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TheIntelligentInvestor

Chapter3:ACenturyofStock-MarketHistory:TheLevelofStockPricesinEarly

1972 Theintelligentinvestorshouldhaveasolidunderstandingofstock-markethistory Pricelevelsandtheirrelationshiptoearningsanddividendspaidareofparamount

importance

Thisbackgroundinformationgivestheinvestortheabilitytogaugetheattractivenessofthecurrentmarketlevel

AchartisdisplayedoftheDowJonesIndustrialAverageandtheS&P500from1871through1972

Inonlytwooftheninedecadesshowndidcorporateearningsdecrease Therewerenodecadeswhereaveragedividendyieldsdecreased Growthratesvariedsignificantlyinmanyofthedecadesstudied

Valuationlevelsanddividendyieldalsofluctuatedwildly TheS&Ptradedat6.3timesearningsin1949androseto22.9timesearningsin

1961

Dividendyieldwas7%in1949and3%in1961 Grahamultimatelyconcludedthatthemarketwasexpensivein1972fortworeasons

Thepricetoearningsratioof18.0washighbyhistoricalstandards Theyieldavailableoncommonstockswaslessthanhalfoftheavailableyieldon

highqualitybonds

Basedonhisconclusionthatthemarketwasovervaluedherecommendedthefollowingcourseofaction

Noborrowingtobuyorholdsecurities Noincreaseintheproportionoffundsheldincommonstocks Areductionincommonstockholdingswhereneededtobringitdowntoa

maximumof50%ofthetotalportfolio

CommentaryonChapter3 Youvegottobecarefulifyoudontknowwhereyourgoing,causeyoumightnotget

there.YogiBerra

Grahamswarningsofdangerousvaluationlevelsin1972provedtopropheticasthemarketdeclined37%duringthebearmarketof1973-1974

Hebelievedthattheintelligentinvestormustneverforecastthefuturebyextrapolatingthepast

Duringthebullmarketofthe1990smanyoftheselessonswerecompletelyforgotten

Forecastersarguedthatbecausestockshadreturned7%onaveragesince1802thatinvestorsshouldexpectthatreturnregardlessofwhatlevelthey

purchasedcommonstocks

Someclaimedthatstocksalwaysbeatbondsovera30yearperiodandasaresultcouldbeboughtwithoutpayingattentiontovaluationsaslongas

theinvestorplannedtoholdforever

Themarketcrashintheearly2000sprovedthatvaluationlevelsalwaysmatterandshouldnotbeignored

Theproblemwithextrapolatingpastmarketreturnsisthatitincludesaninherentsurvivorshipbias

Thismeansthatmanypastcompanieswentbustandarenotaccountedforwhenanalyzinghistoricalmarketreturns

Thisleavesanalystswithahandfullofexceptionalcompaniesthathavesurvivedtouseasdatapoints

ForeveryCocaColatherearetwentycompaniesfrompreviouserasthatarenolongerinexistence

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Becausetheprofitsthatcompaniescanearnarefinitethepricethatinvestorsarewillingtopaymustalsobefinite

Iffuturereturnsareguaranteedtomatchsuccessfulpastreturnsinvestorswouldbidupstockstounsustainablelevels

ExtrapolatingrosyhistoricalreturnsintothefutureisillogicalanddangerousaccordingtoGraham

Theperformanceofthestockmarketreliesonthreefactors Realgrowth(theriseofcompaniesearningsanddividends) Inflationarygrowth(thegeneralriseofpricesthroughouttheeconomy) Speculativegrowthordecline(anyincreaseordecreaseintheinvesting

publicsappetiteforstocks)

Corporateearningspersharehavegrown1.5%to2%annually Aswediscussedinthelastchapter3%isasuitableinflationestimate AveragedividendyieldontheS&P500iscurrently1.7% Bytotalingthesethreepercentagestheinvestorcanfindtheexpectedreturnfor

commonstocks

Currentlytheexpectedreturnforcommonstockswouldbe6.7%or3.7%afterinflation

Theonlyconstantinmarketsisthattheycontinuetosurpriseinvestors Itisthereforeextremelyimportantforinvestorstobehumbleandrealizethattheir

forecastsandprojectionsarefarfromcertain

Infinancialmarketstheworsethefuturelooksthebetteritusuallyturnsouttobe