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The Intelligent Investor by Benjamin Graham - Chapter Three

This is a summary of Chapter Three: A Century of Stock Market History: The Level of Stock Prices in Early 1972 of The Intelligent Investor By Benjamin Graham

The investor's portfolio of common stocks represents a small cross-section of the stock market and prudence suggests that an investor should have an idea of stock market history, particularly the major fluctuation in price level, and the relationships between stock prices as a whole and their earnings and dividends. This provides a background for the investor to form some judgement of the attractiveness or dangers of the market level at different times. 

Graham presents data of 100 years, going back to 1871, in order to show in general how the underlying value of stocks have increased through the many cycles of the century and by viewing the data in terms of consecutive ten-year averages, to establish the relationship between stock prices, earnings and dividends. He summarizes the long-term history of the stock market in the following 2 tables and chart:

Table 3-1  

Source: The Intelligent Investor - Revised Edition By Benjamin Graham, page 66

Chart 1 
Source: The Intelligent Investor - Revised Edition By Benjamin Graham, page 68

  • Chart 1 shows the market fluctuations of the S&P 425 industrial stock index from 1900 to 1970. 
  • There are 3 distinct patterns, each covering about a third of the 70 years.
  • From 1900 to 1924:
  • The first pattern shows a series of similar market cycles lasting from three to five years.
  • The annual advance in this period averaged about 3%.
  • From 1925 to 1949:
  • The "New Era" bull market started which reached a high point in 1929 before it collapsed, followed by irregular fluctuations until 1949. 
  • The annual advance in this period averaged about 1.5%.
  • From 1949 to 1969:
  • The greatest bull market in the period of 70 years reached its highest point in December 1968.
  • Table 3-1 showed setbacks in 1956-57 and 1961-62, but the rapid recoveries meant that they were denominated as recessions in a bull market rather than separate market cycles.
  • Between the low level of 162 in 1949 and the high of 995 in early 1966, the advance was more than six times in 17 years. The average compounded rate was 11% per year, not counting dividends of about 3.5% per year. 
  • The returns of about 14% created a satisfaction among investors on Wall Street who were convinced that equally good results could be expected from common stocks in future, however few people had considered that the extent of the increase in prices might have indicated that prices were too high. The stock market subsequently suffered a decline from the 1968 high to the 1970 low (around 36% for S&P composite and 37% from DJIA, Table 3-1), which was the largest since the 44% decline in 1939-1942 during World War II.
  • The low level of May 1970 was followed by a recovery of both averages, with an all time high for the S&P composite in early 1972. 
  • The annual rate of increase in price between 1949 and 1970 was about 9% for the S&P composite, and this rate of increase was much greater than for any similar period before 1950. 

Table 3-2

Source: The Intelligent Investor - Revised Edition By Benjamin Graham, page 71

  • Table 3-2 provides corresponding figures of earnings and dividends to supplement the record of price movements over 10 decades from 1871 to 1970. 
  • The full decade figures smooth out year to year fluctuations, and leaves a picture of persistent growth in general. 
  • Only 2 of the 9 decades (1891-1900 & 1931-1940) showed a decrease in earnings and average prices, and no decade after 1900 showed a decrease in average dividends.
  • In general, the performance since WWII has been superior compared to earlier decades, but the advance in 1960s was less than that of 1950s. 
  • Today's investor cannot tell from this record what he might expect of percentage gain in earnings, dividends and prices in the next decade but the data provides much encouragement for the investor to maintain a consistent policy of common stock investment. 
  • Graham made a point that was not presented in the table. There was a drop in overall earnings of American companies in the year 1970, and the rate of profit on invested capital fell to the lowest percentage since World War years. A number of companies reported net losses for the year, and many became financially troubled, with a few bankruptcy proceedings. This prompted that the great boom era have ended in 1969-1970.
  • The change in the price/earning ratios since World War II has been striking as shown in Table 3-2. In June 1949, the S&P composite sold at around 6.3 times the earnings of the past 6 months but in March 1961 the ratio was 22.9 times. The dividend yield had fallen from over 7% in 1949 to only 3.0% in 1961, which was a contrast to the rise in interest rates on high grade bonds from 2.60% to 4.5%. This was the most remarkable change in people's attitude in stock market history.
  • For people with experience and are cautious about the change from one extreme to the other, they believed this is a warning of trouble ahead, due to past history (1926-1929 bull market and its decline), however these fear were allayed as the closing price in 1970 was the same as 6.5 years earlier. 

The Stock Market Level in Early 1972

Graham attempts to draw some conclusions about the level of 900 for DJIA and 100 for the S&P composite index in 1972. 

He first provided a summary of the conclusions of the levels for 1948, 1953, 1959 and 1965. 

In 1948, Graham applied conservative standards to the DJIA level of 180 and reached the conclusion that it was not too high in relation to its underlying values. In 1953, the market level reached 275 which is a gain of about 50% in five years. Graham advised a cautious or compromise policy, as the averages had advanced for a longer period of time than in most bull markets, but it did not turn out to be good advice, due to the advance of additional 100% in the next five years. 

In 1959, the DJIA reached an all time high of 584. and Graham expressed concern that the level in 1959 was dangerously high. Graham's caution was better justified as the market level rose to 735 in late 1961 and declined to a low of 536 in Jun 1962, showing a loss of 27% within 6 months. During this period, there was far more serious decline in the most popular growth stocks, with IBM being the most striking, as it dropped from a high of 607 in Dec 1961 to a low of 300 in Jun 1962.  This period also saw newly launched common stocks of small companies (hot issues) which was offered to the public at high prices, which were pushed up further to even higher levels due to speculation and many lost more than 90% in just a few months.

In an unexpected manner, the market recovered to a high level of 892 in Nov 1964. Graham offered 3 conclusions after appraising the Nov 1964 level of the DJIA of 892:
  1. Old standards  of valuation is no longer applicable, new standards have not yet been tested by time.
  2. The investor must base his portfolio policy on major uncertainties, including a protracted increase in the market, e.g. by 50% to 1350 for DJIA, or a collapse by 50% to around 450. 
  3. If the 1964 level was not too high, how could any price level be too high?
Graham suggested for the investor to be cautious and offered the following policy under 1964 conditions:
  1.  No borrowing to buy or hold stocks.
  2. Do not increase proportion of funds held in stocks.
  3. Reduce where necessary to bring common stock holdings to 50% of total portfolio. Pay capital gains tax as early as possible and the proceeds from investment to be held in high quality bonds or savings deposit. 
  4. For investors who followed a dollar cost averaging plan, continue with periodic purchases or stop until they feel the market level is no longer dangerous. 
Graham felt vindicated this time as the DJIA closed at 1970 at a level lower than 1964, which was the first time such a thing happened since 1944.

Table 3-3
Source: The Intelligent Investor - Revised Edition By Benjamin Graham, page 77

As shown in Table 3-3, Graham compares the 1971 figures, using data from year ended 1948, 1953, 1958, 1963 and 1968, and set the current price level of 1971 at 100. Earnings figures were the average of past 3 years. For 1971 dividends and bond interests figures, last 12 months figures were used. Aug 1971 prices were used for wholesale prices. 
  • The 3 year P/E ratio was lower in 1971 (18.1) compared to 1963 (20.7) and 1968 (19.5). It was around the same as 1958 (17.6) but much higher compared to 1948 (9.2) and 1953 (10.2). By itself, this indicator does not imply that the market was too high in Jan 1972. 
  • However, when interest yield on high grade bonds is taken into consideration, stocks appeared to be less favourable. The ratio of stock earnings yield to bond yield has worsened from 1948 to 1971 and similarly, the ratio of dividend yield to bond yield had declined between 1948 to 1972, where stocks yielded twice as much as bonds in early years, but that trend had reversed and bonds yielded twice as much as stocks in 1972. 
  • Graham believes the adverse decline in bond-yield/stock-yield ratio offsets fully the better P/E ratio, hence his view of the 1972 market level is similar to 7 years ago, which is an unattractive one from conservative point of view. 
  • From historical market swings, the 1971 level appears to be an irregular recovery from the setback in 1969-1970. In the past a recurrent and persistent bull market follows a bad setback, beginning in 1949. 
  • Public buyers of low grade common stock offerings (hot issues) during the 1968-1970 cycle suffered and it may be too early at 1971 for another cycle of new-issue of speculative low grade offerings. 
  • It may appear that the current outlook at 1971 seem to favour another huge rise beyond the 900 DJIA level but the market does not seem to take into consideration the decline suffered during the 1968-1970 cycle. Graham cautions that the investor must be prepared for difficult times, particularly a repeat of the 1968-1970 cycle or in the form of another bull market swing followed by a catastrophic decline.  

What course to follow

Graham recommended the same policy in late 1964 level, for the price level of 900 DJIA in early 1972: 
  1.  No borrowing to buy or hold stocks.
  2. Do not increase proportion of funds held in stocks.
  3. Reduce where necessary to bring common stock holdings to 50% of total portfolio. Pay capital gains tax as early as possible and the proceeds from investment to be held in high quality bonds or savings deposit. 
  4. For investors who followed a dollar cost averaging plan, continue with periodic purchases or stop until they feel the market level is no longer dangerous. 


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