The Nefarious Confusions of Inflation
Inflation is an insidious instrument for bamfoozling the unwary. It’s very difficult to understand previous financial transactions without correcting them for inflation. For example, in the 1930’s, the mark of the financially successful male was the $10,000-a-year man. Corrected for inflation, $10,000 a year in 1940 equates to about $125,000 a year today.
Shocking Facts Revealed by the Inflation-Adjusted Dow Jones Index
Figure 1, below, shows a plot of the inflation-corrected Dow Jones Index from its peak in 1929 to its approximate peak at the end of 1999. (All dollars have been adjusted to current dollars.).
There are two shocking facts about this chart. First, there's the steep straight line at the right, in which the Dow Jones Index, taking off from the top of a normal bull market peak (which was also a super-bull market peak) proceeded to double again in five years ,in defiance of the law of gravity! What happened there? What's going on? At least as plotted here, it's virtually a straight line from 1995 through 1999. If we saw this on a picture of Mars, we'd say, "That's an intelligent artifact." Having only discovered this last night when I plotted the curve of Figure 1, I want to know more about this phenomenon than I do now before I contemplate returning to the stock market.
The Meaning of Dividend Yields
Figure 2, below, plots the dividend yield over the past 70 years. (This doesn't go back before 1929, but you can examine those numbers by reviewing Harry Rood's CPCUG InvestSIG charts.) As you can see, the dividend yield simply fell out of bed.
To see what this collapsing dividend yield means, we need to return to Figure1
Virtually No Blue-Chip Capital Gains. You Can't Buy 'Em and Hold 'Em
The second shocking fact about Figure 1's inflation-corrected Dow Jones Index is that it shows that there has been little, if any, long-term escalation of the DJI (or the S&P 500) since its inception in 1896. Harry Rood arrives at a real rate of rise of about 1.3% to 1.4% per year. He may certainly be right, although it depends upon a judgment call regarding how you draw your trend lines. But the important fact is that, at least for the 30 Dow stocks and the 500 S&P stocks, the average long-term capital gains on those stocks will be no greater than 1.4% per year. What's worse, the values of the 30 Dow stocks fluctuates wildly from one era to another. If you had failed to sell your Westinghouse stock at the peak of the market in 1966, and decided to wait until it recovered its value in inflation-corrected dollars, you would have had to wait until 1996 before the inflation-corrected Dow regained the real value it had in 1966.
Westinghouse is probably a good example to use. The Dow Index changes its 30 stocks fairly often, as older companies in older industries are replaced by newer competitors. It's quite possible that Westinghouse stock will never sell for as much (in inflation-adjusted dollars) as it did in 1966.
The bottom line is that there's virtually no long-term capital gain to be had by buying and holding large blue-chip companies. (I realize that this flies in the face of what we're commonly led to believe. I'm not sure at the moment how these two conflicting views are to be reconciled.)
And Now, Back to Dividends
The other--and main--source of income from stocks is dividends. Dividend rates can be considerably lower than conventional interest rates because dividends can be expected to rise over time to keep up with inflation (or so it is hoped). Excluding the last few years from our dividend calculation, it might be reasonable to guess at a long-term average dividend yield of 4.2% to 4.4% between 1929 and 1995. You can see from Figure 2 what's happened to dividend yields.
It may be argued that, with inflation running about 3%, and interest rates not much higher than that, dividend yields can afford to be down in the 1.5% - 2% range. However, the next move in interest rates will be up, and as Warren Buffett points out, when interest rates rise, stocks have to fall so that their dividend yields can remain competitive with other sources of income. (This would seem to particularly true when inflation is expected to remain low. When inflation is high, people would probably seek a higher fixed-rate interest premium over dividends than they would in the face of a low-interest-rate outlook. Inflation grows exponentially, and it can rapidly rob you of purchasing power in a high interest rate environment.)
Price-to-Book-Value Ratios Have Gone Around the Bend, Also
Figure 3, below, shows the average ratio of the stock prices to the book values (liquidation values) of the 30 Dow industrial stocks. As you can see, only twice since 1929 had the price-to-book ratio gone slightly above two, both times at super-bull market peaks. In early 2000, it probably reached nearly seven-to-one.
Could It Be... Say It Isn't So!... "Creative Accounting"?
Warren Buffett mentions that in 1987, a change in Financial Accounting Standards Board accounting rules allowed companies to add pension income to their reported earnings. GE got 9% of last year's income from pension credit, versus a 20% pension charge in 1982. Mr. Buffett says, "Last year, according to Goldman Sachs, 35 companies in the S&P 500 got more than 10% of their earnings from pension credits, even as, in many cases, the value of their pension investments shrank."
Somehow, assumptions about future investment rates of return affect the reported pension fund income. Mr. Buffett says,
"Heroic assumptions do wonders, however, for the bottom line. By embracing those expectation rates shown in the far right column, these companies report much higher earnings--much higher--than if they were using lower rates. And that's certainly not lost on the people who set the rates. The actuaries who have roles in this game know nothing special about future investment returns. What they do know, however, is that their clients desire rates that are high. And a happy client is a continuing client."
Hm-m-m.
But It's All Just Improved "Return on Equity"
In a way, I know what caused this sudden surge in stock prices: an unprecedented rise (by a factor of two) in the ROE (Return on Equity). But that's just a buzz word. The question is: what permitted this surge in return-on-equity? It could have been something like the shifting of jobs to third-world nations. Another, more sinister possibility would be a loosening of accounting rules that allowed companies to report fluffy earnings. How substantial are these earnings? Enron and Arthur Anderson have shown us what corporate managements can do. The major question is: are these earnings going to increase at the last five years' heroic rates?
Can Things Pick Up Where They Left Off? Can We Have Even Higher "Returns on Equity"?
Michael Sivy ("Forecast 2002", Money Magazine, January 2002, pg. 63) reports 2001 earnings that fell 27% below 2000 earnings. He says,
"Profit gains should pick up in 2002, as GDP (Gross Domestic Product) growth picks up smartly--perhaps to an annual rate of 4% o 5%--near the end of the year. But that sharp rebound won't continue for more than two or three more years. Investors looking out a decade or more should be prepared for a less robust economy--and lower returns. To continue outpacing the market, you'll have to find companies that can maintain their earnings momentum no matter what happens to the broad market."
Mr. Sivy predicts 2003 earnings that are a little above those of the previous peak (in 2000), and 2004 returns that should exceed prior earnings by, perhaps, 10%. (Note that inflation will be of the order of 12% to 13% between now and 2004.)
What Will Happen Next?
On fact seems uncomfortably clear: the stock market is at unprecedented price levels. A lot depends upon the legitimacy and sources of its rapidly rising "returns on equity". It stands a lot better chance of falling than it does of rising. There's a general warning that the rate of rise will be slower. Once the Federal Reserve begins raising interest rates, with estimates ranging from this June to this December, the stock market is going to have to respond with lower prices. The old rule regarding interest rate hikes has been "two steps and a stumble". The Fed could make two interest rate hikes without disturbing the market, but the third interest rate hike caused the stock market to stumble. This last time, I seem to remember that it didn't happen this way, perhaps because Alan Greenspan was gentle with rate hikes, and has a good track record of cooling the economy without bringing it to its knees. But he had to keep raising rates to get the market to pay attention, and eventually, it did. Now, he's predicting a strong recovery, which, ironically, might conceivably dampen the stock market recovery somewhat if he has to raise interest rates aggressively..