Five Myths about the Dow: James K. Glassman explains

Aug 15, 2011

With the Dow Jones industrial average fluctuating on a now daily basis, former Post financial columnist James K. Glassman is here to explain five myths about the stock market index and how it plays into the current market. In his Five Myths piece Glassman writes, "Charles Dow devised the index in 1896 to give investors a snapshot of the performance of big manufacturing stocks (and of the U.S. economy) each day. The Dow still has an antique feel to it, but as a metaphor for the stock market, it remains unsurpassed: endlessly cited, parsed, followed, predicted - and misunderstood."

Have a question? Ask now, then join the chat Monday, Aug. 15 at noon ET.

It's great to be back talking to Washington Post readers. My article on Sunday was meant, not just to comment about the Dow itself, but to help investors cope with the current, turbulent environment. Please feel free to ask me any questions about the market. -- Jim Glassman

I'm in my prime stock-acquisition years (late forties), is there any reason for me to do anything differently right now? If prices go down, my current holdings lose value but next paycheck's automatic deduction buys more shares. Do I really care about current movements?

You are absolutely right about the consequences of making regular investments. When prices go down, you get to own more shares. You should not worry about short-term movements. My message, however, to all investors -- even those in their forties -- is that the world has changed and that you need to protect yourself on the downside. Therefore, in my new book, "Safety Net," I argue for more bonds in your asset allocation. For most investors, a 50-50 ratio is about right.

This question is not meant as a gotcha question but to gain your insight. What is different about your view of the stock market today than when you wrote your book? For example, what were some of the (incorrect) assumptions that led you to believe that the Dow was on well on its way to hitting 36,000? How does your re-visioning of how the market behaves (or of its strength) help us invest in and interpret market activities today? Thanks for the chat.

In my new book, "Safety Net," I say clearly that the Dow 36,000 strategy (loading up on U.S. stocks in diversified portfolios) no longer applies for today's investors. I write, "I was wrong." Here is how the world has changed: 1) the US is no longer the be-all and end-all of the global economy, and 2) shocks such as the S&P downgrade, the 9/11 attacks, and the Japan tsunami have the power to disrupt markets severely, and such disruptions will be more frequent. As a result, I argue for more of a balance between stocks and bonds. It's a new world.

If some of your theories are correct, shouldn't the widespread use of 401k's, mutual funds, and other vehicles that encourage small investors to participate in the stock market, have narrowed our wealth gap and income disparity? How come the US Gini Index (a measure of income dispersal) now as great as Mexico's and wider than India's?

Income dispartiy is a complicated subject. Absolutely, a society that encourages stock ownership should see disparities narrow, but there are other factors at play. Here are two: 1) entrepreneurial societies tend toward more disparity, because entreprenurs can win very big, and 2) the education premium has widened, not just in the US but around the world -- having a college degree now means you'll make twice as much over a lifetime. I think both of these two reasons for disparity are benign. We WANT a society where people are encouraged to start new businesses and get more education. In other words, income disparity isn't all bad.

Is the Dow solely an indicator for the markets, or does it have other value?

Great question, and I am sorry that my article on Sunday did not address this point. I really like the Dow as a bunch of well-chosen companies that pay decent dividends and have been tested over time. There are few Dow stocks I would not want to own. In my book, "Safety Net," I recommend four categories of stock holdings: 1) foreign, especially developing markets, stocks, 2) small and micro-cap US stocks, 3) value stocks, and 4) stocks that pay good dividends. The stocks on the Dow Jones Industrial Average generally fit categories 3 and 4. Take a look at two Dow stocks: Microsoft, flush with cash and a profit machine, is trading at a foward P/E, based on expected earnings for the year ahead, of just 8 and a dividend yield of 2.5%. Who would have believed this only a few years ago. MSFT paying more in dividends than the 10-yr T-bond pays in interest? Or Pfizer, also with a forward P/E of 8 and a dividend yield of 4.5%. Dow stocks are good stocks to own.

You must think there's no inflation coming. How can you/anyone be sure of that given the structural government debt, coming explosion of the senior population, and weakening value of the dollar?

I actually do think that inflation is coming, but there is a simple way to own bonds to protect yourself against inflation, and I talk about it in my book "Safety Net." You should LADDER your bonds, so that they mature in successive years. Say you invest $100,000 in 10 bonds, $10,000 each maturing over the next one, two, three and so on up to 10 years. When the first bond matures, take the proceeds and invest in a new 10-yr bond. If inflation (and interest rates) rise, then the new bond will carry a higher yield. Rising interest rates are NOT bad for a well-chosen bond portfolio.

Is it still safe to invest? Should newbies to the stock market be investing in anything right now? Or is it smarter to wait out the turbulence?

Don't wait it out. The truth is that you HAVE to invest, whether you like it or not. Putting money under the mattress is a sure way to lose purchasing power to inflation. My strong suggestion, as outlined in my book "Safety Net," is to construct a portfolio balanced roughly equally between stocks and bonds. What we have been seeing is that when stocks do poorly, bonds do well. They provide ballast for your portfolio.For example, at the depths last week, the US stock market (as reflected in the S&P 500) was down about 10% for the year, but a balanced portfolio was up about 5%. So, yes, get into the market now, but do it with regular contributions from your paycheck. Don't try to time the market, and accept that turbulence is with us.

Let me see if I can articulate this right: for a given company, does being a component of the DJIA create a greater demand, and hence raise its price, than would be justified if the company was not in the Dow? There are people who buy stocks just because they're in the Dow, or because its components are better researched than other, equal good, companies.

I doubt if membership in the Dow creates more demand, especially for a typical Dow company with a market cap of $100 billion to start with. Where you see membership creating demand and boosting prices is on the S&P 500, which has among itss 500 components many smaller stocks. If a company with a market cap of $1 billion is moved onto the S&P, there is typically an uptick. By the time a company is admitted to the Dow, it is already a big stock -- well covered by analysts. Cisco, which joined in 2009, is a good example.

 

What role do Hedge Funds play in the movement of the DOW? Especially short-selling hedge funds, after all they control approximately $2 Trillion in assets with enormous flexibility to buy and sell on a whim. I do not believe the average investor coupled with Mutual Fund Managers caused the seesaw movement of the DOW last week.

Hedge funds alone can't move the market over sustained periods (meaning more than a day). They just aren't big enough. They can move individual stocks, certainly, but they can't push a market up or down 400 points in a day. The markets movements lately are the result of EXTREME uncertainty about what will happen in Europe, coupled with a developing consensus that the US will be growing at a low rate for a long time. My feeling, though, is that current stock valuations reflect both of these negatives, and that many stocks -- especially strong multinationals that pay good dividends, like Procter & Gamble, Google, Microsoft, and Merck are excellent buys for the long-term  at today's prices.

Do you suggest meeting with a financial analyst of some sort? Is that the best first step to take? Or is this easy to figure out on your own?

Most people need help. I strongly suggest talking with a professional -- not so much for specific stock recommendations but for developing a strategy and for having someone at the other end of the phone when times are tough. It's not easy to find such a person, but use the same techniques you use in searching for a good physician or lawyer: ask people you trust. Yes, some investors can go it alone, but most people need help.

If what investors need is a safety against big drops, what do you think of the use of long-term LEAP Puts against a huge drop? Like protecting against a drop of more than 25% two years out.

In my book "Safety Net," I advise investors to buy hedges against large declines in the market. Index puts, which are options that rise in value when the market falls, are a good example. You mention LEAPs, which have a longer time horizon. You can simply buy one of the many "bear" mutual funds, which also go in the opposite direction of the market. Or you can put an effective "collar" around your stock holdings by selling calls. In such a case, you are letting another investor own the upside of your stock above a certain level, in return for a payment. Hedges are a great idea. Just don't use them to speculate.

Isn't 50% stocks/50% bonds way too timid for most investors, especially under 35 investors? Wouldn't that allocation negatively impact future earnings for young investors?

Age and rsik aversion should play a role in your asset allocation. I am comfortable with young investors who are not risk averse owning stocks and bonds with a 60-40 or even 70-30 ratio. Since 1926, a 90-10 stock-bond portfolio has returned an average of 8.6 percent while a 50-50 portfolio returned 7 percent. The question for you, as an investor, is whether that difference (and I am using an extreme case here) is a good insurance premium to pay for some substantial downside protection. The worst one-year loss for a 90-10 portfolio in history was 40 percent; the worst for a 50-50 portfolio was 25 percent.

Theoretically, the value of a stock should be the discounted cash flow divided by number of shares, right? That's how analysts supposedly set share price targets and rate stocks as buy, sell or hold. So how do events vary share prices to such an extent, and has there been any analysis of the relative weight of expected cash flows and other external factors in determining whether stocks fall or rise and by how much?

You are right about valuation. I am not completely up to date on the research, but it is not hard to see how changes in expected cash flow can have a huge effect on today's stock prices. That is what I think has been going on in the market. We are seeing a growing realization that the US is not going to be growing at 3 percent but at a rate far lower, and that growth is going to affect company profits and cash flow.

Is your change from Perma-Bull status partly because of your dissociation from the American Enterprise Institute, and now you're director of something called the George W Bush Institute?

Not at all. I am still bullish -- in the sense that I have faith in American imagination and drive, but it is simply a matter of realism to recognize that, unless policies change drastically, we aren't going to be growing at the historic rate of 3.3 percent. Plus, I underestimated the power of technology to disrupt markets catastrophically. The Bush Institute has launched something we call the 4% Project to find and promote ways to get the US growing at 4%. I think that can happen. If it does, the picture will look a lot better for stock investors.

The Dow Jones index is only one index (in fact, doesn't Dow Jones have several indexes themselves)? What may be useful is to undertand the degree of deviation from the indexes and how they change over time. Is the deviation more volatile in recent weeks (meaning many stocks are sharply diverging from these averages)?

Your question raises a very important point. What counts in investing is not just average returns but also volatility -- which in investing is generally measured in terms of deviation around an average. For instance, which investment would you rather have: one that guarantees you that you will get 7% year after year (that is, no volatility at all) or one that averages 7% but that in some years returns 50% and in other years loses 40%? The choice is obvious. One of the attractions of the Dow is relatively low volatility. For example, Dow Diamonds, the ETF that mimics the Dow, has a standard deviation of 19 percent vs. 21 percent for the S&P 500. So it is approximately one-tenth less risky (if you judge by history). What this means is that, if the average return for the Dow is about 10 percent, then two-thirds of the time, its returns will vary between a loss of 9 percent and a gain of 29 percent.

While I agree that SOME wealth disparity is certainly a good thing, the concentration of so much wealth in the hands of a very few cannot be a good thing. The thing that boggles my mind is that these rich companies want less regulation, taxes etc at a time of such high unemployment and economic pain. How do they expect the economy to come back? Who do they think is going to buy all of their stuff if the overwhelming majority has no money?

I don't think I agree. Yes, there is something morally disturbing about wealth disparity. But it seems to me what a good society wants to offer is equality of opportunity -- that is, no disparity in people having the chance to succeed. In such a world, you would certainly end up with some people accumulating more wealth than others -- through talent, harder work, more frugality, or just plain luck. The problem is that, if you take a lot more money away from people just because they are rich, you will reduce their incentive to work hard. I don't think the US is close to the situation you describe with people not having any money to buy stuff. Look at businesses, like Wal-Mart, that cater to a broad audience. They are not suffering any more than businesses that cater to the very rich.

As a gov't retiree, my Thrift Savings Plan is by far my biggest pot of money, although I also have Roth IRAs and about 3 year's worth of income in savings accounts and CDs. I am in my early 60's. Does a distribution of 40% bonds (half gov't, half non-gov't), and 60% divided between common stocks, small-cap stocks, and internation stocks sound like a good division for the long haul? I need this money to last for about 30 years or so, and I'm not making any new investments since I'm retired, so I want to be very careful about how I thread the needle between risk/safety vs. growth.

First, congratulations. It sounds like you have done an excellent job building up capital for your retirement years. I think a 40-60 stock-bond ratio is fine for you because you have what sounds like a substantial nest egg, so you can take a bit more risk. I would prefer, for most people your age, a ratio that is closer to 50-50 or even 40 percent stocks and 60 percent bonds (or even 30-70). The issue, of course, is that we could be hit with another 2008-09. The stock market CAN drop 30 percent in a year and might not quickly recover. Let me also congratulate you on the way you have divided up your major asset classes. In my book "Safety Net," I suggest a mix of Treasury (include inflation-protected T bonds) and corporate bonds and a mix of international, dividend-paying, micro-cap, and value stocks. You are definitely on the right track.

We are winding down now. Only about five minutes to go. If you have any more questions, please ask them now. Thanks.--Jim

Is your new book because of short-term conditions in the country right now, or do you think the long term outlook has changed?

I think the long-term outlook has changed. What I say in the book is that I could be wrong. The economy could pick up and stocks could soar, and, in that case, the rest of your fiinancial life would improve greatly too. The problem is that all of us are LONG the US economy (that is, we do well when it does well). But we all need a hedge in case it doesn't do well. You can't hedge your job. You can't sell your house short. But you can protect yourself with your financial investments. It is the prudent thing to do in a turbulent world. I am optimistic, yes, but also believe in protecting your downside. I hope that makes sense.

Siging off now. Thanks for a great discussion. -- Jim

In This Chat
James K. Glassman
James K. Glassman, executive director of the George W. Bush Institute, wrote the Investing column for The Washington Post from 1993 to 2004. He is a columnist for Kiplinger’s Personal Finance and the author of "Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence."
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