Right in Practice, Right in Theory

Once again, Slate writers are attacking our book even though they haven't read it. The book, Dow 36,000, which will be out in early September, explains the reasons for the stock market's rise between August 1982, when the Dow Jones industrial average stood at 777, and today, when it's over 10,000. During nearly this entire ascent, financial journalists, academic economists, and Wall Street analysts have claimed the market was heading for a fall. After all, just look at price-to-earnings ratios and other measurements of valuation, goes the conventional wisdom. They're too high!

What my co-author--Kevin Hassett, a former Federal Reserve economist whose work has been widely published in scholarly journals--and I offer in our book is a new model for pricing stocks, one that is consistent with the market's performance and with the basic principles of finance. Our starting point is that the value of a stock, like that of any other asset (a rental condo, a bond), is determined by the amount of cash it puts into your pockets over time. With stocks, that amount has been sky-high--and will continue to be, we believe, until shares are bid up by investors to where they should be. That proper level is about 36,000 on the Dow.

This argument is laid out at length in an annotated 300-page book, which also includes extensive advice on how to implement an investing strategy based on the theory.

In Slate on June 9 ("When Good Things Happen to Bad Ideas"), Paul Krugman rehashed the criticisms made in Slate by Bruce Gottlieb and Clive Crook before him. Our response to Krugman is the same as our response to Gottlieb and Crook: You're accusing us of making an assertion we don't make.

Krugman wrote that our theory is based "on a simple misunderstanding of corporate accounting"--that "businesses can eat their seed corn and plant it too." What he means is that, while we rely on the growth in cash flowing to investors as justification for higher stock prices, that cash is needed by corporations themselves. In other words, we "double-count" by using reported corporate earnings for our calculations. But we don't. Nowhere in the book do we claim that free cash flow is equal to earnings. In fact, we say that it would be an "egregious error" to make such a statement or to use it in calculations of stock values. Instead, what we have written from our first March 1998 piece in the Wall Street Journal to our book--and have repeated, without provoking objection, at academic conferences from Princeton to Tokyo--is that the measure of cash is somewhere between the lower bound of dividends and the upper bound of earnings. In the book, we discuss simple ways to determine cash flow as a percentage of earnings. (Hint: The answer is far from 100 percent.)

The thrust of Krugman's piece is the irony that stocks have kept rising, just as Glassman predicted, so that "the guy who had no idea what he was talking about gave what turned out to be good advice." This twisted argument--that we are right in practice but wrong in theory--has become the last refuge of people who simply do not understand what has been happening in the stock market over the past two decades and who cling to an old paradigm that recent history has clearly repudiated.

We have written a serious book--one that will launch a debate over discovering a new and useful model for determining the true value of stocks. But see for yourself. Don't read premature reviews of a book that the reviewers haven't read. Just hang on. Dow 36,000 will be out in 10 weeks.

--James K. Glassman

Washington