long-term perspective on stock prices

CFA Institute

Long-Term Perspective on Stock PricesAuthor(s): Andrew P. FerrettiSource: Financial Analysts Journal, Vol. 18, No. 6 (Nov. - Dec., 1962), pp. 19-26Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4469412 .

Accessed: 11/06/2014 10:42

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 185.44.78.120 on Wed, 11 Jun 2014 10:42:56 AMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=cfa

http://www.jstor.org/stable/4469412?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Long -Term Perspective on Stock Prices

by Andrew P. Ferretti

FROM THE POINT OF VIEW OF THE TRADER, many factors enter into an assessment of the outlook for prices of common stocks. On the assumption

that stock prices lead business, he can base his policy on a forecast of the business cycle and the outlook for corporate profits. He can attempt mass psychiatry, evaluating the effect of "investor psychology" on business conditions and on price earnings ratios as well. Or, he can choose a short cut, concentrating on techni- cal approaches such as the popular point-and-figure charts. At best, the trader's lot is insecure.

The problem of the investor is by comparison much simpler. He is concerned with long-term trends. He can find comfort in the knowledge that prices of common stocks are tied to some basic elements of our economy. Over the long run, these forces can be analyzed and evaluated, so that an expectable rate of annual growth can be woven into a long term investment policy. This relationship between prices of common stocks and national growth has survived some pretty remarkable social, political and economic changes.

When this century began, the United States was on the gold standard. In the years that followed, it prog- ressed through a period of managed currency and is today on the gold exchange standard. We have seen two world wars and the greatest depression in history. We've been through colonialism, nazism, communism. We've seen a flood of immigrants and a trickle; no taxes at all and high level progressive income taxes; a laissez faire system and extensive government regulation; no unions and widespread growth of unionism sheltered by government legislation; the covered wagon and a bundle of instruments speeding toward Venus.

Through the past six decades of change, the more significant of which are outlined in the following pages, the central trends of common stock prices and national wealth have followed parallel paths.

1900-1919

The United States emerges as a world and industrial power. Its image was strengthened by the opening of the Panama Canal and its major contribution to an

Allied Victory in World War I. The census of 1890 had shown that income from manufacturing had ex- ceeded that from agriculture for the first time in the nation's history.

Regulation of interstate commerce appears. Reacting against a laissez-faire philosophy which had resulted in a rash cf unrestrained competition, pools, trusts, holding companies and interlocking directorates, laws regulating interstate commerce were adopted. Among these were the Interstate Commerce Act (1887), the Sherman Anti-Trust Act (1890), and the Clayton Act (1914) aimed at curbing unfair competition, monop- olies and concentration of power.

Broad markets go hand in hand with mass production. A rapidly expanding rail system effectively broadened markets so that mass consumption formed a solid base for mass production. The development of new, high speed carbon steel made possible the machine tool industry and stimulated the technological progress of the early 1900's. The use of electrical power in fac- tories grew rapidly.

The banking system is overhauled. When the panic of 1907 once again revealed weaknesses in the financial system, the Federal Reserve Act was passed in 1913. Its aim was to establish an elastic currency base which would relieve strain and avoid recurrence of money panics.

The first corporate income tax is levied in 1909. The sixteenth amendment authorizing the personal income tax levy was adopted in 1913. It was first used in that same year as a part of the Underwood Tariff Act, to offset the expected loss of revenue resulting from the accompanying reduction in tariffs.

Government interferes with private business in an emergency. The first instance of actual government interference (exclusive-if you like-of the famed 1911 break-up of The Standard Oil Trust) with business came in 1917. The country was grossly unprepared for entry into World War I and centralized supervision and direction of production and distribution were essen- tial to successful prosecution of the national war effort.

Nation unsympathetic toward unions. Immigration was heavy during all except the war years and the supply of labor helped contain wages. On the whole the nation was unsympathetic toward unionism, and the use of injunctions by local and national governments to break up strikes was common.

The auto industry which began at the turn of the century as a "machine-shop product" was recognized by the Bureau of the Census as a separate industry in 1914. By 1920 exports of finished manufactures had risen to nearly 40% of the total, outstripping the aggre-

Andrew P. Ferretti, staff economist for Keystone Custodian Funds, Inc., graduated from Yale University in 1937. He has been connected with Keystone's research and supervisory divi- sion since then, with time out for brief periods with the War Production Board and as a navigator with the Navy Air arm, with the rank of Lieutenant. An expert in the field of financial research and business cycle analysis, he is a member of the National Association of Business Economists and The Boston Security Analysts Society. He is also an instructor at Boston College, where he conducts a seminar in finance, and is the author of rmny economic articles.

NOVEMBER-DECEMBER 1962 19



o 0 0 0 o 0 0 0 0 r o 0 0 0 0 0

LC) ~ ~ ~ ~ C

z U r z

0 W 0

O~LL

U))

z

u~~~~~~~~~~~~ o ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

HW 0W

WH~~

1 ~~~~~~~~~U)

0

(D M ~ ~ (

H

AC~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~,

U <~~~~ a:

N: It w HD

o U It0

(~~~~~~~~~ z -I~~~~~~~~~~~~~~~~~ WO u 0 ~~~~~~~~~~~~~~~~~~~~~~~(nO0 U ZW 0)

z ~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 0~~~~~~~~~~~~~~~~~~~~~~~~~~~~

0 0 0 0 0 0 0 0 0a



gate proportion of raw materials and food stuffs which historically had been the United States' major exports.

1920-1939

Nation resumes rapid industrial growth. The economy moved ahead rapidly with the auto industry leading the way. The use of electric power expanded, benefitted by the rising utilization of electrical machinery and home appliances. Building proceeded at high levels and the movies, radio and advertising grew apace. Commercial air transportation was inaugurated. There were some weaknesses, a reaction to the forced draft of the war effort. Coal, cotton, textiles, ships, shoes and especially agriculture suffered from over-capacity but the forces of expansion were more than sufficient to keep the economy moving.

Immigration curbed sharply in 1924. Submitting to pressure exerted by labor unions and those concerned with the impact on the American scene of the influx of unskilled labor from Italy, Poland and other low income nations, the Congress adopted a law establishing quotas which sharply restricted immigration from these areas. Meanwhile incomes continued to rise, aided in no small way by profit from wide-spread speculation in securities. Some $5 billion of foreign bonds were dis- tributed in the United States between 1925 and 1929. The German economy carried a heavy burden of repara- tions imposed by the victorious Allies after World War I. Warnings of impending trouble went unheeded as the nation followed a path into the "New Era".

Business and financial circles demoralized by the Great Depression. Stock values contracted nearly 90%, reflecting the complete demoralization of the economic structure. Businessmen had been successful in following policies which curbed the growth of unions in the years before the crash. Cutting of wage rates was a common practice during the depression. In 1932 hourly wage rates for those who were still at work had slumped 21 %. The United States followed Britain in abandoning the gold standard.

"New Era" Succeeded by "New Deal." The national economy was so completely prostrated that the New Deal was ushered in with sweeping powers. With the banks closed and 25% of the people unemployed, the nation embarked on a program of controlled inflation through a managed currency. Many new regulations and agencies were born: the Reconstruction Finance Act, the Norris-LaGuardia Act, the Gold Reserve Act, the Securities Exchange Act, the National Industrial Recovery Act (declared unconstitutional in 1935), the Public Utility Holding Company Act, the National Labor Relations Act, the Social Security Act, the Walsh-Healey Act, the Civil Aeronautics Act, the Com- munications Act, the Rural Electrification Act, the Tennessee Valley Authority among them.

Unions are strengthened and government "primes the pump." Much of the legislation imposed controls on business and strengthened the hand of labor leaders. Aid to farmers was another major effort, and social

legislation aimed at inflating the economy was enacted. Between 1933 and 1935, $5.7 billion was passed out in "dole" before the program was terminated.

Unsettled period of recovery ends, with nation's eyes on developments overseas. The period ended with the economy still in a hesitant mood. Recovery had proceeded until 1937 but was unable to sustain its progress. Corporate income tax rates began the period at an effective rate of about 8% and ended near 14%. The business scene was overshadowed by ominous developments abroad which were reflected in heavy liquidation of American securities by Europeans in order to finance rapidly increasing military procurement in the United States.

1940-1959

World War II brings sweeping controls. With the outbreak of World War II, price and production controls were instituted, men called up and the whole direction of the economy reoriented. Labor made great strides, expanding membership from 8.9 million in 1940 to 14.8 million in 1945. The aircraft industry came of age and vied with the auto industry for first place in the economy. Nuclear power was born, technological progress swift. National debt expanded from $43 billion in 1940 to $269 billion in 1946. The effective corporate tax rate climbed from 22.7% in 1940 to 55.5% in 1943.

Russia emerges as a world power. As a result of World War II, Russia displaced the European nations in the front ranks of world power. Strong idealogical differences with the free world led to a high degree of unity between nations, victor and vanquished. The United States and Canada held by far the biggest part of the world's production capacity. Foreign currencies were weak and a "dollar shortage" existed. In order to rehabilitate the economies of nations devastated by war, the United States undertook foreign aid, notably the Marshall Plan.

Concern about a difficult post-war adjustment. Fears that there would be widespread unemployment in- fluenced the Congress to pass the Employment Act of 1946 which required the cooperation of all Federal agencies to promote national growth. With the huge pent-up demands at home and abroad, a shortage of world production capacity, and a high degree of liquid- ity stemming from forced savings during the war, these fears proved unfounded. There was a shortage of labor, and the country reacted against labor leaders' continued abuse of their privileges. Congress passed the Taft- Hartley Act. Commercial TV grew rapidly. Man began the exploration of space.

Inflation characterizes the entire period. While price controls curbed quoted prices during the war, deteriora- tion of quality and black market activities attested to the inflation which was taking place. Price controls were eliminated in 1946 and the general price level rose quickly to the point where it reestablished normal relations with unit labor costs. The absence of competition




0 00 000 0 0 0 0 0 0 0 00 0 0 0 0 00 0 0 0 in 0

7, 01 N C in M C C'4 (M

_ _ _ _ _ _ _

0 ~ ~ ~ ~ ~ ~ ~ ~ - U

01 0~~~~~~~~~0

C'~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ZL

Ln ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ C

C, W

01 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 0R T C5)

CD ID q* U

01

C'

a-0~~~~~~



from abroad made possible a wage-price spiral which persisted until 1957.

European economies re-enter world scene. The Euro- pean Economic Community (European Common Mar- ket) came into being March 25, 1957. The six member nations aimed at initial economic unity, to be followed by political unity. At about the same time restrictions on the international movement of the pound, mark, franc and lire were relaxed or removed. This signaled the end of the "dollar shortage." The Marshall Plan had done its work and the economies of Europe were back on their feet, in position once again to compete at home and abroad.

* * *

Now let's look at the record of changes established by national wealth and common stocks since the turn of the century. In the last 20 years, common stock prices have risen 348.6%, keeping pace with economic growth of 328% as measured by national wealth. In the previous 20-year period ending in 1939, the prices of common stocks were up 38.1 % compared to about 33% for national wealth. The changes for the past 60 years are shown in Chart I by 20-year periods.

In the first 20-year period of this century, national wealth rose at the rate of 6.01% per year compared with 3.88% for common stock prices as measured by the Dow-Jones Industrial Average. This is the only period during which the stock price index failed to keep pace with national wealth. There are several reasons why the measure of common stock prices fell short, but two of them stand out.

In the first instance, the Dow-Jones Industrial Aver- age during three-quarters of the original 20-year period consisted of 12 stocks. Two of them were preferred stocks, representing nearly one-quarter of the weighted average. Since preferred stocks reflect money market conditions rather than the growth of equity values, the Dow-Jones Industrial Average was weighted heavily in the direction of stability.

The second, and possibly the more important explan- ation, lies in the fact that the corporate form did not figure as prominently in the business scene. Corpora- tions were organized only when large concentrations of capital were required. The early years of this century were the years during which huge family fortunes were being built. Income tax laws were largely non-existent. The corporate income tax was first legislated in 1909.

Personal income taxes were not imposed until 1913. In the absence of personal income taxes and faced with the reality of corporate income taxes for part of the period, individuals who owned business had no incen- tive to incorporate. It was not until World War I that the income tax rate on top bracket income rose to the point where it became profitable for wealthy individuals to incorporate their business, sell some of the equity, and invest in the tax exempt government bonds which were issued at the time. Since then, the corporate form has been more and more widely utilized in business circles.

It is fair to say then (and the record so indicates),

that the fortunes of business corporations have become closely intertwined with developments in the national economy. Common stock prices for the last 40 years have moved in consonance with developments in national wealth.

What is national wealth? National wealth represents the estimated value of all structures, all equipment both consumer and business, all inventory, land, monetary reserves, and the value of foreign assets. Seven years ago, Dr. Raymond W. Goldsmith completed a massive research program, compiling statistics which would make available to the student total value of national wealth, estimated at important periods in the past. This research furnishes the basis for statistics which were used in arriving at the figures plotted at the terminal dates shown on Chart I. They represent the resources which are available to the American economy in pro- moting and in building its standard of living.

Gross National Product is closely related to national wealth. The table shows the high degree of correlation between the rate of growth in GNP and the rate of growth in national wealth during the three 20-year periods covered by this study. GNP represents the value of the annual output of all goods and services consumed by the private economy (including producers and consumers), the value of new construction, net change in inventories, purchases of goods and services by government, and net foreign investment.

1900-19 1920-39 1940-59 1900-59 Gross National Product 6.8% -0.5% 7.4% 5.3% National Wealth 6.2 1.0 7.9 4.7

With this record at hand, the investor is in a pretty fair position to take advantage of some research into national growth conducted by the staff of the Joint Economic Committee. In 1960 the staff of the Commit- tee published Study Paper No. 20, a study of "The Potential Economic Growth of the United States."

The staff's first objective was to examine the past in an effort to determine the interrelationship of factors which had guided the nation's growth potential in years gone by. Having done this, the outlook for future changes in these same forces was to be assessed, so that a bench mark for growth during the years to come might be set.

In its work, the Committee's staff studied the basic factors which determine the economic potential of any nation:

1. The size of the labor force. 2. Time devoted to production. 3. The amount and age of tangible capital. 4. An efficiency factor-commonly known as pro-

ductivity.

The effect of price change was excluded so that the impact of the more basic elements of growth could be viewed more clearly. Data for the 50-year period beginning in 1909 were analyzed; and, with the help of many hours on electronic computers, a formula was developed which, using the actual data, would best




O 0 Q W)O u ) O D0 U) - ? t > te t~~N ?UN N N N W

r~ ~ ~~~~- 0, w_

~~~~~~ ~~~~~0 0

W a.~~~

2 0

J WI 6

<: ~~~~~~~~~~~~~~~~~~~~~~~~~X *'O

W W

(-)~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~c

T T U N N ^ O - N > |~~~~~~~~Oz U

o~~~~~

_ __'"t'''' 0.I

I- H~~~~~~~~~~~~~~~~~~~~~~~~

O = Q In O u) Q ID O u O Q U O W CQ o 00 oZ 000 o

0N~ ~ ~ ~~~~~~~~~~i

< z 1i~~~~~~~~~~~ 9-~~J

<hi~~~~~~~~~~~~~~~~ _ _ 0~~~~~~~~~~~~~~~~~~~~~

o H 0~~~~~~~~~~~~~~~~~~~~~~~

0~~~~~~~~~~~~~~~~~~~f

0 0 ~ ~ ~ ~~0. 0

<~~~



measure the growth in our economic potential. Potential levels of output were compared with the economy's actual production for the 50-year period beginning in 1909 and ending in 1958. Both sets of data are plotted in Chart 11.

The dotted line in the chart represents the growth in the economic potential of the United States. The solid line plots what actually happened to output during the same years. In the first place we find that measured by arbitrary 20-year periods, the nation's economic potential has been growing at an accelerating rate: 2.3% 1909-1919; 2.8% 1920-1939; and 3.6% 1940- 1959.

More significant perhaps is the fact that for most of the time, the economy tended to move closely with its potential. There were times when the output fell short- seriously short in the case of the Great Depression. Then again, there was a period during World War II when the economy operated above its potential. Never- theless, over the long term, through all the changes which have taken place, the growth in actual output came close to matching the potential output, which could have been forecast through an accurate appraisal of the outlook for the forces which determine our economic growth. For the long term investor, this record of accomplishment is surely of interest if the future of our economic growth potential can be foretold within reasonable limits.

The staff made some estimates of the rate of growth for the next 20 years. But before discussing their implications for the investor, it may be helpful to take a quick look at the future of each of the basic forces involved.

The labor force is drawn from the adult population of the United States. In 1960 there were 99.5 million people between the ages of 18 and 65. The 73.1 million people in the labor force, 95 % of them employed, were largely drawn from the people in these age brackets. In the next 20 years, these same age groups will expand by some 33% to about 133 million, raising the labor force potential by a like proportion. The increase in the next 20 years will be some four percentage points greater than was witnessed in the past 20 years of rapid growth.

Although the total number of people in the labor force will be up one-third, the total number of hours worked by the American people will rise less than that, perhaps by one-fourth. This is, of course, due to the fact that the average worker has a strong inclination toward shorter hours of work each year, a tendency which is apparent in the steady trend toward longer vacations, more paid holidays, and a shorter work week.

As to tangible capital available for production, sur- veys made by McGraw-Hill Publishing Co. indicate that manufacturers feel their stock of machinery has aged to the point where modernization is a pressing need. The corporate tax burden which has remained substantially unchanged since World War II and is now at far higher levels than was the case during those years of peace needs overhauling. Pressure for such action

is building in Congress. Depreciation schedules have already been liberalized. Studies and hearings conducted by the Joint Economic Committee have laid the groundwork for the required revision. It appears that the outlook for a more ample supply of internally generated funds so necessary as a source of investment capital is better now than it has been for the past 20 years.

The nation's productive efficiency (which has ac- counted for between one-half and two-thirds of the annual increase in our output potential) has been increasing during each of the 20-year periods since the beginning of this century, and at an accelerating rate. This happy circumstance is attributable to an upgrading in the capabilities of our population. The improvement has been due in part to the higher average level of education. In 1900 6.4% of the 17-year-old population graduated from high school. In 1920 it was 16.8%; in 1939, 48.0%; and in 1958, 64.8%. Not only is the proportion of high school graduates rising, but the demand for college training is already taxing the capacity of the nation's universities, necessitating a massive building program.

Research Opening New Frontiers

Another factor in the accelerating rate of improvement in productive efficiency is the eagerness with which

Facts about industrial opportunities in the area

Utah Sreasu Che s Idaho 0te Colorado Gow Wvyoming Ws

Write for FREE COPY Box 899, Dept. G

E _ Salt Lake City 10, Utah

Inquiries held in strict confidence.

-~~~~~M _A, <2m" (U)et-




the population of the United States is ready to accept innovation. The tremendous research effort which has been undertaken in the past decade is sure to result in improved technology. Research into space promises new metals, microminiaturization, new energy sources such as solar energy and solid fuels, international tele- communications, medical instrumentation, and continued rapid strides in electrodata processing. In light of the continued increase in the nation's educational level and the massive research effort which is built-in to our economy, there is every indication that the rate of productivity improvement will continue to accelerate.

The outlook for these four factors, the labor force, the work week, the level of tangible capital invested, and productivity, were assessed by the staff of the Joint Economic Committee. The Committee used three sets of assumptions in estimating the average annual growth rate for the next 20 years. Common to all assumptions was the premise that the United States would succeed in avoiding a depression. during the period ahead. The most conservative set of projections resulted in an estimated growth rate of 3.5% per year compounded during the next 20-year period. The middle series registered a 4.0% annual rate of improvement and the more optimistic estimates 4.6%. In other words, the lowest rate of Growth for the next 20 years would be nearly equal to that of the past 20 years. The middle rate and the high rate would represent a continuation of the trend toward accelerating the rate of growth in the potential economic level noted earlier.

None of these assumptions makes allowance for changes in price level. At the moment prices appear to be under the pressure of competition from abroad. In other words, the business picture has returned to what we knew as normal during the years prior to the be-

ginning of World War II. But there is strong indication that an inflationary bias is built into our economy. While much has been heard about the inflationary tendencies of the past 20 years, it has been generally overlooked that inflation during the first 20 years of this century was at a more extreme rate than was ex- perienced during the last 20 years. The record indicates that the consumer price index rose 133% between 1900 and 1920 compared to a more moderate 108% between 1940 and 1960.

There is strong evidence to support the contention that the general price level in this country and, for that matter in any country, is tied closely to unit labor costs. The price deflation which was witnessed principally between 1929 and 1933 of the Great Depression was coincident with a reduction in unit labor costs during that same period, attributable to sharp cuts in hourly wage rates which were instituted by management un- hindered by union labor contracts. The realities of 1962 indicate that similar cuts in hourly wages are a remote possibility in view of the extent to which the labor contract, particularly 2 and 3-year contracts, have penetrated the business scene.

Wlhat can the investor conclude from all this? First, he may assume that the economy will grow at the rate of somewhere between 31/2 and 41/2 % per year compounded during the years ahead, without inflation. If he assumes a 4% growth rate and no inflation, Le has a tentative bench mark of 1500 for the Dow-Jones Industrial Averages in 1979. If he assumes a basic growth rate of 4% plus 2% per year inflation, his bench mark will be 2200 on the Dow-Jones Industrial Aver- age. In either case, the Dow-Jones Industrial Average at around 570 is well below the 750-800 bench mark indicated for 1963.

Newport News Shipbuilding and Dry Dock Company Quarterly Statement of Billings, Estimated Unbilled Balance

of Major Contracts and Number of Employees Three Fiscal Months Ended Nine Fiscal Months Ended

September September September September 24, 1962 25, 1961 24, 1962 25, 1961

Billings during the period from __-_

shipbuilding, ship conversions and repairs, hydraulic turbines and other work . . . . . $63,034,303 $62,139,249 $191,862,697 $151,264,674

At September At September 24, 1962 25, 1961

Estimated balance of major con- 2 16 2

tracts unbilled at the close of the period . . . . . . . $391,574,318 $543,662,115

Equivalent number of employees, on a 40-hour basis, working during the last full work-week of the period .19,293 21,333

The Company reports income from long-term shipbuilding contracts on the percentage-of-completion basis; such income for any period will therefore vary from the billings on the contracts. Contract billings and estimated unbilled balances are subject to possible adjustments resulting from statutory and contractual provisions.

By Order of the Board of Directors October 24, 1962 R. I. FLETCHER, Financial Vice President



long-term perspective on stock prices

Documents