on the work of S. F. Nicholson in 1960, discovered that stocks with low price-to-earnings ratios have significantly higher returns than stocks with high price-to-earnings ratios.9 8 The beta of the Russell 2000 Index has been less than one during this period, meaning that most of the risk of small stocks is diversifiable and their return should be less than the S amp P 500 Stock Index. 9...

International Returns

Some economists have maintained that the superior returns to equity are a consequence of choosing data from the United States, a country that has been transformed from a small British colony to the world's greatest economic power over the last 200 years.15 But equity returns in other countries have also substantially outpaced those on fixed-income assets. Figure 1-6 displays the total real stock return index for the United States, the United Kingdom, Germany, and Japan from 1926 to the...

Spread between SP Futures and SP Index

FIGURE 15-2 Trading Bands and Futures Trading, July 18, 1997 FIGURE 15-2 Trading Bands and Futures Trading, July 18, 1997 Stock index futures were launched in February 1982 by the Kansas City Board of Trade using the Value Line Index of about 1,700 stocks. But two months later in Chicago, at the Chicago Mercantile Exchange, the world's most successful stock index future based on the S amp P 500 Index was introduced. Only two years after its introduction, the value of the contracts traded on...

Risk and Holding Period

For many investors, the most meaningful way to describe risk is by portraying a worst case scenario. Figure 2-1 displays the best and worst real returns for stocks, bonds, and bills from 1802 over holding periods ranging from 1 to 30 years. Note how dramatically the height of the bars, which measures the difference between best and worst returns, declines so rapidly for equities compared to fixed-income securities when the holding period increases. Stocks are unquestionably riskier than bonds...

Early Views of Stock Investing

Throughout the nineteenth century, stocks were deemed the province of speculators and insiders, but certainly not conservative investors. It was not until the early twentieth century that researchers came to realize that stocks, as a class, might be suitable investments under certain economic conditions. At that time, Irving Fisher himself maintained that stocks would indeed be superior to bonds during inflationary times, but that common shares would likely underperform bonds during periods of...

The Benefits of Deferring Capital Gains Taxes

Many investors assume that capital gains are beneficial solely because of the favorable rates at which such gains have been taxed. But lower capital gains tax rates are not the only advantage of investing in appreciating assets. Taxes on capital gains are paid only when the asset is sold, not as the gain is accrued. The advantage of this tax deferral is that assets accumulate at the higher before-tax rates, rather than after-tax rates of return. Table 8-2 documents the increase in the effective...

Appendix A What Happened to the Original 12 Dow Industrials

Two stocks General Electric and Laclede retained their original name and industry five American Cotton, American Tobacco, Chicago Gas, National Lead, and North American became large public companies in their original industries one Tennessee Coal and Iron was merged into the giant U.S. Steel and two American Sugar and U.S. Rubber went private both in the 1980s. Surprisingly, only one Distilling and Cattle Feeding changed its product line from alcoholic beverages to petrochemicals, although it...

Arithmetic and Geometric Returns

The average arithmetic return, rA, is the average of each yearly return. If r to rn are the n yearly returns, rA r r2 rn n. The average geometric, or compound return, re, is the nth root of the product of one-year total returns minus one. Mathematically this is expressed as re 1 n 1 r2 1 rn 1 n -1. An asset that achieves a geometric return of re will accumulate to 1 re n times the initial investment over n years. The geometric return is approximately equal to the arithmetic return minus...

The Price Level and Gold

Price Level Goldstandard

Figure 1-3 depicts consumer prices in the U.S. and the United Kingdom over the past 200 years. In each country, the price level was essentially the same at the end of World War II as it was 150 years earlier. But since World War II, the nature of inflation has changed dramatically. The price level has risen almost continuously over the past 50 years, often gradually, but sometimes at double-digit rates as in the 1970s. Excluding wartime, the 1970s witnessed the first rapid and sustained...