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Foreword  xvii
Preface  xix
Acknowledgments  xxiii
Chapter 1
The Case for Equity
Historical Facts and Media Fiction 3
“Everybody Ought to Be Rich” 3
Asset Returns Since 1802  5
Historical Perspectives on Stocks as Investments 7
The Influence of Smith’s Work  8
Common Stock Theory of Investment  8
The Market Peak   9
Irving Fisher’s “Permanently High Plateau”  9
A Radical Shift in Sentiment 10
The Postcrash View of Stock Returns 11
The Great Bull Market of 1982–2000 12
Warnings of Overvaluation  14
The Late Stage of the Great Bull Market, 1997–2000  15
The Top of the Market   16
The Tech Bubble Bursts  16
Rumblings of the Financial Crisis 17
Beginning of the End for Lehman Brothers  18
Chapter 2
The Great Financial Crisis of 2008
Its Origins, Impact, and Legacy 21
The Week That Rocked World Markets 21
Could the Great Depression Happen Again? 22
The Cause of the Financial Crisis 23
The Great Moderation  23
Subprime Mortgages  24
The Crucial Rating Mistake  25
The Real Estate Bubble  28
Regulatory Failure   30
Overleverage by Financial Institutions in Risky Assets  31
The Role of the Federal Reserve in Mitigating the Crisis 32
The Lender of Last Resort Springs to Action  32
Should Lehman Brothers Have Been Saved?  34
Reflections on the Crisis  36
Chapter 3
The Markets, the Economy, and Government Policy
in the Wake of the Crisis  39
Avoiding Deflation 41
Reaction of the Financial Markets to the Financial Crisis 41
Stocks  41
Real Estate  45
Treasury Bond Markets  45
The LIBOR Market  46
Commodity Markets  47
Foreign Currency Markets  48
Impact of the Financial Crisis on Asset Returns and Correlations  48
Decreased Correlations  50
Legislative Fallout from the Financial Crisis  52
Concluding Comments  55
Chapter 4
The Entitlement Crisis 
Will the Age Wave Drown the Stock Market? 57
The Realities We Face 58
The Age Wave 58
Rising Life Expectancy 59
Falling Retirement Age 59
The Retirement Age Must Rise 60
World Demographics and the Age Wave 62
Fundamental Question 64
Emerging Economies Can Fill the Gap 68
Can Productivity Growth Keep Pace? 69
Conclusion 71
Chapter 5
Stock and Bond Returns Since 1802 75
Financial Market Data from 1802 to the Present 75
Total Asset Returns 76
The Long-Term Performance of Bonds 78
Gold, the Dollar, and Inflation 79
Total Real Returns 81
Real Returns on Fixed-Income Assets 84
The Continuing Decline in Fixed-Income Returns 86
The Equity Premium 87
Worldwide Equity and Bond Returns 88
Conclusion: Stocks for the Long Run 90
Appendix 1: Stocks from 1802 to 1870 91
Chapter 6
Risk, Return, and Portfolio Allocation
Why Stocks Are Less Risky Than Bonds in the Long Run 93
Measuring Risk and Return 93
Risk and Holding Period 94
Standard Measures of Risk 97
Varying Correlation Between Stock and Bond Returns 99
Efficient Frontiers 101
Conclusion 102
Chapter 7
Stock Indexes
Proxies for the Market 105
Market Averages 105
The Dow Jones Averages 106
Computation of the Dow Index  108
Long-Term Trends in the Dow Jones Industrial Average  108
Beware the Use of Trendlines to Predict Future Returns   109
Value-Weighted Indexes 110
Standard & Poor’s Index  110
Nasdaq Index  111
Other Stock Indexes: The Center for Research in Security Prices   113
Return Biases in Stock Indexes 113
Appendix: What Happened to the Original 12 Dow Industrials? 115
Chapter 8
The S&P 500 Index
More Than a Half Century of U.S. Corporate History 119
Sector Rotation in the S&P 500 Index 120
Top-Performing Firms 126
How Bad News for the Firm Becomes Good News for Investors 128
Top-Performing Survivor Firms 128
Other Firms That Turned Golden 129
Outperformance of Original S&P 500 Firms 130
Conclusion 131
Chapter 9
The Impact of Taxes on Stock and Bond Returns
Stocks Have the Edge 133
Historical Taxes on Income and Capital Gains 133
Before- and After-Tax Rates of Return 135
The Benefits of Deferring Capital Gains Taxes 135
Inflation and the Capital Gains Tax 137
Increasingly Favorable Tax Factors for Equities 139
Stocks or Bonds in Tax-Deferred Accounts? 140
Conclusion 141
Appendix: History of the Tax Code 141
Chapter 10
Sources of Shareholder Value
Earnings and Dividends 143
Discounted Cash Flows 143
Sources of Shareholder Value 144
Historical Data on Dividends and Earnings Growth 145
The Gordon Dividend Growth Model of Stock Valuation  147
Discount Dividends, Not Earnings  149
Earnings Concepts 149
Earnings Reporting Methods  150
Operating Earnings and NIPA Profits  152
The Quarterly Earnings Report  154
Conclusion 155
Chapter 11
Yardsticks to Value the Stock Market   157
An Evil Omen Returns 157
Historical Yardsticks for Valuing the Market 159
Price/Earnings Ratio and the Earnings Yield  159
The Aggregation Bias  161
The Earnings Yield  161
The CAPE Ratio  162
The Fed Model, Earnings Yields, and Bond Yields  164
Corporate Profits and GDP  166
Book Value, Market Value, and Tobin’s Q  166
Profit Margins  168
Factors That May Raise Future Valuation Ratios 169
A Fall in Transaction Costs  170
Lower Real Returns on Fixed-Income Assets  170
The Equity Risk Premium  171
Conclusion 172
Chapter 12
Outperforming the Market
The Importance of Size, Dividend Yields,
and Price/Earnings Ratios 173
Stocks That Outperform the Market 173
What Determines a Stock’s Return?  175
Small- and Large-Cap Stocks 176
Trends in Small-Cap Stock Returns  177
Valuation: “Value” Stocks Offer Higher Returns Than “Growth” Stocks 179
Dividend Yields 179
Other Dividend-Yield Strategies  181
Price/Earnings Ratios 183
Price/Book Ratios 185
Combining Size and Valuation Criteria 186
Initial Public Offerings: The Disappointing Overall
Returns on New Small-Cap Growth Companies 188
The Nature of Growth and Value Stocks 190
Explanations of Size and Valuation Effects 191
The Noisy Market Hypothesis  191
Liquidity Investing  192
Conclusion 193
Chapter 13
Global Investing   195
Foreign Investing and Economic Growth 196
Diversification in World Markets 198
International Stock Returns  199
The Japanese Market Bubble  199
Stock Risks 201
Should You Hedge Foreign Exchange Risk?  201
Diversification: Sector or Country?  202
Sector Allocation Around the World  203
Private and Public Capital  206
Conclusion 206
Chapter 14
Gold, Monetary Policy, and Inflation  209
Money and Prices 210
The Gold Standard 213
The Establishment of the Federal Reserve 213
The Fall of the Gold Standard 214
Postdevaluation Monetary Policy 215
Postgold Monetary Policy 216
The Federal Reserve and Money Creation 217
How the Fed’s Actions Affect Interest Rates 218
Stock Prices and Central Bank Policy 218
Stocks as Hedges Against Inflation 220
Why Stocks Fail as a Short-Term Inflation Hedge 223
Higher Interest Rates  223
Nonneutral Inflation: Supply-Side Effects  223
Taxes on Corporate Earnings   224
Inflationary Biases in Interest Costs  225
Capital Gains Taxes  226
Conclusion 226
Chapter 15
Stocks and the Business Cycle   229
Who Calls the Business Cycle? 230
Stock Returns Around Business Cycle Turning Points 233
Gains Through Timing the Business Cycle 235
How Hard Is It to Predict the Business Cycle? 236
Conclusion 238
Chapter 16
When World Events Impact Financial Markets   241
What Moves the Market? 243
Uncertainty and the Market 246
Democrats and Republicans 247
Stocks and War 250
Markets During the World Wars  252
Post-1945 Conflicts  253
Conclusion 255
Chapter 17
Stocks, Bonds, and the Flow of Economic Data   257
Economic Data and the Market 258
Principles of Market Reaction 258
Information Content of Data Releases 259
Economic Growth and Stock Prices 260
The Employment Report 261
The Cycle of Announcements 262
Inflation Reports 264
Core Inflation  265
Employment Costs  266
Impact on Financial Markets 266
Central Bank Policy 267
Conclusion 268
Chapter 18
Exchange-Traded Funds, Stock Index Futures, and Options 271
Exchange-Traded Funds 272
Stock Index Futures 273
Basics of the Futures Markets 276
Index Arbitrage 278
Predicting the New York Open with Globex Trading 279
Double and Triple Witching 280
Margin and Leverage 281
Tax Advantages of ETFS and Futures 282
Where to Put Your Indexed Investments: ETFS, Futures, or Index Mutual
Funds? 282
Index Options 284
Buying Index Options  286
Selling Index Options  286
The Importance of Indexed Products 287
Chapter 19
Market Volatility  289
The Stock Market Crash of October 1987 291
The Causes of the October 1987 Crash 293
Exchange Rate Policies  293
The Futures Market  294
Circuit Breakers 296
Flash Crash—May 6, 2010 297
The Nature of Market Volatility 300
Historical Trends of Stock Volatility 300
The Volatility Index 303
The Distribution of Large Daily Changes 305
The Economics of Market Volatility 307
The Significance of Market Volatility 308
Chapter 20
Technical Analysis and Investing with the Trend   311
The Nature of Technical Analysis 311
Charles Dow, Technical Analyst 312
The Randomness of Stock Prices 312
Simulations of Random Stock Prices 314
Trending Markets and Price Reversals 314
Moving Averages 316
Testing the Dow Jones Moving-Average Strategy  317
Back-Testing the 200-Day Moving Average  318
Avoiding Major Bear Markets  320
Distribution of Gains and Losses  321
Momentum Investing 322
Conclusion 323
Chapter 21
Calendar Anomalies  325
Seasonal Anomalies 326
The January Effect 326
Causes of the January Effect  328
The January Effect Weakened in Recent Years  329
Large Stock Monthly Returns 330
The September Effect 330
Other Seasonal Returns 334
Day-of-the-Week Effects 336
What’s an Investor to Do? 337
Chapter 22
Behavioral Finance and the Psychology of Investing   339
The Technology Bubble, 1999 to 2001 340
Behavioral Finance 342
Fads, Social Dynamics, and Stock Bubbles  343
Excessive Trading, Overconfidence, and the Representative Bias  345
Prospect Theory, Loss Aversion, and the Decision
to Hold on to Losing Trades  347
Rules for Avoiding Behavioral Traps  350
Myopic Loss Aversion, Portfolio Monitoring,
and the Equity Risk Premium  350
Contrarian Investing and Investor Sentiment:
Strategies to Enhance Portfolio Returns  352
Out-of-Favor Stocks and the Dow 10 Strategy  354
Chapter 23
Fund Performance, Indexing, and Beating the Market   357
The Performance of Equity Mutual Funds 358
Finding Skilled Money Managers 363
Persistence of Superior Returns  364
Reasons for Underperformance of Managed Money 365
A Little Learning Is a Dangerous Thing 365
Profiting from Informed Trading 366
How Costs Affect Returns 367
The Increased Popularity of Passive Investing 367
The Pitfalls of Capitalization-Weighted Indexing 368
Fundamentally Weighted Versus Capitalization-Weighted Indexation 369
The History of Fundamentally Weighted Indexation 371
Conclusion 372
Chapter 24
Structuring a Portfolio for Long-Term Growth   373
Practical Aspects of Investing 373
Guides to Successful Investing 374
Implementing the Plan and the Role of an Investment Advisor 377
Concluding Comment 378
Notes  379
Index  405
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In July 1997 I called Peter Bernstein and said I was going to be in New
York and would love to lunch with him. I had an ulterior motive. I
greatly enjoyed his book Capital Ideas: The Improbable Origins of Modern
Wall Street and the Journal of Portfolio Management, which he founded
and edited. I hoped there might be a slim chance he would consent to
write the preface to the second edition of Stocks for the Long Run.
His secretary set up a date at one of his favorite restaurants, Circus
on the Upper East Side. He arrived with his wife Barbara and a copy of
the first edition of my book tucked under his arm. As he approached, he
asked if I would sign it. I said “of course” and responded that I would be
honored if he wrote a foreword to the second edition. He smiled; “Of
course!” he exclaimed. The next hour was filled with a most fascinating
conversation about publishing, academic and professional trends in
finance, and even what we liked best about Philly and New York.
I thought back to our lunch when I learned, in June 2009, that he had
passed away at the age of 90. In the 12 years since our first meeting, Peter
had been more productive than ever, writing three more books, including
his most popular, The Remarkable Story of Risk. Despite the incredible pace
he maintained, he always found time to update the preface of my book
through the next two editions. As I read through his words in the fourth
edition, I found that his insights into the frustrations and rewards of
being a long-term investor are as relevant today as they were when he
first penned them nearly two decades ago. I can think of no better way to
honor Peter than to repeat his wisdom here.
Some people find the process of assembling data to be a deadly bore.
Others view it as a challenge. Jeremy Siegel has turned it into an art form.
You can only admire the scope, lucidity, and sheer delight with which
Professor Siegel serves up the evidence to support his case for investing in
stocks for the long run.
But this book is far more than its title suggests. You will learn a lot of
economic theory along the way, garnished with a fascinating history of
both the capital markets and the U.S. economy. By using history to maxi-
mum effect, Professor Siegel gives the numbers a life and meaning they
would never enjoy in a less compelling setting. Moreover, he boldly does
battle with all historical episodes that could contradict his thesis and
emerges victorious—and this includes the crazy years of the 1990s.
With this fourth edition, Jeremy Siegel has continued on his merry
and remarkable way in producing works of great value about how best to
invest in the stock market. His additions on behavioral finance, globaliza-
tion, and exchange-traded funds have enriched the original material with
fresh insights into important issues. Revisions throughout the book have
added valuable factual material and powerful new arguments to make his
case for stocks for the long run. Whether you are a beginner at investing or
an old pro, you will learn a lot from reading this book.
Jeremy Siegel is never shy, and his arguments in this new edition
demonstrate he is as bold as ever. The most interesting feature of the whole
book is his twin conclusions of good news and bad news. First, today’s
globalized world warrants higher average price/earnings ratios than in the
past. But higher P/Es are a mixed blessing, for they would mean average
returns in the future are going to be lower than they were in the past.
I am not going to take issue with the forecast embodied in this view-
point. But similar cases could have been made in other environments of
the past, tragic environments as well as happy ones. One of the great les-
sons of history proclaims that no economic environment survives the long
run. We have no sense at all of what kinds of problems or victories lie in
the distant future, say, 20 years or more from now, and what influence
those forces will have on appropriate price/earnings ratios.
That’s all right. Professor Siegel’s most important observation about
the future goes beyond his controversial forecast of higher average P/Es
and lower realized returns. “Although these returns may be diminished
from the past,” he writes, “there is overwhelming reason to believe stocks
will remain the best investment for all those seeking steady, long-term
“[O]verwhelming reason” is an understatement. The risk premium
earned by equities over the long run must remain intact if the system is
going to survive. In the capitalist system, bonds cannot and should not out-
perform equities over the long run. Bonds are contracts enforceable in
courts of law. Equities promise their owners nothing—stocks are risky
investments, involving a high degree of faith in the future. Thus, equities
are not inherently “better” than bonds, but we demand a higher return
from equities to compensate for their greater risk. If the long-run expected
return on bonds were to be higher than the long-run expected return on
stocks, assets would be priced so that risk would earn no reward. That is an
unsustainable condition. Stocks must remain “the best investment for all
those seeking steady, long- term gains” or our system will come to an end,
and with a bang, not a whimper.
—Peter Bernstein
The fourth edition of Stocks for the Long Run was written in 2007. During
the last several years, as many of my colleagues my age had slowed the
pace of their research, I was often asked why I was working so hard on yet
another edition of this book. With a serious face I responded, “I believe
that a few events of significance have occurred over the past six years.”
A few events indeed! The years 2008 and 2009 witnessed the deep-
est economic recession and market collapse since the Great Depression
of the 1930s. The disruptions were so extensive that I put off writing this
edition until I gained better perspective on the causes and consequences
of the financial crisis from which we still have not completely recovered.
As a result, this edition is more thoroughly rewritten than any of
the previous editions were. This is not because the conclusions of the
earlier editions needed to be changed. Indeed the rise of U.S. equity mar-
kets to new all-time highs in 2013 only reinforces the central tenet of this
book: that stocks are indeed the best long-term investment for those who
learn to weather their short-term volatility. In fact, the long-term real
return on a diversified portfolio of common stocks has remained virtu-
ally identical to the 6.7 percent reported in the first edition of Stocks for
the Long Run, which examined returns through 1992.
Because of the severe impact of the crisis, I felt that what transpired
over the last several years had to be addressed front and center in this
edition. As a result I added two chapters that described the causes and
consequences of the financial meltdown. Chapter 1 now previews the
major conclusions of my research on stocks and bonds and traces how
investors, money managers, and academics regarded stocks over the
past century.
Chapter 2 describes the financial crisis, laying blame where blame
is due on the CEOs of the giant investment banks, the regulators, and
Congress. I lay out the series of fatal missteps that led Standard and
Poor’s, the world’s largest rating agency, to give its coveted AAA rating
to subprime mortgages, foolishly declaring them as safe as U.S. Treasury
Chapter 3 analyzes the extraordinary impact of the financial crisis
on the financial markets: the unprecedented surge of the “libor spread”
that measured cost of capital to the banks, the collapse of stock prices
that wiped out two-thirds of their value, and, for the time since the dark
days of the 1930s, Treasury bill yields falling to zero and even below.
Most economists believed that our system of deposit insurance,
margin requirements, and financial regulations rendered the above
events virtually impossible. The confluence of forces that led to the crisis
were remarkably similar to what happened following the 1929 stock
market crash, with mortgage-back securities replacing equities as the
main culprit.
Although the Fed failed miserably at predicting the crisis,
Chairman Ben Bernanke took unprecedented measures to keep financial
markets open by flooding the financial markets with liquidity and guar-
anteeing trillions of dollars of loans and short-term deposits. These
actions ballooned the Fed’s balance sheet to nearly $4 trillion, 5 times its
precrisis level, and raised many questions about how the Fed would
unwind this unprecedented stimulus.
The crisis also changed the correlation between asset classes. World
equity markets became much more correlated, reducing the diversifying
gains from global investing, while U.S. Treasury bonds and the dollar
became “safe haven” assets, spurring unprecedented demand for feder-
ally guaranteed debt. All commodities, including gold, suffered during
the worst stages of the economic downturn, but precious metals
rebounded on fear that the central bank’s expansionary policies would
generate high inflation.
Chapter 4 addresses longer-run issues impacting our economic well-
being. The economic downturn saw the U.S. budget deficit soar to $1.3
trillion, the highest level relative to GDP since World War II. The slow-
down in productivity growth generated fears that increase in living stan-
dards will slow markedly or even grind to a halt. This raises the question
of whether our children will be the first generation whose standard of liv-
ing will fall below that of their parents.
This chapter updates and extends the results of earlier editions by
using new data provided by the U.N. Population Commission and pro-
ductivity forecasts provided by the World Bank and the IMF. I now cal-
culate the distribution of world output of the major countries and
regions of the world to the end of the twenty-first century. This analysis
strongly suggests that although the developed world must increase the
age at which social security and medical benefits are offered by the gov-
ernment, such increases will be moderate if productivity growth in the
emerging economies remains strong.
Although the financial crisis and its aftermath are front and center in this
fifth edition, I have made other significant changes as well. Not only
have all the charts and tables been updated through 2012, but the chap-
ter on the valuation of equities has been expanded to analyze such
important new forecasting models such as the CAPE ratio and the sig-
nificance of profit margins as a determinant of future equity returns.
Chapter 19, “Market Volatility,” analyzes the “Flash Crash” of
May 2010 and documents how the volatility associated with the finan-
cial crisis compares with the banking crisis of the 1930s. Chapter 20
shows that, once again, following a simple technical rule such as the
200-day moving average would have avoided the worst part of the
recent bear market.
This edition also addresses whether the well-known calendar anom-
alies, such as the “January effect, the “small stock effect,” and the
“September effect,” have survived over the two decades since they were
described in the first edition of this book. I also include for the first time a
description of “liquidity investing” and explain how it might supplement
the “size” and “value” effects that have been found by researchers to be
important determinants of individual stocks’ return.
I am both honored and flattered by the tremendous reception that Stocks
for the Long Run has received. Since the publication of the first edition
nearly 20 years ago, I have given hundreds of lectures on the markets
and the economy around the world. I have listened closely to the ques-
tions that audiences pose, and I have contemplated the many letters,
phone calls, and e-mails from readers.
To be sure, there have been some extraordinary events in the capi-
tal markets in recent years. Even those who still believed in the long-
term superiority of equities were put to severe test during the financial
crisis. In 1937 John Maynard Keynes stated in The General Theory of
Employment, Interest and Money, “Investment based on genuine long-
term expectation is so difficult today as to be scarcely practicable.” It is
no easier 75 years later.
But those who have persisted with equities have always been
rewarded. No one has made money in the long run from betting against
stocks or the future growth of our economy. It is the hope that this latest
edition will fortify those who will inevitably waver when pessimism
once again grips economists and investors. History convincingly
demonstrates that stocks have been and will remain the best investment
for all those seeking long-term gains.
Jeremy J. Siegel
November 2013
It is never possible to list all the individuals and organizations that have
praised Stocks for the Long Run and encouraged me to update and
expand past editions. Many who provided me with data for the first four
editions of Stocks for the Long Run willingly contributed their data again
for this fifth edition. David Bianco, Chief U.S. Equity Strategist at
Deutsche Bank, whose historical work on S&P 500 earnings and profit
margins was invaluable for my chapter on stock market valuation, and
Walter Lenhard, senior investment strategist at Vanguard, once again
obtained historical data on mutual fund performance for Chapter 23. My
new Wharton colleague, Jeremy Tobacman, helped me update the mate-
rial on behavioral finance.
This edition would not have been possible without the hard work
of Shaun Smith, who also did the research and data analysis for the first
edition of Stocks for the Long Run in the early 1990s. Jeremy Schwartz,
who was my principal researcher for The Future for Investors, also pro-
vided invaluable assistance for this edition.
A special thanks goes to the thousands of financial advisors from
dozens of financial firms, such as Merrill Lynch, Morgan Stanley, UBS,
Wells Fargo, and many others who have provided me with critical feed-
back in seminars and open forums on earlier editions of Stocks for the
Long Run.
As before, the support of my family was critical in my being able to
write this edition. Now that my sons are grown and out of the house, it
was my wife Ellen who had to pay the whole price of the long hours
spent revising this book. I set a deadline of September 1 to get my mate-
rial to McGraw-Hill so we could go on a well-deserved cruise from
Venice down the Adriatic. Although I couldn’t promise her that this
would be the last edition, I know that completing this project has freed
some very welcome time for both of us.
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Past, Present, and Future
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The Case for Equity
Historical Facts and Media Fiction
The “new-era” doctrine—that “good” stocks (or “blue chips”) were
sound investments regardless of how high the price paid for them—
was at the bottom only a means of rationalizing under the title of
“investment” the well-nigh universal capitulation to the gambling
Investing in stocks has become a national hobby and a national obses-
sion. To update Marx, it is the religion of the masses.
Stocks for the Long Run by Siegel? Yeah, all it’s good for now is a
In the summer of 1929, a journalist named Samuel Crowther inter-
viewed John J. Raskob, a senior financial executive at General Motors,
about how the typical individual could build wealth by investing in
stocks. In August of that year, Crowther published Raskob’s ideas in a
Ladies’ Home Journal article with the audacious title “Everybody Ought
to Be Rich.”
In the interview, Raskob claimed that America was on the verge of
a tremendous industrial expansion. He maintained that by putting just
$15 per month into good common stocks, investors could expect their
wealth to grow steadily to $80,000 over the next 20 years. Such a
return—24 percent per year—was unprecedented, but the prospect of
effortlessly amassing a great fortune seemed plausible in the atmos-
phere of the 1920s bull market. Stocks excited investors, and millions put
their savings into the market, seeking quick profit.
On September 3, 1929, a few days after Raskob’s plan appeared, the
Dow Jones Industrial Average hit a historic high of 381.17. Seven weeks
later, stocks crashed. The next 34 months saw the most devastating
decline in share values in U.S. history.
On July 8, 1932, when the carnage was finally over, the Dow
Industrials stood at 41.22. The market value of the world’s greatest cor-
porations had declined an incredible 89 percent. Millions of investors’
life savings were wiped out, and thousands of investors who had bor-
rowed money to buy stocks were forced into bankruptcy. America was
mired in the deepest economic depression in its history.
Raskob’s advice was ridiculed and denounced for years to come. It
was said to represent the insanity of those who believed that the market
could rise forever and the foolishness of those who ignored the tremen-
dous risks in stocks. Senator Arthur Robinson of Indiana publicly held
Raskob responsible for the stock crash by urging common people to buy
stock at the market peak.4In 1992, 63 years later, Forbes magazine
warned investors of the overvaluation of stocks in its issue headlined
“Popular Delusions and the Madness of Crowds.” In a review of the his-
tory of market cycles, Forbes fingered Raskob as the “worst offender” of
those who viewed the stock market as a guaranteed engine of wealth.5
Conventional wisdom holds that Raskob’s foolhardy advice epito-
mizes the mania that periodically overruns Wall Street. But is that ver-
dict fair? The answer is decidedly no. Investing over time in stocks has
been a winning strategy whether one starts such an investment plan at a
market top or not. If you calculate the value of the portfolio of an
investor who followed Raskob’s advice in 1929, patiently putting $15 a
month into the market, you find that his accumulation exceeded that of
someone who placed the same money in Treasury bills after less than 4
years. By 1949 his stock portfolio would have accumulated almost
$9,000, a return of 7.86 percent, more than double the annual return in
bonds. After 30 years the portfolio would have grown to over $60,000,
4 PART I Stock Returns: Past, Present, and Future
with an annual return rising to 12.72 percent. Although these returns
were not as high as Raskob had projected, the total return of the stock
portfolio over 30 years was more than eight times the accumulation in
bonds and more than nine times that in Treasury bills. Those who never
bought stock, citing the Great Crash as the vindication of their caution,
eventually found themselves far behind investors who had patiently
accumulated equity.6
The story of John Raskob’s infamous prediction illustrates an impor-
tant theme in the history of Wall Street. Bull markets and bear markets
lead to sensational stories of incredible gains and devastating losses. Yet
patient stock investors who can see past the scary headlines have always
outperformed those who flee to bonds or other assets. Even such calami-
tous events as the Great 1929 Stock Crash or the financial crisis of 2008 do
not negate the superiority of stocks as long-term investments.
Asset Returns Since 1802
Figure 1-1 is the most important chart in this book. It traces year by year
how real (after-inflation) wealth has accumulated for a hypothetical
investor who put a dollar in (1) stocks, (2) long-term government bonds,
(3) U.S. Treasury bills, (4) gold, and (5) U.S. currency over the last two
centuries. These returns are called total real returns and include income
distributed from the investment (if any) plus capital gains or losses, all
measured in constant purchasing power.
These returns are graphed on a ratio, or logarithmic scale. Economists
use this scale to depict long-term data since the same vertical distance
anywhere on the chart represents the same percentage change. On a log-
arithmic scale the slope of a trendline represents a constant after-inflation
rate of return.
The compound annual real returns for these asset classes are also
listed in the figure. Over the 210 years I have examined stock returns, the
real return on a broadly diversified portfolio of stocks has averaged 6.6
percent per year. This means that, on average, a diversified stock portfo-
lio, such as an index fund, has nearly doubled in purchasing power every
decade over the past two centuries. The real return on fixed-income
investments has averaged far less; on long-term government bonds the
average real return has been 3.6 percent per year and on short-term
bonds only 2.7 percent per year.
The average real return on gold has been only 0.7 percent per year.
In the long run, gold prices have remained just ahead of the inflation
rate, but little more. The dollar has lost, on average, 1.4 percent per year
CHAPTER 1  The Case for Equity 5
of purchasing power since 1802, but it has depreciated at a significantly
faster rate since World War II. In Chapter 5 we examine the details of
these return series and see how they are constructed.
I have fitted the best statistical trendline to the real stock returns in
Figure 1-1. The stability of real returns is striking; real stock returns in
the nineteenth century do not differ appreciably from the real returns in
the twentieth century. Note that stocks fluctuate both below and above
the trendline but eventually return to the trend. Economists call this
behavior mean reversion, a property that indicates that periods of above-
average returns tend to be followed by periods of below-average returns
and vice versa. No other asset class—bonds, commodities, or the dol-
lar—displays the stability of long-term real returns as do stocks.
In the short run, however, stock returns are very volatile, driven by
changes in earnings, interest rates, risk, and uncertainty, as well as psy-
6 PART I Stock Returns: Past, Present, and Future
Total Real Returns on U.S. Stocks, Bonds, Bills, Gold, and the Dollar, 1802–2012
chological factors, such as optimism and pessimism as well as fear and
greed. Yet these short-term swings in the market, which so preoccupy
investors and the financial press, are insignificant compared with the
broad upward movement in stock returns.
In the remainder of this chapter, I examine how economists and
investors have viewed the investment value of stocks over the course of
history and how the great bull and bear markets impact both the media
and the opinions of investment professionals.
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
equities might be suitable investments under certain economic condi-
tions for investors outside those traditional channels.
In the first half of the twentieth century, the great U.S. economist
Irving Fisher, a professor at Yale University and an extremely successful
investor, believed that stocks were superior to bonds during inflationary
times but that common shares would likely underperform bonds during
periods of deflation, a view that became the conventional wisdom dur-
ing that time.7
Edgar Lawrence Smith, a financial analyst and investment manager
of the 1920s, researched historical stock prices and demolished this con-
ventional wisdom. Smith was the first to demonstrate that accumula-
tions in a diversified portfolio of common stocks outperformed bonds
not only when commodity prices were rising but also when prices were
falling. Smith published his studies in 1925 in a book entitled Common
Stocks as Long-Term Investments. In the introduction he stated:
These studies are a record of a failure—the failure of facts to sustain a pre-
conceived theory, . . . [the theory being] that high-grade bonds had proved
to be better investments during periods of [falling commodity prices].8
Smith maintained that stocks should be an essential part of an
investor’s portfolio. By examining stock returns back to the Civil War,
Smith discovered that there was a very small chance that an investor
would have to wait a long time (which he put at 6 to, at most, 15 years)
before being able to sell his stocks at a profit. Smith concluded:
We have found that there is a force at work in our common stock holdings
which tends ever toward increasing their principal value. . . . [U]nless we
CHAPTER 1  The Case for Equity 7
have had the extreme misfortune to invest at the very peak of a noteworthy
rise, those periods in which the average market value of our holding remains
less than the amount we paid for them are of comparatively short duration.
Our hazard even in such extreme cases appears to be that of time alone.9
Smith’s conclusion was right not only historically but also prospec-
tively. It took just over 15 years to recover the money invested at the 1929
peak, following a crash far worse than Smith had ever examined. And
since World War II, the recovery period for stocks has been even better.
Even including the recent financial crisis, which saw the worst bear mar-
ket since the 1930s, the longest it has ever taken an investor to recover an
original investment in the stock market (including reinvested divi-
dends) was the five-year, eight-month period from August 2000 through
April 2006.
The Influence of Smith’s Work
Smith wrote his book in the 1920s, at the outset of one of the greatest bull
markets in our history. Its conclusions caused a sensation in both aca-
demic and investing circles. The prestigious weekly The Economist
stated, “Every intelligent investor and stockbroker should study Mr.
Smith’s most interesting little book, and examine the tests individually
and their very surprising results.”10
Smith’s ideas quickly crossed the Atlantic and were the subject of
much discussion in Great Britain. John Maynard Keynes, the great
British economist and originator of the business cycle theory that
became the paradigm for future generations of economists, reviewed
Smith’s book with much excitement. Keynes stated:
The results are striking. Mr. Smith finds in almost every case, not only
when prices were rising, but also when they were falling, that common
stocks have turned out best in the long-run, indeed, markedly so. . . . This
actual experience in the United States over the past fifty years affords
prima facie evidence that the prejudice of investors and investing institu-
tions in favor of bonds as being “safe” and against common stocks as hav-
ing, even the best of them, a “speculative” flavor, has led to a relative
over-valuation of bonds and under-valuation of common stocks.11
Common Stock Theory of Investment
Smith’s writings gained academic credibility when they were published
in such prestigious journals as the Review of Economic Statistics and the
8 PART I Stock Returns: Past, Present, and Future
Journal of the American Statistical Association.12 Smith acquired an interna-
tional following when Siegfried Stern published an extensive study of
returns in common stock in 13 European countries from the onset of
World War I through 1928. Stern’s study showed that the advantage of
investing in common stocks over bonds and other financial investments
extended far beyond America’s financial markets.13 Research demon-
strating the superiority of stocks became known as the common stock the-
ory of investment.14
The Market Peak
Smith’s research also changed the mind of the renowned Yale economist
Irving Fisher, who saw Smith’s study as a confirmation of his own long-
held belief that bonds were overrated as safe investments in a world
with uncertain inflation. In 1925 Fisher summarized Smith’s findings
with these prescient observations of investors’ behavior:
It seems, then, that the market overrates the safety of “safe” securities and
pays too much for them, that it overrates the risk of risky securities and
pays too little for them, that it pays too much for immediate and too little
for remote returns, and finally, that it mistakes the steadiness of money
income from a bond for a steadiness of real income which it does not pos-
sess. In steadiness of real income, or purchasing power, a list of diversified
common stocks surpasses bonds.15
Irving Fisher’s “Permanently High Plateau”
Professor Fisher, cited by many as the greatest U.S. economist and the
father of capital theory, was no mere academic. He actively analyzed
and forecast financial market conditions, wrote dozens of newsletters on
topics ranging from health to investments, and created a highly success-
ful card-indexing firm based on one of his own patented inventions.
Although he hailed from a modest background, his personal wealth in
the summer of 1929 exceeded $10 million, which is over $100 million in
today’s dollars.16
Irving Fisher, as well as many other economists in the 1920s,
believed that the establishment of the Federal Reserve System in 1913
was critical to reducing the severity of economic fluctuations. Indeed
the 1920s were a period of remarkably stable growth, as the instability
in such economic variables as industrial production and producer
prices was greatly reduced, a factor that boosted the prices of risky
CHAPTER 1  The Case for Equity 9
assets such as stocks. As we shall see in the next chapter, there was a
remarkable similarity between the stability of the 1920s and the decade
that preceded the recent 2008 financial crisis. In both periods not only
had the business cycle moderated, but there was great confidence—
later shattered—that the Federal Reserve would be able to mitigate, if
not eliminate, the business cycle.
The 1920s bull market drew millions of Americans into stocks, and
Fisher’s own financial success and reputation as a market seer gained him
a large following among investors and analysts. The market turbulence in
early October 1929 greatly increased interest in his pronouncements.
Market followers were not surprised that on the evening of October
14, 1929, when Irving Fisher arrived at the Builders’ Exchange Club in
New York City to address the monthly meeting of the Purchasing
Agents Association, a large number of people, including news reporters,
pressed into the meeting hall. Investors’ anxiety had been rising since
early September when Roger Babson, businessman and market seer,
predicted a “terrific” crash in stock prices.17 Fisher had dismissed
Babson’s pessimism, noting that Babson had been bearish for some time.
But the public sought to be reassured by the great man who had cham-
pioned stocks for so long.
The audience was not disappointed. After a few introductory
remarks, Fisher uttered a sentence that, much to his regret, became
one of the most-quoted phrases in stock market history: “Stock
prices,” he proclaimed, “have reached what looks like a permanently
high plateau.”18
On October 29, two weeks to the day after Fisher’s speech, stocks
crashed. His “high plateau” turned into a bottomless abyss. The next
three years witnessed the most devastating market collapse in history.
Despite all of Irving Fisher’s many accomplishments, his reputation—
and the thesis that stocks were a sound way to accumulate wealth—was
The collapse of both the economy and the stock market in the 1930s left an
indelible mark on the psyches of investors. The common stock theory of
investment was attacked from all angles, and many summarily dismissed
the idea that stocks were fundamentally sound investments. Lawrence
Chamberlain, an author and well-known investment banker, stated,
Common stocks, as such, are not superior to bonds as long-term investments,
because primarily they are not investments at all. They are speculations.19
10 PART I Stock Returns: Past, Present, and Future
In 1934, Benjamin Graham, an investment fund manager, and
David Dodd, a finance professor at Columbia University, wrote Security
Analysis, which became the bible of the value-oriented approach to ana-
lyzing stocks and bonds. Through its many editions, the book has had a
lasting impact on students and market professionals alike.
Graham and Dodd clearly blamed Smith’s book for feeding the bull
market mania of the 1920s by proposing plausible-sounding but falla-
cious theories to justify the purchase of stocks.
They wrote:
The self-deception of the mass speculator must, however, have its element
of justification. . . . In the new-era bull market, the “rational” basis was the
record of long-term improvement shown by diversified common-stock
holdings. [There is] a small and rather sketchy volume from which the
new-era theory may be said to have sprung. The book is entitled Common
Stocks as Long-Term Investments by Edgar Lawrence Smith, published in
Following the Great Crash, both the media and analysts trashed both the
stock market and those who advocated stocks as investments.
Nevertheless, research on indexes of stock market returns received a big
boost in the 1930s when 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
York Stock Exchange. His total-return indexes included reinvested divi-
dends and are virtually identical to the methodology that is used today
to compute stock returns. Cowles confirmed the findings that Smith
reached before the stock crash and concluded that most of the time
stocks were undervalued and enabled investors to reap superior returns
by investing in them.21
After World War II, two professors from the University of
Michigan, Wilford J. Eiteman and Frank P. Smith, published a study of
the investment returns of actively traded industrial companies and
found that by regularly purchasing these 92 stocks without any regard
to the stock market cycle (a strategy called dollar cost averaging), stock
investors earned returns of 12.2 percent per year, far exceeding those in
fixed-income investments. Twelve years later they repeated the study,
using the same stocks they had used in their previous study. This time
the returns were even higher despite the fact that they made no adjust-
CHAPTER 1  The Case for Equity 11
ment for any of the new firms or new industries that had surfaced in the
interim. They wrote:
If a portfolio of common stocks selected by such obviously foolish meth-
ods as were employed in this study will show an annual compound rate
of return as high as 14.2 percent, then a small investor with limited knowl-
edge of market conditions can place his savings in a diversified list of
common stocks with some assurance that, given time, his holding will
provide him with safety of principal and an adequate annual yield.22
Many dismissed the Eiteman and Smith study because the period
studied did not include the Great Crash of 1929 to 1932. But in 1964, two
professors from the University of Chicago, Lawrence Fisher and James
H. Lorie, examined stock returns through the stock crash of 1929, the
Great Depression, and World War II.23 Fisher and Lorie concluded that
stocks offered significantly higher returns (which they reported at 9.0
percent per year) than any other investment media during the entire 35-
year period, 1926 through 1960. They even factored taxes and transac-
tion costs into their return calculations and concluded:
It will perhaps be surprising to many that the returns have consistently
been so high. . . . The fact that many persons choose investments with a
substantially lower average rate of return than that available on common
stocks suggests the essentially conservative nature of those investors and
the extent of their concern about the risk of loss inherent in common
Ten years later, in 1974, Roger Ibbotson and Rex Sinquefield pub-
lished an even more extensive review of returns in an article entitled
“Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns
(1926–74).”25 They acknowledged their indebtedness to the Lorie and
Fisher study and confirmed the superiority of stocks as long-term
investments. Their summary statistics, which are published annually in
yearbooks, are frequently quoted and have often served as the return
benchmarks for the securities industry.26
The 1970s were not good years for either stocks or the economy. Surging
inflation and sharply higher oil prices led to negative real stock returns
for the 15-year period from the end of 1966 through the summer of 1982.
But as the Fed’s tight money policy quashed inflation, interest rates fell
sharply and the stock market entered its greatest bull market ever, a
12 PART I Stock Returns: Past, Present, and Future
market that would eventually see stock prices appreciate by more than
tenfold. From a low of 790 in August 1982, stocks rose sharply, and the
Dow Industrial Average surged past 1,000 to a new record by the end of
1982, finally surpassing the 1973 highs it had reached nearly a decade
Although many analysts expressed skepticism that the rise could
continue, a few were very bullish. Robert Foman, president and chair-
man of E.F. Hutton, proclaimed in October 1983 that we are “in the
dawning of a new age of equities” and boldly predicted the Dow Jones
average could hit 2,000 or more by the end of the decade.
But even Foman was too pessimistic, as the Dow Industrials broke
2,000 in January 1987 and surpassed 3,000 just before Saddam Hussein
invaded Kuwait in August 1990. The Gulf War and a real estate recession
precipitated a bear market, but this one, like the stock crash of October
1987, was short lived.
Iraq’s defeat in the Gulf War ushered in one of the most fabulous
decades in stock market history. The world witnessed the collapse of
communism and the diminished threat of global conflict. The transfer
of resources from military expenditures to domestic consumption
enabled the United States to increase economic growth while keeping
inflation low.
As stocks moved upward, few thought the bull market would last.
In 1992, Forbes warned investors in a cover story “The Crazy Things
People Say to Rationalize Stock Prices” that stocks were in the “midst of
a speculative buying panic” and cited Raskob’s foolish advice to invest
at the market peak in 1929.27
But such caution was ill advised. After a successful battle against
inflation in 1994, the Fed eased interest rates, and the Dow subsequently
moved above 4,000 in early 1995. Shortly thereafter, BusinessWeek
defended the durability of the bull market in an article on May 15, 1995,
entitled “Dow 5000? Don’t Laugh.” The Dow quickly crossed that bar-
rier by November and then reached 6,000 eleven months later.
By late 1995, the persistent rise in stock prices caused many more
analysts to sound the alarm. Michael Metz of Oppenheimer, Charles
Clough of Merrill Lynch, and Byron Wien of Morgan Stanley expressed
strong doubts about the underpinnings of the rally. In September 1995,
David Shulman, chief equity strategist for Salomon Brothers, wrote an
article entitled “Fear and Greed,” which compared the current market
climate with that of similar stock market peaks in 1929 and 1961.
Shulman claimed intellectual support was an important ingredient in
sustaining bull markets, noting Edgar Smith’s and Irving Fisher’s work
CHAPTER 1  The Case for Equity 13
in the 1920s, the Fisher-Lorie studies in the 1960s, and my Stocks for the
Long Run, published in 1994.28 But these bears had little impact as stocks
continued upward.
Warnings of Overvaluation
By 1996, price/earnings ratios on the S&P 500 Index reached 20, consid-
erably above its average postwar level. More warnings were issued.
Roger Lowenstein, a well-known author and financial writer, asserted in
the Wall Street Journal:
Investing in stocks has become a national hobby and a national obsession.
People may denigrate their government, their schools, their spoiled sports
stars. But belief in the market is almost universal. To update Marx, it is the
religion of the masses.29
Floyd Norris, lead financial writer for the New York Times, echoed
Lowenstein’s comments by penning an article in January 1997, “In the
Market We Trust.”30 Henry Kaufman, the Salomon Brothers guru whose
pronouncements on the fixed-income market had frequently rocked
bonds in the 1980s, declared that “the exaggerated financial euphoria is
increasingly conspicuous,” and he cited assurances offered by optimists
equivalent to Irving Fisher’s utterance that stocks had reached a perma-
nently high plateau.31
Warnings of the end of the bull market did not emanate just from
the media and Wall Street. Academicians were increasingly investigat-
ing this unprecedented rise in stock values. Robert Shiller of Yale
University and John Campbell of Harvard wrote a scholarly paper
showing that the market was significantly overvalued and presented
this research to the Board of Governors of the Federal Reserve System in
early December 1996.32
With the Dow surging past 6,400, Alan Greenspan, chairman of the
Federal Reserve, issued a warning in a speech before the annual dinner
for the American Enterprise Institute in Washington on December 5,
1996. He asked, “How do we know when irrational exuberance has
unduly escalated asset values, which then become subject to unexpected
and prolonged contractions as they have in Japan over the past decade?
And how do we factor that assessment into monetary policy?”
His words had an electrifying effect, and the term irrational exuber-
ance became the most celebrated utterance of Greenspan’s tenure as Fed
chairman. Asian and European markets fell dramatically as his words
14 PART I Stock Returns: Past, Present, and Future
were flashed across computer monitors, and the next morning Wall
Street opened dramatically lower. But investors quickly regained their
optimism, and stocks closed in New York with only moderate losses.
The Late Stage of the Great Bull Market, 1997–2000
From there it was onward and upward, with the Dow breaking 7,000 in
February 1997 and 8,000 in July. Even Newsweek’s cautious cover story
“Married to the Market,” depicting a Wall Street wedding between
America and a bull, did nothing to quell investor optimism.33
The market became an ever-increasing preoccupation of middle-
and upper-income Americans. Business books and magazines prolifer-
ated, and the all-business cable news stations, particularly CNBC, drew
huge audiences. Electronic tickers and all-business TV stations were
broadcast in lunchrooms, bars, and even lounges of the major business
schools throughout the country. Air travelers flying 35,000 feet above the
sea could view up-to-the-minute Dow and Nasdaq averages as they
were flashed from monitors on phones anchored to the backs of the seats
facing the travelers.
Adding impetus to the already surging market was the explosion of
communications technology. The Internet allowed investors to stay in
touch with markets and with their portfolios from anywhere in the
world. Whether it was from Internet chat rooms, financial websites, or e-
mail newsletters, investors found access to a plethora of information at
their fingertips. CNBC became so popular that major investment houses
made sure that all their brokers watched the station on television or their
desktop computers so that they could be one step ahead of clients call-
ing in with breaking business news.
The bull market psychology appeared impervious to financial and
economic shocks. The first wave of the Asian crisis sent the market down
a record 554 points on October 27, 1997, and closed trading temporarily.
But this did little to dent investors’ enthusiasm for stocks.
The following year, the Russian government defaulted on its
bonds, and Long-Term Capital Management, considered the world’s
premier hedge fund, found itself entangled in speculative positions
measured in the trillions of dollars that it could not trade. These events
sent the Dow Industrials down almost 2,000 points, or 20%, but three
quick Fed rate cuts sent the market soaring again. On March 29, 1999, the
Dow closed above 10,000, and it then went on to a record close of
11,722.98 on January 14, 2000.
CHAPTER 1  The Case for Equity 15
The Top of the Market
As has happened so many times, at the peak of the bull market the dis-
credited bears retreat while the bulls, whose egos have been reinforced
by the continued upward movement of stock prices, become even
bolder. In 1999, two economists, James Glassman and Kevin Hassett,
published a book entitled Dow 36,000. They claimed that the Dow Jones
Industrial Average, despite its meteoric rise, was still grossly underval-
ued, and its true valuation was three times higher at 36,000. Much to my
surprise, they asserted that the theoretical underpinning for their analy-
sis came from my book Stocks for the Long Run! They claimed that since I
showed that bonds were as risky as stocks over long horizons, then stock
prices must rise threefold to reduce their returns to those of bonds,
ignoring that the real comparison should be with the Treasury inflation-
protected bonds, whose yield was much higher at that time.34
Despite the upward march of the Dow Industrials, the real action in
the market was in the technology stocks that were listed on the Nasdaq,
which included such shares as Cisco, Sun Microsystems, Oracle, JDS
Uniphase, and other companies as well as the rising group of Internet
stocks. From November 1997 to March 2000, the Dow Industrials rose 40
percent, but the Nasdaq index rose 185 percent, and the dot-com index
of 24 online firms soared nearly tenfold from 142 to 1,350.
The Tech Bubble Bursts
The date March 10, 2000, marked the peak not only of the Nasdaq but
also of many Internet and technology stock indexes. Even I, a longtime
bull, wrote that the technology stocks were selling at ridiculous prices
that presaged a collapse.35
When technology spending unexpectedly slowed, the bubble burst,
and a severe bear market began. Stock values plunged by a record
$9 trillion, and the S&P 500 Index declined by 49.15 percent, eclipsing
the 48.2 percent decline in the 1972 to 1974 bear market and the worst
since the Great Depression. The Nasdaq fell 78 percent and the dot-com
index by more than 95 percent.
Just as the bull market spawned the irrational optimists, the col-
lapsing stock prices brought back the bears in droves. In September
2002, with the Dow hovering around 7,500 and just a few weeks before
the bear market low of 7,286, Bill Gross, the legendary head of the
PIMCO, home of the world’s largest mutual fund, came out with a piece
entitled “Dow 5,000” in which he stated that despite the market’s awful
16 PART I Stock Returns: Past, Present, and Future
decline, stocks were still nowhere near as low as they should be on the
basis of economic fundamentals. It was startling that within a period of
two years, one well-regarded forecaster claimed the right value for the
Dow was as high as 36,000, while another claimed it should fall to 5,000!
The bear market squelched the public’s fascination with stocks.
Televisions in public venues were no longer tuned to CNBC but instead
switched on sports and Hollywood gossip. As one bar owner colorfully
put it, “People are licking their wounds and they don’t want to talk
about stocks anymore. It’s back to sports, women, and who won the
The declining market left many professionals deeply skeptical of
stocks, and yet bonds did not seem an attractive alternative, as their
yields had declined below 4 percent. Investors wondered whether there
might be attractive investments beyond the world of stocks and bonds.
David Swenson, chief investment officer at Yale University since
1985, seemed to provide that answer. At the peak of the bull market, he
wrote a book, Pioneering Portfolio Management: An Unconventional
Approach to Institutional Investment, that espoused the qualities of “non-
traditional” (and often illiquid) assets, such as private equity, venture
capital, real estate, timber, and hedge funds. As a result, hedge funds,
pools of investment money that can be invested in any way the fund
managers see fit, enjoyed a boom.37 From a mere $100 billion in 1990,
assets of hedge funds grew to over $1.5 trillion by 2007.
But the surge of assets into hedge funds drove the prices of many
unconventional assets to levels never before seen. Jeremy Grantham, a
successful money manager at GMO and a onetime big booster of uncon-
ventional investing, stated in April 2007, “After these moves, most
diversifying and exotic assets are badly overpriced.”38
From the ashes of the technology bust of 2000–2002, the stock market
almost doubled from its low of 7,286 on October 9, 2002, to an all-time
high of 14,165 exactly five years later on October 9, 2007. In contrast to
the peak of the technology boom, when the S&P 500 was selling for 30
times earnings, there was no general overvaluation at the 2007 market
peak; stocks were selling for a much more modest 16 times earnings.
But there were signs that all was not well. The financial sector,
which in the bull market had become the largest sector of the S&P 500
Index, peaked in May 2007, and the price of many large banks, such as
Citi and BankAmerica, had been falling all year.
CHAPTER 1  The Case for Equity 17
More ominous developments came from the real estate market.
Real estate prices, after having nearly tripled in the previous decade,
peaked in the summer of 2006 and were heading downward. All of a
sudden, subprime mortgages experienced large delinquencies. In April
2007 New Century Financial, a leading subprime lender, filed for bank-
ruptcy, and in June Bear Stearns informed investors that it was suspend-
ing redemptions from its High-Grade Structured Credit Strategies
Enhanced Leverage Fund, a fund whose name is as complex as the secu-
rities that it held.
At first the market ignored these developments, but on August 9,
2007, BNP Paribas, when France’s largest bank, halted redemptions in its
mortgage funds, world equity markets sold off sharply. Stocks recovered
when the Fed lowered the Fed funds rate 50 basis points in an emer-
gency meeting in August and another 50 basis points at its regular
September meeting.
Yet 2008 brought no relief from subprime troubles. Bear Stearns,
which had to take an increasing volume of subprime mortgages back on
its own balance sheets, began to experience funding problems, and the
price of its shares plummeted. On March 17, 2008, the Federal Reserve,
in an effort to shield Bear from imminent bankruptcy, arranged an emer-
gency sale of all of Bear Stearns’s assets to JPMorgan at a price of $2
(later raised to $10) a share, almost 99 percent below its high of $172.61
reached in January of the prior year.
Beginning of the End for Lehman Brothers
But Bear Stearns was only the appetizer for this bear market, and the
main dish was not far behind. Lehman Brothers, founded in the 1850s,
had a storied history that included bringing such great companies as
Sears, Woolworth’s, Macy’s, and Studebaker public. Its profitability
soared after the firm went public in 1994, and in 2007 the firm reported
its fourth consecutive year of record profitability as net revenues
reached $19.2 billion and the number of employees neared 30,000.
But Lehman Brothers, like Bear Stearns, was involved in the sub-
prime market and other leveraged real estate investments. Its price had
sunk from over $40 to $20 a share when Bear was merged into JPMorgan
in March. Lehman was well known for financing large real estate deals,
booking significant fees as investors sold and refinanced commercial
real estate at ever higher prices. In July, Blackstone, another large invest-
ment house that went public in July 2007, had purchased Sam Zell’s
18 PART I Stock Returns: Past, Present, and Future
Equity Office Property for $22.9 billion, collecting high fees for placing
almost all of the properties before the market collapsed.
Lehman felt confident despite the chaos enveloping the subprime
market. Many analysts were convinced that commercial real estate did
not suffer from the overbuilding that plagued the residential sector. In
fact, commercial real estate prices continued to rise well after the general
market peaked. Reacting favorably to lower interest rates, the Dow
Jones REIT Index of all publicly traded real estate investment trusts
peaked in February 2008, four months after the general market and more
than a year after the major commercial banks hit their highs.39
In May, just after commercial real estate prices reached their peak,
Lehman financed a huge $22 billion stake in Archstone-Smith Trust, hop-
ing to flip the properties to buyers, just as Blackstone did a few months
earlier.40 But as in the child’s game of musical chairs, the music stopped
in the summer of 2008. Blackstone got the very last chair in the real estate
closing room, but Lehman was left standing. On September 15, 2008, as
Lehman CEO Richard Fuld thrashed about to find a last-minute buyer,
Lehman Brothers, an investment firm that had thrived for more than a
century and a half, filed for bankruptcy. It was the largest in U.S. history,
and Lehman listed a record $613 billion in liabilities. Just as the Great
Crash of 1929 launched the Great Depression of the 1930s, the fall of
Lehman Brothers in 2008 precipitated the greatest financial crisis and
deepest economic contraction that the world had seen in nearly a century.
CHAPTER 1  The Case for Equity 19
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The Great Financial
Crisis of 2008
Its Origins, Impact, and Legacy
Regarding the Great Depression. You’re right, we did it. We’re very
sorry. But thanks to you, we won’t do it again.
It was only Wednesday, September 17, but I had already had an exhaust-
ing week trying to make sense of the upheaval in the financial markets.
On Monday, stocks surprised investors by opening higher despite the
Sunday night news of the bankruptcy of Lehman Brothers, the largest
bankruptcy filing in U.S. history. With no government aid forthcoming,
Lehman Brothers, a 150-year-old investment firm that had survived the
Great Depression, had no chance this time.
But that hopeful opening was quickly countered by rumors that
key firms would not clear trades for Lehman customers, throwing mar-
kets into a state of anxiety.1As Monday morning’s gains turned into
losses, fear enveloped the financial markets. Investors wondered: What
assets were safe? Which firm would be the next to fail? And could this
crisis be contained? Risk premiums soared as lenders backed away from
all credit markets except U.S. Treasury bonds.2By the end of the day, the
Dow Industrials had fallen more than 500 points.
The following day, speculators attacked AIG, the world’s largest
and most profitable insurance company. AIG’s stock price, which had
reached nearly $60 a share a year earlier, plunged below $3, down from
its closing price of over $10 the previous Friday. AIG’s collapse sent
stocks sharply lower; but some traders speculated, correctly as it turned
out, that the Fed could not risk letting another major financial firm go
under, and the market stabilized later in the day. Indeed, after the close of
trading, the Fed announced that it had loaned $85 billion to AIG, avoid-
ing another market-shaking bankruptcy. The Fed’s decision to bail out
AIG was a dramatic turnaround, as Chairman Ben Bernanke had rejected
the giant insurer’s request for a $40 billion loan just a week earlier.
But the crisis was far from over. After the markets closed on
Tuesday, the $36 billion Reserve Primary Money Market Fund made a
most ominous announcement. Because the Lehman securities that the
money fund held were marked down to zero, Reserve was going to
“break the buck” and pay investors only 97 cents on the dollar.3
Although other money funds reassured investors that they held no
Lehman debt and that they were honoring all withdrawals at full value,
it was clear that these declarations would do little to calm investor anxi-
ety. Bear Stearns had repeatedly reassured investors that everything was
fine before the Fed forced the failing firm to merge into JPMorgan six
months earlier. Similarly Lehman CEO Richard Fuld told investors just
a week before filing for bankruptcy that all was well and blamed short
sellers for driving down the price of his stock.
I returned to my office after lunch that Wednesday and looked at my
Bloomberg screen. Yes, stocks were down again, and that didn’t surprise
me. But what caught my attention was the yield on U.S. Treasury bills. A
Treasury auction of three-month bills conducted that afternoon was so
heavily oversubscribed that buyers sent the interest rate down to 6 hun-
dredths of 1 percent.
I had monitored markets closely for almost 50 years, through the sav-
ings and loan crises of the 1970s, the 1987 stock market crash, the Asian
crisis, the Long-Term Capital Management crisis, the Russian default, the
9/11 terrorist attack, and many other crises. But I had never seen investors
22 PART I Stock Returns: Past, Present, and Future
rush to Treasuries like this. The last time Treasury bill yields had fallen
toward zero was during the Great Depression, 75 years earlier.4
My eyes returned to the screen in front of me, and a chill went
down my spine. Was this a replay of a period that we economists
thought was dead and gone? Could this be the start of the second “Great
Depression”? Can policy makers prevent a repeat of that financial and
economic catastrophe?
In the ensuing months the answers to these questions started to
emerge. The Federal Reserve did implement aggressive programs to
prevent another Depression. But the credit disruptions that followed the
Lehman bankruptcy caused the world’s deepest economic contraction
and the deepest decline in equity prices since the Great Depression. And
the recovery from the “Great Recession,” as the economic downturn
became known, was one of the slowest in U.S. history, causing many to
question whether the future of the U.S. economy could ever be as bright
as it appeared when the Dow Industrials crossed 14,000 in October 2007.
The Great Moderation
The economic backdrop for the financial crisis of 2008 was the “Great
Moderation,” the name that economists gave to the remarkably long and
stable economic period that preceded the Great Recession. The volatility
of key economic variables, such as the quarterly changes in real and nom-
inal GDP, fell by about one-half during the 1983–2005 period compared
with the average levels that existed since World War II.5Although part of
this stability was ascribed to the increase in the size of the service sector
and advances in inventory control that moderated the “inventory cycle,”
many attributed the reduction of economic volatility to the increasing
effectiveness of monetary policy, primarily as practiced during the tenure
of Alan Greenspan as Fed chairman from 1986 through 2006.
As one might expect, risk premiums on many financial instruments
declined markedly during the Great Moderation as investors believed
that prompt central bank action would counteract any severe shock to
the economy. Indeed, the 2001 recession reinforced the market’s opinion
that the economy was more stable. That recession was very mild by his-
torical standards despite the popping of the huge tech bubble in 2000
and the consumer retrenchment that followed the 9/11 terrorist attacks.
The unusual economic stability that preceded the Great Recession
was very similar to the 1920s, a period of calm that preceded the 1929
CHAPTER 2  The Great Financial Crisis of 2008 23
stock crash and the Great Depression. The standard deviation of changes
in industrial production from 1920 to 1929 was less than one-half of
what it was in the preceding 20 years, similar to what occurred during
the Great Moderation. During the 1920s, many economists, including
the influential Irving Fisher of Yale University, attributed the increased
stability to the Federal Reserve, as did economists before the recent
financial crisis. And in the 1920s, investors also believed that the Federal
Reserve, created in the preceding decade, would “backstop” the econ-
omy in the case of a crisis, moderating any downturn.
Unfortunately, the increased appetite for risky assets during a stable
economic environment may set the stage for a more severe crisis to fol-
low. A slowdown in business activity, which under normal times would
be well tolerated, can easily overwhelm highly leveraged borrowers who
have too little cushion to insulate them from a market decline.
Some economists believe that the cycle of falling risk premiums
and rising leverage is the major cause of economic fluctuations. Hyman
Minsky, an economics professor from Washington University in St.
Louis, formulated the “financial instability hypothesis,”6in which he
believed long periods of economic stability and rising asset prices drew
in not only speculators and “momentum” investors but also swindlers
who engage in Ponzi schemes that trap ordinary investors who wish to
ride the market’s upward breaks. Minsky’s theories never gained much
currency with mainstream economists because he did not formulate
them in a rigorous form. But Minsky had a strong impact on many,
including the late Charles Kindleberger, an economics professor at MIT
whose five editions of Manias, Panics, and Crashes: A History of Financial
Crises have drawn a large following.
Subprime Mortgages
In contrast to 1929, where rampant lending against a soaring stock mar-
ket contributed to the financial crisis, the primary cause of the 2008
financial crisis was the rapid growth of subprime mortgages and other
real estate securities that found their way into the balance sheets of very
large and highly leveraged financial institutions. When the real estate
market reversed direction and the prices of these securities plunged,
firms that had borrowed money were thrown into a crisis that sent some
into bankruptcy, others into forced mergers with stronger firms, and still
others to the government for capital to ensure their survival.7
Many investors welcomed these higher-yielding mortgage securi-
ties, believing that the Great Moderation and a Federal Reserve “safety
24 PART I Stock Returns: Past, Present, and Future
net” had significantly reduced their risks of default. But the proliferation
of these securities accelerated when the major rating agencies, such as
Standard & Poor’s and Moody’s, gave these subprime mortgages their
highest ratings. This allowed hundreds of billions of dollars of mortgage-
based securities to be marketed worldwide to pension funds, municipal-
ities, and other organizations that demanded only the highest-quality
fixed-income investments. And it also lured many Wall Street firms that
were seeking higher yields to buy, attracted by their AAA ratings.
Although some assume that the investment banks pressured the
rating agencies to give these securities investment-grade ratings so that
the banks could enlarge the pool of potential buyers, in fact these securi-
ties were rated by statistical techniques very similar to those used to
evaluate other securities. Unfortunately, these techniques were ill suited
to analyze default probabilities in a housing market where real estate
prices soared far above fundamentals.
The Crucial Rating Mistake
Figure 2-1 is a yearly plot of housing prices from the end of World War
II, measured both before and after inflation. The period from 1997
through 2006 was marked by an accelerating pace of real estate appreci-
ation, in both real and nominal terms. Over these years, nominal home
prices, as measured by the Case-Shiller Index of 20 metropolitan com-
munities, nearly tripled, and real home prices increased 130 percent,
well exceeding the increase during the 1970s and topping the previous
record-breaking increases that immediately followed World War II.
Before the housing price boom, conventional mortgages were
based on an 80 percent loan-to-market ratio, and the creditworthiness of
the borrower was important to the lender. This is because the price of an
individual home, or even the average price of homes in specific geo-
graphic regions, could fall more than 20 percent and thus impair the
value of the lender’s collateral.
But what if mortgages from many diverse localities could be bun-
dled together to form a security that would greatly reduce the risk of
local real estate fluctuations? Then the price of the underlying assets
backing the security should look more like the nominal home price
series shown in Figure 2-1, which—until 2006—showed very little
downside movement. In fact, prior to 1997 there were only three years
when the nominal national home index had declined: two of these
declines were less than 1.0 percent, and the third, from the second quar-
ter of 1990 to the second quarter of 1991, was 2.8 percent. Therefore,
CHAPTER 2  The Great Financial Crisis of 2008 25
based on postwar historical data, there would have been no period
when the nationwide real estate price index even began to approach the
20 percent decline necessary to cut into the collateral of the standard
mortgage.8, 9
Standard & Poor’s, as well as Moody’s and other rating agencies,
analyzed these historical home price series and performed the standard
statistical tests that measure the risk and return of these securities. On
the basis of these studies, they reported that the probability that collat-
eral behind a nationally diversified portfolio of home mortgages would
be violated was virtually zero. The risk management departments of
many investment banks agreed with this conclusion.
An equally important conclusion reached by this analysis was that
as long as the real estate behind the mortgage was virtually always
going to be worth more than the mortgage, the creditworthiness of the
26 PART I Stock Returns: Past, Present, and Future
Nominal and Real U.S. Home Prices 1950–2012
borrower should not be important to the lender. If the borrower defaults,
the lender can take over the property and sell it for more than the value
of the loan. The rating agencies therefore stamped “AAA” on these secu-
rities, ignoring the creditworthiness of the home buyer. This assumption
provided the impetus for the sale of hundreds of billions of dollars of
subprime and other “nonconventional” mortgages backed by little or no
credit documentation as long as the loan was collateralized by a pool of
geographically diversified mortgages.
Some rating agencies knew that the high credit ratings for these
mortgages depended on the continued appreciation and negligible
downside risk of home prices. This was illustrated by the following
exchange between an associate of First Pacific Advisors, a California-
based investment advisory firm, and the Fitch rating agency in June
2007, as reported by First Pacific CEO Robert Rodriguez:
My associate asked [Fitch], “What are the key drivers of your rating
They [Fitch] responded, FICO [credit] scores and home price appre-
ciation of low single digit or mid single digit range, as appreciation has
been for the past 50 years.
My associate then asked, “What if home-price appreciation was flat
for an extended period of time?”
They responded that their model would start to break down.
He then asked, “What if home prices were to decline 1% to 2% for an
extended period of time?”
They responded that their models would break down completely.
He then asked, “With 2% depreciation, how far up the rating’s scale
would it harm?”
They responded that it might go as high as the AA or AAA tranches.10
It should be noted that by the time this exchange took place, homes
prices had already fallen 4 percent from a year earlier, a greater decline
than any previous postwar period, so that a scenario of falling home
prices became highly likely. Yet this likelihood was not built into the
credit ratings of these securities.
As Fitch predicted in the previous exchange, as home prices
declined, the ratings of these top mortgage securities deteriorated rap-
idly. In April 2006, a few months before the peak of housing prices,
Goldman Sachs sold investors 12 mortgage bonds, of which 10 were
originally rated investment grade and 3 were rated AAA. By September
2007, seven of the original ten investment-grade tranches were down-
graded to junk status, and four were totally wiped out.11
CHAPTER 2  The Great Financial Crisis of 2008 27
The Real Estate Bubble
What should have alerted the rating agencies that the sustained increase
in housing prices could not continue can be found in Figure 2-2. The
ratio of housing prices to median family income remained in a tight
range between 2.5 and 3.1 from 1978 to 2002 but then moved sharply
higher and eventually surpassed 4.0 in 2006, nearly 50 percent above
previous levels.
But even when the price of an asset moves beyond its economic fun-
damentals, this does not guarantee that there is a “bubble.” Investors
should recognize that there could be structural changes that justify the
price rise. Indeed there have been periods in history when prices have
moved away from fundamentals but were fully justified on the basis of
changes in the economic environment. One such episode that I will
describe in Chapter 11 is the relationship between the dividend yield on
28 PART I Stock Returns: Past, Present, and Future
Ratio of U.S. Home Prices to Median Family Income 1978–2012
stocks and the interest rate on long-term Treasury bonds. Between 1871
and 1956 the dividend yield was always above the bond yield, and this
was thought to be necessary since stocks were seen as riskier than bonds.
The strategy of selling stocks when the spread narrowed and buying
them when the spread widened was profitable for many decades.
But when the United States left the gold standard, chronic inflation
began to be factored into the interest rate, and in 1957 rates rose above
the dividend yield on stocks and remained that way for more than a half
century. Those who sold stocks and bought bonds in 1957 when this
fundamental-based indicator flashed “Sell!” experienced poor returns,
as stocks proved to be a much better hedge against inflation and pro-
vided far greater returns than fixed-income investments.
In a similar vein, there were plausible reasons why real estate prices
rose above their historical relation to median family income in the early
2000s. First there were significant declines in both nominal and real inter-
est rates that made the cost of home financing extremely low. Second,
there was the proliferation of new mortgage instruments, such as sub-
prime and “full-funding” mortgages, which loaned up to—and in some
cases more than—the purchase price of the home. These mortgages
opened the door to borrowers who previously did not qualify for a loan
and greatly expanded the demand for housing. The popularity of these
full-funding mortgages was driven home by the National Association of
Realtors (NAR) when in January 2006 the NAR announced that 43 per-
cent of first-time home buyers purchased their homes with no-money-
down loans and that the median down payment was a mere 2 percent of
a median-priced $150,000 home.12
There were well-known and highly respected economists, such as
Charles Himmelberg, senior economist of the Federal Reserve Bank of
New York, Chris Mayer, director of the Center for Real Estate at
Columbia University Business School, and Todd Sinai, an associate pro-
fessor of real estate at the Wharton School, who argued that the lower
interest rates justified the high level of real estate prices.13 Some also
pointed to the boom in second homes, a factor that many thought would
persist for many years as the baby boomers entered retirement.14
But many others questioned the sustainability of the housing price
increase. Professor Robert Shiller of Yale University and his colleague
Karl Case, who developed the Case-Shiller residential housing indexes
that have become the benchmark for the profession, first warned about
the bubble of real estate in a 2003 Brookings Papers article entitled, “Is
There a Housing Bubble?”15 Dean Baker, codirector of the Center for
Economic and Policy Research in Washington, also had written and lec-
CHAPTER 2  The Great Financial Crisis of 2008 29
tured extensively about the dangers of the housing bubble in 2005 and
early 2006.16, 17 The disagreement among experts about whether a real
estate bubble actually existed should have alerted the rating agencies to
refrain from rating these securities as if there were essentially no proba-
bility that they could default.18
Regulatory Failure
Despite these warnings, regulatory bodies in general, and the Federal
Reserve in particular, did not believe the house price inflation posed a
threat to the economy, and they did not question the high ratings given
to the subprime mortgage securities. Furthermore, they did not monitor
the buildup of risky mortgage-related securities in the balance sheet of
key financial institutions. These failures leave a serious blot on the
record of the U.S. Monetary Authority.
It is especially tragic that Federal Reserve Chairman Alan Greenspan,
by far the most influential public official in economic affairs, did not warn
the public of the increasing risks posed by the unprecedented rise in hous-
ing prices. Greenspan should have been aware of the burgeoning sub-
prime debt and the potential threat that it posed to the economy since one
of his fellow governors at the Federal Reserve, Edward Gramlich, wrote
extensively about these subprime instruments and published a book enti-
tled Subprime Mortgages: America’s Latest Boom and Bust in June 2007.19
Some have maintained that the Fed lacked oversight over nonbank
financial institutions and that the impact of higher real estate prices was
outside its purview. But why then did Greenspan worry sufficiently
about the rise in stock prices a decade earlier to fashion his famous “irra-
tional exuberance” speech before the Economic Club in Washington,
D.C., in December 1996? All matters impacting the stability of the finan-
cial sector are the responsibility of the Federal Reserve, whether they
originate in banks or not. Greenspan’s lack of concern about the buildup
of risky assets in the balance sheets of financial firms was revealed when
he declared before congressional committees in October 2008 that he
was in a state of “shocked disbelief” that the leading lending institutions
did not take measures to protect shareholders’ equity against a housing
meltdown, nor had they neutralized their exposure to risk by using
financial derivatives or credit default swaps.20, 21
Although Greenspan failed to foresee the financial crisis, I do not,
contrary to others,22 hold him responsible for creating the housing bubble.
That is because the Fed’s policy of slowly raising interest rates was not the
primary force driving real estate values upward. The fall in long-term
30 PART I Stock Returns: Past, Present, and Future
interest rates, driven by slowing of economic growth, the switch from
equities to bonds in corporate pension funds, the huge buildup of reserves
in Asian countries, particularly China, and the proliferation of subprime
and full-funding mortgages, were far more important in propelling real
estate prices higher than the level of the Fed funds rate set by Greenspan
and the Federal Open Market Committee. Furthermore, the forces push-
ing real estate prices upward asserted themselves on a worldwide basis
and in currencies of nations with completely independent central banks.
For example, housing prices soared in Spain and Greece, countries whose
monetary policy was set by the European Central Bank.
Overleverage by Financial Institutions in Risky Assets
It is unlikely that the rise and fall in real estate prices and the related
mortgage-backed securities by itself would have caused either the finan-
cial crisis or a severe recession had it not been for the buildup of these
securities in the balance sheets of key financial firms. The total value of
subprime, alt-A (slightly higher-quality debt than subprime), and jumbo
mortgages reached $2.8 trillion by the second quarter of 2007.23 Even if
the price of all these securities went to zero, the loss in value would be
less than the decline in the value of technology stocks during the crash
of the dot-com boom that occurred seven years earlier. And that stock
market collapse, even when followed by the economic disruptions that
occurred after the devastating 9/11 terrorist attacks, caused only a mild
The big difference between the two episodes is that at the peak of
the tech boom, brokerage houses and investment banks did not hold
large quantities of speculative stocks whose price was set to plummet.
This is because investment firms had sold off virtually all their risky
technology holdings to investors before the dot-com bubble burst.
In sharp contrast, at the peak of the real estate market, Wall Street
was up to its ears in housing-related debt. As noted earlier, in a declin-
ing interest rate environment, investors were hungry for yield, and these
mortgage-based securities carried interest rates that were higher than
comparably rated corporate and government debt. This tempted invest-
ment banks, such as Bear Stearns, to sell these bonds to investors with
the promise of higher yield with comparable safety.24 Although many
investment banks held these bonds for their own account, their holdings
of subprime debt grew substantially when they were forced to take back
the faltering subprime funds they sold to investors because of com-
plaints that investors were not fully informed of their risks.25
CHAPTER 2  The Great Financial Crisis of 2008 31
Risks to the financial system were compounded when AIG, the
world’s largest insurance company, offered to insure hundreds of bil-
lions of dollars of these mortgages against default through an instru-
ment called the credit default swap. When the prices of these mortgages
fell, AIG had to come up with billions of dollars of reserves that it did
not have. At the same time, the investment banks that had borrowed
heavily to purchase these mortgages found that their funding had dried
up when creditors called their loans that were pledged against these
assets. The decline in the value of these real estate–related securities pre-
cipitated the financial crisis. It is likely that had investment banks held
the tech stocks on margin when prices collapsed in late 2000, a similar
liquidity crisis would have occurred at that time. But they did not.
Lending is the lifeblood, the oil that lubricates all large economies. In a
financial crisis, institutions that were once believed to be safe and trust-
worthy are suddenly viewed with suspicion. When Lehman failed, fears
spread that many other financial institutions were also in difficulty. This
prompted lenders to call their loans and cut their lines of credit at the
same time investors sold risky assets and attempted to increase the level
of “safe” assets in their portfolios.
But there is only one entity that can provide such liquidity in the
time of crisis, and that is the central bank—an institution that Walter
Bagehot, a nineteenth-century English journalist, dubbed “the Lender of
Last Resort.”26 The central bank creates liquidity by crediting reserves to
banks that either borrow from or sell securities to the central bank.
Banks can, on demand, turn these reserves into central bank notes or
“currency,” the ultimate liquid asset. In this way the central banks can
respond to a “run on a bank,” or the desire of depositors to withdraw
their deposits in the form of currency, by loaning such banks any quan-
tity of reserves against their assets, whether or not the quality or price of
these assets had declined.
The Lender of Last Resort Springs to Action
After the Lehman bankruptcy, the Fed did provide the liquidity the mar-
ket desired. On September 19, three days after the Reserve Primary Fund
announced it would break below a dollar, the Treasury announced that
it was insuring all participating money market funds to the full amount
of the investor’s balance. The Treasury indicated that it was using the
32 PART I Stock Returns: Past, Present, and Future
money in its Exchange Stabilization Fund, normally used for foreign
exchange transactions, to back its insurance plan. But since the Treasury
had only $50 billion in its fund, less than 2 percent of the assets in money
market funds, the Treasury would have had to rely on an unlimited line
of credit to the Fed to make good on its pledge. The Fed itself created a
credit facility to extend nonrecourse loans to banks buying commercial
paper from mutual funds,27 and a month later the Money Market
Investor Funding Facility was established.
On September 29, 2008, the Federal Deposit Insurance Corporation,
or FDIC, announced that it had entered into a loss-sharing arrangement
with Citigroup on a $312 billion pool of loans, with Citigroup absorbing
the first $42 billion of losses and the FDIC absorbing losses beyond that.
The Fed provided a nonrecourse loan on the remaining $270 billion of
the plan. This was followed in January by a similar agreement at about
one-third the size with Bank of America. In return, Citigroup issued the
FDIC $12 billion in preferred stock and warrants. On September 18 the
Fed entered into a $180 billion swap arrangement with leading world
central banks to improve liquidity within the global financial markets.
In addition to the money market mutual fund guarantees announced
immediately following the Lehman bankruptcy, the FDIC announced on
October 7 an increase in deposit insurance coverage to $250,000 per depos-
itor, which was authorized by the Emergency Economic Stabilization Act
of 2008 that Congress had passed four days earlier. On October 14 the FDIC
created a new Temporary Liquidity Guarantee Program to guarantee the
senior debt of all FDIC-insured institutions and their holding companies,
as well as deposits in non-interest-bearing deposit accounts.28 In effect, the
government’s guarantee of senior debt effectively guaranteed all deposits
since deposits have prior claim in the bankruptcy code.
The only way the FDIC was able to guarantee the funds provided
through these policy initiatives was with the full backing of the Federal
Reserve. The FDIC does have a trust fund, but its size is a tiny fraction of
the deposits it insures.29 The credibility of the FDIC to make good on its
promises, like that of the Exchange Stabilization Fund used to “insure”
the money market accounts, depends on an unlimited line of credit that
the agency has with the Federal Reserve.
Why did the Federal Reserve and Chairman Bernanke take all these
bold actions to ensure sufficient liquidity to the private sector? Because
of the lessons that he and other economists learned from what the cen-
tral banks did not do during the Great Depression.
Every macroeconomist has studied the 1963 work The Monetary
History of the United States written by the University of Chicago Nobel-
CHAPTER 2  The Great Financial Crisis of 2008 33
winning economist Milton Friedman. His research built a damning case
against the Federal Reserve for failing to provide reserves to the banking
system during the Great Depression. It was certain that Ben Bernanke,
who received his Ph.D. in economics with a specialty of monetary theory
and policy at the Massachusetts Institute of Technology, was acutely
aware of Friedman’s research and was determined to avoid repeating
the Fed’s mistakes.30 In a speech delivered at Milton Friedman’s nineti-
eth birthday celebration in 2002, six years before the financial crisis,
Bernanke, addressing Professor Friedman, said, “Regarding the Great
Depression. You’re right, we did it. We’re very sorry. But thanks to you,
we won’t do it again.”31
Should Lehman Brothers Have Been Saved?
Although the Federal Reserve sprang into action following the demise of
Lehman Brothers, economists and policy analysts will debate for years
whether the central bank should have bailed out the ailing investment
bank in the first place. Despite denials by the Federal Reserve that it did
not have full legal authority to rescue Lehman, the facts dictate other-
wise. In 1932 Congress amended the original Federal Reserve Act of
1913 by adding Section 13 (3), which stated:
In unusual and exigent circumstances, the Board of Governors of the
Federal Reserve System, by the affirmative vote of not less than five mem-
bers, may authorize any Federal reserve bank, during such periods as the
said board may determine, . . . to discount for any individual, partnership,
or corporation, notes, drafts, and bills of exchange when [they] are
secured to the satisfaction of the Federal Reserve bank: Provided, that
before discounting . . . the Federal Reserve bank shall obtain evidence that
such individual, partnership, or corporation is unable to secure adequate
credit accommodations from other banking institutions.32
There is no doubt that on the weekend before Lehman Brothers
declared bankruptcy, it qualified for Fed lending, as Lehman was clearly
“unable to secure adequate credit accommodations from other banking
The reason that the Fed did not bail out Lehman was more about
politics than economics. Earlier government bailouts of Bear Stearns,
Fannie Mae, and Freddie Mac garnered considerable criticism from the
public and particularly Republicans. After the March bailout of Bear
Stearns, the word went out from the Bush administration: “No More
Bailouts.” Secretary of Treasury Henry Paulson told Lehman Brothers
34 PART I Stock Returns: Past, Present, and Future
shortly after the Bear bailout that it should get its house in order and that
it should not expect help from the Fed. Just days before Lehman filed,
the Fed had rejected a $40 billion loan request from the firm. Treasury
Secretary Paulson and the Fed hoped that with so much advance notice,
a Lehman failure would be digested by the financial markets without
significant disruption.33
But the truth of the matter was that in March when Treasury warned
Lehman to clean up its balance sheet, it was already too late. Lehman not
only had borrowed heavily to buy subprime mortgages but had recently,
with the Bank of America, lent $17 billion to Tishman Speyer to buy the
Archstone-Smith Trust for $22.2 billion. Lehman was hoping to sell the
debt to new buyers for hefty fees, much as Blackstone did when it sold
Sam Zell’s properties at the peak of the market. But Lehman was left with
$5 billion in unsold real estate in what some describe as the worst deal
Lehman Brothers ever made.34 Although CEO Richard Fuld continued to
insist that Lehman was solvent, traders knew that because of the falling
real estate market, Lehman had little chance to survive. The path to bank-
ruptcy had been irrevocably set after Lehman plunged into mortgage-
related securities and the overheated property market.
The Fed’s decision to bail out AIG was necessitated by the unex-
pected financial chaos that immediately followed the Lehman bank-
ruptcy. The Fed and the Treasury, shocked by investors’ sudden rush to
cash and the surging risk premiums in international money markets,
believed that another bankruptcy that threw hundreds of billions of dol-
lars of bonds and credit default swaps into question would likely bring
down the global financial system. Despite the fact that AIG, as an insur-
ance company, was arguably further from the Federal Reserve’s sphere
of responsibility than Lehman, the Fed saved the insurance giant.35 I
have little doubt that had AIG failed first, the ensuing financial panic
would have forced the Fed to bail out Lehman the next day.
TARP, or the Troubled Asset Relief Program, described in detail in
the next chapter, was not at all essential in staving off the financial crisis.
That is because all the funds authorized by TARP, and even more, could
have been supplied by the Federal Reserve under existing legislation
without Congressional approval. TARP was pushed by Bernanke and
Paulson to gain political cover. They knew that the bailouts would be
very unpopular, and they wanted Congress to approve the actions that
they had taken.
Fed historian Allan Meltzer, an economics professor at Carnegie-
Mellon University, claimed that the Fed blundered by setting up expec-
tations that it would bail out systemic institutions, such as Bear Stearns,
CHAPTER 2  The Great Financial Crisis of 2008 35
whose failure threaten the financial system, but then standing aside and
letting Lehman collapse.36 This is echoed by Charles Plosser, president of
the Federal Reserve Bank of Philadelphia, who believed that a Bear
Stearns failure in March could have been absorbed by the market and
would have prompted other firms to increase their liquidity, stemming
further damage.
But I believe that it is far more likely that had Bear been allowed to
fail, it would have greatly accelerated the run on Lehman, precipitating
the crisis in March rather than September. It is inconceivable that finan-
cial firms took the Fed’s rescue of Bear Stearns as a signal to “lever up”
with more risky assets because the Fed would rescue those firms in trou-
ble. It should be noted that even the “rescue” of Bear meant breaking up
the firm and giving shareholders a tiny fraction of their book value. The
owners of AIG are still litigating the near total takeover of the insurance
giant by the federal government when it was rescued from certain bank-
ruptcy. In 2008, it was already too late for regulators to stem the crisis.
Regulators needed to take action years earlier, when the rating firms
were stamping AAA on subprime mortgages and banks, seeking higher
yields, began to increase their leverage in these securities.
Reflections on the Crisis
The overleveraging that took place prior to the financial crisis was moti-
vated by the decline in risk that took place during the long period of
financial stability that preceded the financial crisis, the misrating of
mortgage-related securities by the rating agencies, the approval by the
political establishment of the expansion of homeownership, and the lack
of oversight by critical regulatory organizations, particularly the Federal
Reserve. But it was the management of many of these financial firms
who should be held most accountable. They were unable to grasp the
threats that would befall their firms once the housing boom ended, and
they abdicated responsibility for assessing risks to technicians running
faulty statistical programs.
The financial crisis also punctured the myth that grew during
Greenspan’s tenure as Fed chairman that the Federal Reserve could fine-
tune the economy and eliminate the business cycle. Nevertheless,
despite having failed to see the crisis brewing, the Federal Reserve acted
quickly to assure liquidity and prevented the recession from becoming
far more severe than it turned out to be.
The financial crisis of 2008 is illustrated by the following analogy.
There is no doubt that the improvements in engineering have made the
36 PART I Stock Returns: Past, Present, and Future
passenger car safer than it was 50 years ago. But that does not mean that
the automobile is safe at any speed. A small bump on the road can flip the
most advanced passenger car speeding 120 mph today just as surely as
an older model traveling 80 mph. During the Great Moderation, risks
were indeed lower, and financial firms rationally leveraged their balance
sheets in response. But their leverage became too great, and all that was
needed was an unexpected increase in the default rate on subprime mort-
gages—that “bump on the road”—to catapult the economy into a crisis.
CHAPTER 2  The Great Financial Crisis of 2008 37
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The Markets, the Economy,
and Government Policy in
the Wake of the Crisis
You don’t ever want a serious crisis to go to waste. It’s an opportu-
nity to do important things that you otherwise couldn’t get done.
The credit shock, sharply falling real estate prices, and plunging stock
markets precipitated the deepest recession in the developed world
economies since World War II. In the United States, real GDP declined
4.3 percent from the fourth quarter of 2007 through the second quarter of
2009, eclipsing the previous record of 3.1 percent during the 1973–1975
recession by a wide margin. The 18-month recession, which lasted from
December 2007 to June 2009, was also the longest since the 43-month
Great Depression of the early 1930s as unemployment reached 10.0 per-
cent in October 2009. Although this was 0.8 percentage points below the
record postwar level of 10.8 percent set in November 1982, the jobless
rate remained above 8 percent for three years, more than twice as long as
the 1981–1982 recession.
As Figure 3-1 shows, though the crisis originated in the United
States, the decline in U.S. GDP was less than in most of the developed
world: output declined 9.14 percent in Japan, 5.50 percent in the
Eurozone, and 6.80 percent in Germany, Europe’s largest economy.
Canada, whose banks never became as overleveraged in real estate
assets as in the United States, experienced the mildest downturn.
Figure 3-1 also shows that the emerging economies withstood the
economic shock much better than the developed world; real GDP
growth slowed but did not decline in fast-growing countries such as
China and India. For emerging economies as a whole, GDP declined
only 3 percent; and by the second quarter of 2009, their output had sur-
passed their previous high. In contrast, it was not until the end of 2011
that the United States regained the output lost, while Japan just
reached its peak output by the end of 2013 while Europe was still
below its peak.
40 PART I Stock Returns: Past, Present, and Future
International Comparisons of GDP Through the Financial Crisis and Great Recession (2007 Q4 = 100)
Despite the severity of the Great Recession, its depth in no way com-
pares with the decline in economic activity that occurred during the
Great Depression of the 1930s. Real GDP in the United States fell 26.3
percent between 1929 and 1933, more than 5 times the decline in the
Great Recession, and unemployment soared to between 25 and 30 per-
cent.1, 2 One reason for the difference between the Great Depression of
1929–1933 and the Great Recession of 2007–2009 was the behavior of the
price level. Consumer prices declined by 27 percent between September
1929 and March 1933, while the maximum decline of the consumer price
index during the Great Recession was 3.5 percent.3By March 2010, the
CPI surpassed its precrisis peak, while it took 14 years for consumer
prices to recover to their 1929 level following the Great Depression.
Deflation worsens a business cycle, since a fall in wages and prices
increases the burden of debt, which increases in real value as prices
decline. Consumers were already burdened by record debt levels in 2007
before the financial crisis. Had wages and prices fallen as they did in the
Great Depression, the burden of consumer and mortgage debt would
have been more than one-third larger in real terms, greatly increasing
the number of insolvencies.4That is the reason that stabilization of the
price level was a priority for the Federal Reserve and is a major reason
why consumer and business spending did not decline as much in the
2007–2009 recession compared with what happened in the 1930s.5
The Federal Reserve was able to avoid deflation by stabilizing the
money supply. In the Great Depression, the money supply, measured as the
sum of demand and savings deposits (M2), fell by 29 percent between
August 1929 and March 1933.6In contrast, the money supply actually rose
during the 2008 financial crisis as the Federal Reserve increased the total
reserves by over $1 trillion. This action provided sufficient reserves so that
banks were not forced to call in loans as they were forced to in the 1930s.
Although one can certainly question whether the later injections of reserves
(called quantitative easing) aided the economy, there was little doubt that the
initial provisions of liquidity were critical to stabilizing the financial mar-
kets and preventing the downturn from becoming substantially worse.
Despite the actions taken by the Federal Reserve to moderate the eco-
nomic contraction, the credit disruption that followed the Lehman bank-
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 41
ruptcy had a devastating impact on the equity markets, which suffered
their worst decline in 75 years. In the 9 weeks following September 15, the
S&P 500 Index fell 40 percent to an intraday low of 740 on November 21.
Ultimately this broad-based benchmark sank to a 12-year low of 676 on
March 9, 2009, nearly 57 percent below its closing peak reached 1½ years
earlier. Although the decline in the benchmark index exceeded the previ-
ous postwar record of 48 percent that occurred between January 1973 and
October 1974, it did not approach the decline that ushered in the Great
Depression, when stocks fell by more than 87 percent.7From the market
high of October 2007 through March 2009, U.S. stock market wealth had
declined $11 trillion, a sum of more than 70 percent of U.S. GDP.
The volatility of stock prices increased sharply, as it always does in
bear markets. The VIX volatility index, which measures the premium
built into put and calls on the stock market (in effect measuring the cost
of “insuring” a stock portfolio), soared from under 10 in March 2007,
before the crisis began, to nearly 90 immediately following the Lehman
bankruptcy. This level exceeded any other in the postwar period except
that immediately following the October 19, 1987, stock market crash.8
Another measure of volatility, the number of days that the stock
market rose or fell by 5 percent or more, increased sharply to levels not
reached since the early 1930s. Between the Lehman bankruptcy on
September 15 and December 1, there were 9 days when the Dow
Industrials dropped by at least 5 percent and 6 days when it rose by 5
percent or more. Except for the 1930s when a record 78 days saw
changes of 5 percent or more, these 15 days of changes of 5 percent or
more exceeded the total for any other decade since 1890.9
The plunge in the U.S. equity markets was echoed abroad. Around
the world, approximately $33 trillion of stock market wealth was lost,
about half the world’s annual GDP.10 In local currency, the Morgan
Stanley EAFE Index for non-U.S. developed markets declined by nearly
the same magnitude as in the United States, but because the dollar appre-
ciated during the period, the total decline was 62 percent in dollar terms.
The emerging market stocks fell 64 percent in dollar terms, although they
fell less in the local currency as the currencies of almost all emerging mar-
kets, except for the Chinese yuan, depreciated against the dollar.11
The decline in the emerging stock markets was nearly identical to
the decline suffered during the Asian financial crisis in 1997–1998. But
the emerging market indexes at their 2009 lows remained well above the
levels reached at the bottom of the 2002 bear market. This contrasted
with the United States and most other developed markets that fell below
their 2002 bear market lows.
42 PART I Stock Returns: Past, Present, and Future
Certain equity sectors that held up well in the early stages of the
market decline fell sharply as credit markets froze. Real estate invest-
ment trusts (REITs) are a case in point. Buying them for their yield,
investors at first flocked to these stocks as interest rates fell and REITs
actually rallied in the week after Lehman went under. But when
investors feared that lenders would pull credit lines, REITs lost on aver-
age an astounding two-thirds of their value in the next 10 weeks and fell
a total of 75 percent by the time the bear market ended in March 2009.
Real estate trusts that were funded by short-term loans or that took on
extra leverage during the boom in an effort to boost yields to investors
were hit particularly hard.12
The financial sector of the S&P 500 declined 84 percent from its
peak in May 2007 to its trough in March 2009, wiping out about $2.5 tril-
lion of equity. The percentage decline exceeded the 82.2 percent decline
in the S&P 500 technology sector that occurred from 2000 to 2002, but
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 43
The S&P 500 and the LIBOR—Fed Funds Spread Through the Financial Crisis, January 2007 – June 2013
since the tech sector had valuations at the peak more than three times
that of the financial sector, the equity values lost in the tech crash were a
much higher $4 trillion.13 Nevertheless, while the tech crash wiped out
the previous 5 years of total stock market gains, the financial crisis
wiped out 17 years, sending equity prices down to 1992 levels.
Many financial firms declined much more than the 84 percent aver-
age for the sector. Peak to trough, Bank of America lost 94.5 percent of the
market value of its equity, Citibank lost 98.3 percent, and AIG lost an
astounding 99.5 percent.14 The equity holders of Lehman Brothers,
Washington Mutual, and a large number of smaller financial institutions
lost everything, while shareholders of Fannie Mae and Freddie Mac, the
giant government-sponsored enterprises that went public in the early
1980s, hold on to a sliver of hope that they might recover some of their
capital.15 Many international banks fared just as poorly as U.S. banks.
From peak to trough, Barclays fell 93 percent, BNP Paribas 79 percent,
HSBC 75 percent, and UBS 88 percent. The Royal Bank of Scotland, which
needed a loan from the Bank of England to survive, fell 99 percent.
The percentage fall in the S&P 500 Index exceeded the decline in
operating earnings of firms in the index. S&P 500 operating earnings
declined 57 percent from a record $91.47 in the 12 months ending on
June 30, 1997, to $39.61 in the 12 months ending September 30, 2009. But
the decline in reported earnings was much greater: as a result of the
record $23.25 loss for S&P 500 firms in the fourth quarter of 2008, the S&P
500 12-month reported earnings fell from a high of $84.92 in 1997 to only
$6.86 for the 12 months ending March 31, 2009. This 92 percent decline in
earnings exceeds the 83 percent decline in earnings that took place in the
Great Depression from 1929 through 1932.16
The huge write-downs by the financial firms were the main cause
of the devastating earnings drop of the S&P 500 in 2008 and 2009. When
calculating earnings on the S&P 500 Index, it is the policy of Standard &
Poor’s to sum all the profits and losses of each firm dollar for dollar and
to compare the aggregate earnings with the aggregate value of the S&P
500 portfolio in order to compute the P/E ratio of the index. The $61 bil-
lion fourth-quarter 2008 loss of AIG, which had a weight of less than 0.2
percent in the index, more than wiped out the total profits of the 30 most
profitable firms in the S&P 500, which composed almost half the index
value. S&P’s method of aggregating firms’ earnings dollar for dollar
understates the earnings and vastly overstates the P/E ratio of the index
during recessions when a few firms report very large losses.17 In fact,
after-tax aggregate corporate profits taken from the national income and
44 PART I Stock Returns: Past, Present, and Future
product accounts fell by only 24 percent for the 12-month period ending
in June 30, 2007, to the year ending March 31, 2009.
Real Estate
I noted that the buildup of real estate and real estate–related assets in the
portfolios of highly leveraged financial institutions was the primary
cause of the financial crisis. The Federal Reserve reported in its quarterly
Flow of Funds Report that from the third quarter of 2007 through the
first quarter of 2009, the value of residential real estate fell from $24.2
trillion to $17.6 trillion, a decline of 27 percent. The price index of resi-
dential real estate declined by 26 percent as measured by the Case-
Shiller Index of 20 metropolitan areas,18 and commercial real estate
prices fell by 41 percent from October 2007 through November 2009.19
Fluctuations in real estate prices have a significant impact on the
economy. It has been estimated that consumers spent between 25 and 30
percent of the home equity borrowings during the real estate boom
between 2002 and 2006.20 Given that such borrowings averaged 2.8 per-
cent of GDP, the spending boost powered by the rise in home equity val-
ues contributed about a ¾ percentage point, or one quarter of the annual
growth rate of the U.S. economy during that period. After 2008, the fall
in real estate prices reduced consumption and contributed significantly
to the slow recovery from the Great Recession.
Treasury Bond Markets
After the Lehman bankruptcy, the rush to safety sent the yield on
Treasury bills to zero and even lower. On December 4, 2008, the 90-day-
bill rate fell to an all-time low of minus 1.6 basis points.21 The huge
demand for Treasury securities extended to the long end, as the 10-year
U.S. Treasury notes fell to near 2 percent at the end of 2008. The yield on
Treasury long bonds continued to fall for four more years, with the 10-
year bond reaching its low of 1.39 percent in July 2012.
During the crisis, the Federal Reserve not only provided liquidity
to the markets but also sharply lowered the fed funds rate. The Fed low-
ered the funds target rate from 2 to 1.5 percent in an emergency meeting
on October 23, 2008 and lowered it further to 1 percent at its regular
November meeting. On December 16, as conditions continued to
worsen, the Federal Open Market Committee reduced the federal funds
rate to an all-time low of between zero and 0.25 percent; and at the end
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 45
of 2013, the funds rate remains at this level, the longest period since
World War II that the rate has remained unchanged.
Even though the Federal Reserve guarantees on bank deposits and
money market funds stopped the liquidity panic, the Fed could not pre-
vent the shock waves that reverberated through the credit markets.
While long-term Treasury rates fell substantially, interest rates on non-
Treasury debt rose. The spread between the lowest investment-grade
corporate bond and the 10-year Treasury reached 6.1 percent in
November 2008, the highest since the record 8.91 percent spread in May
1932 that was reached near the bottom of the Great Depression. The
spread between lower-rated 30-year B-rated industrial bonds and
Treasury bonds widened from 4 percentage points to nearly 8 percent-
age points after the rescue of Bear Stearns and to a record 15.1 percent-
age points in the first week of January 2009.
The LIBOR Market
One of the most watched spreads in the money market is that between
the rate set by the Federal Reserve in the fed funds market (a market to
facilitate the borrowing and lending of reserves between U.S. banks) and
the interbank lending rates outside the United States, called the London
Interbank Offered Rate, or LIBOR.
There are literally hundreds of trillions of dollars of loans and finan-
cial instruments around the world that are based on the LIBOR, includ-
ing almost one-half of all adjustable-rate mortgages. The history of the
LIBOR goes back to the 1960s, when the market for overseas dollar lend-
ing grew dramatically after the U.S. government put restrictions on dol-
lar outflows in a futile attempt to reverse its balance-of-payments deficit
and staunch its gold outflow. The LIBOR rate is computed for 15 time
periods from one day to one year in duration and for 10 different curren-
cies. By far, the dollar LIBOR is the most important of these fixings.
Return to Figure 3-2. Before the financial crisis, the LIBOR stayed
very close (usually within 10 basis points) to the federal funds target. The
first rumblings of trouble in the banking sector came in August 2007 when
the LIBOR–fed funds spread jumped above 50 basis points in response to
the BNP Paribas announcement of stopping fund redemptions and the
problems at Northern Rock in the United Kingdom. Over the next 12
months, as the subprime crisis grew, the LIBOR-funds spread remained
mostly between 50 and 100 basis points. But the LIBOR spread soared
after the Lehman bankruptcy, and on October 10 the difference between
the LIBOR and the fed funds rate reached an unheard-of 364 basis points.
46 PART I Stock Returns: Past, Present, and Future
It was extraordinarily frustrating to policy makers that the interest
rate upon which so many loans were based actually rose at the same
time the Fed was aggressively lowering the fed funds rate. After the
Federal Reserve flooded the financial system with reserves, the LIBOR
spread finally came down, but it did not fall decisively under 100 basis
points until the stock market began to recover from its bear market low
in March 2009, three months before the National Bureau of Economic
Research called the recession over.
For all its importance in setting loan rates, the LIBOR does not rep-
resent actual transactions but what a bank expects the cost of its own
noncollateralized borrowing to be, even if it does not borrow any funds.
Following the Lehman crisis, fears for the solvency of banks skyrock-
eted, and the interbank lending market between banks effectively froze.
But banks were still obligated to submit LIBOR rates to the British
Bankers Association although they had little actual data on which to
base such submissions. Mervyn King, governor of the Bank of England,
told the U.K. Parliament in November 2008 that “[the LIBOR rate] is, in
many ways, the rate at which banks do not lend to each other.”22
Many regulatory agencies, in both the United States and United
Kingdom, strongly suspected that several banks underreported their
cost of borrowing to avoid signaling to the market that creditors feared
for their solvency. Nevertheless, it was not until July 2012 that the British
government announced that it had fined Barclays bank $453 million for
submitting false interbank interest rates and intimated that other banks
also submitted false rates.23 The outcry over the scandal raised the call to
reform this multitrillion-dollar market, an effort that would require a
total restructuring of the way this benchmark rate is calculated or a shift
to alternative instruments.
Commodity Markets
In the early stages of the subprime crisis, the prices of commodities rose
rapidly as the emerging economies continued to grow strongly. Oil
(West Texas Intermediate) rose from $40 a barrel in January 2007 to an
all-time high of $147.27 in July 2008, and the Commodity Research
Bureau Index of 18 actively traded commodities rose by over 60 percent.
But following the Lehman crisis, the decline in economic activity sent
commodity prices down sharply. Oil fell to $32 a barrel in December, and
the CRB Index fell by 58 percent to its lowest level since 2002.
It is remarkable that the commodity price decline measured by the
CRB Index was almost the same magnitude as the decline in world stock
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 47
markets. Investors who believed that commodities provided them a
hedge against a severe stock market decline were wrong. As we explore
later in this chapter, virtually no asset, except for long-term U.S.
Treasury bonds, served as an effective hedge against the sudden and
sharp decline in asset values that took place during the financial crisis.
Even gold, which had peaked just below $1,000 per ounce in July 2008,
fell below $700 after the Lehman bankruptcy.
Foreign Currency Markets
After hitting a 15-year high in the summer of 2001, the dollar declined
steadily against the currencies of the major developed countries and
continued to do so in the early stages of the financial crisis. In the imme-
diate wake of the Bear Stearns merger into JPMorgan, the dollar reached
its all-time low on March 17, 2008, a full 23 percent below its precrisis
high in November 2005 and 41 percent below its 25-year high reached in
2001. But as the financial crisis worsened, the dollar regained its “safe-
haven” status, and foreign investors switched back to dollar securities.
This caused the greenback to rise by over 26 percent against developed
world currencies, reaching its high on March 4, 2009, just a week before
the U.S. equity market reached its bear market low. Only the Japanese
yen advanced against the dollar during the financial crisis, as the market
tumult caused investors to unwind their “carry trade,” the name given
to the strategy of borrowing from Japan at the world’s lowest interest
rates in order to invest in riskier, higher-yielding currencies elsewhere.
As the crisis eased and the equity markets began to recover, the dollar
lost some of its safe-haven premium, and its price fell.
Impact of the Financial Crisis on Asset Returns and Correlations
One of the principal conclusions of financial theory is that to attain the
best return for a given risk, investors should seek to diversify their hold-
ings not only within an asset class but also among asset classes. For that
reason investors put a premium on assets whose prices are negatively
correlated with the market, and discount assets that are positively corre-
lated with the market.
Figure 3-3 shows the correlations of various asset classes with the S&P
500 over all five-year windows from 1970 through 2012. One can see that
the financial crisis had a significant impact on the correlation between asset
classes, in most cases accelerating trends that had taken place before the
crisis. The correlation between both developed economies’ equity markets
48 PART I Stock Returns: Past, Present, and Future
(EAFE) and emerging economies’ equity markets (EM) with the U.S. stock
market has grown significantly, reaching 0.91 for EAFE and 0.85 for EM.
There are good economic reasons why the correlation between
stock markets has become greater over recent years. First, there is an
increase in the economic interdependence as world trade constitutes an
ever-greater share of world output. The second is that traders and
investors operate in many different markets simultaneously so that
market sentiment is much less likely to be isolated to a given market.
And third, most of the shocks to the financial and commodity markets
since 2008 have been global in nature, overwhelming idiosyncratic
shocks that impact one country or one market.
Not only has the correlation between equity markets increased, but
Figure 3-3 shows the correlation between the equity markets and com-
modities, measured by either the CRB Index of commodity prices or the
price of oil, has increased sharply since the financial crisis.24 Commodity
prices are impacted by demand factors, such as the growth in the world
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 49
Monthly Correlations of S&P 500 and Various Assets Classes from 1970–2012
economy, and supply factors, such as weather (for crops) and political
developments (for oil). Fluctuations in demand cause a positive correla-
tion between stock prices and commodity prices, while fluctuations in
supply induce a negative correlation. If the major source of disturbances
to the price of commodities arises from supply fluctuations, then hold-
ing commodities will serve as a good hedge against stocks. But when
global demand shocks predominate, then commodity prices will move
in tandem with stock prices, and commodities will serve as poor diver-
sifiers against equity fluctuations.
There are good reasons why the correlation between commodity
and equity prices may continue to be high. Recent developments in the
energy markets mean that OPEC is not likely to have as great an impact
on the supply of oil as in the past. Alternative sources of oil and gas from
non-OPEC countries arising from shale exploration, fracking, and other
extractive techniques are becoming more important. These develop-
ments mean that fluctuations in demand may take an upper hand in
determining the price of energy, leading to a positive correlation
between stock and commodity prices. And this means that commodities
will likely decline as an effective hedge against stocks.
Some argue that the increased correlation between world stock mar-
kets reduces or even eliminates the incentive to diversify one’s portfolio.
If international stocks move in tandem, the proponents of the argument
maintain, then investing in foreign markets will do little to offset the fluc-
tuations in one’s home market. But correlations are usually calculated
over relatively short periods of time, say one week or one month. Long-
term correlations between asset returns are significantly lower than
short-term correlations. This means that long-term investors should con-
tinue to diversify even though such diversification does not lead to sig-
nificant reductions in the short term volatility of portfolio returns.
Decreased Correlations
In contrast to commodities, which have increased their correlation with
stocks since the financial crisis, there are two notable asset classes whose
returns have become significantly less correlated with equities: U.S.
Treasury bonds and the U.S. dollar.
The price of a dollar in foreign exchange markets is impacted by the
strength of the U.S. economy and the safe-haven status that international
investors accord the U.S. dollar. The first factor leads to a positive corre-
lation between U.S. equities and the exchange rate: good or bad news
50 PART I Stock Returns: Past, Present, and Future
about the economy will impact stock prices and the exchange rate in the
same direction.
But the safe-haven status of the U.S. dollar leads to the opposite
correlation: bad economic news, particularly emanating from outside
the United States, will elicit a flight to the dollar, raising its value at the
same time that the news sends world and U.S. stock prices lower. Since
the onset of the financial crisis and particularly the European monetary
crisis, the safe-haven status of the U.S. dollar has increased dramatically.
Bad news about Europe negatively impacts world stock markets but
drives the euro downward and therefore the dollar higher in exchange
markets. The European crisis has led to a record negative correlation
between the U.S. dollar and U.S. stocks, as seen in Figure 3-3.
U.S. Treasury bonds have also enjoyed enhanced safe-haven status
since the financial crisis. Bad news, originating either within or outside
the United States, has prompted investors to purchase Treasury bonds
and has led to a strong negative correlation between Treasury bond
prices and stock prices. This negative correlation enhances the attrac-
tiveness of Treasury bonds to investors wishing to hedge their equity
portfolios and has no doubt supported the high prices and correspond-
ingly low yields on long-term U.S. Treasury securities during and imme-
diately following the financial crisis.
The ability of long-term U.S. Treasury bonds to hedge equity risk is
even stronger for the non-dollar-based investor. For non-dollar investors,
bad news increases the demand for dollar-denominated assets and in
particular Treasury bonds. This leads to an even higher negative correla-
tion of U.S. Treasury bonds and stock markets measured in non-dollar
currencies. Long-term Treasuries have de facto become the world’s ulti-
mate “hedge” asset, and this explains why so many sovereign wealth
funds hold a high percentage of their assets in Treasury bonds despite
their very low yields and expected returns.
The single asset class whose correlation with the equity markets has
not been impacted by the financial crisis is gold. The rise in the price of
gold after the financial crisis has been caused by the increased fear of
hyperinflation and financial collapse, but the correlation with the equity
markets has remained near zero over the past 50 years. By early 2013 the
price of gold had increased markedly since 2008, although it never was
as high, after inflation, as it was at the top of the 1980 bubble when it
reached $850 per ounce, or $2,545 in 2013 prices.
The positive correlations of equity markets with commodities and
oil and the negative correlation with Treasury bonds and the dollar have
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 51
given rise to the term risk-on/risk-off market. A risk-on market occurs
when good news about the economy entices investors to buy stocks and
go long commodities and sell the U.S. dollar and Treasury bonds. In
such markets, stocks and commodity prices rise while U.S. Treasury
bond prices and the dollar fall. Risk-off markets are the opposite, where
bad economic news entices investors to buy U.S. Treasuries and the dol-
lar while selling commodities and stocks. Gold prices can either rise or
fall on these days.
But as Figure 3-3 shows, the correlation between asset classes has
not been stable. In particular, the correlation between stock prices and
Treasury bonds in the 1970s and 1980s was positive, not negative. This is
because the major threat to the economy in those years was inflation,
and lower inflation was good for both stocks and bond prices. It is only
when inflation is not a threat and the financial stability of the private sec-
tor is in question that the Treasury bonds take on safe-haven status and
become negatively correlated with equity prices.
Certainly under current monetary policy, the risk that inflation will
once again be a concern for policy makers is high. In that situation,
Treasury bonds will cease to be a hedge asset, and bond prices could fall
substantially since investors will require much higher yield for an asset
that no longer acts as a diversifier to the equities in their portfolios. The
unprecedented bull market in Treasury bonds, supported by the belief
that Treasury bonds are “insurance policies” in the case of financial col-
lapse, could end as badly as the bull market in technology stocks did at
the turn of the century. When economic growth increases, Treasury
bondholders will receive the double blow of rising interest rates and loss
of safe-haven status.
One of the prime lessons learned from long-term analysis is that no
asset class can stay permanently detached from fundamentals. Stocks
had their comeuppance when the technology bubble burst and the
financial system crashed. It is quite likely that bondholders will suffer a
similar fate as the liquidity created by the world’s central banks turns
into stronger economic growth and higher inflation.
Legislative Fallout from the Financial Crisis
Just as the Great Depression generated a host of legislation such as the
Securities and Exchange Act, which created the SEC, the Glass-Steagall
Act, which separated commercial and investment banks, and establish-
ment of the Federal Deposit Insurance Corporation, the financial crisis of
2008 spurred legislators to design laws to prevent a repeat of the financial
52 PART I Stock Returns: Past, Present, and Future
collapse. The result was embodied in a massive 849-page piece of legisla-
tion crafted by Senator Christopher Dodd (D-Conn) and Representative
Barney Frank (D-Mass), called the Dodd-Frank Wall Street Reform and
Consumer Protection Act, which was signed into law by President
Obama in July 2010. The act’s powers range from establishing the fees for
debit cards, to setting the regulations of hedge funds, restricting “preda-
tory lending,” addressing compensation of CEOs and other employees,
and formulating measures designed to stabilize the economy and finan-
cial system. The act comprises 16 titles and requires that regulators create
243 rules, conduct 67 studies, and issue 22 periodic reports.25
The three most important parts of the law that impact the overall
economy are (1) the “Volcker rule,” which limits the proprietary trading
of commercial banks, (2) Title II, which provides for the liquidation of
large financial firms not under the purview of the Federal Deposit
Insurance Corporation, and (3) Title XI, which adds responsibilities but
also places new restrictions on the Federal Reserve.
The Volcker rule was named after Paul Volcker, former chairman of
the Federal Reserve and chair of President Obama’s President’s
Economic Recovery Advisory Board, who argued that financial stability
required that Congress sharply limit the ability of banks to trade for
their own accounts. Such a provision was not in the original bill submit-
ted to Congress but inserted later. Originally the Volcker proposal
specifically prohibited a bank or an institution that owns a bank from
engaging in proprietary trading that is not at the behest of its clients and
from owning or investing in a hedge fund or private equity fund.
However, this proposal was later modified to allow up to 3 percent of
the capital of banks to go into proprietary trading and exempts hedging
operations as well as trading in U.S. Treasury debt. The Volker rule was
designed to restore the separation between investment banks and com-
mercial banks that was first mandated by the Glass-Steagall Act of 1933
but was effectively repealed by Congress in 1999 in the Gramm-Leach-
Bliley Act.
But would the Volcker amendment, had it been law in 2007, have
prevented the 2008 financial crisis? The financial crisis was caused by
the overleveraging of real estate–related securities in Bear Stearns and
Lehman Brothers, which were investment banks and would not have
fallen under the purview of the Volcker amendment. Nor would it have
applied to the insurance giant AIG, which the Fed chose to save after
seeing the turmoil unleashed by the Lehman bankruptcy. Furthermore,
banks that obtained loans from the Fed, specifically Citibank and Bank
of America, ran into trouble because of bad real estate loans, not propri-
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 53
etary trading. Given this history, it is dubious that the Volcker amend-
ment, had it been in effect in 2007, would have changed the course of the
financial crisis.
Title II of the Dodd-Frank Act permits the government to dismantle
expeditiously financial firms that become a threat to the stability of the
financial system in order to minimize the risk of a financial crisis.
Although the Federal Deposit Insurance Corporation has rules for the
liquidation of commercial banks and the Securities Investor Protection
Corporation has powers to liquidate the assets of brokerage houses, the
government had no guidelines for dismantling investment banks, such
as Bear Stearns and Lehman, nor insurance companies such as AIG.
Under the usual bankruptcy laws, a determination of order of claims
may take months or years, far too long to calm the waters in a crisis.
Title II specifies that financial firms submit to the government the
order that assets should be liquidated if a firm cannot meet its financial
obligations and prohibits the government from taking equity positions
in the firm being dismembered. The law also specifies measures to avoid
exposing taxpayers to undue losses that can be absorbed by other credi-
tors to the firm. This part of the bill would have prohibited the Federal
Reserve taking the equity stakes that it did in AIG, Citibank, or any other
financial firm.
Title XI restricts the actions of the Federal Reserve by basically abol-
ishing the Section 13(3) amendments to the Federal Reserve Act that
gave the central bank virtually unlimited power to lend to any financial
firm in crisis. Under the new law, the Federal Reserve cannot lend to
individual firms, although it can use its powers to provide broad-based
liquidity to the financial system as long as it gets the approval of the sec-
retary of treasury. Furthermore the act requires that the Federal Reserve
disclose which financial firms are receiving assistance within seven days
of authorizing an emergency facility.26
Whether these restrictions prove to be detrimental in the next finan-
cial crisis remains to be seen. Most of these restrictions were inserted to
buy Republican support for passage of the bill, since a vast majority of
Republicans opposed both the Fed’s and Congress’s bailout of the finan-
cial institutions. Many were particularly unhappy about the Troubled
Asset Recovery Program, or TARP, signed into law on October 3, 2008,
that provided up to $700 billion to financial institutions but also was
used to provide funds to General Motors.27
The $700 billion TARP was a very controversial piece of legislation,
first proposed by Treasury Secretary Paulson and Fed Chairman
Bernanke just days after the Lehman bankruptcy. Although supported
54 PART I Stock Returns: Past, Present, and Future
by President Bush, the Republicans in the House voted down the legis-
lation on September 29, 2008, sending the Dow Industrials to a 777-point
(6.98 percent) loss. After minor changes were made (and undoubtedly
quite a few phone calls to Republican legislators from agitated
investors), many House Republicans reversed themselves and passed
the legislation four days later.
As noted in the last chapter, Bernanke did not need Congress to
pass TARP to extend credit to either financial or nonfinancial firms
stressed by credit developments, because Section 13(3) of the Federal
Reserve Act provided him with the authority to do so. But having taken
the heat for the Fed’s previous interventions, Bernanke and Paulson
felt they needed congressional approval to proceed. Had the restric-
tions in the Dodd-Frank Act been in effect in 2008, the Fed would not
have the ability to lend to individual firms like AIG, an action that
stanched the crisis.
Yet the Fed will still likely have enough flexibility to act in order to
calm the markets. Under Dodd-Frank the Federal Reserve can, with
Treasury approval, establish liquidity facilities for classes of institutions,
such as investment banks or even insurance companies. Certainly
Treasury Secretary Henry Paulson worked closely with Ben Bernanke
throughout all the stages of the financial crisis, and the two men devel-
oped a good working relationship. Bernanke would have most likely
obtained approval by Paulson of the general lending facilities that the
Fed established to provide liquidity to the market.
Nevertheless, the relationship between the treasury secretary and
the Fed chairman may not always be so cordial. There have been times
at which the administration has been critical of the Fed, and although
the treasury secretary can be removed by the president at any time, the
chairman of the Fed is appointed for a four-year term and can only be
removed by impeachment by the Senate.
Time will tell how effective—or harmful—the provisions of the
Dodd-Frank Act turn out to be. Most of the rules and regulations are yet
to be written by committees and groups of “experts” chosen by the gov-
ernment to craft the rulebooks and procedures. It has often been said
that the devil is in the details, and most of those details have yet to be
Concluding Comments
The financial crisis and subsequent recession spawned the deepest bear
market in stocks and the greatest bull market in Treasury bonds since the
CHAPTER 3  The Markets, the Economy, and Government Policy in the Wake of the Crisis 55
Great Depression of the 1930s. And the sharp downturn in economic
activity that followed caused record peacetime government budget
deficits, one of the slowest economic recoveries in our nation’s history,
and a growing pessimism about the future of America.
But debt, deficits, and slow economic growth need not be the
legacy of the Great Recession. The next chapter peers into the future to
identify those trends that will dominate the economic landscape over
the remainder of this century and explains why there is significant cause
for optimism about the future of the U.S. and world economy.
56 PART I Stock Returns: Past, Present, and Future
The Entitlement Crisis
Will the Age Wave Drown
the Stock Market?
Demography is Destiny
The Great Recession led to record peacetime government budget deficits
in the United States, Europe, and Japan and highlighted the unsustain-
ability of the generous and increasingly costly entitlement programs that
had been enacted years earlier. Furthermore, the housing and stock mar-
ket collapse erased trillions of dollars of wealth from consumer balance
sheets, leaving many with insufficient assets to realize the comfortable
retirement that they had once expected.
Against this backdrop of declining economic fortunes, pollsters
detected a marked loss of confidence in America’s future. In 2010 less
than half of the Americans responded yes to the question, “Do you think
that your children will be better off than you are?”1The faith in an ever-
rising standard of living, which served as a core belief for American fam-
ilies and a beacon for millions of immigrants throughout the country’s
history, was fading.
This chapter examines whether this pessimism is justified. Is it true
that our children, for the first time in our country’s history, have a bleaker
future than their parents, or are there forces that might renew the
American Dream and restore economic growth?
Two conflicting forces will impact the world economy over the coming
decades. The first force, which gives rise to rising government budget
deficits and strains private and public pension programs, is the “age
wave,” or the unprecedented rise in the number of individuals in the
developed world who will enter retirement. The age wave poses two
fundamental questions: Who will produce the goods and services that
the retirees will consume, and who will buy their assets that they plan on
selling to finance their retirement? It can be shown that if the developed
world must rely solely on its own population to produce these goods,
then the age that people will be able to retire must increase significantly.
The second offsetting force is the strong growth of emerging
economies, particularly in India, China, and the rest of Asia, that will
soon produce the bulk of the world’s output. Is it possible that emerging
economies will be productive enough to produce the goods and gener-
ate enough saving to purchase the assets of these new retirees? This
chapter answers these questions and reveals what is ahead for the
United States and world economy.
August Comte’s famous quotation “Demography is Destiny” reminds
us how important the age wave is to the world’s future. After World War
II, population increased rapidly, as those who had delayed childbearing
during the Great Depression and war envisioned a future bright enough
to take on the burdens of parenthood. Between 1946 and 1964, birthrates
rose significantly above the average of the previous two decades,
spawning a cohort dubbed “the baby boom generation.”
But the baby boom was followed by the baby bust. The fertility rate,
the number of children born to a woman, fell dramatically in the mid-
1960s; and in most of the developed world, it has remained below the 2.1
level that stabilizes the population. The fertility rate in Europe fell from
more than 2.5 in 1960 to 1.8 in 2010, and in some countries, such as Spain,
Portugal, Italy, and Greece, fertility rates have fallen to well below 1.5.
The fertility rate fell even more in many Asian economies and is now 1.3
in Japan and South Korea, 1.1 in Taiwan, and below 1 in Shanghai. In
2011 the U.S. fertility rate fell below 2.0, and the birthrate (number of
58 PART I Stock Returns: Past, Present, and Future
births per 1,000 women aged 15–44) fell to an all-time low of 63.2, nearly
one-half the level that prevailed in 1957.
The period since World War II has also been marked by rising life
expectancy. When the United States passed the Social Security Act in
1935, which provided income benefits beginning at the age of 65, life
expectancy for males, who made up the vast majority of the workforce,
was only 60. By 1950, life expectancy of males reached 66.6; and in 2010
male life expectancy hit 76.2; and reached 81.1 for females.2
James Vaupel and James Oeppen of Cambridge University have
determined that since 1840 life expectancy in the developed world has
increased at a remarkably constant rate of 2.5 years per decade, a trend
that shows only slight signs of abating.3But until the middle of the twen-
tieth century, life expectancy rose primarily because infant and child-
hood deaths declined. Between 1901 and 1961, male life expectancy at
birth rose by more than 20 years, but the life expectancy for men age 60
rose by less than 2 years.
But in the last half century, the life expectancy of the elderly is
being extended significantly by medical advances. Throughout most of
history, there have been more young than old, as disease, wars, and nat-
ural forces depleted the population. But the drop in the mortality rate
among the baby boomers combined with the reduction in fertility rates
has dramatically changed the age distribution of the world’s developed
countries. By the middle of this century, the age profiles of Japan and
many of the southern European countries, such as Greece, Spain, and
Portugal, will be “inverted”; i.e., instead of the normal pattern of more
young than old that has ruled through most of history, the most heavily
populated age bracket will consist of those well into their seventies and
eighties, and the number of those over 80 will outnumber children
below age 15.
Despite the increase in life expectancy, the retirement age continued to
fall in the developed world. In 1935 when social security was instituted
to give income benefits to individuals 65 and older, the average retire-
ment age was 67. In the postwar period, the fall in the retirement age
accelerated in 1961 when Congress allowed social security recipients to
begin collecting reduced benefits at age 62.
CHAPTER 4  The Entitlement Crisis 59
In Europe the decline in the retirement age was even greater than in
the United States. In the early 1970s many European governments low-
ered the minimum retirement age from 65 to 60 and in many cases to 55.4
In contrast to the United States, where social security payments are
increased if you continue to work, few if any incentives were created in
Europe for those considering a later retirement. In France, from 1970 to
1998, the proportion of the men in the workforce from age 60–64 fell
from about 70 percent to under 20 percent, and in West Germany it fell
from over 70 percent to 30 percent, while in the United States it remained
well above 50 percent.5
The twin forces of rising life expectancy and falling retirement age
resulted in a dramatic increase in the number of years the average
worker was retired, a period that I call the retirement period. In the United
States between 1950 and 2010, life expectancy increased from age 69 to
78, while the average age of retirement fell from 67 to 62. As a result, the
retirement period increased more than eightfold, from 1.6 to 15.8 years,
and the increase was even larger in Europe.
The rapid increase in the retirement period is an extremely signifi-
cant change in the lifestyle of the average worker. Before World War II,
very few workers enjoyed a lengthy retirement, and even fewer did so in
good health. Now there are millions in the United States, Europe, and
Japan who are enjoying retirement with generous health and income ben-
efits provided either by the state or through corporate retirement plans.
But this golden trend of increasing life expectancy and falling retirement
age cannot continue. As Figure 4-1A shows, in 1950 there were 14 retired
persons for every 100 workers in the United States. This ratio rose to 28
retirees per 100 workers in 2013, and by 2060 it is expected to rise to 56.
In Japan the number of retirees will rise from 49 per 100 workers today
to 113 in 2060, while Europe’s ratio will rise to 75. And these ratios are
apt to understate the number of retirees, as they assume a retirement age
of 65, above that in the United States and Japan and well above the level
now in Europe.
Even though the demographic trends in Japan and Europe are more
severe than in the United States, the spending in those countries impacts
all retirees, no matter where they reside. Since goods and services are
traded in global markets, the future demands by the European and
Japanese retirees will drive up world prices and adversely influence
Americans as well.
60 PART I Stock Returns: Past, Present, and Future
CHAPTER 4  The Entitlement Crisis 61
Ratio of Retirees to Workers in Developed and Emerging Economies 1950–2060
But the impact of the age wave reaches beyond raising the prices of
the goods and services that are traded on world markets. The age wave
also has a negative impact on the value of assets that workers accumu-
late to enable them to consume during retirement. This is because the
value of stocks and bonds, like the value of any good, is determined by
supply and demand. The buyers are savers, and the savers are the work-
ers who consume less than they earn, using the money they save to accu-
mulate assets that they can, in turn, sell in their retirement. The sellers of
assets are the retirees who need to generate funds to consume during the
period when they do not earn income from working.
An increase in the number of retirees generates an excess of sell-
ers over buyers, a situation that could depress asset prices substan-
tially. Lower asset prices are the market’s way of saying that the
economy cannot accommodate retirees’ expectations of early retire-
ment and generous health and income benefits. As the value of their
assets falls, baby boomers will have to work longer and retire later
than they had planned.
But how much longer will that be? The impact of the baby boomers
on the retirement age in the United States can be seen by referring to
Figure 4-2. Scenario A is the case where the developed world must rely
on the output produced by its own workers and not on increased
imports from abroad to supply the goods demanded by the retirees.
The impact on the retirement age is dramatic. The retirement age
must increase from the current age of 62 to 77 by the middle of this cen-
tury, a 15-year rise that easily outstrips the increase in life expectancy.
This scenario will reduce the retirement period from the current level of
15.8 years to 7 years, a reduction of more than 50 percent, and will
reverse most of the gains made by retirees in the postwar period.6
It is analyses such as these that have led to the pessimistic forecasts of
asset returns by those evaluating the aging of the population. Some
researchers have used the specific demographics of each country to pre-
dict country asset returns based on these demand and supply conditions.7
But viewing the future through the lens of each country’s demo-
graphics is wrong. One must envision the world as one economy and
not as separate nations where each tries to match its own consumption
to its own production. In a world of expanding global trade, the young
of the developing nations can produce goods for—and buy assets
from—the retirees of the world’s developed nations.
62 PART I Stock Returns: Past, Present, and Future
The reason that this could be significant is that although the devel-
oped world has a marked “age wave,” the rest of the world does not.
Outside Japan, Europe, and the United States, the emerging economies
have very young populations.
Figure 4-1B plots the retiree-to-worker ratio of the developing coun-
tries. To be sure, the ratio of retirees to workers rises in almost all coun-
tries. But with the exception of China, the rise in the number of retirees in
the emerging economies is much more gradual than in the developing
countries. From 2013 to 2033 when the majority of baby boomers in
developed countries retire, the number of retirees per 100 workers rises
from 11 to only 18 in the emerging economies, far less than the United
States, where the ratio increases from 27 to 45. For Africa, the number of
retirees per 100 workers is virtually unchanged at the extremely low level
of 7.5. And even for China, the most rapidly aging emerging economy
because of its one-child policy, the number of retirees per 100 workers
CHAPTER 4  The Entitlement Crisis 63
Life Expectancy and Retirement Age Under Different Growth Scenarios 1950–2060
rises from 14 to 30 over the next 20 years, and its retiree ratio does not
eclipse that of the United States until 2060.
The question is, can the workers in the emerging markets produce
enough goods to provide for the retirees of the developed world, and
can these workers save enough income to purchase the assets that must
be sold by the developed-world retirees to finance their retirement?
Right now, the answer is no. Although 80 percent of the world’s popula-
tion lives in the developing countries, those economies only produce
about one-half of the world’s output.
But that proportion is changing rapidly. In 1980 in China, Deng
Xiaoping altered the course of the Chinese economy, opened it to market
forces, and launched the country into a period of rapid and sustained
growth. Per capita income, measured in terms that equate the purchasing
power of the U.S. and Chinese currencies, has risen from only 2.1 percent
of the U.S. level in 1980 to 16.1 percent in 2010. Since China has nearly
four times the population as the United States, China will be the world’s
largest economy when its per capita income reaches 25 percent of that of
the United States, which is forecast to occur around 2016. And the econ-
omy of China will become twice the size of the U.S. economy in 2025 if
both countries’ per capita income continues to grow at recent rates.
A decade after China began its rapid growth, a similar transforma-
tion occurred in India. Prime Minister Narasimha Rao, along with his
finance minister Manmohan Singh, initiated the economic liberalization
of India in 1991. The reforms did away with many bureaucratic require-
ments, reduced tariffs and interest rates, and ended many public
monopolies. Since that time, India has begun growing more rapidly, and
although current growth is less than that of China, India’s total GDP will
likely exceed that of the United States in the 2030s and eventually exceed
China’s output.
Figure 4-3 shows how the distribution of world GDP will evolve
based on IMF and OECD forecasts of productivity growth and U.N. fore-
casts of population growth in each country. In 1980, the developed world
produced three-quarters of the world output, with the United States pro-
ducing one-quarter. Currently, the developed world produces about one-
half of the world’s GDP. In 20 years that will shrink to one-third, and by
the end of this century, it will fall to one-quarter. By contrast, the output
of the emerging economies will increase to three-quarters of the world
GDP by the end of this century.
64 PART I Stock Returns: Past, Present, and Future
The GDP growth of China and India is particularly noteworthy.
China has grown from only 2 percent of world output in 1980 to 16 per-
cent today and is forecast to reach a maximum of 32 percent of world
output in 2032 before falling back to 14 percent by the end of the century.
This decline is due to China’s one-child policy plus the fact that as its per
capita GDP nears that of developed countries, its growth will slow. India
has grown from 3 percent of world GDP in 1980 to 6 percent today and
is forecast to be 11 percent of world GDP by 2032. By 2060, India’s econ-
omy is projected to be larger than China’s because of its greater popula-
tion growth. India is forecast to produce about one-quarter of world
GDP from 2040 through the rest of this century.
Africa remains a small part of the world economy until 2070, when
it begins to expand rapidly, reaching 14 percent, the same size as the
economy of China, by the end of the century. The assumptions used to
CHAPTER 4  The Entitlement Crisis 65
World GDP 1980-2100 Based on IMF, OECD, and U.N. Forecasts
project Africa’s growth are quite conservative and will likely understate
the importance of Africa in the second half of this century. It is very dif-
ficult to determine when and whether an underdeveloped economy will
take off, as China’s did in the 1980s and India’s did one decade later.
Current IMF assumptions assume a 5 percent growth rate for sub-
Saharan Africa, greater than that of the developed world but far below
what Asia has achieved. Since Africa is forecast to house nearly one-
third of the world’s population by the end of this century (and that
assumes that the fertility rate of Africa will decline markedly over this
period), if this continent can achieve rapid growth, it could potentially
overtake Asia as the world’s largest producer.
Other researchers have confirmed the importance of the emerging
nations to the world economy. Homi Khara, of the OECD Development
Centre, has estimated that the “middle class,” defined as those earning
between $3,650 and $36,500 per year, will increase by more than 3 bil-
lion, or 170 percent, between 2009 and 2030.8And their spending will
increase by 150 percent, rising by over $34 trillion, more than twice the
current size of the U.S. economy. More than 80 percent of that growth is
projected to occur in Asia. In contrast, total spending in Western Europe
and the United States will barely increase over that time.
The growth of the emerging economies has profound implications
for developed countries. First, many of the goods that will be demanded
by the retirees in the developed world will be produced by the workers
in the emerging world. And the income earned from selling those goods
will be used to increase not only the workers’ consumption but also their
saving. Asians are naturally high savers; even rich and aged countries
like Japan have national saving ratios of nearly 25 percent, well above
that of most Western economies and more than double that of the United
The growth in savings by investors in the emerging economies sug-
gests that the financial markets in the developed world may not be over-
whelmed by assets sold by the aging boomers. If the growth of
productivity in the emerging markets can average 4.5 percent a year
over the next half century, which is equal to the average since 1990, then
the future retirement age in the United States will follow Scenario B in
Figure 4-2.
To be sure, Scenario B does not allow for a further decline in the
retirement age, nor does it stabilize the retirement age at its current level
of 62. But it does stabilize the number of years an average worker will
live in retirement—by increasing the retirement age at the same rate as
the increase in life expectancy.
66 PART I Stock Returns: Past, Present, and Future
Figure 4-4 shows the past and future projected rates of productivity
growth in developed and developing countries from 1980 through 2035.
Productivity growth has averaged nearly 5 percent over the past 20
years in the emerging economies, a period that includes the Great
Is it possible that the retirement age in the developed world could
continue to fall? Scenario C presents the extremely optimistic prospects
that would prevail if all the emerging economies can grow as fast as the
9 percent rate that China has grown over the past 20 years. In that case
there will be so many goods produced that the demands of the baby
boomers in the developed world will be completely offset by the surge
in production of goods and services by the developing world. The retire-
ment age in the United States would continue to decline and lead to a
retirement period that would exceed 26 years by 2060.
CHAPTER 4  The Entitlement Crisis 67
Historical and Forecast Productivity Growth of Developed and Emerging Economies 1980–2035
At the beginning of the chapter, I posed the question: Who will produce
the goods that the retirees will consume, and who will buy the assets
that they must sell to finance that consumption?
We now know the answer is the workers and investors from the
developing countries. As they sell their output to the developed
economies, they will be paid by the proceeds for selling the stocks and
bonds that are now held by the baby boom population. The extent to
which they can mitigate the age wave is directly linked to their economic
growth. If they continue to grow rapidly, it is likely that most of
the stocks and bonds issued by firms in the United States, Europe, and
Japan will be owned by investors in the developing world. By the mid-
dle of this century, Chinese, Indians, and other investors from these
young economies will gain majority ownership of most of the large
global corporations.
Some may question why investors from emerging economies will
buy Western assets when their countries are growing so rapidly. The
answer is that in a global environment, firms’ prospects are no longer
tied to their country of origin. The growth of the emerging markets gen-
erates huge opportunities for Western firms marketing to the new mid-
dle class. And growth in the emerging economies also puts tremendous
demands on their infrastructure. Infrastructure spending in emerging
economies is estimated to be between 2 and 3 percent of global GDP
over the next 20 years. This amounts to over $2 trillion per year, and U.S.
firms are leading beneficiaries of this spending.9
There is little doubt that consumers in rapidly expanding economies
are attracted to brand names, and Western brand names hold a special
appeal. This is illustrated by the 2013 Best Global Brands report from
Interbrand, a consulting company owned by the Omnicom Group. The
report ranks what it deems the 100 most valuable global brands on crite-
ria that include financial performance, the role the brand plays in influ-
encing the choices made by consumers, and the brand’s ability to help its
parent’s earnings. U.S.-headquartered firms own the top 7 brands (Apple,
Google, Coca-Cola, IBM, Microsoft, GE, and McDonald’s) and 14 of the
top 20.
What happens if Western firms do not compete effectively in the
global marketplace? In that case, one can be certain that foreign com-
petitors will step up to fill the void. But those Western firms with brand-
name recognition are more likely to be bought by foreign investors who
will supply the expertise needed to sell in these foreign markets.
68 PART I Stock Returns: Past, Present, and Future
Productivity growth drives our standard of living.10 The rapid produc-
tivity growth in the emerging economies is based on borrowing and
using the technology that has already been developed by the most
advanced economies.
But productivity growth in the developed countries must rely on
innovation and invention since these economies are already operating at
the frontier of technological know-how. Historically, productivity in the
developed world has increased at a remarkably steady 2 to 2½ percent per
year, which means that every 35 years the standard of living doubles.11
But some economists, such a Professor Robert Gordon of
Northwestern University, believe that productivity growth is due to fall
dramatically in the United States.12 He cites the aging of the population,
growing income inequality, and faltering educational achievement,
among others factors, as the reasons for the decline. Except for the top 1
percent of the income distribution, Gordon predicts the vast majority of
the U.S. population will experience growth of only 0.5 percent per year,
less than one-quarter the long-term average.
Others have echoed Professor Gordon’s pessimism and complain
that discoveries today have not changed people’s lives as fundamentally
as they did a century ago. Tyler Cowen, an economist at George Mason
University and author of The Great Stagnation, has voiced his belief that
the developed world is on a technological plateau and that all the low-
hanging fruit has already been discovered.13
Indeed, look at Table 4-1. It shows the most important life-changing
inventions of the past 100 years. Those that took place in the first half of
that period appear far more important than those of the second half in
transforming the life of the average individual.14
There are some in Silicon Valley who also believe that the United
States is in a downtrend. Peter Thiel, founder of PayPal, has claimed that
innovation in America is “somewhere between dire straits and dead.”15
This downbeat view has spread to many in the investment community.
Bill Gross and Mohammed El-Erian, heads of the giant investment firm
PIMCO, coined the term new normal in 2009 to describe a condition
where U.S. economic growth will sink to 1 to 2 percent, well below the
3+ percent that it has averaged in the post–World War II period.16 Other
investment managers have also embraced the concept.17
Even if growth is slower in the United States, this does not mean that
growth rates will decline around the world. Although the life-changing
innovations cited in the first column of Table 4-1 have long existed in the
CHAPTER 4  The Entitlement Crisis 69
developed world, the developing world is just beginning to acquire the
conveniences of advanced economies. In 2006 the United Nations Human
Development Report estimated that 2.6 billion people, or 40 percent of the
world’s population, had no indoor plumbing. Electrification, refrigera-
tion, and basic healthcare still elude billions of people. Indeed, a large part
of the increase in the world’s income and wealth over the next several
decades involves the developing world acquiring the lifestyle that the
developed world has long possessed.
I do not believe that even the developed world’s productivity is
necessarily on a downward path. The digitization and instant availabil-
ity of information will combine to spur faster productivity growth.
When we study history, we find that inventions that hastened com-
munication, such as Ts’ai Lun’s discovery of paper in the first century
and Johannes Guttenberg’s invention of the printing press in the fif-
teenth century, preceded periods of rapid discovery and innovation.18 In
the nineteenth and twentieth centuries, the telegraph and then the tele-
phone spurred growth by enabling the first instant communication
between distant individuals.
But no recent discovery has as much potential to foster innovation
as the Internet. Soon virtually everything that has ever been written and
recorded—on tape, on film, in print, or digitally—will be instantly acces-
sible online. For the first time in human history, there is the real prospect
of virtually free and unlimited connectivity of every researcher to the
world’s body of knowledge on any subject.
70 PART I Stock Returns: Past, Present, and Future
T A B L E 4–1
Life-Changing Inventions of the Past 100 Years
1910–1960 1960–2010
Electricity Birth control
Indoor plumbing Mobile phone
Washing machine Internet
Refrigeration Personal computer
Large computers
Air travel
Atomic energy
Professor Charles Jones of Stanford University has conducted
extensive research on productivity growth and claims that 50 percent of
U.S. growth between 1950 and 1993 can be attributed to the rise in
worldwide—not just country specific—research intensity. His paper
“Sources of U.S. Economic Growth in a World of Ideas” claims that a sig-
nificant determination of productivity growth is “the implementation of
ideas that are discovered throughout the world . . . which in turn is pro-
portional to the total population of innovating countries.”19
It is, indeed, the growth in the number of the “innovating countries”
that paints a bright picture for our future. In the past century over 90 per-
cent of the Nobel Prize winners in the scientific discipline were European
and American, even though they constituted only a small fraction of the
world’s population. That is set to change radically. The opening of China
and India alone has more than doubled those with access to the world’s
research. And language barriers are disappearing as technology enables
instant translation. This implies that productivity growth will not decline
but will actually rise in the coming decades.20
If most high-income countries, including the United States, have to rely on
their own workers to produce goods and services for their aging popula-
tion, there must be a dramatic rise in the retirement age, an increase that
would far outstrip the expected increase in life expectancy. But as produc-
tivity rises in the world’s developing economies, there will likely be enough
workers to produce the goods and sufficient savers to buy the assets of the
retiring boomers with only moderate increases in the retirement age. This
growth will enable the future returns on equities to be near their historical
Clearly this favorable scenario may not come to pass. Trade wars,
restrictions on the flow of capital, and a pullback from the pro-growth
policies in Asia and elsewhere will have a negative impact on both the
economy and equity returns. Yet there are also good reasons why produc-
tivity may advance more rapidly, not only in the developing world, but
also in developed economies. The communications revolution has enabled
researchers to collaborate on a scale unthinkable just a few years ago. And
collaboration drives discovery, innovation, and invention. As Fed
Chairman Ben Bernanke stated in his 2013 graduation address at Bard
College at Simon’s Rock, “Both humanity’s capacity to innovate and the
incentives to innovate are greater today than at any other time in history.”21
CHAPTER 4  The Entitlement Crisis 71
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Stock and Bond Returns
Since 1802
I know of no way of judging the future but by the past.
This chapter analyzes the returns on stocks, bonds, and other assets
classes over the last two centuries. U.S. history is divided here into three
subperiods. In the first subperiod, from 1802 through 1870, the United
States made a transition from an agrarian to an industrialized economy,
comparable to the changes that many “emerging markets” of Latin
America and Asia are making today. In the second subperiod, from 1871
through 1925, the United States became the foremost political and eco-
nomic power in the world. The third subperiod, from 1926 to the pres-
ent, covers the Great Depression, the postwar expansion, the tech
bubble, and the 2008 financial crisis.
These time periods are chosen not only because they are historically
significant, but because they also mark breaks in the quality and com-
prehensiveness of the historical data on stock returns. The most difficult
stock returns to collect were those from 1802 through 1871 because few
dividend data were available from that period. In prior editions of Stocks
for the Long Run I used a stock price index based on the research of
Professor William Schwert.1But his research did not include dividends,
so I estimated a dividend yield using dividend data and macroeconomic
information from the second subperiod. The dividend yields I obtained
for the first period were consistent with other historical information that
had been published about early-period dividend yields.2
In 2006, two of the prominent researchers in the field of U.S. stock
returns, Bill Goetzmann and Roger Ibbotson of Yale University, pub-
lished the most thoroughly documented research on stock returns before
1871.3Their research, which took more than a decade to complete, deter-
mined monthly price and dividend data on more than 600 individual
securities over more than a century of stock data. The 6.9 percent annual
stock return that I use in this volume for the 1802–1871 period is based
on this Goetzmann-Ibbotson research and is only 0.2 percentage points
below my earlier estimates of early-nineteenth-century stock returns.4
For the years 1871 through 1925, the returns on stocks are calcu-
lated using a capitalization-weighted index of all NYSE stocks (includ-
ing reinvested dividends) and are taken from the well-regarded indexes
compiled by the Cowles Foundation and reported in Shiller.5The data
from the third period, from 1925 to the present, are the most thoroughly
researched and are taken from the Center for Research in Security Prices.
These returns represent a capitalization-weighted index of all New York
Stock Exchange stocks and, starting in 1962, all American and Nasdaq
stocks. The behavior of stock and bond returns since 1925 has also been
researched by Roger Ibbotson, who has published yearbooks that have
become benchmarks for U.S. asset returns since 1972.6All the stock and
bond returns reported in this volume, including those from the early
nineteenth century, are free from “survivorship bias,” a bias that arises
from only using the returns from firms that have survived and ignoring
the lower returns from firms that have disappeared over time.
The story of these assets is told in Figure 5-1. It depicts the total nominal
(not inflation adjusted) return indexes for stocks, long- and short-term
government bonds, gold, and commodities from 1802 through 2012.
Total return includes changes in the capital value plus interest or divi-
dends and assumes that all these cash flows are automatically rein-
vested in the asset over time.
It can be easily seen that over the last two centuries the total return
on equities dominates all other assets. The amount of $1 invested in a
capitalization-weighted portfolio in 1802, with reinvested dividends,
would have accumulated to almost $13.5 million by the end of 2012.
76 PART II The Verdict of History
Even the cataclysmic stock crash of 1929, which caused a generation of
investors to shun stocks, appears as a mere blip in the total stock return
index. Bear markets, which so frighten those who hold equity invest-
ments, pale in the context of the upward thrust of stock returns.
It is important to understand that the total return on stocks
depicted in Figure 5-1 does not represent the growth in the total value of
the U.S. stock market. The wealth in stocks increases at a rate signifi-
cantly slower than that of total stock return. The reason that total return
grows faster than stock wealth is because investors consume most of the
dividends paid by stocks, and therefore these dividends are not rein-
vested and cannot be used by firms to create capital. It would take only
$1.33 million invested in the stock market in 1802 to grow, with divi-
dends reinvested, to about $18 trillion, the total value of U.S. stocks, by
the end of 2012. The sum of $1.33 million in 1802 is equivalent to roughly
CHAPTER 5  Stock and Bond Returns Since 1802 77
Total Nominal Returns and Inflation 1802–2012
78 PART II The Verdict of History
$25 million in today’s purchasing power, an amount far less than the
value of the stock market at that time.7
Although financial theory (and government regulations) require
that total return be calculated with reinvested dividends (or other cash
flows), it is rare for anyone to accumulate wealth for long periods of time
without consuming part of his or her return. The longest period of time
investors typically hold onto assets without touching the principal and
income occurs when they are accumulating wealth in pension plans for
their retirement or in insurance policies that are passed on to their heirs.
Even those who bequeath fortunes untouched during their lifetimes
must realize that these accumulations are often dissipated in the next
generation or spent by the foundations to which the money is
bequeathed. The stock market has the power to turn a single dollar into
millions by the forbearance of generations—but few will have the
patience or desire to endure the wait.
Fixed-income investments are the largest and most important financial
asset competing with stocks. Bonds promise fixed monetary payments
over time. In contrast to equity, the cash flows from bonds have a maxi-
mum monetary value set by the terms of the contract. Except in the case
of default, bond returns do not vary with the profitability of the firm.
The bond series shown in Figure 5-1 are based on long- and short-
term U.S. Treasury bonds, when available; if they were not available, as
occurred in some of the early years of our sample, the highest-grade
municipal bonds were chosen. Default premiums were estimated and
removed from the interest rates of riskier securities in order to obtain a
comparable high-grade sample over the entire period.8
The interest rates on long-term bonds and short-term bonds (called
bills), over the 210-year period, are displayed in Figure 5-2. Interest rate
fluctuations during the nineteenth and early twentieth centuries
remained within a narrow range. But from 1926 to the present, the
behavior of both long- and short-term interest rates changed dramati-
cally. During the Great Depression of the 1930s, short-term interest rates
fell to nearly zero, and in October 1941 the yield on the 20-year Treasury
bond fell to a record low of 1.82 percent. In order to finance record
wartime borrowings, the government maintained extraordinarily low
rates during World War II and the early postwar years.
The 1970s marked an unprecedented change in the behavior of
interest rates. Inflation reached double-digit levels, and interest rates
soared to heights that had not been seen since the debasing of the conti-
nental currency in the early years of the republic. Never before had infla-
tion, and therefore interest rates, been so high for so long.
The public clamored for government action to slow rising prices.
That cry was answered by Paul Volcker, chairman of the Federal Reserve
System since 1979, who sent interest to near 20 percent and eventually
brought inflation and interest rates down to moderate levels. The
change in the behavior of interest rates is directly related to the changes
in the determinants of the price level.
Consumer prices in the United States and the United Kingdom over the
past 200 years are depicted in Figure 5-3. In each country, the price level
CHAPTER 5  Stock and Bond Returns Since 1802 79
U.S. Long- and Short-Term Interest Rates 1800–2012
80 PART II The Verdict of History
at the beginning of World War II was essentially the same as it was 150
years earlier. But after World War II, the nature of inflation changed dra-
matically. The price level rose almost continuously after the war, often
gradually, but sometimes at double-digit rates, as in the 1970s.
Excluding wartime, the 1970s witnessed the first rapid and sustained
inflation ever experienced in U.S. or British history
The dramatic changes in the inflationary trend can be explained by
the change in the monetary standard. During the nineteenth and early
twentieth centuries, the United States, the United Kingdom, and the rest
of the industrialized world were on a gold standard. As shown in Figure
5-1, the price of gold and the price level were very closely linked during
this period. That is because the gold standard restricts the supply of
money and hence the inflation rate. But from the Great Depression
through World War II, the world shifted to a paper money standard.
Under a paper money standard there is no legal constraint on the
U.S. and U.K. Consumer Price Index 1800–2012
issuance of money, so inflation is subject to political as well as economic
forces. Price stability depends on the desire of central banks to limit the
growth of the supply of money in order to counteract deficit spending
and other inflationary forces that result from government spending and
The chronic inflation that the United States and other developed
economies have experienced since World War II does not mean that the
gold standard was superior to the current paper money standard. The
gold standard was abandoned because of its inflexibility in the face of
economic crises, particularly during the banking collapse of the 1930s.
The paper money standard, if properly administered, can prevent runs
on banks and severe depressions that plagued the gold standard while
maintaining inflation at low to moderate levels.
But monetary policy was not well run. Gold prices soared to $850
per ounce in January 1980, following the rapid inflation of the 1970s.
When inflation was finally brought under control, gold prices fell, but
they rose again after the 2008 financial crisis when the flood of credit
issued by central banks stoked fears of inflation. By the end of 2012, the
price of gold reached $1,675 per ounce, and $1 of gold bullion purchased
in 1802 was worth $86.40 at the end of 2012, while the price level itself
increased by a factor of 19.12. Nevertheless, although gold protects
investors against inflation, the yellow metal offers little more. Whatever
hedging property gold possesses, this precious metal will likely exert a
considerable drag on the return of a long-term investor’s portfolio.10
The focus of long-term investors should be the growth of purchasing
power of their investment—that is, the creation of wealth adjusted for
the effects of inflation. Figure 5-4 reproduces Figure 1-1 in Chapter 1 and
is constructed by taking the dollar returns shown in Figure 5-1 and cor-
recting (or “deflating”) them by the changes in the price level. The annu-
alized real returns for the various asset classes are found in the upper left
corner of the graph.
The compound annual real return on stocks is approximately 6.6
percent per year after inflation. Despite the addition of 20 years of stock
market data since the first edition of Stocks for the Long Run, this return is
just one-tenth of a percentage point lower than the 6.7 percent return
that I reported in 1994.11
Some have maintained that this return is not sustainable since it is
almost double the 3.0 to 3.5 percent growth rate of real GDP.12 But that is
CHAPTER 5  Stock and Bond Returns Since 1802 81
82 PART II The Verdict of History
incorrect. Even if the economy is not growing at all, capital will receive a
positive return because it is a scarce resource, just as labor will be paid
positive wages and land will be paid positive rents. As noted earlier, the
total real return on stocks assumes that all dividends and capital gains
are reinvested into the market, and this sum grows far faster than total
stock wealth or GDP.13
The annual returns on U.S. stocks over various time periods are
summarized in Table 5-1. Note the extraordinary stability of the real
return on stocks over all major subperiods: 6.7 percent per year from
1802 through 1870, 6.6 percent from 1871 through 1925, and 6.4 percent
per year from 1926 through 2012. Even since World War II, during which
all the inflation that the United States has experienced over the past 200
years occurred, the average real rate of return on stocks has been 6.4 per-
cent per year. This is virtually identical to the real return on stocks dur-
ing the previous 125 years, which saw no overall inflation. Stocks
Total Real Returns on U.S. Stocks, Bonds, Bills, Gold, and the Dollar, 1802–2012
Real Returns on Stocks, Gold, and Inflation 1802–2012
Total Nominal Total Real
Nominal Capital Real Capital Real
Return Appreciation Dividend Return % Appreciation Gold Price
Return Risk Return Risk Yield Return Risk Return Risk Return Inflation
1802–2012 8.1 17.6 2.9 17.2 5.1 6.6 18.0 1.5 17.4 0.7 1.4
1871–2012 8.7 18.9 4.1 18.4 4.4 6.5 19.1 2.0 18.5 1.0 2.0
I 1802–1870 6.9 14.5 0.4 14.0 6.4 6.7 15.4 0.3 14.8 0.2 0.1
II 1871–1925 7.3 16.5 1.9 15.9 5.3 6.6 17.4 1.3 16.9 –0.8 0.6
III 1926–2012 9.6 20.3 5.5 19.6 3.9 6.4 20.2 2.5 19.6 2.1 3.0
1946–2012 10.5 17.5 6.8 16.9 3.5 6.4 17.8 2.9 17.2 2.0 3.9
1946–1965 13.1 16.5 8.2 15.7 4.6 10.0 18.0 5.2 17.2 –2.7 2.8
1966–1981 6.6 19.5 2.6 18.7 3.9 –0.4 18.7 –4.1 18.1 8.8 7.0
1982–1999 17.3 12.5 13.8 12.4 3.1 13.6 12.6 10.2 12.6 –4.9 3.3
2000–2012 2.7 20.6 0.8 20.1 1.9 0.3 19.9 –1.6 19.4 11.8 2.4
Return = compound annual return
Risk = standard deviation of arithmetic returns
All data in percent (%)
represent real assets, which in the long run appreciate at the same rate as
inflation, so that real stock returns are not adversely affected by changes
in the price level.
The long-term stability of stock returns has persisted despite the
dramatic changes that have taken place in our society during the last two
centuries. The United States evolved from an agricultural to an industrial
economy and then to the postindustrial, service- and technology-
oriented economy it is today. The world shifted from a gold-based stan-
dard to a paper money standard. And information, which once took
weeks to cross the country, can now be instantaneously transmitted and
simultaneously broadcast around the world. Yet despite mammoth
changes in the basic factors generating wealth for shareholders, equity
returns have shown an astounding stability.
But stability in the long-run returns on stocks in no way guarantees
stability in the short run. From 1982 through 1999 during the greatest
bull market in U.S. history, stocks offered an extraordinary after-
inflation return of 13.6 percent per year, more than double the historical
average. These superior returns followed the dreadful returns realized
in stocks the previous 15 years, from 1966 through 1981, when stock
returns fell behind inflation 0.4 percent per year. Nevertheless, this great
bull market carried stocks too high, and the valuation of the market
reached record levels, which in turn led to the poor returns of the fol-
lowing decade. The subsequent bear market and financial crisis plunged
stocks once again well below trend as real stock returns have fallen to a
mere +0.3 percent in the 12 years following the bull market peak of 2000.
As stable as the long-term real returns have been for equities, the same
cannot be said of fixed-income assets. As Table 5-2 indicates, the real
return on Treasury bills has dropped precipitously from 5.1 percent in
the early part of the nineteenth century to a bare 0.6 percent since 1926,
a return only slightly above inflation.
The real return on long-term bonds has shown a similar, but more
moderate, decline. Bond returns fell from a generous 4.8 percent in the
first subperiod to 3.7 percent in the second and then to only 2.6 percent
in the third. The decline in real yield on government bonds over time can
be partly explained by certain factors that boosted their demand: the
greatly improved liquidity of bonds and the fact that these bonds satisfy
many fiduciary requirements that other fixed-income assets do not.
These demand-boosting factors raised the prices of government bonds
84 PART II The Verdict of History
and therefore reduced their yields. The real returns on longer-term
bonds were also reduced by the unexpected inflation that investors
experienced in the post–World War II period.
The short-run volatility of stock returns from decade to decade is not
unexpected. What may surprise investors is that the volatility of the real
returns on government bonds is also quite large. For the 35-year-period
from 1946 through 1981, the real return on Treasury bonds was negative.
In other words, the coupon on the bonds did not offset the decline in bond
prices brought about by rising interest rates and inflation. As we shall see
in the next chapter, there never has been even a 20-year period, not to
speak of a 35-year period, where real stock returns were negative.
The decline in real returns on bonds since 1926 would have been
much greater if it were not for the stellar bond returns of the past three
decades. Since 1981, the decline in inflation and interest rates has
pushed bond prices upward and greatly improved bondholder returns.
Although bond returns fell well short of equities during stocks’ mega
bull market from 1981 through 1999, bonds easily outpaced stocks in the
following decade. In fact, for the entire three decades that followed the
peak in bond yields in the early 1980s, bond returns virtually matched
those of equities.
CHAPTER 5  Stock and Bond Returns Since 1802 85
T A B L E 5–2
Real Returns on Bonds and Inflation 1802–2012
Long-Term Governments Short-Term Governments
Nominal Real Real
Coupon Return Return Nominal Return Price
Rate Return Risk Return Risk Rate Return Risk Inflation
1802–2012 4.7 5.1 6.7 3.6 9.0 4.2 2.7 6.0 1.4
1871–2012 4.7 5.2 7.9 3.0 9.3 3.6 1.6 4.4 2.0
I 1802–1870 4.9 4.9 2.8 4.8 8.3 5.2 5.1 7.7 0.1
II 1871–1925 4.0 4.3 3.0 3.7 6.4 3.8 3.1 4.8 0.6
III 1926–2012 5.1 5.7 9.7 2.6 10.8 3.6 0.6 3.9 3.0
1946–2012 5.8 6.0 10.8 2.0 11.5 4.3 0.4 3.2 3.9
1946–1965 3.1 1.5 5.0 –1.2 7.1 2.0 –0.8 4.3 2.8
1966–1981 7.2 2.5 7.1 –4.2 8.1 6.8 –0.2 2.1 7.0
1982–1999 8.5 12.1 13.8 8.5 13.6 6.3 2.9 1.8 3.3
2000–2012 4.5 9.0 11.7 6.5 11.6 2.2 –0.2 1.8 2.4
Return = compound annual return
Risk = standard deviation of arithmetic returns
All data in percent (%)
86 PART II The Verdict of History
But those spectacular bond returns cannot continue. Prospective real
returns for Treasury bonds became far easier to determine when, in
January 1997, the U.S. Treasury introduced TIPS, or Treasury inflation-
protected securities. The coupons and principal from these bonds,
backed by the full faith and credit of the U.S. government, are linked to
the U.S. consumer price index, so that the yield on these bonds is a real,
inflation-adjusted yield, shown in Figure 5-5.
The steady decline in the yields on these bonds is readily apparent.
When these bonds were first issued, their yield was just short of 3.5 per-
cent. That is almost identical to the historical real return on government
bonds that I had found in my research analyzing data dating from 1802.
After issuance, the yield on TIPS increased, reaching a high of 4.40 per-
Real Yield on 10-Year Treasury Inflation-Protected Securities (TIPS) 1997–2012
cent in January 2000, the month that also marked the peak of the tech
and Internet bubble.
From that date, the yield on TIPS began a relentless decline. From
2002 through 2007 the yield fell to 2 percent. As the financial crisis deep-
ened, the yield continued to decline and sank below zero in August
2011, reaching nearly –1 percent by December 2012.14 This negative real
yield was similar to the implied after-inflation yields on the standard
Treasury bonds. The yield on the 10-year Treasury bond fell to a 75-year
low of 1.39 percent in July 2012, well below the ongoing and forecast
rate of inflation.
The real yield on Treasury bonds is determined by many factors,
such as the state of the economy, fears of inflation, and the risk attitudes
of investors. But in almost all economic models, the most important fac-
tor influencing the real return on bonds is economic growth. Indeed, the
3.4 percent yield set at the first TIPS auction was almost exactly equal to
real GDP growth in the 1990s. As real economic growth slowed to about
2 percent from 2002 through 2007, the yields on TIPS fell accordingly.
But no forecaster in 2012 predicted real economic growth over the
next decade would be negative, as the yield on TIPS suggested. Only
extreme risk aversion can explain why investors were willing to accept
negative after-inflation returns on government bonds even though other
assets, such as equities, have consistently delivered long-term real
returns of 6 to 7 percent per year.
The excess return of stocks over bonds (either long or short) is referred
to as the equity risk premium, or simply the equity premium. It can be meas-
ured historically, as shown in Figure 5-6, or prospectively, on the basis of
current bond yields and stock valuations. Subtracting stock and bond
returns from Tables 5-1 and 5-2 shows that the equity premium has aver-
aged 3.0 percent against Treasury bonds and 3.9 percent against
Treasury bills over the entire 210 years.
Because of the extraordinary returns on long-term bonds over the
past 30 years, the historical equity premium of stocks over bonds has
shrunk to zero. But the forward-looking equity premium at the end of
2013 is far higher since the prospective real yields on long bonds have
fallen so low. If forward-looking equity returns match their historical
average, the forward-looking equity premium in 2013 could be 6 percent
or more.15
CHAPTER 5  Stock and Bond Returns Since 1802 87
When I published Stocks for the Long Run in 1994, some economists ques-
tioned whether my conclusions, drawn from data from the United
States, might overstate historical equity returns measured on a world-
wide basis. They claimed that U.S. stock returns exhibited survivorship
bias, a bias caused by the fact that returns are collected from successful
equity markets, such as the United States, but ignored in countries
where stocks have faltered or disappeared outright, such as in Russia or
Argentina.16 This bias suggested that stock returns in the United States,
a country that over the last 200 years has been transformed from a small
British colony into the world’s greatest economic power, are unique and
that historical equity returns in other countries would be lower.
88 PART II The Verdict of History
The Equity Premium: Difference between 30 Year Return on Stocks and Bonds and Stocks
and Bills 1831–2012
CHAPTER 5  Stock and Bond Returns Since 1802 89
Prodded by this question, three U.K. economists examined the his-
torical stock and bond returns from 19 countries since 1900. Elroy
Dimson and Paul Marsh, professors at the London Business School, and
Mike Staunton, director of the London Share Price Database, published
their research in 2002 in a book entitled Triumph of the Optimists: 101
Years of Global Investment Returns.17 This book provides a rigorous yet
readable account of worldwide financial market returns in 19 different
Updated returns from this study are given in Figure 5-7, which
shows the average historical real stock, bond, and bill returns of all 19
countries analyzed from 1900 through 2012. Despite the major disasters
visited on many of these countries, such as war, hyperinflation, and
depression, every one of them exhibited substantially positive after-
inflation stock returns.
International Real Returns on Stocks, Bonds, and Bills 1900–2012
Real equity returns ranged from a low of 1.7 percent in Italy to a
high of 7.2 percent in Australia and South Africa. Stock returns in the
United States, although quite good, were not exceptional. The simple
arithmetic mean of the returns of the 19 countries is 4.6 percent, and a
portfolio that put a single dollar in each of those countries’ stock markets
in 1900 would have produced a compound real return of 5.4 percent,
very close to the 6.2 percent that is found in the United States. And those
countries that had lower stock returns also had lower fixed-income
returns, so that the average equity premium against bonds was 3.7 per-
cent and against bills was 4.5 percent, actually higher than found in the
United States.
When all the information was analyzed, the authors concluded:
. . . that the US experience of equities outperforming bonds and bills has
been mirrored in all sixteen countries examined. . . . Every country
achieved equity performance that was better than that of bonds. Over the
101 years as a whole, there were only two bond markets and just one bill
market that provided a better return than our worst performing equity
While the US and the UK have indeed performed well, . . . there is no indi-
cation that they are hugely out of line with other countries. . . . Concerns
about success and survivorship bias, while legitimate, may therefore have
been somewhat overstated [and] investors may have not been materially
misled by a focus on the US.18, 19
This last statement is significant. More studies have been made of
the U.S. markets than the markets of any other country in the world.
Dimson, Marsh, and Staunton are saying that the results found in the
United States have relevance to all investors in all countries. The title
they chose for their book suggests their conclusions: it is the optimists,
not the pessimists, who take positions in the equity market, and they
have decidedly triumphed over more cautious investors over the last
century. International studies have reinforced, not diminished, the case
for equities.
Over the past 210 years, the compound annual real return on a diversi-
fied portfolio of common stock has been between 6 and 7 percent in the
United States, and it has displayed a remarkable constancy over time.
90 PART II The Verdict of History
Certainly the returns on stocks are dependent on the quantity and qual-
ity of capital, productivity, and the return to risk taking. But the ability
to create value also springs from skillful management, a stable political
system that respects property rights, and the capacity to provide value
to consumers in a competitive environment. Swings in investor senti-
ment resulting from political or economic crises can throw stocks off
their long-term path, but the fundamental forces producing economic
growth have always enabled equities to regain their long-term trend.
Perhaps that is why stock returns have displayed such stability despite
the radical political, economic, and social changes that have impacted
the world over the past two centuries.
Yet one must be aware of the political, institutional, and legal frame-
work in which these returns were generated. The superior performance
of stocks over the past two centuries might be explained by the growing
dominance of nations committed to free market economics. Few
expected the triumph of market-oriented economies during the dark
days of the Great Depression and World War II. But if history is any
guide, government bonds in our paper money economies may fare far
worse than stocks in any political or economic upheaval. As the next
chapter shows, even in stable political environments, the risks in govern-
ment bonds actually outweigh those in stocks for long-term investors.
The first actively traded U.S. stocks, floated in 1791, were issued by two
banks: the Bank of New York and the Bank of the United States.20 Both
offerings were enormously successful and were quickly bid to a pre-
mium. But they collapsed the following year when Alexander
Hamilton’s assistant at the Treasury, William Duer, attempted to manip-
ulate the market and precipitated a crash. It was from this crisis that the
antecedents of the New York Stock Exchange were born on May 17, 1792.
Joseph David, an expert on the eighteenth-century corporation,
claimed that equity capital was readily forthcoming not only for every
undertaking likely to be profitable but also, in his words, “for innumer-
able undertakings in which the risk was very great and the chances of
success were remote.”21 Although over 300 business corporations were
chartered by the states before 1801, fewer than 10 had securities that
traded on a regular basis. Two-thirds of those chartered before 1801 were
connected with transportation: wharves, canals, turnpikes, and bridges.
But the important stocks of the early nineteenth century were financial
institutions: banks and, later, insurance companies. Banks and insurance
CHAPTER 5  Stock and Bond Returns Since 1802 91
companies held loans and equity in many of the manufacturing firms
that, at that time, did not have the financial standing to issue equity. The
fluctuations in the stock prices of financial firms in the nineteenth cen-
tury reflected the health of the general economy and the profitability of
the firms to which they lent. One of the first large nonfinancial ventures
was the Delaware and Hudson Canal, issued in 1825, which also became
an original member of the Dow Jones Industrial Average 60 years later.22
In 1830, the first railroad, the Mohawk and Hudson, was listed; and for
the next 50 years, railroads dominated trading on the major exchanges.
92 PART II The Verdict of History
Risk, Return, and
Portfolio Allocation
Why Stocks Are Less Risky
Than Bonds in the Long Run
As a matter of fact, what investment can we find which offers real
fixity or certainty income? . . . As every reader of this book will clearly
see, the man or woman who invests in bonds is speculating in the
general level of prices, or the purchasing power of money.
Risk and return are the building blocks of finance and portfolio manage-
ment. Once the risk, expected return, and correlations between asset
classes are specified, modern financial theory can help investors allocate
their portfolios. But the risk and return on stocks and bonds are not
physical constants, like the speed of light or gravitational force, waiting
to be discovered in the natural world. Investors cannot, as in the physi-
cal sciences, run repeated controlled experiments, holding all other fac-
tors constant, and home in on the “true” value of each variable. As
Nobel laureate Paul Samuelson was fond of saying, “We have but one
sample of history.”
This means that despite the overwhelming quantity of historical
data, one can never be certain that the underlying factors that generate
asset prices have remained unchanged. Indeed we saw in Chapter 3 that
the correlations between assets classes change substantially over time
Yet one must start by analyzing the past in order to plan for the
future. The last chapter showed that not only have fixed-income returns
lagged substantially behind those on equities, but because of the uncer-
tainty of inflation, bonds can be quite risky for long-term investors. In
this chapter investors will see that uncertain inflation will make their
portfolio allocations depend crucially on their planning horizon.
For many investors, the most meaningful way to describe risk is by por-
traying a worst-case scenario. The best and worst after-inflation returns
for stocks, bonds, and bills from 1802 over holding periods ranging from
1 to 30 years are displayed in Figure 6-1. Here stock returns are meas-
ured, as before, by dividends plus capital gains or losses on a broad-
based capitalization-weighted index of U.S. stocks. Note that the height
of the bars, which measures the difference between best and worst
returns, declines far more rapidly for equities than for fixed-income
securities as the holding period increases.
Stocks are unquestionably riskier than bonds or Treasury bills over
one- and two-year periods. However, in every five-year period since
1802, the worst performance in stocks, at –11.9 percent per year, has been
only slightly worse than the worst performance in bonds or bills. And
for 10-year holding periods, the worst stock performance has actually
been better than that for bonds or bills.
For 20-year holding periods, stock returns have never fallen below
inflation, while returns for bonds and bills once fell as much as 3 percent
per year below the inflation rate. During that inflationary episode, the
real value of a portfolio of Treasury bonds, including all reinvested
coupons, fell by nearly 50 percent. The worst 30-year return for stocks
remained comfortably ahead of inflation by 2.6 percent per year, a return
that is not far below the average performance of fixed-income assets.
It is very significant that stocks, in contrast to bonds or bills, have
never delivered to investors a negative real return over periods lasting
17 years or more. Although it might appear to be riskier to accumulate
wealth in stocks rather than in bonds over long periods of time, for the
preservation of purchasing power, precisely the opposite is true: the
94 PART II The Verdict of History
safest long-term investment has clearly been a diversified portfolio of
equities. There is no doubt that inflation-protected U.S. Treasury bonds
safeguard investors from unexpected inflation. But as noted in Chapter
5, the real yields on those securities, even for maturities as long as 20
years, fell below zero in 2012 and remain very low. Stocks, in contrast,
have never given investors a negative real return over a 20-year horizon.
Some investors question whether holding periods of 20 or 30 or
more years are relevant to their planning horizon. But one of the great-
est mistakes that investors make is to underestimate their holding
period. This is because many investors think about the holding periods
CHAPTER 6  Risk, Return, and Portfolio Allocation 95
Highest and Lowest Real Returns on Stocks, Bonds, and Bills over 1-, 2-, 5-, 10-, 20-, and 30-Year
Holding Periods 1802–2012
of a particular stock, bond, or mutual fund. But the holding period that
is relevant for portfolio allocation is the length of time the investors hold
any stocks or bonds, no matter how many changes are made among the
individual issues in their portfolio.
The percentage of times that stock returns outperform bond or bill
returns over various holding periods is shown in Table 6-1. As the hold-
ing period increases, the probability that stocks will outperform fixed-
income assets increases dramatically. For 10-year horizons, stocks beat
bonds about 80 percent of the time; for 20-year horizons, about 90 percent
of the time; and over 30-year horizons, nearly 100 percent of the time.
In the first four editions of Stocks for the Long Run, I noted that the
last 30-year period when the return on long-term bonds beat stocks
ended in 1861, at the onset of the U.S. Civil War. That is no longer true.
Because of the large drop in government bond yields over the past
decade, the 11.03 percent annual return on long-term government bonds
just surpassed the 10.98 percent on stocks for the 30-year period from
January 1, 1982, through the end of 2011. This striking event caused some
96 PART II The Verdict of History
T A B L E 6–1
Percentage of Time Stocks Outperform Bonds and Bills over Various Holding
Stocks Stocks
Outperform Outperform
Holding Period Time Period Bonds T-Bills
1 Year 1802–2012 58.8 62.1
1871–2012 61.3 66.9
2 Year 1802–2012 60.5 62.9
1871–2012 64.1 70.4
3 Year 1802–2012 67.2 70.2
1871–2012 68.7 73.3
5 Year 1802–2012 67.6 68.6
1871–2012 69.0 74.6
10 Year 1802–2012 72.3 73.3
1871–2012 78.2 83.8
20 Year 1802–2012 83.9 87.5
1871–2012 95.8 99.3
30 Year 1802–2012 91.2 91.2
1871–2012 99.3 100.0
researchers to conclude that stock returns can no longer be counted on to
surpass bond returns.2
But a closer look at why bonds outperformed stocks during this
period shows that it is almost impossible for bonds to repeat that feat in
the coming decades. In 1981 the interest rate on 10-year U.S. Treasury
bonds reached 16 percent. As interest rates fell, bondholders benefited
from both high coupons and capital gains on their bonds. This resulted
in a real return on bonds of 7.8 percent per year from 1981 to 2011,
approximately the same real return as on stocks. A 7.8 percent real return
is only about 1 percentage point above the stocks’ 210-year average, but
it is more than double the average historical real return on bonds and
more than 3 times its return over the last 75 years.
As interest rates have fallen to historic lows, bondholders face a
wholly different situation. At the end of 2012, the yield on nominal
bonds was about 2 percent. The only way that bonds could generate a
7.8 percent real return is if the consumer price index fell by nearly 6 per-
cent per year over the next 30 years. Yet a deflation of this magnitude has
never been sustained by any country in world history. In contrast, stocks
can easily repeat their performance over the last three decades and are
likely to do so given their favorable valuation at the end of 2012. As
noted in the last chapter, the prospective returns of stocks over bonds
will likely exceed their historical average by a wide margin.
Although the dominance of stocks over bonds is readily apparent
in the long-run data, it is also important to note that over one- and even
two-year periods, stocks outperform bonds or bills only about three out
of every five years. This means that nearly two out of every five years a
stockholder’s return will fall behind the return he or she would get on
Treasury bills or bank certificates. The high probability that bonds and
even bank accounts will outperform stocks in the short run is the pri-
mary reason why it is so difficult for many investors to stay in stocks.3
The risk—defined as the standard deviation of average real annual
returns—for stocks, bonds, and bills based on the historical sample of
over 200 years is displayed in Figure 6-2. Standard deviation is the meas-
ure of risk used in portfolio theory and asset allocation models.
Although the standard deviation of stock returns is higher than for
bond returns over short-term holding periods, once the holding period
increases to between 15 and 20 years, stocks become less risky than
bonds. Over 30-year periods, the standard deviation of the return on a
CHAPTER 6  Risk, Return, and Portfolio Allocation 97
portfolio of equities falls to less than three-fourths that of bonds or bills.
The standard deviation of average returns falls nearly twice as fast for
stocks as for fixed-income assets as the holding period increases.
If asset returns follow a random walk, the standard deviation of
each asset class will fall by the square root of the holding period. A ran-
dom walk is a process whereby future returns are completely independ-
ent of past returns. The dashed bars in Figure 6-2 show the decline in
risk predicted under the random walk assumption.
But the historical data show that the random walk hypothesis can-
not be maintained for equities. This occurs since the actual risk of aver-
age stock returns declines far faster than predicted by the random walk
hypothesis because of the mean reversion of equity returns.
98 PART II The Verdict of History
Standard Deviation of Average Real Stock, Bond, and Bill Returns Over Various Holding Periods:
Historical Data and Random Walk Hypothesis 1802–2012
The standard deviation of average returns for fixed-income assets,
on the other hand, does not fall as fast as the random walk theory pre-
dicts. This is a manifestation of mean aversion of bond returns. Mean
aversion implies that once an asset’s return deviates from its long-run
average, there is an increased chance that it will deviate further, rather
than return to more normal levels. Mean aversion of bond returns is
especially characteristic of hyperinflations, where price changes proceed
at an accelerating pace, rendering paper assets worthless. But mean
aversion is also present in the more moderate inflations that have
impacted the United States and other developed economies. Once infla-
tion begins to accelerate, the inflationary process becomes cumulative,
and bondholders have virtually no chance of making up losses in their
purchasing power. In contrast, stockholders who hold claims on real
assets rarely suffer a permanent loss due to inflation.
Note that I am not claiming that the risk on a portfolio of stocks falls
as we extend the time period. The standard deviation of total stock
returns rises with time, but it does so at a diminishing rate. On the other
hand, because of uncertain inflation, the standard deviation of real bond
returns increases at an accelerating rate as the investment horizon
increases, and eventually bonds become riskier than a diversified port-
folio of common stocks.
Even though the returns on bonds fall short of that on stocks, bonds may
still serve to diversify a portfolio and lower overall risk. This will be par-
ticularly true if bond and stock returns are negatively correlated, which
would happen if bond and stock prices move in the opposite direction.4
The diversifying strength of an asset is measured by the correlation coef-
ficient. The correlation coefficient ranges between –1 and +1 and measures
the co-movement between an asset’s return and the return of the rest of
the portfolio. The lower the correlation coefficient, the better the asset
serves as a portfolio diversifier. Assets with near-zero or especially neg-
ative correlations are particularly good diversifiers. As the correlation
coefficient between the asset and portfolio returns increases, the diversi-
fying quality of the asset declines.
In Chapter 3 we examined the changing correlation coefficient
between the return on 10-year Treasury bonds and stocks, represented
by the S&P 500 Index. Figure 6-3 displays the correlation coefficient
between annual stock and bond returns for three subperiods between
1926 and 2012. From 1926 through 1965 the correlation was only slightly
CHAPTER 6  Risk, Return, and Portfolio Allocation 99
positive, indicating that bonds were fairly good diversifiers for stocks.
Bonds were good diversifiers in this period because it contained the
Great Depression, which was characterized by falling economic activity
and consumer prices, a situation that was bad for stocks but good for
U.S. government bonds.
However, under a paper money standard, bad economic times are
more likely to be associated with inflation, not deflation. This was true
from the mid-1960s through the mid-1990s, as the government
attempted to offset economic downturns with expansionary monetary
policy that was inflationary. Under these circumstances, stock and bond
prices tend to move together, sharply reducing the diversifying qualities
of government bonds.
But this positive correlation has switched again in recent decades.
Since 1998, stock prices have once again become negatively correlated
with government bond prices. The reason for this switch is twofold. In
100 PART II The Verdict of History
Correlation of Real Bond and Stock Returns Over Various Historical Periods
the early part of that period, the world markets were roiled by economic
and currency upheavals in Asia, the deflationary economy in Japan, and
then the terrorist events of September 11. Later the 2008 financial crisis
stoked fears of the 1930s, when deflation ruled and government bonds
were the only appreciating asset. These events led to the U.S. govern-
ment bond market becoming once again a safe haven for those investors
fearing more economic turmoil and lower stock prices.
Nevertheless, it is unlikely that Treasury bonds will remain good
long-term diversifiers, especially if the specter of inflation looms once
again. If inflation does indeed increase, the premium now enjoyed by
Treasury bonds as a hedge against deflation will again be lost, leading to
further losses for bondholders.
Modern portfolio theory describes how investors may alter the risk and
return of a portfolio by changing the mix between assets. Figure 6-4 dis-
plays the risks and returns that result from varying the proportion of
stocks and bonds in a portfolio over various holding periods ranging
from 1 to 30 years based on 210 years of historical data.
The “blank” square at the bottom of each curve represents the risk
and return of an all-bond portfolio, while the darkened square at the top
of the curve represents the risk and return of an all-stock portfolio. The
circle on the curve indicates the minimum risk achievable by combining
a varying proportion of stocks and bonds. The curve that connects these
points represents the risk and return of all blends of portfolios from 100
percent bonds to 100 percent stocks. This curve, called the efficient fron-
tier, is the heart of modern portfolio analysis and is the foundation of
asset allocation models.
Note that the allocation that achieves the minimum risk is a func-
tion of the investor’s holding period. Investors with a 1-year horizon
seeking to minimize their risk should hold almost their entire portfolio
in bonds, and that is also true for those with the 2-year horizon. At a 5-
year horizon, the allocation of stock rises to 25 percent in the minimum-
risk portfolio, and it further increases to more than one-third when
investors have a 10-year horizon. For 20-year horizons, the minimum-
risk portfolio is over 50 percent in stock, and for a 30-year horizon it is 68
Given these striking differences, it might seem puzzling that the
holding period has almost never been considered in standard portfolio
theory. This is because modern portfolio theory was established when
CHAPTER 6  Risk, Return, and Portfolio Allocation 101
the vast majority of the academic profession supported the random walk
theory of security prices. As noted earlier, when prices are a random
walk, the risk over any holding period is a simple function of the risk
over a single period, so that the relative risk of different asset classes does
not depend on the holding period. In that case the efficient frontier is
invariant to the time period, and asset allocation does not depend on the
investment horizon of the investor. When security markets do not obey
random walks, that conclusion cannot be maintained.6
No one denies that, in the short run, stocks are riskier than fixed-income
assets. But in the long run, history has shown that stocks are actually
safer than bonds for long-term investors whose goal is to preserve the
102 PART II The Verdict of History
Risk-Return Tradeoffs (Efficient Frontiers) for Stocks and Bonds Over Various Holding Period 1802–2012
purchasing power of their wealth. The inflation uncertainty that is inher-
ent in a paper money standard means that “fixed income” and “fixed
purchasing power” are not the same thing, just as Irving Fisher conjec-
tured a century ago.
Despite the dramatic slowing in the rate of inflation over the past
decade, there is much uncertainty about what a dollar will be worth in
the future, especially given the large government deficits and easy mon-
etary policy followed by the world’s central banks. Historical data show
that we can be more certain of the purchasing power of a diversified
portfolio of common stocks 30 years hence than we can of the buying
power of the principal on a 30-year U.S. Treasury bond.
CHAPTER 6  Risk, Return, and Portfolio Allocation 103
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Stock Indexes
Proxies for the Market
It has been said that figures rule the world.
“How’s the market doing?” one stock investor asks another.
“It’s having a good day—it’s up over 100 points.”
For those who follow the markets, no one would ask, “What’s up
100 points?” The Dow-Jones Industrial Average is still the way many
refer to how the market is doing, even though they well recognize the
limitations of this index. This index, popularly called the Dow, is so
renowned that the news media often called the Dow “the stock market.”
No matter how imperfectly the index describes the movement of share
prices—and virtually no money manager pegs his or her performance to
it—the Dow is the way that many investors describe the ups and downs
of the stock market.
But today there are many other, far more inclusive indexes. The
S&P 500, created in March 1957 by Standard & Poor’s, now a division of
the McGraw-Hill Financial, has become the uncontested benchmark
index for large U.S. stocks. And the Nasdaq, an automated electronic
market that began in 1971, has become the exchange of choice for tech-
nology companies. The Nasdaq Index measures the performance of such
large technology firms as Microsoft, Intel, Google, and Apple.
Although the term Industrials conjures up old-line manufacturing
companies, the Dow has become much more representative of firms that
dominate today’s landscape. In 1999, the Dow Industrials entered the
technological age when, for the first time, the company selected two
Nasdaq stocks—Microsoft and Intel—to join its venerable list of 30
stocks. Below is the story of these three very different indexes with three
unique reflections of the stock market.
Charles Dow, one of the founders of Dow Jones & Co.—the company that
also publishes the Wall Street Journal—created the Dow Jones averages in
the late nineteenth century. On February 16, 1885, he began publishing a
daily average of 12 stocks (10 railroads and 2 industrials) that represented
active and highly capitalized stocks. Four years later, Dow published a
daily average based on 20 stocks—18 railroads and 2 industrials.
As industrial and manufacturing firms succeeded railroads in
importance, the Dow Jones Industrial Average was created on May 26,
1896, comprising the original 12 stocks shown in Table 7-1. The old index
created in 1889 was reconstituted and renamed the Rail Average on
October 26, 1896. In 1916, the Industrial Average was increased to 20
stocks, and in 1928 the number was expanded to 30, its present size. The
Rail Average, whose name was changed to the Transportation Average
in 1970, is composed of 20 stocks, as it has been for over a century.
The early Dow firms were centered on commodities: cotton, sugar,
tobacco, lead, leather, rubber, and so on. Six of the twelve companies
have survived in much the same form, but only one—General
Electric—has retained both its membership in the Dow Industrials and
its original name.1
Almost all the original Dow stocks thrived as large and successful
firms, even if they were eventually removed from the index (see the
Appendix at the end of this chapter for historical details). The only
exception was U.S. Leather Corp., which was liquidated in the 1950s.
Shareholders received $1.50 plus one share of Keta Oil & Gas, a firm
acquired earlier. But in 1955, the president, Lowell Birrell, who later fled
to Brazil to escape U.S. authorities, looted Keta’s assets. Shares in U.S.
Leather, which in 1909 was the seventh-largest corporation in the United
States, became worthless.
106 PART II The Verdict of History
Stocks in Dow Jones Industrials 1886–2013
1896 1916 1928 1965 2013
American Cotton Oil American Sugar Allied Chemical Allied Chemical
3M Co.
American Sugar American Can American Can Aluminum Co. of America
American Express
American Tobacco American Car & American Smelting American Can
Chicago Gas Foundry American Sugar American Tel. & Tel.
Distilling & Cattle American Locomotive American Tobacco American Tobacco
Feeding American Smelting Atlantic Refining Anaconda Copper
General Electric American Sugar Bethlehem Steel Bethlehem Steel
Cisco Systems
Laclede Gas American Tel. & Tel. Chrysler Chrysler
National Lead Anaconda Copper General Electric DuPont
North American Baldwin Locomotive General Motors Eastman Kodak
Exxon Mobil
Tennessee Coal and Iron Central Leather General Railway Signal General Electric
General Electric
U.S. Leather General Electric Goodrich General Foods
Goldman Sachs
U.S. Rubber Goodrich International Harvester General Motors
Home Depot
Republic Iron & Steel International Nickel GoodYear
Studebaker Mack Trucks International Harvester
Texas Co. Nash Motors International Nickel
Johnson & Johnson
U.S. Rubber North American International Paper Co.
JPMorgan Chase
U.S. Steel Paramount Publix Johns-Manville
Utah Copper Postum, Inc. Owens-Illinois Glass
Westinghouse Radio Corp. Procter & Gamble
Western Union Sears, Roebuck Sears, Roebuck
Standard Oil (N.J.) Standard Oil of California
Texas Corp. Standard Oil (N.J.)
Procter & Gamble
Texas Gulf Sulphur Swift & Company
Union Carbide Texaco Incorporated
United Technologies
U.S. Steel Union Carbide
Victor Talking Machine United Aircraft
Verizon Comm.
Westinghouse Electric U.S. Steel
Woolworth Westinghouse Electric
Wright Aeronautical Woolworth
Walt Disney
Computation of the Dow Index
The original Dow Jones averages were simply the sum of the prices of
the component shares divided by the number of stocks in the index.
However, this divisor had to be adjusted over time to prevent jumps in
the index when there were changes in the companies that constituted the
average or stock splits. In October 2013, the divisor was about 0.1557, so
that a 1-point rise in any Dow stock caused the average to increase about
6½ points.2
The Dow Industrials is a price-weighted index, which means that the
prices of the component stocks are added together and then divided by
the number of firms in the index. As a result, proportional movements of
high-priced stocks in the Dow averages have a much greater impact
than movements of lower-priced stocks, regardless of the size of the
company. In November 2013, Visa, with a market price of $200 a share,
constitutes more than 8 percent of the index, while Cisco, the lowest-
priced stock, has a weight of less than 1 percent.3
Price-weighted indexes are uncommon since the impact of the
firm’s stock price on the index is unrelated to the size of the company.
This is in stark contrast to a capitalization-weighted index, such as
Standard & Poor’s 500 Index, in which each company’s weight in the
index is proportional to the market value of its shares. As of October 2013,
the 30 Dow stocks were valued at $4.5 trillion, which is a bit less than one-
quarter of the capitalization of the entire U.S. market. At the end of 2013,
the Dow Industrials did not contain the world’s largest market-value
stock, Apple, nor did it contain Google, which was also one of the top 10
highest-market-value stocks.
Long-Term Trends in the Dow Jones Industrial Average
Figure 7-1 plots the monthly high and low of the Dow Jones Industrial
Average from its inception in 1885, corrected for changes in the cost of
living. The inset shows the Dow Industrial Average uncorrected for
A trendline and a channel are created by statistically fitting the Dow
on a time trend. The upper and lower bounds are 1 standard deviation,
or 50 percent, above and below the trend. The slope of the trendline, 1.94
percent per year, is the average compound rate at which the Dow stocks
have appreciated after inflation, since 1885. The Dow Jones average, like
most other popular averages, does not include dividends, so the appre-
ciation of the rise in the index greatly understates the total return on the
108 PART II The Verdict of History
Dow stocks. Since the average dividend yield on all stocks was about 4.3
percent over this period, the total annual real compound return on the
Dow stocks was about 6.2 percent per year over this period.4
The inflation-corrected Dow average has stayed within the channel
about three-quarters of the time. When the Dow broke out of the chan-
nel to the upside, as it did in 1929, in the mid-1960s, and in 2000, stocks
subsequently suffered poor short-term returns. Likewise, when stocks
penetrated the channel on the downside, they subsequently experienced
superior short-term returns. As of August 2013, the inflation-corrected
all-time high of the Dow Industrials occurred in January 2000 at 16,130.
Beware the Use of Trendlines to Predict Future Returns
Using channels and trendlines to predict future returns, however tempt-
ing, can be misleading. Longstanding trends have been broken for good
CHAPTER 7  Stock Indexes 109
Nominal and Real Dow-Jones Industrial Average 1885–2012
economic reasons. Uncorrected for inflation, the Dow Industrials broke
and stayed above the trendline in the mid-1950s, as shown in the inset of
Figure 7-1. This is because inflation, caused by the shift to a paper money
standard, propelled nominal stock prices justifiably above their previous
trend, established during noninflationary times. Those who used trend-
line analysis and who failed to plot stock prices in real instead of nominal
terms would have sold in 1955 and never reentered the market.5
But there is now another justification why the channel may again
be penetrated on the upside. As noted above, stock indexes track only
capital appreciation and therefore understate total returns, which
include dividends. But firms have been paying an ever-lower fraction
of their earnings as dividends, using the difference to buy back their
shares and invest capital in their business. So in recent years a greater
part of the return on stocks now comes through capital gains instead of
dividend income. Because the average dividend yield on stocks has
fallen 2.88 percentage points since 1980, a new channel has been drawn
in Figure 7-1 with a slope that is 2.88 percentage points higher to rep-
resent the increase in the expected growth of capital gains. At the end
of 2012, the real Dow Industrials were above the mean, uncorrected for
the change in dividend yield but below the bottom of the dividend-
corrected channel.
Standard & Poor’s Index
Although the Dow Jones Industrial Average was published in 1885, it
was certainly not a comprehensive index of stock values, covering at
most 30 stocks. In 1906 the Standard Statistics Co. was formed, and in
1918 it began publishing the first index of stock values based on each
stock’s performance weighted by its capitalization, or market value,
instead of its price as Dow-Jones did. Capitalization weighting is now
recognized as giving the best indication of the return on the overall mar-
ket, and it is almost universally used in establishing market bench-
marks.6In 1939, Alfred Cowles, founder of the Cowles Commission for
Economic Research, used Standard & Poor’s market-weighting tech-
niques to construct indexes of stock values back to 1871 that consisted of
all stocks listed on the New York Stock Exchange.
The Standard & Poor’s stock price index began in 1923, and in 1926
it became the Standard & Poor’s Composite Index containing 90 stocks.
The index was expanded to 500 stocks on March 4, 1957, and became the
110 PART II The Verdict of History
S&P 500 Index. At that time, the value of the S&P 500 Index made up
about 90 percent of the value of all NYSE-listed stocks. The 500 stocks
contained exactly 425 industrial, 25 railroad, and 50 utility firms. Before
1988, the number of companies in each industry was restricted to these
guidelines, but since that date, there are no industry restrictions on the
firms selected.
A base value of 10 was chosen for the average value of the S&P Index
from 1941 to 1943, so that when the index was first published in 1957, the
average price of a share of stock (which stood between $45 and $50) was
approximately equal to the value of the index. An investor at that time
could easily identify with the changes in the S&P 500 Index since a 1-point
change approximated the price change for an average stock.
The S&P 500 Index contains a few firms that are quite small, repre-
senting companies that have fallen in value and have yet to be replaced.7
As of the end of 2012, the total value of all S&P 500 companies was about
$13.6 trillion, but this constituted less than 75 percent of the value of all
stocks traded in the United States, significantly less than the 90 percent
share it constituted when the index was first formulated. A history of the
S&P 500 Index, along with the insights that come from analyzing the
stocks in this world-famous index, is described in the next chapter.
Nasdaq Index
On February 8, 1971, the method of trading stocks underwent a revolu-
tionary change. On that date, an automated quotation system called the
Nasdaq (an acronym for National Association of Securities Dealers
Automated Quotations) provided up-to-date bid and asked prices on
2,400 leading over-the-counter stocks. Formerly, quotations for these
unlisted stocks were submitted by the principal trader or by brokerage
houses that carried an inventory. The Nasdaq linked the terminals of more
than 500 market makers nationwide to a centralized computer system.
In contrast to the Nasdaq, stocks traded on the New York or
American Stock Exchange are assigned to a Designated Market Maker
(used to be called “specialist”), who is charged with maintaining an
orderly market in that stock. The Nasdaq changed the way quotes were
disseminated and made trading these issues far more attractive to both
investors and traders.
At the time that the Nasdaq was created, it was clearly more presti-
gious to be listed with an exchange (and preferably the New York Stock
Exchange) than be traded on the Nasdaq. Nasdaq stocks tended to be
small or new firms that had recently gone public or did not meet the list-
CHAPTER 7  Stock Indexes 111
ing requirements of the larger exchanges. However, many young tech-
nology firms found the computerized Nasdaq system a natural home.
Some, such as Intel and Microsoft, chose not to migrate to the Big Board,
as the NYSE is termed, even when they qualified to do so.
The Nasdaq Index, which is a capitalization-weighted index of all
stocks traded on the Nasdaq, was set at 100 on the first day of trading in
1971. It took almost 10 years to double to 200 and another 10 years to
reach 500 in 1991. It reached its first major milestone of 1,000 in July 1995.
As the interest in technology stocks grew, the rise in the Nasdaq
Index accelerated, and it doubled its value to 2,000 in just three years. In
the fall of 1999, the technology stock boom sent the Nasdaq into orbit.
The index increased from 2,700 in October 1999 to its all-time peak of
5,048.62 on March 10, 2000.
The increase in popularity of technology stocks resulted in a
tremendous increase in volume on the Nasdaq. At the onset, the volume
on this electronic exchange was a small fraction of that on the New York
Stock Exchange. But by 1994 share volume on the Nasdaq exceeded that
on the NYSE, and five years later dollar volume on the Nasdaq sur-
passed the NYSE as well.8
No longer was the Nasdaq the home of small firms waiting to qual-
ify for Big Board membership. By 1998 the capitalization of the Nasdaq
had already exceeded that of the Tokyo Stock Exchange. At the market
peak in March 2000, the total market value of firms traded on the
Nasdaq reached nearly $6 trillion, more than one-half that of the NYSE
and more than any other stock exchange in the world. At the beginning
of the millennium, Nasdaq’s Microsoft and Cisco had the two largest
market values in the world, and Nasdaq-listed Intel and Oracle were
also among the top 10.
When the technology bubble burst, trading and prices on the
Nasdaq sank rapidly. The Nasdaq Index declined from over 5,000 in
March 2000 to 1,150 in October 2002 before rebounding to 3,000 at the
end of 2012. Trading also fell off from an average of over 2.5 billion
shares when prices peaked to approximately 2 billion shares in 2007.
Despite the decline in the Nasdaq Index, the Nasdaq still trades in some
of the world’s most active stocks.
But the importance of individual exchanges and “floor trading”
has declined precipitously, as the overwhelming percentage of shares
listed on the New York Stock Exchange is now traded electronically. In
2008 the NYSE bought the American Stock Exchange, and in late 2012,
the ICE, or Intercontinental Exchange, a 12-year-old Atlanta-based firm
112 PART II The Verdict of History
that trades futures contracts electronically, made an $8 billion bid to
acquire the NYSE. Even though it may seem exciting for news reporters
to broadcast from the floor of the New York Stock Exchange, the colon-
naded building, built at Broad and Wall Street in 1903 to trade the
world’s largest and most important companies, may soon go dark.
Other Stock Indexes: The Center for Research in Security Prices
In 1959, Professor James Lorie of the Graduate School of Business of the
University of Chicago received a request from the brokerage house
Merrill Lynch, Pierce, Fenner & Smith. The firm wanted to investigate
how well people had done investing in common stock, and it could not
find reliable historical data. Professor Lorie teamed up with colleague
Lawrence Fisher to build a database of securities data that could answer
that question.
With computer technology in its infancy, Lorie and Fisher created
the Center for Research in Security Prices (CRSP, pronounced “crisp”)
that compiled the first machine-readable file of stock prices dating from
1926 that was to become the accepted database for academic and profes-
sional research. The database currently contains all stocks traded on the
New York and American Stock Exchanges and the Nasdaq.
At the end of 2012, the market value of the nearly 5,000 stocks in the
database was near $19 trillion. The CRSP is the largest comprehensive
index of U.S. firms.
Figure 7-2 shows the size breakdown and total market capitaliza-
tion of the stocks in the CRSP. The top 500 firms, which closely mirror
the S&P 500 Index, constitute 78.6 percent of the market value of all
stocks. The top 1,000 firms in market value, which are virtually identical
to the Russell 1000 and published by the Russell Investment Group,
compose nearly 90 percent of the total value of equities. The Russell 2000
contains the next 2,000-largest companies, which adds an additional 9.6
percent to the market value of the total index. The Russell 3000, the sum
of the Russell 1000 and 2000 indexes, composes 99.1 percent of all U.S.
stocks. The remaining 1,788 stocks constitute 0.8 percent of the value of
all stocks traded.9
Because stock indexes such as the S&P 500 Index constantly add new
firms and delete old ones, some investors believe that the return calcu-
CHAPTER 7  Stock Indexes 113
lated from these indexes will be higher than the return that can be
achieved by investors in the overall market.
But this is not the case. It is true that the best-performing stocks will
stay in the S&P 500 Index, but this index misses the powerful upside
move of many small and mid-sized issues. For example, Microsoft was
not added to the S&P 500 Index until June 1994, eight years after going
public. And while small stock indexes are the incubators of some of the
greatest growth stocks, they also contain those “fallen angels” that
dropped out of the large-cap indexes and are headed downward.
An index is not biased if its performance can be replicated or
matched by an investor. To replicate an index, the date of additions and
deletions to the index must be announced in advance so that new stocks
can be bought and deleted stocks can be sold. This is particularly impor-
tant for issues that enter into bankruptcy: the postbankrupt price (which
114 PART II The Verdict of History
CRSP Total Market Index, 2012
might be zero) must be factored into the index. All the major stock
indexes, such as Standard & Poor’s, Dow Jones, and the Nasdaq, can be
replicated by investors.10 Consequently, there is no statistical reason to
believe that these indexes give a biased representation of the return on
the market.
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 compa-
nies 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 & Cattle Feeding) changed its product line (from alcoholic
beverages to petrochemicals), and only one (U.S. Leather) was liqui-
dated. Here is a rundown of the original 12 stocks (market capitaliza-
tions as of December 2012):
American Cotton Oil became Best Food in 1923, Corn Products
Refining in 1958, and finally CPC International in 1969—a major
food company with operations in 58 countries. In 1997, CPC
spun off its corn-refining business as Corn Products
International and changed its name to Bestfoods. Bestfoods was
acquired by Unilever in October 2000 for $20.3 billion. Unilever
(UN), which is headquartered in the Netherlands, has a current
market value of $115 billion.
American Sugar became Amstar in 1970 and went private in
1984. In September 1991 the company changed its name to
Domino Foods, Inc., to reflect its world-famous Domino line of
sugar products.
American Tobacco changed its name to American Brands (AMB)
in 1969 and to Fortune Brands (FO) in 1997, a global consumer
products holding company with core businesses in liquor, office
products, golf equipment, and home improvements. American
Brands sold its American Tobacco subsidiary, including the Pall
Mall and Lucky Strike brands, to one-time subsidiary B.A.T.
Industries in 1994. In 2011 Fortune Brands changed its name to
Beam Inc (BEAM), which operates as a distribution company in
the spirits industry. The market value is $9 billion.
CHAPTER 7  Stock Indexes 115
Chicago Gas became Peoples Gas Light & Coke Co. in 1897 and
then Peoples Energy Corp., a utility holding company, in 1980.
Peoples Energy Corp. (PGL) was bought by WPS Resources and
changed its name in 2006 to Integrys Energy Group (TEG). It has
a market value of $4.1 billion. PGL was a member of the Dow
Jones Utility Average until May 1997.
Distilling & Cattle Feeding went through a long and complicated
history. It changed its name to American Spirits Manufacturing
and then to Distiller’s Securities Corp. Two months after the
passage of Prohibition, the company changed its charter and
became U.S. Food Products Corp. and then changed its name
again to National Distillers and Chemical. The company became
Quantum Chemical Corp. in 1989, a leading producer of petro-
chemicals and propane. Nearing bankruptcy, it was purchased
for $3.4 billion by Hanson PLC, an Anglo-American conglomer-
ate. It was spun off as Millennium Chemicals (MCH) in October
1996. Lyondell Chemical (LYO) bought Millennium Chemicals
in November 2004. In 2007 Lyondell was taken over by the
Dutch firm that renamed itself Lyondell Basell Industries (LYB).
The current market value of Lyondell Basell is $28 billion.
General Electric (GE), founded in 1892, is the only original stock
still in the Dow Industrials. GE is a huge manufacturing and
broadcasting conglomerate that owns NBC and CNBC. Its mar-
ket value of $218 billion is the third-highest capitalization stock
in the United States.
Laclede Gas (LG) changed its name to Laclede Group, Inc., and it
is a retail distributor of natural gas in the St. Louis area. The
market value is $900 million.
National Lead (NL) changed its name to NL Industries in 1971,
and it manufactures products relating to security and to preci-
sion ball bearings, as well as titanium dioxide and specialty
chemicals. The market value is $520 million.
North American became Union Electric Co. (UEP) in 1956, pro-
viding electricity in Missouri and Illinois. In January 1998, UEP
merged with Cipsco (Central Illinois Public Service Co.) to form
Ameren (AEE) Corp. The market value is $72 billion.
Tennessee Coal and Iron was bought out by U.S. Steel in 1907, and
it became USX-U.S. Steel Group (X) in May 1991. In January
2002, the company changed its name back to U.S. Steel Corp.
U.S. Steel has a market value of $3 billion.
116 PART II The Verdict of History
U.S. Leather, one of the largest makers of shoes in the early part
of this century, liquidated in January 1952, paying its sharehold-
ers $1.50 plus stock in an oil and gas company that was to
become worthless.
U.S. Rubber became Uniroyal in 1961, and it was taken private
in August 1985. In 1990 Uniroyal was purchased by the French
company Michelin Group, which has a market value of $15
CHAPTER 7  Stock Indexes 117
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The S&P 500 Index
More Than a Half Century
of U.S. Corporate History
Most of the change we think we see in life is due to truths being in and
out of favor.
Out of the three major U.S. stock market indexes, the Dow, the Nasdaq,
and the S&P 500, only one became the world standard for measuring the
performance for stocks. It was born on February 28, 1957, and it grew
out of Standard & Poor’s Composite Index, a capitalization-weighted
index begun in 1926 that contained 90 large stocks. Ironically, the 1926
index excluded the largest stock in the world at that time, American
Telephone and Telegraph, because S&P did not want to let the perform-
ance of such a large firm dominate the index. To correct this omission
and to recognize the growth of new firms in the postwar period,
Standard & Poor’s compiled an index of 500 of the largest industrial,
rail, and utility firms that traded on the New York Stock Exchange.
The S&P 500 Index made up nearly 90 percent of the total value of
firms traded on the Big Board in 1957. It soon became the standard
against which the performance of institutions and money managers
investing in large U.S. stocks was compared. The S&P 500 Index origi-
nally contained exactly 425 industrial, 25 rail, and 50 utility firms, but
these groupings were abandoned in 1988 in order to maintain, as
Standard & Poor’s claimed, an index that included “500 leading compa-
nies in leading industries of the economy.”
Since its creation, the index has been continually updated by adding
new firms that meet Standard & Poor’s criteria for market value, earn-
ings, and liquidity while deleting an equal number that fall below these
standards.1The total number of new firms added to the S&P 500 Index
from its inception in 1957 through 2012 was 1,159, an average of about 20
per year. On average, the new firms constitute about 5 percent of the mar-
ket value of the index.
The highest number of new firms added to the index in a single
year occurred in 1976, when Standard & Poor’s added 60 stocks includ-
ing 15 banks and 10 insurance carriers. Until that year, the only financial
stocks in the index were consumer finance companies, because banks
and insurance companies were traded in the over-the-counter market
and because timely price data were not available to compute the index
until the Nasdaq exchange began in 1971. In 2000, at the peak of the tech-
nology bubble, 49 new firms were added to the index, the highest since
Nasdaq stocks were included in 1976. In 2003, the number of additions
fell to a record-tying low of 8.
The evolution of the U.S. economy during the past half century has
brought about profound changes in its industrial landscape. Steel, chemi-
cal, auto, and oil companies once dominated our economy. Today health-
care, technology, finance, and other consumer services firms hold sway.
Increasingly, active investors are using sector analysis to allocate
their portfolios. The most popular industry classification system was
formulated in 1999 when Standard & Poor’s joined Morgan Stanley to
create the Global Industrial Classification Standard (GICS). This system
arose from the earlier Standard Industrial Code (SIC) system devised by
the U.S. government that had grown less suited to our service-based
The GICS divides the economy into 10 sectors: materials (chemicals,
papers, steel, and mining), industrials (capital goods, defense, trans-
portation, and commercial and environmental services), energy (explo-
ration, production, marketing, refining of oil and gas, and coal), utilities
(electric, gas, water, and nuclear generating or transmission firms),
120 PART II The Verdict of History
telecommunication services (fixed line, cellular, wireless, and bandwidth),
consumer discretionary (household durables, autos, apparel, hotels,
restaurants, media, and retailing), consumer staples (food, tobacco, per-
sonal products, retailing, and hypermarkets), healthcare (equipment pro-
ducers, healthcare providers, pharmaceuticals, and biotechs), financial
(commercial and investment banking, mortgages, brokerage, insurance,
and real estate [REITs]), and information technology (software services,
Internet, home entertainment, data processing, computers, and semi-
The share of the market value of each of these sectors in the S&P 500
Index from 1957 through 2012 is displayed in Figure 8-1. Many of the
changes have been dramatic. The materials sector, by far the largest in
1957, had become one of the smallest (along with utilities and telecom)
by the end of 2012. The materials and energy sectors made up almost
one-half of the market value of the index in 1957, but by 2013 these two
CHAPTER 8  The S&P 500 Index 121
Market Value of S&P 500 Sectors as a Percentage of Total S&P 500 1957–2012
122 PART II The Verdict of History
sectors together constituted only 14 percent of the index. On the other
hand, the financial, healthcare, and technology sectors, which started off
as the three smallest sectors and constituted only 6 percent of the index
in 1957, commanded almost one-half of the market value of all S&P 500
firms by 2013.
It is important to realize that when measured over long periods of
time, the rising or falling market shares do not necessarily correlate with
rising or falling investor returns. That is because the change in sector
shares often reflects the change in the number of firms, not just the
change in the value of individual firms. This is especially true in the
financial sector, as commercial and investment banks, insurance compa-
nies, brokerage houses, and government-sponsored enterprises such as
Fannie Mae and Freddie Mac were added to the index.3The technology
share has also increased primarily because of the addition of new firms.
In 1957, IBM’s weight was two-thirds of the technology sector; in 2013,
IBM was only the third largest in a sector that contains 70 firms.
One can see in Figure 8-2 how little relation there is between the
change in the market value of a sector and its return. The fastest-
growing technology sector did have slightly above-average returns, but
the second-fastest-growing financials had the second-worst sector
returns. The weights of the financial and technology sectors increased
primarily because many new firms had been added to the sector, not
because individual stocks increased in value.
It is true that the healthcare and consumer staples sectors both
increased their weights and had above-average returns; but the energy
sector shrank significantly from 20 to 11 percent in market weight, and
yet its return of 11.76 percent was well above the S&P 500 Index.
Statistical analysis shows that over the past 50 years only 10 percent of
the return to a sector is related to whether the sector is expanding or con-
tracting. This means that 90 percent of the investor return of a sector is
based on the returns of the firms in the sector, not the relative growth of
the industry. Rapidly expanding sectors often induce investors to pay
too high a price, which results in lower returns. As a result, the best val-
ues are often found in stagnant or declining sectors that are ignored by
investors and whose price is low relative to fundamentals.
The performance of the 20 largest companies that Standard &
Poor’s put into its first list in 1957 is shown in Table 8-1. One feature that
stands out is that all 9 oil companies on the list finished in the top 10 and
that the returns on all the oil companies beat the S&P 500 by between 96
and 275 basis points per year.
The top-performing firm of the original 20 largest stocks in the S&P
500 Index was Royal Dutch Petroleum, a firm founded in the
Netherlands and one of the companies that Standard & Poor’s deleted
from its index in 2002 when it purged all foreign-based firms. The
second-best-performing stock was Socony Mobil Oil, which dropped the
“Socony” (which stood for Standard Oil Company of New York) in 1966
and merged with Exxon in 1999. Third-ranking Gulf Oil, sixth-ranking
Standard Oil of California, and eighth-ranking Texas Co (Texaco) even-
tually merged to form ChevronTexaco, whose name was shortened to
Chevron. The fourth-best-performing stock was Shell Oil, a U.S.-based
company that was purchased by Royal Dutch in 1985 and is no longer in
the S&P 500 Index. The fifth-best performer was Standard Oil of New
Jersey, which changed its name to Exxon in 1972 and currently vies with
Apple as the world’s largest market-value stock. Ninth-ranked Standard
Oil of Indiana merged into BP Amoco in 1998, and tenth-ranking Phillips
CHAPTER 8  The S&P 500 Index 123
Relation Between Change in Sector Weight and Sector Return for S&P 500, 1957–2012
Petroleum merged with Conoco (Continental Oil Co.) to form
ConocoPhillips in 2002.
The only firm to beat any oil firm is IBM, incorporated in 1911 as C-
T-R (Computer-Tabulating-Recording) Company. IBM had the highest
weight in the S&P 500 Index (at over 6 percent) from 1983 through 1985
and in 2013 is still one of the top 10 most valuable companies.
Ten of the original twenty largest companies lagged the perform-
ance of the S&P 500 Index. U.S. Steel, AT&T, and General Motors were at
one time the largest corporations in the world. U.S. Steel and AT&T have
gone through tortuous paths of industrial changes and corporate divest-
ments and at one time had shrunk to a tiny fraction of their former size.
124 PART II The Verdict of History
T A B L E 8–1
Returns of 20 Largest original S&P 500 Firms, 1957-2012
Return 1957–2012 1957 Market
Rank 1957 Name Return Cap Rank
1 Royal Dutch Petroleum 12.82% 12
2 Socony Mobil Oil 12.76% 13
3 Gulf Oil 12.46% 6
4 Shell Oil 12.40% 14
5 Standard Oil Co NJ 12.28% 2
6 Standard Oil Co CA 12.02% 10
7 IBM 11.57% 11
8 Texaco 11.43% 8
9 Standard Oil Co Ind 11.26% 16
10 Phillips Petroleum 11.03% 20
11 AT&T 9.76% 1
12 Union Carbide 9.75% 7
13 General Electric 9.65% 5
14 Sears, Roebuck 8.04% 15
15 Du Pont 7.42% 4
16 Eastman Kodak 6.09% 19
17 USX Corp. 6.00% 9
18 Aluminum Co. Of America 4.24% 17
19 General Motors 3.71% 3
20 Bethlehem Steel 18
Average Top 10 12.09%
Average Top 20 10.94%
S&P 500 10.07%
Yet both have come back, and as of 2013, AT&T is the thirteenth-largest
company by market value in the United States.
U.S. Steel was formed in 1901 from the merger of 10 steel compa-
nies, led by Andrew Carnegie and financed by J. P. Morgan. After the
merger, it was the first billion-dollar-sales company in history, and it
controlled two-thirds of the U.S. market. To cushion itself against rising
energy costs, it bought Marathon Oil Company in 1982 and renamed
itself USX Corporation. In 1991, U.S. Steel was spun off as a separate
firm, and in 2003, the value of its shares sank to just over $1 billion, the
same size as it was a century earlier. Aggressive cost cutting has brought
U.S. Steel back, and it is now the second-largest U.S. steel producer
behind Mittal Steel USA, which purchased, among other steel firms, the
bankrupt assets from Bethlehem Steel, the eighteenth-largest company
in the S&P 500 Index in 1957.
American Telephone and Telegraph Co. was the largest company
in the world when it joined the S&P 500 Index in 1957, and it remained
that way until 1975. The company boasted a market value of $11.2 bil-
lion in 1957, a capitalization that would rank in the bottom half of the
S&P 500 firms in 2012. The telephone monopoly known as “Ma Bell”
was broken up in 1984, giving birth to the “Baby Bell” regional
providers. But the stripped-down AT&T was bought by one of its chil-
dren, SBC Communications, in 2005, and through other acquisitions, it
worked itself back to the top 20 in market value in the United States by
2007. The 55-year return on AT&T, had you also held all the Baby Bells
when Ma Bell spun them off 23 years ago, would have given you a 9.76
percent annual return, virtually matching the index.
General Motors, which was formed by the consolidation of 17 auto
companies in 1908, was destined to become the largest auto producer in
the world. But the impact of foreign competition and mounting health-
care obligations forced GM into bankruptcy in 2009 during the Great
Recession. The company, however, has reemerged and vies with Toyota
as the largest auto manufacturer in the world. Although GM stock went
to zero, the value of Delphia, Raytheon, and Electronic Data Systems that
the giant automaker spun off before the bankruptcy gave shareholders a
meager 3.71 percent annual return since 1957. A slightly better return
was offered by Eastman Kodak, which declared bankruptcy in January
2012, but because it had spun off its holdings in the highly successful
Eastman Chemical Company in 1994, the parent company managed to
offer its shareholders since 1957 about a 6 percent return. This was not
the case for stockholders of Bethlehem Steel. The world’s second-largest
steel company went bankrupt in 2001, and the original stockholders
CHAPTER 8  The S&P 500 Index 125
have no assets to show for it. The remaining three firms belong to the
materials industry: the returns of Union Carbide (now part of Dow
Chemical) have slightly lagged the market, while the returns of DuPont
and Alcoa have fallen significantly behind the Index.
The 20 best-performing firms of the original S&P 500 that have survived
with their corporate structure intact are shown in Table 8-2, along with
their annual return, sector, and total return per dollar invested. Table 8-
3 lists the 20 best-performing firms whether they have survived intact or
have been merged into another firm.4
By far the best-performing stock is Philip Morris, which in 2003
changed its name to Altria Group and in 2008 spun off its international
division (Philip Morris International).5Philip Morris introduced the
126 PART II The Verdict of History
T A B L E 8–2
Returns of 20 Best Performing Original and Surviving S&P 500 Firms 1957–2012
Rank 1957 Name 2012 Name Ticker Return Sector Accum of $1
1 Philip Morris Altria Group Inc MO 19.47% Consumer staples $ 19,737.35
2 Abbott Labs Abbott Laboratories ABT 15.18% Healthcare $ 2,577.27
3 Coca-Cola Coca Cola Co. KO 14.68% Consumer staples $ 2,025.91
4 Colgate-Palmolive Colgate Palmolive Co. CL 14.64% Consumer staples $ 1,990.55
5 Bristol-Myers Bristol Myers Squibb Co. BMY 14.40% Healthcare $ 1,768.50
6 Pepsi-Cola Co. Pepsico Inc. PEP 14.13% Consumer staples $ 1,547.44
7 Merck & Co. Merck & Co. Inc. New MRK 13.95% Healthcare $ 1,419.26
8 Heinz Heinz H J Co. HNZ 13.80% Consumer staples $ 1,317.34
9 Melville Corp. C V S Caremark Corp. CVS 13.65% Consumer staples $ 1,224.81
10 Sweets Co. Tootsie Roll Inds. TR 13.57% Consumer staples $ 1,178.92
11 Crane Co. Crane Co. CR 13.57% Industrials $ 1,178.44
12 Hershey Foods Hershey Co. HSY 13.53% Consumer staples $ 1,154.02
13 Pfizer Inc. Pfizer Inc. PFE 13.38% Healthcare $ 1,072.61
14 Equitable Gas E Q T Corp. EQT 13.16% Energy $ 964.47
15 General Mills General Mills Inc. GIS 13.12% Consumer staples $ 947.03
16 Oklahoma Nat Gas Oneok Inc. New OKE 13.04% Utilities $ 907.42
17 Procter & Gamble Procter & Gamble Co. PG 13.00% Consumer staples $ 890.97
18 Deere & Co. Deere & Co. DE 12.86% Industrials $ 833.05
19 Kroger Co. Kroger Company KR 12.70% Consumer staples $ 768.88
20 McGraw-Hill Co. McGraw Hill Co. Inc. MHP 12.58% Consumer discretionary $ 725.52
world to the Marlboro Man, one of the world’s most recognized icons,
two years before the formulation of the S&P 500 Index. Marlboro ciga-
rettes subsequently became the world’s best-selling brand and propelled
Philip Morris stock upward.
The average annual return on Philip Morris over the past half cen-
tury, at 19.47 percent per year, almost doubled the 10.07 percent annual
return on the S&P 500 Index. This return means that $1,000 invested in
Philip Morris on March 1, 1957, would have accumulated to almost $20
million by the end of 2102, more than 100 times the $191,000 accumula-
tion in the S&P 500 Index.
Philip Morris’s outstanding performance does not just date from
midcentury. Philip Morris was also the best-performing stock since 1925,
the date when comprehensive returns on individual stocks were first
compiled. From the end of 1925 through the end of 2012, Philip Morris
delivered a 17.3 percent compound annual return, 7.7 percent greater
CHAPTER 8  The S&P 500 Index 127
T A B L E 8–3
Returns of 20 Best Performing Original S&P 500 Firms 1957–2012
Rank Original Company Surviving Company Ann. return
1 Philip Morris Altria Group, Philip Morris International 19.56%
2 Thatcher Glass Altria Group, Philip Morris International 18.43%
3 Lane Bryant Limited Group 17.84%
4 National Can Privatized 17.71%
5 Dr. Pepper Privatized 17.09%
6 General Foods Altria Group, Philip Morris International 17.03%
7 Del Monte Corp. Altria Group, Philip Morris International 16.51%
8 Standard Brands Altria Group, Philip Morris International 16.41%
9 National Dairy Altria Group, Philip Morris International 16.30%
10 Celanese Corp. Privatized 16.19%
11 RJ Reyonolds Tobacco Altria Group, Philip Morris International 15.78%
12 National Biscuit Altria Group, Philip Morris International 15.78%
13 Penick & Ford Altria Group, Philip Morris International 15.64%
14 Flintkote British American Tobacco 15.60%
15 Lorillard Loews Corp 15.29%
16 Abbott Labs Abbott Labs 15.12%
17 Columbia Pictures Coca-Cola 14.85%
18 Coca-Cola Coca-Cola 14.66%
19 Colgate-Palmolive Colgate-Palmolive 14.64%
20 Bristol-Myers Bristol-Myers 14.59%
than the market indexes. Had your grandmother bought 40 shares (cost
of $1,000) of Philip Morris in 1925 and joined its dividend investment
plan, her shares would have been worth over $1 billion dollars by the end
of 2012!
Philip Morris’s bounty did not extend to only its own stockholders.
Philip Morris eventually became the owner of 10 other original S&P 500
firms. Many investors became enormously wealthy because the shares
of their firms were exchanged with shares of successful companies such
as Philip Morris. Riding on the coattails of such winners is an unex-
pected bounty for many stockholders.
Some readers may be surprised that Philip Morris is the top performer
for investors in the face of the onslaught of governmental restrictions
and legal actions that have cost the firm tens of billions of dollars and at
one time threatened the cigarette manufacturer with bankruptcy.
But in the capital markets, bad news for the firm often can be good
news for investors who hold onto the stock and reinvest their dividends.
If investors become overly pessimistic about the prospects for a stock,
the low price enables stockholders who reinvest their dividends to buy
the company on the cheap. These reinvested dividends have turned its
stock into a pile of gold for those who stuck with Philip Morris.
Philip Morris is not the only firm that has served investors well. The
return on the other 19 best-performing surviving companies listed in
Table 8-2 has beaten the return on the S&P 500 Index by between 2½ and
5 percentage points per year. Of the top 20 firms, 15 belong to two indus-
tries: consumer staples, represented by internationally well-known con-
sumer brand-name companies, and healthcare, particularly large
pharmaceutical firms. Hershey chocolate, Heinz ketchup, and Tootsie
Roll, as well as Coca-Cola and Pepsi-Cola, have built up wide brand
equity and consumer trust.
Three other winners are Crane, a manufacturer of engineered
industrials products founded in 1855 by Richard Crane; Deere, a manu-
facturer of agricultural and construction machinery, established in 1840
by John Deere; and McGraw-Hill (now McGraw Hill Financial), a global
information provider, founded by James H. McGraw in 1899 and now
128 PART II The Verdict of History
the owner of Standard & Poor’s. In the last five years, this top 10 list has
been joined by gas producers EQT, formerly Equitable Gas (founded in
1888 in Pittsburgh), and ONEOK Inc., formerly Oklahoma Natural Gas
(founded in 1906).
One firm of particular note is CVS Corporation, which in 1957
entered the S&P 500 Index as Melville Shoe Corp., a company whose
name was taken from the founder, Frank Melville, who started a shoe
company in 1892 and incorporated as Melville Shoe in 1922. Shoe com-
panies have been among the worst investments over the past century,
and even Warren Buffett bemoans his purchase of Dexter Shoe in 1991.
But Melville Shoe was fortunate enough to buy the Consumer Value
Store chain in 1969, specializing in personal health products. The chain
quickly became the most profitable division of the company, and in 1996
Melville changed its name to CVS. So a shoe manufacturer, destined to
be a bad investment, turned to gold as a result of the management’s for-
tuitous purchase of a retail drug chain.
There are similar stories for the firms in Table 8-3, which, as noted
earlier, lists the 20 best-performing stocks whether they have survived in
their original corporate form or have been merged into another firm.
Thatcher Glass was the second-best performing of all the original S&P
500 stocks behind Philip Morris and was the leading milk bottle manu-
facturer in the early 1950s. But as the baby boom turned into the baby
bust and glass bottles were replaced by cardboard cartons, Thatcher’s
business sank. Fortunately for Thatcher shareholders, in 1966 the firm
was purchased by Rexall Drug, which became Dart Industries, which
merged with Kraft in 1980 and was eventually bought by Philip Morris
in 1988. An investor who purchased 100 shares of Thatcher Glass in 1957
and reinvested the dividends would have owned 140,000 shares of
Philip Morris stock and an equal number of shares of Phillip Morris
International, worth more than $16 million at the end of 2012.
As the medical, legal, and popular assault on smoking accelerated
through the 1980s, Philip Morris, as well as the other giant tobacco
manufacturer, RJ Reynolds, diversified into brand-name food products.
In 1985 Philip Morris purchased General Food, and in 1988 it purchased
Kraft Foods for $13.5 billion, which had originally been called National
Dairy Products and was an original member of the S&P 500 Index.
Philip Morris completed its food acquisitions with Nabisco Group
Holdings in 2000.
CHAPTER 8  The S&P 500 Index 129
Nabisco Group Holdings was the company that Kohlberg Kravis
Roberts & Co. (KKR) spun off in 1991 after taking RJR Nabisco private in
1989 for $29 billion, at that time the largest leveraged buyout in history.
Under our methodology for computing long-term returns, if a firm is
taken private, the cash from the buyout is assumed to be invested in an
S&P 500 Index fund until the company is spun off, at which point the
shares are repurchased in the new IPO.6RJ Reynolds Tobacco Co. had
previously absorbed six original S&P companies: Penick & Ford,
California Packing, Del Monte Foods, Cream of Wheat (purchased in
1971 by Nabisco), Standard Brands, and finally National Biscuit Co. in
1985. All these companies became top-20 performers in large part
because of their ultimate purchase by Philip Morris.
One of the most remarkable aspects of these original 500 firms is that the
investor who purchased the original portfolio of 500 stocks and never
bought any of the more than 1,000 additional firms that have been added
by Standard & Poor’s in the subsequent 50 years would have outper-
formed the dynamic updated index. The return of the original 500 firms
is more than 1 percentage point higher than the updated index’s 10.07
percent annual return.7
Why did this happen? How could the new companies that fueled
our economic growth and made America the preeminent economy in the
world underperform the older firms? The answer is straightforward.
Although the earnings and sales of many of the new firms grew faster
than those of the older firms, the price that investors paid for these
stocks was simply too high to generate good returns.
Stocks that qualify for entry into the S&P 500 Index must have suf-
ficient market value to be among the 500 largest firms. But a market
value this high is often reached because of unwarranted optimism on
the part of investors. During the energy crisis of the early 1980s, firms
such as Global Marine and Western Co. were added to the energy sector,
and they subsequently went bankrupt. In fact, 12 of the 13 energy stocks
that were added to the S&P 500 Index during the late 1970s and early
1980s did not subsequently match the performance of either the energy
sector or the S&P 500 Index.
About 30 percent of the 125 firms that have been added to the tech-
nology sector of the S&P 500 Index since 1957 were added in 1999 and
2000. Needless to say, most of these firms have greatly underperformed
the market. The telecommunications sector added virtually no new
130 PART II The Verdict of History
firms from 1957 through the early 1990s. But in the late 1990s, firms such
as WorldCom, Global Crossing, and Quest Communications entered the
index with great fanfare, only to collapse afterward.
Of all 10 industrial sectors, only the consumer discretionary sector
has added firms that have outperformed the original firms put into the
index. This sector was dominated by the auto manufacturers (GM,
Chrysler, and then Ford), their suppliers (Firestone and Goodyear), and
large retailers, such as JCPenney and Woolworth’s.
The superior performance of the original S&P 500 firms surprises most
investors. But value investors (as described in Chapter 12) know that
growth stocks often are priced too high, and excitement over their
prospects often induces investors to pay too high a price. Profitable
firms that do not catch investors’ eyes are often underpriced. If investors
reinvest the dividends of such firms, they are buying undervalued
shares that will add significantly to their return.
The study of the original 500 companies also gives you an appreci-
ation of the dramatic changes that the U.S. economy has undergone in
the past half century. Although, many of the top performers are produc-
ing the same brands that they did 50 years earlier, most have aggres-
sively expanded their franchise internationally. Brands such as Heinz
ketchup, Coca-Cola, Pepsi-Cola, and Tootsie Roll are as profitable today
as they were when these products were launched, some over a hundred
years ago.
But we also see that many companies make good investments by
being merged into a stronger company. And four of the top-performing
original companies—Dr. Pepper, Celanese, National Can, and Flintkote—
are now owned by foreign companies. In fact, it is more likely than not
that many of the future winners will not be headquartered in the United
States. As we noted in Chapter 4, foreign firms, clearly of secondary
importance when the S&P 500 Index was founded in 1957, are apt to be
the ultimate owners of many of today’s top firms.
CHAPTER 8  The S&P 500 Index 131
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The Impact of Taxes on
Stock and Bond Returns
Stocks Have the Edge
In this world nothing is certain but death and taxes.
The power to tax involves the power to destroy.
For all long-term investors, there is only one objective—maximum
total real return after taxes.
John Templeton’s objective to maximize total real return after taxes is an
essential investment strategy. And stocks are very well suited to this
purpose. In contrast to fixed-income investments, both capital gains and
dividends are treated favorably by the U.S. tax code. So in addition to
having superior before-tax returns, stocks often hold an even larger
after-tax advantage over bonds.
Figure 9-1 plots the historical marginal tax rate at three income levels:
the highest tax bracket, the tax rate for income of $150,000, and the tax
134 PART II The Verdict of History
Federal Tax Rates on Interest and Dividend Income and Capital Gains 1913–2012
rate for real income of $50,000 all adjusted to 2012 dollars. Figure 9-1A is
the tax rate for ordinary income (including interest income) from 1913,
when the federal income tax was established, and for dividends until
2003, when the dividend tax was set at the same rate as the capital gains
tax. Figure 9-1B plots the marginal tax rate for capital gains and (since
2003) dividend income. A history of the tax code applicable to stock
investors is provided in the Appendix at the end of this chapter.
The historical real after-tax returns for various asset classes are dis-
played in Table 9-1 for four tax brackets. Since 1913, when the federal
income tax was instituted, the after-tax real return on stocks has ranged
from 6.1 percent for untaxed investors to 2.7 percent for investors in the
highest bracket who realize their capital gains each year. For taxable
bonds, the real annual return ranges from 2.2 percent for the untaxed
investor to –0.3 for the investor in the maximum tax bracket, while the
real return on bills ranges from 0.4 to –2.3 percent. Municipal bonds
have realized a 1.3 percent annual real return since 1913.
Despite the debilitating effect of taxes on equity accumulations,
taxes cause the greatest damage to the returns on fixed-income invest-
ments. On an after-tax basis, an investor in the top tax bracket who put
$1,000 in Treasury bills at the beginning of 1946 would have $138 after
taxes and after inflation today, a loss in purchasing power of more than
86 percent. Instead, a highest-bracket investor would have turned
$1,000 into over $5,719 in stocks, a 470 percent increase in purchasing
In fact, for someone in the highest tax bracket, short-term Treasury
bills have yielded a negative after-tax real return since 1871, even lower
if state and local taxes are taken into account. In contrast, top-bracket
taxable investors would have increased their purchasing power in
stocks 288-fold over the same period.
In May 2003 President George W. Bush signed the Jobs and Growth
Reconciliation Act, which reduced the highest tax rate on qualified divi-
dends and capital gains to 15 percent. This is the first time that dividend
and capital gains taxes have been equalized for a significant length of
time at a preferential rate. In 2013 both taxes were set at 20 percent for
high-income investors. Nevertheless, effective taxes on capital gains are
CHAPTER 9  The Impact of Taxes on Stock and Bond Returns 135
After-Tax Real Returns on Stocks, Bonds, and Bills for Various Income Levels, 1802–2012
Stocks Tax Bracket Bonds Tax Bracket Bills Tax Bracket
$0 $50K $150K Max $0 $50K $150K Max $0 $50K $150K Max Muni Bds Gold CPI
1802–2012 6.6 5.7 5.4 5.0 3.6 2.9 2.7 2.4 2.7 2.2 1.7 1.4 3.1 0.7 1.4
1871–2012 6.5 5.2 4.7 4.1 3.0 2.0 1.7 1.2 1.6 0.8 0.1 –0.4 2.2 1.0 2.0
1913–2012 6.1 4.2 3.6 2.7 2.2 0.8 0.3 –0.3 0.4 –0.7 –1.6 –2.3 1.3 1.2 3.2
I 1802–1870 6.7 6.7 6.7 6.7 4.8 4.8 4.8 4.8 5.1 5.1 5.1 5.1 5.0 0.2 0.1
II 1871–1925 6.6 6.6 6.5 6.2 3.7 3.7 3.6 3.4 3.1 3.1 3.0 2.7 3.3 –0.8 0.6
III 1926–2012 6.4 4.4 3.7 2.8 2.6 1.0 0.4 –0.2 0.6 –0.6 –1.7 –2.2 1.5 2.1 3.0
1946–2012 6.4 4.0 3.3 2.8 2.0 0.0 –0.5 –1.0 0.4 –1.1 –2.4 –3.1 1.1 2.0 3.9
1946–1965 10.0 7.0 5.2 3.9 –1.2 –2.0 –2.7 –3.5 –0.8 –1.5 –2.3 –2.7 –0.6 –2.7 2.8
1966–1981 –0.4 –2.2 –3.0 –3.3 –4.2 –6.2 –7.0 –7.5 –0.2 –3.0 –5.2 –6.1 –1.0 8.8 7.0
1982–1999 13.6 9.4 9.1 9.1 8.5 5.0 4.5 4.5 2.9 0.8 –0.8 –1.7 2.7 –4.9 3.3
1982–2012 7.8 5.5 5.3 5.3 7.6 4.8 4.4 4.3 1.6 0.1 –1.0 –1.7 3.4 1.8 2.9
*Federal income tax only. Assume 1-year holding period for capital gain portion of return.
still lower than on dividends since 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 the return from capital gains accumulates at the
higher before-tax rates rather than the after-tax rates, as would be the
case from reinvested dividends. I call the advantage of capital gains over
dividend income the “deferral benefit.”
For long-term investors the advantage of the deferral benefit can be
substantial. For example, take two stocks, one yielding 10 percent per
year in dividend income and the other yielding 10 percent per year
solely in capital gains. Assume an investor is taxed 20 percent on divi-
dends and capital gains. For an untaxed investor, both investments
would yield identical 10 percent returns. But the after-tax yield on the
dividend-paying stock is 8.0 percent per year, while, if the investor waits
for 30 years before selling the capital gains–paying stock, the after-tax
return is 9.24 percent per year. This is only 76 basis points less than the
return of an untaxed investor.
Therefore, from a tax standpoint, there is still a motivation for firms
to deliver capital gains as opposed to dividend income. This is unfortu-
nate since, as we shall note in Chapter 12, dividend-paying stocks
generally yield better before- and after-tax returns than non-dividend-
paying stocks. The government can put dividends on the same tax basis
as capital gains if the tax authorities allow investors to obtain a tax defer-
ral on reinvested dividends until the stock is sold.
In the United States, capital gains taxes are paid on the difference
between the price of an asset when it is purchased (its nominal price) and
the value (price) of that asset when it is sold, with no adjustment made
for inflation. This nominally based tax system means that an asset that
appreciates by less than the rate of inflation—resulting in a loss of pur-
chasing power—will nevertheless be taxed upon sale.
Although the appreciation of stock prices generally compensates
investors for increases in the rate of inflation, especially in the long run,
a tax code based on nominal prices penalizes investors in an inflationary
environment. For a given real return, even a moderate inflation rate of 3
percent causes an investor with a five-year average holding period to
lose 60 basis points per year compared with the after-tax return that
would result if the inflation rate were zero. If the inflation rate rises to 6
percent, the decline in annual return rises to 112 basis points per year. I
call this effect the “inflation tax.” The inflation tax for various inflation
CHAPTER 9  The Impact of Taxes on Stock and Bond Returns 137
138 PART II The Verdict of History
rates and various holding periods under the current tax system is dis-
played in Figure 9-2.4
The inflation tax has a far more devastating effect on after-tax real
returns when the holding period is short than when it is long. This is
because the more frequently an investor buys and sells assets, the more
frequently the government can tax the nominal capital gain, which
might not be a real, after-inflation gain at all.
There is considerable support, both inside and outside govern-
ment, to make some adjustment for inflation in the tax system. In 1986,
the U.S. Treasury proposed the indexation of capital gains, but this pro-
vision was never enacted into law. In 1997, the House of Representatives
included capital gains indexation in its tax law, but it was removed by
House-Senate conferees under threat of a presidential veto. Under these
plans, investors would pay taxes on only that portion of the gain (if any)
Real After-Tax Return and Inflation for Various Holding Periods Under 2013 Tax Law
that exceeded the increase in the price level over the holding period of
the asset. Since inflation has remained low in recent years, there is less
pressure to adjust the capital gains tax for inflation, and legislation to
correct this defect is dormant.
Despite the passage of the American Taxpayer Relief Act of 2012, which
raised the top rate on dividends and capital gains to 20 percent (23.8 per-
cent if the Medicare tax is included), there have been some very favor-
able tax developments for stockholders over the last several decades.
They include the following:
1. A reduction in the capital gains tax rate from a maximum of 35
percent in 1978 to 23.8 percent and comparable reductions for
lower-bracket taxpayers5
2. Lower inflation, which reduces the inflation tax imposed on
nominal capital gains
3. A switch to capital gains from dividends, which increases the
deferral benefit
Until 2003, when the tax rate on dividends was for the first time
decoupled from the tax rate on ordinary income, the tax rate on divi-
dends ranged as high as 90 percent in the immediate postwar period.
As noted above, since the tax law is based on only nominal values
unadjusted for inflation, inflation imposes an additional tax on capital
gains. The inflation rate has fallen from double-digit levels in 1979 to the
2 to 3 percent level in the past decade. Since tax brackets are indexed to
inflation, the tax rate on dividends is not directly affected by inflation.
Furthermore, since the capital gains tax is based on realizations instead
of accruals, firms have been buying back shares, in lieu of paying divi-
dends, and generating more capital gains income. As a result, the aver-
age dividend yield has fallen from about 5 percent before 1980 to only 2
percent in more recent years.
It can be calculated that all these factors have increased the real
after-tax return on stocks by about 2 percentage points over the past 30
years for a given before-tax return. Although the real after-tax return on
bonds has also increased as a result of the drop in the tax rates on ordi-
nary income, the increase in the real return on stocks has been greater. In
any equilibrium model of asset pricing, the favorable tax factors for
equities suggest that stocks should be priced at a higher multiple of
earnings, an issue that will be discussed in Chapter 10.
CHAPTER 9  The Impact of Taxes on Stock and Bond Returns 139
The most important savings vehicles for many individuals are their tax-
deferred accounts (TDAs) such as Keogh, IRA, and 401(k) plans. Many
investors hold most of their stock (if they hold any at all) in their tax-
deferred accounts, while they hold primarily fixed-income assets in their
taxable accounts.
Yet many of the recent changes in the tax laws argue that investors
should do the opposite. Dividends will enjoy the lower tax rates, and
appreciation on shares will gain the lower capital gains tax advantage
only if they are held in taxable accounts. This is because when a tax-
deferred account is cashed out at retirement, an individual pays the full
ordinary income tax on the entire withdrawal regardless of how much of
the accumulation has been realized through capital gains and how much
through dividend income.
The above counsel, however, ignores two factors. First, if you are
an active trader or buy mutual funds that actively trade, then there
may be significant capital gains realized, some short run, that would
be best kept in a tax-deferred account. Trading in tax-deferred accounts
also does not require complicated tax computations since no taxes are
paid until money is withdrawn and the source of the profits is of no
Second, although the government taxes capital gains and dividends
at ordinary rates when withdrawn from a TDA, the government also
shares more of the risk. If you realize a capital loss in a taxable account,
the government limits your ability to offset this loss against ordinary
income. However, when funds are withdrawn from a tax-deferred
account, the full withdrawal is treated as taxable income, so that all losses
become totally deductible from taxable income. Therefore, there is less
after-tax risk by putting one’s savings in tax-deferred accounts.
When all the factors are considered, it is better for most investors to
hold stocks in their taxable accounts, unless they are active traders. If
you have a long horizon, the possibility that you will have a loss in your
stock accounts is minimal, so the loss-sharing aspect of TDAs is less
important. It is advisable, though, to hold stocks that do not pay tax-
qualified dividends, such as REITs and other income trusts, in your tax-
deferred account to avoid current taxes. However, some risk-averse
investors who are reluctant to hold stocks in their personal accounts
because of short-term volatility find it easier to hold stocks in their
retirement accounts where they have a longer-term perspective and may
be better able to tolerate short-term losses.
140 PART II The Verdict of History
Tax planning is important to maximize returns from financial assets.
Because of favorable dividend and capital gains tax rates and the poten-
tial to defer those capital gains taxes, stocks hold a significant tax advan-
tage over fixed-income assets. These advantages have risen in recent
years, as capital gains and dividend taxes have been reduced, inflation
has remained low, and firms have repurchased shares to increase capital
gains. These favorable developments have increased the after-tax return
of equities by about 2 percentage points over the average after-tax return
of the past 50 years. As favorable as stocks are over bonds for long-term
investors, the tax advantage of equities is even greater.
Federal income tax was first collected under the Revenue Act of 1913,
when the Sixteenth Amendment to the U.S. Constitution was ratified.
Until 1921 no tax preference was given to capital gains income. When tax
rates were increased sharply during World War I, investors refrained
from realizing gains and complained to Congress about the tax conse-
quences of selling their assets. Congress was persuaded that such “frozen
portfolios” were detrimental to the efficient allocation of capital, and so
in 1922 a maximum tax rate of 12.5 percent was established on capital
gains income. This rate became effective when taxable income reached
$30,000, which is equivalent to about $240,000 in today’s dollars.
In 1934, a new tax code was enacted that, for the first time, excluded
a portion of capital gains from taxable income. This exclusion allowed
middle-income investors, and not just the rich, to enjoy the tax benefits
of capital gains income. The excluded portion of the gain depended on
the length of time that the asset was held; there was no exclusion if the
asset was held 1 year or less, but the exclusion was increased to 70 per-
cent if the asset was held more than 10 years. Since marginal tax rates
ranged up to 79 percent in 1936, the effective maximum tax on very long-
term gains was reduced to about 24 percent.
In 1938, the tax code was amended again to provide for a 50 percent
exclusion of capital gains income if an asset was held more than 18
months, but in no case would the tax exceed 15 percent on such capital
gains. The maximum rate on capital gains income was raised to 25 per-
cent in 1942, but the holding period was reduced to 6 months. Except for
a 1 percent surtax that raised the maximum rate to 26 percent during the
Korean War, the 25 percent rate held until 1969.
CHAPTER 9  The Impact of Taxes on Stock and Bond Returns 141
In 1969, the maximum tax rate on capital gains in excess of $50,000
was phased out over a number of years, so ultimately the 50 percent
exclusion applied to all tax rates. Since the maximum rate on ordinary
income was 70 percent, this meant the maximum tax rate on capital
gains rose to 35 percent by 1973. In 1978, the exclusion was raised to 60
percent, which lowered the effective maximum tax rate on capital gains
to 28 percent. When the maximum tax rate on ordinary income was
reduced to 50 percent in 1982, the maximum tax rate on capital gains
was again reduced to 20 percent.
In 1986, the tax code was extensively altered to reduce and simplify
the tax structure and ultimately eliminate the distinction between capi-
tal gains and ordinary income. By 1988, the maximum tax rates for capi-
tal gains and ordinary income were identical, at 33 percent. For the first
time since 1922, there was no preference for capital gains income. In
1990, the top rate was lowered to 28 percent on both ordinary and capi-
tal gains income. In 1991, a slight wedge was reopened between capital
gains and ordinary income: the top rate on the latter was raised to 31
percent, while the former remained at 28 percent. In 1993, President
Clinton raised tax rates again, increasing the top rate on ordinary
income to 39.6 percent while keeping the capital gains tax unchanged. In
1997, Congress lowered the maximum capital gains tax to 20 percent for
assets held more than 18 months and the following year returned to the
12-month capital gains period. Starting in 2001, investors could take
advantage of a new 18 percent top capital gains rate for assets held at
least 5 years.
In 2003 President Bush signed into law legislation that lowered the
top rate on capital gains and qualified dividend income to 15 percent.
Qualified dividend income must come from taxable enterprises, not
“flow-through” organizations such as real estate investment trusts or
investment companies. In 2013 the top bracket on capital gains was
raised to 20 percent for married couples earning over $450,000, and for
the first time a Medicare surtax of 3.8 percent was applied to investment
income for couples earning more than $250,000. The tax rates on quali-
fied dividend income were set equal to the new capital gains tax rates.
142 PART II The Verdict of History
Sources of
Shareholder Value
Earnings and Dividends
The importance of dividends for providing wealth to investors is self-
evident. Dividends not only dwarf inflation, growth, and changing
valuations levels individually, but they also dwarf the combined
importance of inflation, growth, and changing valuation levels.
It is just after 4 p.m. eastern time, and the major U.S. stock exchanges
have just closed. The anchorperson of one of the major financial net-
works excitedly proclaims: “Intel just out with its earnings! It ‘beat the
Street’ by 20 cents, and its price has jumped $2 in after-hours trading.”
Earnings drive stock prices, and their announcements are eagerly
awaited by Wall Street. But exactly how should we calculate earnings,
and how do firms turn these earnings into stockholder value? This chap-
ter addresses those questions.
The fundamental source of asset values derives from the expected cash
flows that can be obtained from owning that asset. For stocks these cash
flows come from dividends or from cash distributions resulting from
earnings or the sale of the firm’s assets. Stock prices also depend on the
rate at which these future cash flows are discounted. Future cash flows
are discounted because cash received in the future is not valued as highly
as cash received in the present. The reasons investors discount the future
are (1) the existence of a risk-free rate, a yield on a safe alternative asset
such as government or other AAA-rated securities, which allows
investors the ability to transform a dollar invested today into a greater
sum tomorrow; (2) inflation, which reduces the purchasing power of cash
received in the future, and (3) the risk associated with the magnitudes of
expected cash flows, which induces investors of risky assets, such as
stocks, to demand a premium to that on safe securities. The sum of these
three factors—the risk-free rate, the inflation premium, and the equity
risk premium—determines the discount rate for equities. This discount
rate is also called the required return on equity or the cost of equity.
Earnings are the source of cash flows to shareholders. Earnings (also
called profits or net income) are the difference between the revenues to the
firm and the costs of production. The costs of production include all
labor and material costs, interest on debt, taxes, and allowances for
Firms can transform these earnings into cash flows to shareholders
in a number of ways. The first and historically the most important is pay-
ment of cash dividends.
Earnings that are not used to pay dividends are called retained earn-
ings. Retained earnings create value by raising future cash flows
Retirement of debt, which reduces interest expense
Investment in securities or other assets, including the acquisi-
tion of other firms
Investment in capital projects designed to increase future profits
Repurchase of the firm’s own shares (which is known as a buyback)
If a firm retires its debt, it reduces its interest expense and therefore
increases the profits available to pay dividends. If a firm buys assets, the
income from these assets is available to pay future dividends. Retained
earnings can be used to expand the capital of the firm in order to gener-
ate higher future revenues and/or reduce costs and thereby increase
144 PART II The Verdict of History
future cash flows to shareholders. Finally