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One other chart that reinforces that buying the dow at 892 in 1965 would not have been a good investment.

http://stockcharts.com/freecharts/historical/djia1900.html

This shows that the Dow was as low as 777 in 1982. In 17 years your total return would have been -13% + dividends - inflation. From eyeballing that earlier chart, the dividend yield probably averaged about 4.5% over this period. Here is an inflation chart:
http://4.bp.blogspot.com/-NQAuKUEl4Y0/T3EjXaTS-2I/AAAAAAAABU...

It looks like it averaged similar or slightly higher.

It would seem that an investor buying the Dow in 1965 would still have a negative total return 17 years later suggesting that Graham's words of caution were indeed merited.

StevnFool
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1st post on this board in about a year and a half ....

I won't claim to be an authority to answer your questions but some thoughts ...

....In 1965 the investor could obtain about 4.5% on high-grade taxable bonds and 3.25% on good tax-free bonds. The dividend return on leading common stocks (with the DJIA at 892) was only about 3.2%. This fact and others , suggests caution?

I'm not sure why people would need to be cautious? If anyone can explain the difference between the two bonds that would be nice. Am I wrong in interpreting 3.2% as being a good return.


He describes the taxable bonds as "high-grade" and the tax free bonds as "good". It is probably reasonable to assume that both of these terms are interchangeable and that these bonds would be unlikely to default and would pay out their coupons until maturity.

The higher yield on the taxable bonds makes sense if say you were paying 28% tax (I have no idea what tax rate a typical US investor would have paid in 1965), but you see the logic - i.e. a $4.50 coupon would turn into $3.25 after 28% tax.

As the dividend from a stock would be taxable, if you were comparing a bond coupon with a stock dividend, you would need to compare the dividend with the taxable bond yield.

Dividend = 3.2% return pretax
Bond = 4.5% return pre-tax.

I believe Graham was suggesting that the stock was overvalued - i.e. the price of the stock would have to drop by about 29% for the same dividend to provide a 4.5% dividend yield.

This view is perhaps not entirely correct as good stocks tend on average over the last century or so to increase in price at something like 1-2% plus inflation. Average inflation in 1965 was 1.58% so on average a reasonable expectation in 1965 would have been for stock prices to be increasing at about 3% per year if they were fairly valued to start with.

If we add this to the dividend yield, it actually suggests that the total expected return from stocks should have been around 6.2% per annum (pre-tax) which compares favourably with the bond yields.

The other consideration is that I believe Graham viewed stocks in general as riskier assets than bonds. One reason for this is that bond holders are entitled to be paid preferentially over shareholders. For example, a company could not suspend the bond coupon and still pay the stock dividend. Another example would be that in the case of a liquidations, all the bond holders would be paid first before any payment to shareholders. This leads to the situation that if a company runs into trouble, the price of the stock is likely to decline more and quicker than the decline in the price of the bond.

So if you accept that the stock is a riskier asset than the bond, it is only reasonable that you would demand a "risk premium" for holding the stock.

Is a 1.7% additional pre-tax return (6.2% versus 4.5%) considered a sufficient risk premium? I think Graham was suggesting that perhaps it was not enough.

Here is an interesting chart:
http://1.bp.blogspot.com/-QIolLXRTQNY/URPmdW5IlnI/AAAAAAAABq...

Look only at the history from 1900 to 1965. You will see that the dividend yield in 1965 was at the lowest end of the range it had ever been in the previous 65 years. The median would seem to have been somewhere between 5% and 6%. For the yield to increase from 3.2% to say 5.5% would have required a 42% drop in stock prices.

Note that today, the yield is in the region of 3%. Many people feel that the S&P 500 (not sure about the Dow) is in the region of 50% over valued today which would bring the yield back up again into the range seen from 1900 to 1965.

Perhaps Graham was saying that both bonds and stocks were over-priced. I am not sure. I haven't read II in some years, but this is an interesting chart on bond yields.

http://research.stlouisfed.org/fred2/series/AAA

Note that a rising yield means that the price of the bond goes down so the buyer of bonds in 1965 probably saw a drop in price although if he held to maturity and the bond didn't default, he would still have got his 4.2% nominal return.

I didn't check, but I suspect the rising bond yield coincided with rising inflation which could result in the bond holder receiving a negative real return after inflation and taxes - i.e. if the inflation rate exceeds the after tax return, your real return is negative. In 1965, the real return on a 3.25% after tax bond would have been about 1.67% (=3.25% - 1.58% inflation). Nothing to sing about.

Hopefully I haven't totally confused you.

StevnFool
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One other chart that reinforces that buying the dow at 892 in 1965 would not have been a good investment.

http://stockcharts.com/freecharts/historical/djia1900.html

This shows that the Dow was as low as 777 in 1982. In 17 years your total return would have been -13% + dividends - inflation. From eyeballing that earlier chart, the dividend yield probably averaged about 4.5% over this period. Here is an inflation chart:
http://4.bp.blogspot.com/-NQAuKUEl4Y0/T3EjXaTS-2I/AAAAAAAABU...

It looks like it averaged similar or slightly higher.

It would seem that an investor buying the Dow in 1965 would still have a negative total return 17 years later suggesting that Graham's words of caution were indeed merited.

StevnFool
Print the post Back To Top