In the Wall Street Journal, Ken Rogoff revisits the book Dow 36,000, published in 1999 by James Glassman and Kevin Hassett, which predicted that the iconic stock index could nearly quadruple from its then-current value within five years. Many economists, including Rogoff and myself (separately), thought that Glassman and Hassett were kind of loony. But today the Dow is approaching that level. Rogoff thinks that it is time for critics to re-examine our thinking. He writes,
I confess that I, too, strongly questioned Messrs. Glassman and Hassett’s zero long-run risk logic
Rogoff links to a piece that he published almost 15 years ago, in which he wrote
there is a big hole in the Dow 36,000 logic. Stocks are risky, depressions can happen, and it is dangerous to extrapolate the past to the future. If prices rise simply because investors decide that there is no longer any risk, then prices will collapse all the more precipitously if investors collectively change their minds.
In my case, I wrote in January of 2000,
Even if we assume that investors in stocks require no risk premium, economists would argue that the market price-earnings ratio ought to be the inverse of the real interest rate (the interest rate after inflation is subtracted). Today, the interest rate on the Treasury's inflation-indexed bonds is about 4 percent. That means that the risk-neutral price-earnings ratio ought to be 25 for the market as a whole. For stocks whose earnings are going to grow faster than the economy, the p-e ratio can be higher. For stocks whose earnings are going to grow more slowly than the economy, the p-e ratio ought to be lower. If 25 is the right p-e ratio for the Nasdaq, then the Nasdaq needs to fall 87.5 percent to be valued correctly.
Very bravely, I wrote,
The probability of a stock market crash over the next four years, in which at least 25 percent of all stock market wealth is wiped out, is 90 percent.
Even though this turned out to be correct (the Dotcom bubble popped a few months later), in retrospect I cannot justify the confidence I placed in that forecast.
Rogoff is the co-author of This Time is Different, a deliberately ironically-titled treatise on financial crises. In his recent WSJ essay, Rogoff points out that Glassman-Hassett were extrapolating a scenario in which stock market investors gradually increased their tolerance for risk in holding equities. That may have taken place, but does it explain today’s high stock prices?
In part, yes. But surely the biggest driver of prices for all long-lived assets—including equities, housing, art and even bitcoin—has been the extraordinarily low level of real interest rates. It’s not so much that the equity premium has fallen as that the interest rate on bonds has collapsed.
So this time is different because interest rates, after adjusting for inflation, have declined to record levels. For example, the interest rate on inflation-indexed Treasury securities is negative. The reasons for this are not clear, and I wrote six weeks ago that this seems like an anomaly.
The two-plus decades of experience since “Dow 36,000” has changed my mind far more about the equilibrium real interest rate than it has about the riskiness of stocks, including in the medium and long run. Risk markets could wilt if and when global real interest rates start trending up, or if there were a real or cyber war. There is ample reason to be nervous.
My personal emphasis is on inflation risk. In that context, investing in stocks or in real estate is understandable. But I think that bonds that are not indexed for inflation are a time bomb. I feel almost as confident about that as I did in January of 2000 that the NASDAQ was in a bubble.