The Dow Will Hit 36,000! (Someday)

Fortune issue: November 8, 1999


First Principles




The Dow Will Hit 36,000! (Someday)

By N. Gregory Mankiw


"You can write about anything you like," an economics professor once told me as he explained the term-paper assignment, "as long as it's not about the stock market." Economists were famous for saying silly things about stocks, he said. It's better just to avoid the whole subject.

Of course, many economists have ignored this wise advice--and many have come to regret it. In October 1929, Irving Fisher, a prominent Yale professor, famously announced that "stocks have reached a permanently high plateau." Oops. In December 1996, Robert Shiller, another prominent Yale professor, and John Campbell, one of my Harvard colleagues, warned the Federal Reserve Board that the stock market was poised for a big fall. This was back when the Dow was at 6,437.

The latest entry in this minefield is the book Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market, by James K. Glassman and Kevin A. Hassett. Normally, economic fortunetellers aren't much better than the real ones. But Hassett, an economist with a fine academic pedigree, is not prone to making preposterous assertions, and I am pleased to report that the book is a lot more sensible than its title suggests.

The book comes in two parts. The second contains the advice. Here it is, in a nutshell: Invest most, though not all, of your portfolio in stocks. Diversify. Buy and hold for the long term. Don't try to time the market. Use low-cost mutual funds, including index funds. This is hardly the "new strategy" the title claims--Burt Malkiel offered much the same advice back in 1973 in his classic A Random Walk Down Wall Street--but it's not a bad one either.

The other, non-advice part of Dow 36,000 is what's interesting. Glassman and Hassett argue that the market, rather than being overvalued as we sober people believe, is wildly undervalued. If investors valued stocks as Glassman and Hassett think they should, the Dow would rise immediately to 36,000. In fact, that is what the authors predict will happen over the next few years.

Here's the argument: Investors have historically viewed stocks as much riskier than bonds. This is why stocks have paid an average return about six percentage points higher than that of bonds: Investors have required this extra return, called the equity risk premium, to compensate for the greater risk. But the data show that for investors with a long-time horizon--say, 20 years--stocks and bonds are about equally risky. As investors realize this, they will require a smaller risk premium for stocks, and eventually none at all.

A smaller risk premium, in turn, means higher stock prices. Why? According to textbook theory, stock prices reflect the present discounted value of the future cash flows that investors expect the underlying businesses to throw off. The smaller the risk premium, the less those future cash flows are discounted, and the more valuable the companies are in the eyes of investors. Dow 36,000 is what Glassman and Hassett calculate the market will reach once the risk premium shrinks to zero.

This argument isn't as laughable as it sounds. A vast academic literature addresses what is called the "equity premium puzzle." The puzzle is why stocks have offered such a large historical return compared with bonds. The answer, put simply, is that we don't know. When economists compute the risk of stocks and do the math that's supposed to explain risk premiums, they find that the equity risk premium should be less than a percentage point. In other words, throughout history, stocks have been a great buy.

In explaining the market's amazing performance in the 1990s, therefore, Glassman and Hassett may have a point. Perhaps investors, gradually learning that stocks are a terrific investment, are shrinking the risk premium toward where it should be and bidding stocks higher. It is hard to think of any other good explanation for the record-high P/E ratios we have seen recently (other than, of course, "irrational exuberance").

But should one be as confident as Glassman and Hassett that the process will continue until the risk premium shrinks to zero and the Dow reaches 36,000? I don't think so. It is easy to imagine that some short-term event might shake investor confidence in the long-term stability of the market and push the equity risk premium back up. In fact, a stock market crash might be precisely such a self-fulfilling event.

My own guess is that while investors are now satisfied with a smaller equity risk premium than they have had in the past, the risk premium will never fall all the way to zero. Perhaps it will stay near the level needed to justify current stock prices. Maybe this time stocks have really settled on that "permanently high plateau." But don't quote me on it.



N. GREGORY MANKIW is a Harvard economics professor and author of Principles of Economics.