CWS Market Review – November 2, 2021

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Today, the Dow Jones Industrial Average closed above 36,000 for the first time in history. This is noteworthy because of a book published 22 years ago called Dow 36,000.

In it, authors James K. Glassman and Kevin A. Haslett argued that the investing world had radically changed and that stock valuations were far too low. They claimed that the Dow, then around 9,000, needed to be four-fold higher to be properly valued.

They weren’t predicting that the Dow would eventually rise to 36,000. Instead, they said that it should be at 36,000 at the time, which was October 1999.

The authors have come in for a lot of ribbing which I think is mostly unfair. Make no mistake – they were completely and totally wrong, but I admire anyone who puts forth a heterodox position, especially so publicly.

These topics are very much what I’m interested in. Twenty-two years ago, I bought Dow 36,000 and read it in one day. My goal was to find the exact mistakes in their theory. I wrote up a book review and shopped it around to different publications. No takers.

This was a shame because I believe I’m the only person who has correctly identified where and how they’re wrong. I had an email exchange with the authors. (One was friendly. The other was not.)

In any event, now I don’t need the approval of a newspaper to get my views to the public. I have a newsletter. Below I’m reproducing my book review from 22 years ago. I should apologize in advance because I go deep into the weeds on some arcane topics so some of it may bore you. Still, I’m proud of what I wrote.

Here it is:

Why the Dow 36,000 Argument Doesn’t Work

Now that the Dow Jones Industrial Average has soared over 4,500 points since Alan Greenspan warned us of the market’s “irrational exuberance,” a mini-industry has evolved of publishing books that attempt to explain the “new market.” The latest addition to the genre is Dow 36,000 by James K. Glassman and Kevin A. Hassett, both of the American Enterprise Institute. To give you an idea of how crowded the field is becoming, two other books are titled Dow 40,000 and Dow 100,000.

Unfazed by the Dow’s stunning climb, mega-bulls Glassman and Hassett have developed their own theory as to why the market has risen so much and why it will continue to rise. Their theory isn’t the usual litany one hears from Wall Street bulls (demographics, triumph of capitalism). Instead, their “36,000” theory goes right to the heart of investment analysis by questioning one of its elemental suppositions: namely, the idea that investments in stocks should demand a premium over investments in bonds due to the riskier nature of stocks. This isn’t split hairs they’re taking on.

Reciting historical data, Glassman and Hassett show that over the long haul, there is no difference between the risks of stocks and Treasury bonds. Therefore, they reason, there should be no risk premium at all. The authors claim that with the risk premium excised from the market, the perfectly reasonable price, or PRP as they call it, for the Dow is 36,000 (more on that later). Mind you, they’re not merely saying the Dow will eventually hit this magic number sometime in the future. Instead, Glassman and Hassett claim that 36,000 is where the Dow ought to be right now. Or more precisely, that’s where the Dow should have been early this year when they started writing the book. Could they be onto something? At the time, the Dow was at 9000.

The Dow very well may head to 36K, but it will have little to do with Glassman and Hassett’s theory. Their theory is seriously flawed due to major methodological errors.

First, Glassman and Hassett err in their selection of an appropriate measure of risk for their purpose. The free market prices risk, just like it prices everything else. That price is included in the price of stocks. In order to measure risk, Glassman and Hassett should use a measurement that isolates risk from the price of stocks. They don’t do this. Instead, they compare the standard deviation of stock returns to the standard deviation of risk-free-bond returns. That’s a different animal. Sure enough, with progressively longer holding periods, stock returns’ standard deviations gradually get smaller. Upon realizing that at long term, the standard deviation of stock returns is the same as bond returns’, actually slightly less, Glassman and Hassett conclude that stocks are “no more risky” than Treasury bonds.

That’s a faulty conclusion. Even if the standard deviations are the same size, it doesn’t say anything about the risk that they’re looking for. The point is, that risk has still never been isolated: It’s inside those returns no matter how long term you go. The variability of risk’s part of all these returns may be diminishing as well. That can happen even if risk stays exactly the same size. With Glassman and Hassett’s method, we have no idea how big the risk inherent in stock ownership is.

Without all the mumbo-jumbo, think of two houses, identical in every way except one has a great view of the river, the other does not. How much does the river view cost? Easy. Compare the prices of the two homes, and the difference must be the price of the view. The fact that the prices paid may deviate from their own respective averages the same way, speaks nothing as to the price of the view. Glassman and Hassett are saying that since those deviations are the same, the river view is free.

Running with this assumption, Glassman and Hassett reason that since risk and reward are related, assets with the same risk will have the same return. Therefore, stocks and bonds will have the same returns. For this to happen, they claim, “the Dow should rise by a factor of four.” How do they get four?

Glassman and Hassett start with the “Old Paradigm” premise that bond returns plus a risk premium equals stock returns. With the risk premium “properly” removed, the yield on Treasuries—meaning their expected return—should be the same as the expected return for stocks. And that’s their dividend yield plus the dividend’s growth rate. So far, so good. Since the sum of these two is now about 1.5% above today’s Treasury yield, the yield on stocks needs to be adjusted downward in order to bring everything into balance. Specifically, it needs to drop from about 2% to 0.5%. With the yield dropping to one-fourth its previous level, stock prices will jump fourfold. Presto. That’s how we get from 9000 to 36000.

Not exactly. The authors have made another mistake. It’s impossible to have a one-time-only ratcheting down of the market’s dividend yield. The reason is that if long-term stock returns don’t change, as the authors do assume, a lower dividend yield will always create a commensurate increase in the dividend growth rate. As a result, there will always be a new higher dividend whose yield will always be in need of being notched back down. And as a result, the dividend growth rate will increase, and the cycle will continue ad infinitum. The correct conclusion from their model is not a one-time-only fourfold increase in stocks, but one-time-only infinite increase in stocks. This means the authors are actually insufficiently bullish and, moreover, they’ve mistitled their book.

Fortunately, the second half of the book is the more valuable by far. Once the authors stop making theories, they start making some sense. In this section, the authors discuss how investors can capitalize on the continuing market boom. The authors estimate the market has another three to five years perhaps before 36K is reached. In any case, their strategies are rather conservative: Buy and hold, diversify, don’t trade too much, don’t let market fluctuations rattle you, don’t time the market. All perfectly sound ideas and not specifically dependent on “Dow 36,000.”

Glassman and Hassett also give the names of stocks and mutual funds they like. There’s nothing wrong with their stocks in the realm of theory, but readers definitely ought to avoid the author’s so-called Perfectly Reasonable Prices, which invite comparison to the famous description of the Holy Roman Empire—not holy, not Roman, not an empire.

I’m not familiar with Kevin Hassett’s former work, but I’ve always liked James Glassman’s investing articles for The Washington Post. His articles are consistently incisive and informative. This book, however, is nothing of the sort. Dow 36,000 contains egregious errors and fallacious reasoning.

Still, I do admire their ambition. With this book, Glassman and Hassett challenged a well-entrenched perception of reality. Being that this perception underwrites trillions of dollars, it’s a very, very, very, well-entrenched perception. Glassman and Hassett lost, and they lost badly. Old paradigms die hard, but they do die.

Me again in 2021. Reading the review again, I wasn’t as clear as I could have been. The older Eddy today would be brief and point out their math error. The authors argue that the market needs a lower dividend yield but they overlook the fact that a lower yield will in turn lower returns going forward.

Mueller Industries Soars to a New High

In June, I told you about Mueller Industries (MLI). At the time, I wrote, “Keep an eye on Mueller. This could be a big winner in the months ahead.” In the last six weeks, Mueller is up 34%. This is one of those little stocks that have delivered tremendous gains, and no one knows about them.

So what does Mueller do? Let’s get to brass tacks…literally.

Mueller is a leading manufacturer of copper, brass, aluminum and plastic products. This is a classic small-cap cyclical stock. Once you realize the scope of their business, you understand that the use of Mueller’s products is seemingly endless. Mueller makes everything from copper tubing and fittings to brass and copper alloy bars and refrigeration valves.

You can find Mueller most anywhere. Some of the companies that rely on Mueller are in sectors like plumbing, heating, air conditioning, refrigeration, appliance, medical, automotive, military and defense, marine and recreational.

Over the last 30 years, the stock is up more than 150-fold.

Mueller is pretty small. The market cap is about $3 billion. Two weeks ago, Muller reported very good earnings.

It helps that the price for copper is going up. Sales rose 59% to $982.2 million. Earnings rose from 76 cents per share for last year’s Q3 to $3.01 per share for this year’s Q3. Those aren’t exactly comparable since Mueller sold off some businesses. The company reduced its debt by $230 million. Even without the business sales, Mueller is doing well. MLI closed at another all-time high today.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

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Posted by on November 2nd, 2021 at 10:45 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.