How High – Part III – Andrew Tobias

I’m writing this three or four days ahead, with the Dow at 7,782. By the time you read this, it could be 8,000 or 9,000 — or maybe there will be another one of those cute little scares, where it drops almost 10% before bouncing back twice as far.

So how high can it go? If the market is at the “right” level today, then it could just keep going up 7% or so a year (with another 2% or 3% paid out in dividends), more or less in line with its historical growth. Or perhaps it can do even a little better if there’s been some fundamental oomph in our prosperity equation. (Such oomph might be attributed to, say, the lessened drain on our prosperity from lower defense spending, or a technology-driven speedup in productivity, or freer trade.)

At 7% a year, the market doubles every decade. The Dow would hit 10,000 on Thursday, March 1, 2001.

At a 9% growth rate (plus more from dividends, remember), it would double every 8 years, hitting 10,000 sooner still: Friday, May 12, 2000.

Or it could just keep up its pace of the first half of 1997 — the roaring ’90s redux — and reach 10,000 this coming February.

But what if the market isn’t sensibly priced today? In hindsight, it could turn out it is way too low — that a reasonable man, looking back years from now, would be slapping himself silly for not taking advantage of the screaming bargain represented by the Dow Jones industrials at 7,782 in June of 1997. Or it could appear to have been priced way too high or just about right. Only time will tell.

But shouldn’t all this be based on some logic? Yes. The market’s future price depends on two things, basically. One is supply and demand. As long as more people are buying stock than selling, the market will keep going up, regardless of where it “should” sell.

(Of course, on any given day, just as many shares are sold as bought. But you know what I mean. If there’s more pressure to buy than sell, the market “clears” by hiking prices, bringing buyers and sellers into balance. But if the pressure continues, so do the price climbs.)

If people continue to dump their retirement money into the market — even if they begin to do it knowing they’re playing a sort of musical chairs, but expecting to get out with their profits before the music stops — prices will just go higher and higher. The market could continue to rise at 20% or 30% or 40% a year for several more years. And that could be just the start of the bull market if, by then, every newly-prosperous Chinese person bought just 100 shares of some U.S. stock. Imagine. That would add demand for 100 billion shares of stock, driving prices higher still. (Isn’t 2007 the Year of the Pig? I can hardly wait.)

But at some point people will focus on the second reason to buy stocks: their share of the underlying companies’ profits. Isn’t that the fundamental reason to own a business — to make money? You can take it out in salary if it’s a small business you run yourself, or in dividends if you’re just a shareholder. But the point is to make money. Ultimately, that’s what makes a business valuable. And ultimately, it’s cash that pays the rent and gasses up the car.

If you have $1 million at retirement, you could get $10,000 a year in cash investing it in a portfolio of stocks yielding an average of 1% a year in dividends (Microsoft, Coke and Intel don’t pay even that much), or you could get $70,000 a year investing it in, say, U.S. Treasury bonds (or in any number of other investments, including utility stocks and real estate investment trusts).

Of course, as long as stocks are going up 20% a year, you’d be better off keeping all your money there and selling a few shares periodically to replenish your checking account. And as long as lots of people feel that way, and thus keep putting their money into stocks, no matter what (since “stocks always outperform other investments over the long run”), stocks will keep going up 20% a year. Maybe 40% a year.

Until they don’t. But hold on — many of you, and almost all the potential Chinese investors, are nowhere near retirement. So for them, dividends are unimportant. All money should go into stocks, at whatever price they sell, because over the long run everyone knows stocks always outperform other investments.

As suggested a couple of weeks ago, “everyone knows” and “always” are the kinds of expressions that have been known to — forgive my French — piss off Mr. Market. Mr. Market takes some pleasure in not being seen as easy. He likes to tease, but he also likes to torment. Faced with so many people falling in love with him, he plays hard-to-get-rich.

Over the long run, superstition and psychology are not what move the market; numbers do. And in the U.S., one thing likely to keep the market from going to and/or staying at too crazy a high or low level is the corps of trained professionals who understand these numbers. That is, whatever lunatic or irresponsible things you or I might do on a tip from a friend, most of the really big money is managed by professionals who have to at least be able to make some rational case — based on the numbers — before they buy more shares of whatever stock. That doesn’t mean they’ll be right or that their underlying assumptions of sales growth, profit margins, inflation and the rest will be right. There’s huge room here for error, huge room for getting carried away with consensus thinking that turns out to be all wet. But still, they do try to act logically most of the time.

So what is logical?

Is it logical to pay $2.5 billion for a company with no profits? Yes, if you expect it to have big profits soon, or very big profits in a while, or gigantic profits 10 or 20 years from now. That’s the story with a lot of the high tech companies, which are obviously the hardest to evaluate — and more apt to get caught up in a frenzy of irrational exuberance than, say, a 50-year-old cement company earning $2 a share.

Is it logical to pay $70-plus a share for Coca-Cola, or about 46 times its last year’s earnings? Yes, if you expect its earnings to zoom, as Coke sales skyrocket in the developing, much-of-it-until-recently-communist world. No, if you think its profits will grow at “only” 15% a year — a growth rate many large companies only dream of. What about Coke, or about the world, has changed in the last three years, during which time its stock has tripled? Were people morons for selling their shares at $23 three years ago? Are they morons for paying $71 today? Or does the truth lie someplace in between? Coke’s excellent management hasn’t changed. No new Berlin Walls have fallen. (Well, Albania’s — but could that be it?) My guess is that Coke stock didn’t adequately reflect its prospects at $23 in 1994 and that it over-exuberantly reflects them today. This is no reason necessarily to sell and pay the taxes. (I’ve sold KO in my tax-deferred account; can’t bear to in my taxable account.) But my guess is that the stock is a bit “ahead of itself.” And that this may be true of much of the rest of the market.

That doesn’t mean it won’t continue to zoom, at least for a while. If you have a life-strategy of steady periodic investments in the market, in up markets and in down, don’t ever quit. It is a great life-strategy to have. But if you just got into the market in the last year or two, because it’s so easy to make money, I’d be getting nervous. What’s that? You say you’ve got a brilliant broker who’s done really well for you? It’s an old line but it’s true: everyone’s a genius in a bull market. Has he really done better than a monkey throwing darts? Oh — you’re planning to take some profits but are waiting till they cut the capital gains tax? You and quite a few others. Unless there are an equal number of people waiting to buy until they pass the tax break, it will be interesting to see whether, in the short-term at least, such a tax break doesn’t tip the balance from buying pressure to selling pressure.

One way or another, we will get to 10,000 on the Dow. And I am definitely not smart enough to know whether we’ll get to 5,000 first.