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Arkhipov agreed, the nuclear launch would have almost certainly
set off an interchange that could have “destroyed the Northern
hemisphere,” as Eisenhower had warned.8

How much have U.S. stocks benefited by global luck? This is extremely
difficult to ascertain because it requires assigning probabilities to events
that didn™t happen. Furthermore, such analysis should include all possi-
ble alternative scenarios including those that would have exceeded the
actual outcome.
Presumably humans could have had an even better outcome than we
realized. For example, we could live in a world without holes in the
ozone layer, where Princess Diana is still alive and married to Prince
Charles, and where there are no nuclear weapons that can be hijacked and
used to hold the world hostage.
How can we quantify these alternate possible histories? The mathe-
matical tool of Monte Carlo simulations allows one to run the calcula-
tion, but still depends on the assumptions. Some of the best efforts to
generalize this stronger form of survivorship bias have been done by
Nassim Nicholas Taleb and are contained in academic papers, his first
book Fooled by Randomness, and his forthcoming book The Black
Swan.9
Taleb concludes it is likely that all of the excess return of U.S. stocks
is due to luck, not skill. While we can™t know the answer for sure, I lean
toward believing that things have turned out better than we could have
expected.
Putting both weak and strong forms of survivorship bias into the analy-
sis of U.S. stocks requires adding some lines to Professor Siegel™s table.
The amended data might look something like what we see in Table 8.2.
So where do we stand on assessing the elements of luck and skill in
historical U.S. stock market performance? U.S. stocks have done better
than stocks in other countries. Furthermore, it seems likely that the world
has been lucky in avoiding any global wars, nuclear or otherwise, since
1945. Both of these suggest that luck played a significant, and perhaps
dominant, role in the fantastic performance of U.S. stocks.
Stocks 171



TABLE 8.2 U.S. Stocks Have Benefited from Good Luck
Investment of $1000 in 1802 1997 value

U.S. Consumer Price Index $13,370
Gold $11,370
U.S. Government Bonds $10,750,000
U.S. Stocks $7,470,000,000
East German Stocks $0
U.S. Stocks had there been a nuclear war $0
Source: Stocks for the Long Run, Second edition



U.S. Stocks Have Survived. Are They
Expensive Today?

The historical survivorship analysis suggests that the amazing perfor-
mance of U.S. stocks is unlikely to be repeated. Buying stocks today is
not the easy choice that it would be if we had a time machine and could
go back into U.S. history.
My father is a physician of the old school. He likes to mock modern-
day physicians and their reliance on technology. He jokes, “If all else
fails, let™s look at the patient.” His meaning is, of course, that we ought to
start by looking at the patient. Similarly we are several pages into a dis-
cussion of stocks without actually looking at any stocks. Let™s look at the
financial patient and analyze some stocks.
We begin with Microsoft and then move to the entire S&P 500.
Microsoft is one of the most profitable companies in the world and con-
sequently one with among the highest stock market value. It is also part
of all the major financial indices including the Dow Jones Industrial
Average, the S&P 500, and the NASDAQ 100. Beyond financial strength,
Microsoft generates strong emotions in many people, ranging from frus-
tration with Windows glitches to the joys of a beautiful Excel spreadsheet.
When it comes to investing, we put aside our feelings and look at the
numbers. Perhaps the most common analysis uses the so-called “Fed
172 Applying Science and Art to Bonds, Stocks, and Real Estate



model” that compares a stock to the 10-year Treasury bond. The 10-year
Treasury bond is a safe alternative to risky stock investments. Figure 8.1
shows the projected return on a $100 investment in the next year for
Microsoft stock and for the 10-year Treasury bond.
Investing $100 in a Treasury bond earns $4.40 in interest per year (at
current rates of 4.4%). The person who puts $100 into Microsoft stock (at
$28) will receive a dividend of $1.14. In addition, $100 of Microsoft
stock buys ownership in additional profits that will be retained by the
company. This figure for 2005 at Microsoft is expected (by Wall Street
analysts) to be $3.43 for every $100 investment.
So is Microsoft stock a good investment? The answer is that it depends
on your optimism about the future. The T-Bond is going to pay $4.40 a
year for 10 years and then you will get back the $100 investment.
Microsoft stock could be much better or much worse. The payoff to
Microsoft is the fact that it could grow substantially. Microsoft is far
riskier, however, than the government bond and even big companies can
go bankrupt. While the bond investor can be pretty confident of getting


$5.00
$4.50
$4.00
$3.50
$3.00 $3.43
$ earned but not paid
$2.50
$4.40
$ paid in 2005
$2.00
$1.50
$1.00
$1.14
$0.50
$0.00
Microsoft 10-year T-Bond

FIGURE 8.1 Microsoft vs. 10-Year T-Bond (1-Year Return on
$100 Investment)
Sources: Federal Reserve, Microsoft, The Wall Street Journal
Stocks 173



back the original $100, the stock investment contains an element of spec-
ulation.
Is the risk of stock investing worth the reward? Before addressing this
question, Figure 8.2 shows the same calculation for the S&P 500.
A $100 investment in the S&P 500 is estimated to return $5.92 in
expected 2005 profits versus $4.57 in Microsoft profits. So the stock
market places a premium valuation on Microsoft profits, presumably
reflecting the superior value of the company™s franchise. Beyond this dif-
ference, an investment in the S&P 500 also yields more money today in
dividends than a similar investment in Microsoft.
This Fed model framework provides an easy summary of optimistic
and pessimistic views on U.S. stocks.
The pessimistic view of stocks (Figure 8.3) is that earnings will be (or
actually are) lower than projected. The negative view on earnings
includes both a pessimistic view on the economy as well as the way in
which earnings are calculated. Accounting rules still allow for earnings
games related to issues including stock options and pensions. In addition,


$7.00

$6.00

$5.00

$4.00 $4.11
$ earned but not paid
$3.00 $ paid in 2005
$4.40
$2.00

$1.81
$1.00

$0.00
S&P 500 10-year T-Bond

FIGURE 8.2 S&P 500 vs. 10-Year T-Bond (1-Year Return on
$100 Investment)
Sources: Federal Reserve, Standard & Poor™s, Goldman, Sachs & Co.
174 Applying Science and Art to Bonds, Stocks, and Real Estate



$7.00

$6.00

$5.00

$4.00
$ earned but not paid
$5.96
$3.00 $ paid in 2005
$2.05
$2.00

$1.00
$0.90
$0.00
S&P 500 10-year T-Bond

FIGURE 8.3 A Pessimistic View of Stock Prices (Return on $100)
Sources: Federal Reserve, Standard & Poor™s



most pessimistic stock analyses include an expectation of higher interest
rates. Thus, the pessimist contrasts lower stock returns to higher bond
interest rates and concludes that stock prices are too high.
The optimistic view centers on the growth in earnings. The optimistic
chart (Figure 8.4) assumes that the economy will grow modestly and that
corporate profits will grow at the same rate as the economy. As we™ll see,
profits have had a good run where they have done better than the econ-
omy, but even with the more conservative assumptions, it is easy to build
a positive case for stocks. (Figure 8.4 assumes 7% annual growth in the
economy, which could come from 3% growth in productivity, 3% infla-
tion, and a 1% growth in the population.)
Even though this Fed model view of stocks avoids many of the details,
we can already draw some conclusions about stock valuations.

Stock Prices Do Not Look Ridiculously High
Stock and bond returns are about equal. Good arguments can be made to
suggest that stocks are expensive or cheap. This balance of possible
reward and risk is characteristic of fair value.
Stocks 175




$12.00

$10.00

$8.00
S&P 500
10-year T-Bond
$6.00

$4.00

$2.00

$0.00
2005

2005

2006

2007

2008

2009

2010

2011

2012

2013
FIGURE 8.4 An Optimistic View of Stock Prices (Return on $100)
Sources: Federal Reserve, Standard & Poor™s



Stock Prices Are Not Cheap
While stocks do not look terribly expensive, by most measures they are
priced above historical averages and far above the valuation levels that
existed at true market bottoms. So stocks appear to be either fairly valued
from a current perspective, or richly valued from a historical perspective.
It is hard to characterize stocks as really cheap.

Growth Rate Is Crucial to Determining Stock Valuations
The expected growth rate is enormously important to valuations. In the
case of Microsoft, a $100 investment earns less today than the same
investment in a 10-year Treasury bond. Furthermore, investors in
Microsoft stock risk losing part or all of their money. To make the risk
worth the reward, Microsoft earnings must rise over time to be substan-
tially above the payoff to the ultra-safe Treasury bond. This question of
earnings growth is so crucial that we will examine it further.
Beyond simple valuation calculations, emotional mood swings play a
major role in stock prices. In some periods, investors are willing to take
risk and predict good futures. In other periods, investors are skeptical and
176 Applying Science and Art to Bonds, Stocks, and Real Estate

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