The investor's ordinary share portfolio represents a small but important part of that vast and influential institution known as the stock market. The wise man thinks he knows all about the history of the stock market, particularly the major fluctuations in its price levels and their various relationships with the overall share price and with returns and dividends. Against this background he is probably in a position to make informed judgments on the attractions and risks of the market as it behaves from time to time. Incidentally, useful statistical data on prices, returns and dividends are available only for the last 100 years, up to 1871. (The material is not as complete or reliable in the former half as in the latter half, but it is still adequate.) In this chapter we will look at the data in great detail with two purposes in mind. First, we will show how shares have made fundamental gains in the last century through several cycles. In the second, we will present a graph showing continuous year-on-year averages of not only stock prices, but also current income and labor, so that the fluctuating relationship between these three important factors can be seen. Against the background of this material, we will consider the stock market prices in early 1972.The long-term history of the stock market is summarized in two tables and art. Table 1-1 shows nineteen bearish and bullish market cycles over the past 100 years. The first shows the use of a composite, starting with the Cowles Commission study in 1870 and continuing with the well-known Standard & Poor's 500-stock composite index. The second shows some of the more well-known Dow Jones Industrial Average (DJIA.
or the Dow) since 1897; consisting of 30 companies, one of which was American Telephone & Telegraph, and the remaining 29 large industrial enterprises.'Chart 1, courtesy of Standard & Poor's, shows market movements for a 425-industrial-stock index from 1900 to 1970. (A chart of the DJIA for this period would look very similar.) Readers will notice three very different patterns, each covering about one-third of the 70 years. The first pattern, from 1900 to 1924, shows a series of fairly consistent market cycles, lasting three to five years. The annual average gain over this period was about 3%. We then enter the 'new era' of the bull market, which begins in 1929 after a wild crash and has had very erratic fluctuations until 1949. Comparing the average levels of 1949 and 1924, we find that the annual rate of progress was only 11/26. Thus at the end of our second period we find that people were no longer enthusiastic about common stocks. By the law of opposites, this was the best time for the start of the most spectacular bull market in our history, which appears in the last third of our chart. This phase probably peaked in December 1968, when the Standard & Poor's 425-industrial-stock index (and 108 of its 500 composite stocks) reached 118. As Table 3-1 shows, there were several major downturns between 1949 and 1968 (especially in the years 1956-57 and 1961-62), but subsequent recovery was so rapid that they were considered (in long-accepted economics) downturns in a single bull market rather than as separate market cycles. The Dow rose sixfold in the 17 years between its low of 162 in mid-1949 and its high of 995 in early 1966, at an average compound rate of 11% per year, excluding dividends, which works out to be about 31.2% per year. (The Standard & Poor's Composite Index's gain is somewhat greater than that of the DJIA.)This superior 14% return was reported in a well-publicized study in 1963 and beyond." This led to a natural complacency on Wall Street about such impressive achievements, as well as a logical paradox that such returns would be expected in the future.
Similar spectacular results could be expected from ordinary stocks. Few could even imagine that this meteoric rise was perhaps a sign that the extreme was already over. The subsequent decline from the 1968 high to the 1970 low was 36% for the S&P Composite (and 37% for the DJIA), the largest decline since the 44% drop recorded in 1939-1942. This reflected the insecurity and uncertainty after Pearl Harbor. The Wall Street eccentricity led to a dramatic recovery in both averages after the May 1970 low. The S&P set a new all-time high in early 1972. Using average data from both periods, the annual growth rate gain in the S&P Composite (or industrial index) in 1949 and 1970 was about 1%. Of course, that rate of growth was much higher than any similar period dating back to 1950. (But the growth over the past decade was far less: 5.25% for the S&P Composite Index and 3% for the once-familiar DJIA.)A comprehensive view of what happened to our shaver economy these decadesTo find out, we need to add the corresponding data for earnings and dividends to the price action record. We have provided such a brief description in our Table 3-2. It is unlikely that the text will study these figures carefully, but we hope that some will find them interesting and instructive.We comment on this as follows: The data for the full decade shows little year-on-year variation and generally paints a picture of steady growth.Only two of the decades (1891-1900 and 1931-1940) saw earnings and average prices fall after the initial disappearance, and no decade after 1900 saw a fall in average dividends, but the growth rates in all three periods varied considerably. Overall performance since World War 11 has been better than in the decades before, but the 1960s were slower than the 1950s. Today's investor cannot look at this record to say what percentage increase he can expect in dividends earned and prices over the next ten years, but it will give him the incentive he needs to make a sustainable policy for common share investing.However, we would like to touch upon a point not made in our tables. In 1970, our companies' overall earnings performance declined sharply. The percentage profitability of invested capital fell to its lowest level since the war. Equally striking is the fact that so many companies reported net losses that year, with many reporting: 'financial problems.'
And for the first time in three decades, some important bankruptcy cases were also reported. These facts, along with others, confirm the above statement that the era of the Great Boom had ended between 1969-1970.The fascinating thing about Table 3-2 is that it shows the changes in the price/earnings ratio since the Second World War. In June 1949, the S&P Composite Index traded at just 6.3 times the trailing 12 month earnings; in March 1961, this ratio was 21.9 times. Similarly, the dividend yield on the S&P index fell from 7% in 1949 to only 3.0% in 1961, which is contrasted by the fact that interest rates on high-grade bonds had increased from 2.60% to 4.50% in the meantime. Certainly, this is the most remarkable reversal of public opinion in the entire history of the stock market.For people with long experience and extreme alertness, this passage from one extreme to the other was a solid warning of what was to come. He remembered with apprehension the boom market of 1926-1929 and its dire consequences. But circumstances did not confirm this fear. True, the DJIA's closing prices in 1970 were the same as they had been 612 years earlier, and the pre-announced arrival of the 'Soaring Sixties' was again a major confirmation of a series of ups and downs, but this time neither businesses nor stock prices did anything that could be compared to the bear market and its decline of 1929-1932.Stock market levels in early 1972After looking at a century overview of stocks, prices, earnings and dividends, let us try to draw some conclusions regarding the DJIA 500 and S&P Composite Index 100 in January, 1972.
In all our previous editions we have discussed the levels of the stock market at the time of writing and attempted to answer the question of whether they were too high for conservative consideration. It will be informative for readers to review the conclusions we reached earlier. This is certainly not an exercise in self-punishment. It will serve as a thread connecting the various phases of the stock market over the past twenty years. At the same time, it will give a clear picture of the difficulties faced by those who are trying to make informed and critical decisions about current market levels. Let us first summarize the analysis of 1948, 1953, and 1959 that we gave in the 1965 edition.In 1948 we used a conservative standard for the Dow Jones level of 180, and had no difficulty in reaching the conclusion that "it is not too high relative to fundamental value." When we reached this problem in 1953, the market had reached 275 that year, a gain of over 50% in five years. The question we asked ourselves was, "Is 275 too high for the Dow Jones Industrials in our opinion for a good investment or not?" In light of the spectacular progress that followed, it seems strange to report that this did not make it easier for us to reach any firm conclusions about the attractiveness of the 1953 level. Positive enough, we said, "Given our key investment guideline price signals, the 1953 stock price conclusion should be favorable." But we were also mindful that in 1953, the averages had been rising for a long time, as never before in a bull market, and the highs were historically high. We weighed these factors against our favorable price conclusion and recommended a cautious or tame policy. As it turns out, this was not particularly great advice. A good forecaster would have foreseen that this market was going to rise another 100% over the next five years. Perhaps we can say in self-defense that among those in the business of stock market forecasting, few had a better sense of what was coming next than we did. We are not in the business of forecasting, after all.In early 1959 we found the DJIA at its highest level ever at 584. Our detailed analysis, which took into account the points, can be summarized as follows (in the 1959 edition): Overall, we are forced to conclude that the trend of stock prices has been rising.
The current level of is also dangerous. It would be risky because prices are already quite high, but even if that were not the case, the market momentum is such that it could inevitably push it to unjustifiable heights. To put it simply, we cannot imagine a market in the future in which there will never be serious losses, and in which every novice can be guaranteed a large profit on his share purchase.The caution we expressed in 1959 was justified somewhat better by the sequel than our attitude in 1954, yet it was far from being entirely vindicated. The DJIA rose to 685 in 1961, and then fell slightly later that year to below the 584 level (to 566). It rose again to 735 by the end of 1961, and in May 1962 it fell to an almost sensational low of 536, representing a loss of 27% in the short six-month period. At the same time there was a more serious contraction in the most popular 'growth stocks', as evidenced by the great decline in such undisputed giants as International Vision Machine, which fell from a high of 607 in December 1961 to 300 in June 1962.Ordinary shares of small enterprises also completely collapsed during this period. These so-called 'hot issues' were offered to the public at ridiculously high prices and the subsequent speculation on their level was nothing short of foolish. Most of them fell by up to 90% of their offer price within a few months.The decline of early 1962 was alarming, if not disastrous, to many self-confessed speculators and to many unreasonable people who called themselves investors, but the reversal later that year was equally unexpected to the financial community. The stock market averages resumed their upward march and had lower volumes.
The recovery and new highs in common stock prices were certainly extraordinary, and Beale Street sentiment rose accordingly. The forecasts at the bottom in June 1962 were primarily for a bear market, and after a partial recovery, by year's end, sentiment was mixed, leaning toward skepticism, but early in 1964, optimism began to rise again among the ardent brokerage sons. Nearly every forecast was bullish, and that continued as 1964 progressed.We then turned to the valuation of the November 1964 stock market level (892 for the BJIA). After an instructive discussion of it from a number of angles, we arrived at three main conclusions. First, 'the old standards (of valuation) do not appear to be useful and the new standards have not stood the test of time.' Second, investors, "must base their policy on the major uncertainties. They are the possibilities of an extreme situation, on the one hand, leading to a prolonged and continuing market level of, say, 50%, or the DJIA at 1.350, or, on the other hand, a large unforeseen decline of similar magnitude, leading to a mean of, say, 450. The third was expressed on a more concrete scale. We said, "Put simply, if the 1964 price level was not too high, how can we call any price level too high?" And then the chapter ends.which route to takeInvestors should not dismiss the 1964 market level as dangerous just because they have read it in this book. They should compare our reasons with the opposing reasons of the most capable and experienced people on Ball Street they will hear. Ultimately, each individual must make his own decision and take responsibility for it, but we recommend that if an investor is unsure about which path to take, he should err on the side of caution. Here we lay out the investment principles that call for the following policy in a 1964-like situation. These principles are, in order of urgency:
1. Do not borrow to buy or hold securities.
2. Do not increase the proportion of investment made in private shares.
3. If necessary, reduce holdings of ordinary stocks to a maximum of 50% of the total portfolio. Avoid capital gains tax as much as possible is in the maturity period, and invest the remaining amount in first class bonds or savings account.Investors who have been running standard dollar cost averaging strategies for some time should rationally either continue their periodic purchases or hold off on them until they feel market levels no longer seem risky. We recommend not starting a new dealer averaging scheme at the 1904 low, since most investors simply do not have the stamina to follow through even when the outcome appears to be extremely unfavorable so soon after initiating it.This time we can say that our caution was justified. The DJIA rose about 11% to 995, but then fell erratically to 632 in 1970, and to 839 by the end of that year. The price of the 'hot issues' also experienced a similar decline, that is, a decline of as much as 90%, as in the 1961-62 shock. And, as indicated in the introduction, the overall financial picture seemed to be changing in the direction of less euphoria and more skepticism. This single fact is the crux of the story: in 1970 the DJIA closed at its lowest level in six years, the first time this had happened since 1944.Such were our attempts to evaluate past stock market levels. Is there anything else we and our readers can learn from this? We judged the market levels of 1948 and 1953 to be favorable for investment (but with great caution in 1953), 1959 to be 'risky' (when the DJIA was at 584), and 1964 to be 'very high' (at 892). These judgments can still be defended today with clever arguments, but it is doubtful that they are as useful as our usual economic advisors who, on the one hand, advocate a consistent and controlled ordinary share policy and, on the other hand, discourage attempts to 'beat the market' or 'pick winners.'Nevertheless, we think our readers will benefit from this new thinking on the level of the stock market this time around, late 1971, whether what we say is more interesting than of practical use or more suggestive than conclusive. There is a sentence in Aristotle's book Everest, almost at the beginning, that says: It is the mark of an educated mind to expect a degree of accuracy commensurate with the nature of the subject it is allowed to. It is improper to accept only probable conclusions from a mathematician, and to demand certainty from an orator. The job of the financial analyst lies somewhere between that of a mathematician and that of an orator.
On several occasions in 1971, the Dow Jones Industrial Average reached the 1964 level of 892, which we used as a measure in our previous edition, but in the present statistical study we decided to use price levels and related data from the Standard & Poor's Composite Index (or S&P 500) because it is more comprehensive and representative of the public market than the 30-stock DJIA. We have concentrated this material on a close comparison of four dates from our previous four editions, the year-ends of 1948, 1953, 1958, and 1963 and 1968. For the current price level we have taken a smooth figure of 100, which occurred several times in 1971 and early 1972. Table 3-3 presents the key statistics. For our earnings data, we have used the previous year and three-year averages. For 1971 dividends we use the last 12 months' data, and for 1971 bond interest and wholesale prices we use August 1971 data.The market's 3-year price/earnings ratio was lower in October 1971 than it was in late 1963 and 1968. It was about the same as in 1958, but much higher than during the long bull market. This key indicator cannot be used by itself to indicate that the market was particularly high in January 1972, but when interest on high-grade bonds comes into the picture, its implications are not so favorable. Readers will see in our table that the ratio of stock returns (earnings/price) worsened relative to bond returns throughout this period. Therefore, the January 1972 data on this measure did not favor stocks on a previous year-tested basis. If we compare dividend yields to bond yields, we find that the relationship was exactly the opposite from 1948 to 1972. At the beginning of the year, stocks were about twice as valuable as bonds. Now bonds yield more than double that of stocks.Our final conclusion is that, based on 3-year earnings data, the adverse change in the bond yield/stock-yield ratio completely wipes out the excellent price earnings ratio of late 1971. Hence, our view of the early 1972 market level is likely to be similar to what it was 7 years ago, i.e., attractive from a conservative investment perspective. This applies to most of the DDEA's 1971 price range, from 800 to 950.Looking at historical market fluctuations, the 1971 crash appears to be an anomalous recovery from the bad shocks of 1969-1970. In the past, such recoveries have heralded a new era of recurrent and persistent bull markets, starting in 1949. (The Ball Street fire of 1971 was expected to be similar. The public buying low-grade ordinary shares offered in the 1968-1970 cycle was a major problem.)
After the bad experience, it was too early (in 1971) for the bearish cycle to be a happy one. So while the market was absent reliable signs of imminent trouble, as it was at the 892 level of the DJIA in November 1964, which we considered in the previous edition, technically, another upward trend appeared to be in store before the next serious breakout or decline, which would have been beyond 100 DJIA. But we cannot stop there, as we probably should. To us, the market of early 1971 was indifferent to the painful experience of a year of disquieting signals. Should such indifference go unpunished? We think investors should be prepared for tough times ahead, which will probably be a fairly quick replay of the 1960-1970 crash or perhaps another bull market shakeout followed by a more disastrous crash.which route to takeTo reiterate what we said in the previous edition, our outlook for the DJIA at this low level - say 900 - in early 1972 is the same as it was in late 1964.
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