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By BuildMWell
August 1, 2007

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"It has also been argued that the 110-year chart is not relevant due to paradigm shifts in the way stocks are valued pre and post The Great Depression. I don't believe this., The stock market responds as a function of human behavior, and that has not changed over the course of recorded human history." - abFatPitch

We have talked about this many times right here. So, let me start with abFatPitch's non-belief. Why do you not believe that there is a difference between pre-1929 Depression and post-Depression dynamics of the market? I see the difference very clearly and it makes complete sense to me.

But, you see, abFatPitch answered this in the very next sentence with, "The stock market responds as a function of human behavior, and that has not changed over the course of recorded human history."

BINGO! Right and wrong at the same time. Surely, the markets give us a picture of the American experience over time, but I would argue that is changing all along the way. The whole goal being to maximize the net CAGR. The question is, how do we achieve that goal?

Let's look again at the 110 year chart.

http://invest.kleinnet.com/bmw1/special/DJIA.html

But, let's compare it to the 30 year chart:

http://invest.kleinnet.com/bmw1/stats30/%5EDJI.html

Obviously, they are both correct because they are just the history of the actual data. The 110 year chart says that we are at a high relative CAGR right now while the 30 year says we are somewhat below the average CAGR. Since we know that they are both correct, how can we explain the difference? I think that I can do that quite easily.

Prior to the Depression, and even through WW-II, there was no 10 year or 30 year US Treasury Note market. The idea of having huge Federal debt was alien to the politicians of the 19th and early 20th centuries. The bond market back then was actually corporate bonds. Corporations sold bonds to raise capital and they also sold stocks to do the same thing. Stockholders were in third position for any potential profits. First, the creditors of the business were paid, then the bond holders and lastly the stockholders. Thus, stocks were riskier and had to offer higher yields.

Typically, a bond paid 3% to 5% so a stock had to offer dividends that were 4% to 6%. Meanwhile, the thing that few understood, was that stocks actually rose slowly in value over time at a rate of about 2-1/2%. Edgar Lawrence Smith was the first to publish a book that proved this fact. That book was first published in 1924 and it was a huge hit. It was republished many times over the next 5 years and many believe that it helped lead America into the market crash of 1929. However, the fact remains that stocks grew over time at a CAGR of 2-1/2% WHILE they paid an average of 5-1/2% dividend yield. Thus, stocks beat bonds by about 1 to 1-1/2% on the yield AND grew at a rate of 2-1/2%, which bonds did not do at all. This was exciting news in 1924 and created a boom in stocks.

During the Depression, Benjamin Graham and David Dodd co-authored the Bible of investing entitled "Security Analysis" and it has been the basis of most education into business evaluation and investing ever since. It went out of its way to discredit the work of Smith and it based everything on the underlying earnings. This was an excellent approach since the market bust happened because the investor had been led to pay far too much for far too few earnings. This was the underlying cause of the 1929 crash.

Once investors finally understood the proper way to value an equity, the market slowly came back and following WW-II it was booming once again, but stock prices were then limited by their earnings. Even so, the market grew at 8% to 10% AND paid competitive dividend yields of 4% to 6%! But that could not continue...it was not sustainable. WW-II left America with a huge demand for goods, meanwhile Europe and Japan were being rebuilt. This created a huge demand on American business to supply the needed goods, but that was not going to last forever.

At about this time, and due to these same factors, the bond market was dying. Corporations were paying off their bonds and this left the stock market without competition for the investor's dollar. However, our Government had been selling bonds like crazy to support the war effort, and that had left us with a huge national debt. Instead of paying it off lake we had in the past, it was decided that we could just continue borrowing and spending. However, that was a problem because our government was preparing to go into competition with the stock market for the investor's dollar. Investors were not real happy with the 2-1/2% yield on war bonds, but that was offset by their patriotism. There was a good reason for accepting low yields in 1945...by 1955 investors wanted more.

In 1958, a new story emerged. The future was in growth! No longer would stocks have to pay dividends that exceeded the bond's yield, we were going to grow our way to prosperity. By reinvesting dividends into a company's growth, the stock price would rise at a great rate and actually pay the investor a higher rate of return than he could get by taking the dividends for himself. This, of course, was based on the assumption that an investor could not reinvest his own dividends and get a better rate than the company could. The idea sold because most people had no desire to study the markets, which they were not that good at anyway, because they were busy doing the jobs that they were good at and being paid for it.

The idea that we were going to grow our way to prosperity reached it's peak in 2000 with the collapse of the NASDAQ. The exact same conditions we saw in 1929 were repeated in 2000. But, thank God, it was not repeated in the DOW 30 or the S&P 500. The brunt of the collapse due to low earnings and over payment was isolated in the NASDAQ...the highest growth market! Do you see how that growth story was over sold to the public over time?

So, today we are back to reality. The bubbles are behind us and we are once again basing our investment decisions on real earnings. That explains the differences in the 110 year and 30 year charts completely.

The CAGR we can plot for the DOW prior to 1929 was 2-1/2%, but the dividend yield was 5-1/2%. The CAGR we can plot after WW-II shows a CAGR of about 10%, but the dividend is about 2%. Thus, the growth story was correct and a business can make more money for the investor by growing the business rather than paying high dividends. However, there is a limit to how fast that business can grow over time. Dividends do matter and they may be too low right now. That, in my opinion, is proven by the number of options being given to management for growth that is actually not there. Some investors are still falling for the growth story...and as I have said, it is still valid. However, we must keep our eyes on the CAGR of the business and refuse to pay management of something that we are not getting.

Taking all of this into consideration, I believe that we need to concentrate on the 30 or 40 year chart and ignore the 110 year chart since there have been several paradigm shifts that changed everything significantly. We have just been through one of them with the collapse of the NASDAQ. What we proved was that there was no new paradigm as some folks tried to tell us in 1996. The recent collapse came from a lack of a new paradigm! That, in itself, is a great thing.

We learn by figuring out what does and what does not work. The 1800's taught us that high dividends and low growth worked and gave a 2-1/2% CAGR on stocks. However, that could be abused if we lost track of the underlying earnings.

Following that, we learned that we could get an 8% to 10% CAGR if we put some dividends back into the companies and grew them at a faster pace. That actually made things better overall...so we learned something more with that approach. However, we also learned that approach could lead to abuse if we did not keep track of the underlying earnings. Do you see a pattern here?

I am overjoyed with the situation that we have today. Government bonds yield under 5% and they should be even lower...not higher. That was as it was before 1958! Inflation is low...as it was before the government went into the debt business and re-created a bond market. Unemployment is at record lows and the economy is growing at a sustainable pace. What is not to love about all this?

Now, if we can use the 30-year DOW CAGR chart as our guide, we can see that we are behind schedule. The DOW is too low, not too high and the growth needs to just continue. That will happen if the corporations will just keep on doing what they have done in the past. Maybe they can even do a little better for us. But, we have to demand that they do that. If we believe the naysayers, we will waste precious time and fail to use our resources at their peak efficiency. Let's learn for the past instead and get on with the task of building wealth.

I hope this makes sense to you because it surely does to me. I think we are on a very solid foundation and the volatility on the markets today is all contrived by people trying to manipulate our thoughts. We have to just ignore them and move ahead. We have history on our side.


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