SECURITIES IN AN INSECURE WORLD ~ A LECTURE dy BENVARIN GRARAN ros | StFrancitHotel November 15-1963 Ot per copySECURITY Ty AN INSECURE WORLD ‘ALLECTURE BY BENJAMIN GRABAN Doctor Reppaport has chosen a very intriguing title for ay talk, "SECURITY ‘UH AW INSECURE WORLD." T hope that not saay of you cane under the mistaken in pression thet I am going to telx about security in general. I an going to talk Only about fineneiel security, not about physical eecurity, sentel security, matrimonial security, or other types. ven as fer as financial security is con- cerned, T an going to address myself only to investaent policy in stocks and bonds. ‘The title of this telk might better have Deen SBIURIFIES IN All INSECURE WORLD, Daceuse securities are ay field. I an not going to talk ebout savings and bulget policy, life insurance, hone ommership, pension plans and other axtters of that Hind. “The reason ie that I don't consider yself an expert in those areas, end I would rather talk to you tbout things I hope T know more about than you do. ‘This reminds we of the fact that when the New York Society of Security Analysts eoteblished « Journel in 1946 ve gave it the simple title "The Anelysts Journsl.” But then we got 0 many inquiries and even subscriptions from psychoanalysts that ‘ye were forced in self-defense to change the nane to the present title "Ihe Financial Analysts, Journal, In the f1014 of financial security, es Limited to the problems of investamnt policy, I vould sey there are three Kins of thrests or daagers that investors ‘Should’ recognize ea possibly existing et the present tine, One of than would be ‘he trent. fron etoaie ver; the aecoad vould be the three’ from inflation; and t hind vould be the treat fron severe mrket fluctuations up and dova, and of course Primzity dova How, I have no prescription for financiel security or for portfolio poliey thet could desi with the possibility of etonie var. I don't think enyout Sine aaa; ve prefer to eveep that problen under the rug snd go forvard to thing ‘aot ve can deel with sore effectively. ‘The aecood dager I mentioned vas iafintion. Inflation hes been « big factor in investors finanotel experience going beck es Tar ‘86 1500, Not many people realize thet we had nore inflation in the firet thirty Years of this century then in the sucond thirty years, oa neasured by the gual inden The continustion of sone degree of inflation ts certainly probable in the future, and thet ie the chief reason wiy wost intelligent investors now recognise ‘toxt sowe common stocks must be ineluded in their portfolio. However, tat ie omy pert of the question of the effect of inflation on investamat policy. The fect ie Bhat Both the extent of inflation and the investor's reaction fo #8 have varied grectly over the years. Tt in by bo means « straight-line natter, A good exaaple Sate woet recent one. We have had « ausll inflation in recent youre eccompanied by a very large increase in stock-mrket prices, vaicn seen to be geared not to the inflation experienced but rather to the expectation of greeter tafletion in fe Futures” You probably know there hag Deen ineroue sn the Wolesale-prict fvorage since 1958, There bas indeed deen a rise of 6} per cent in the cost of \ Living'sn the last ive years, which of course is not negligible, but it could \ scarcey in itaele bee sound beste for «100 per cent rise in stock prices. Con~ \ Yersely, diring the youre 1945-1949 ve Aid have « rather explosive Kini of infle~ Hone-the consumer price index, (that ie, the "cost of Iiving") advanced over ‘totually ad © sual! decline. \35 per cente-but during that period tock priction bere ie that investors" feelings ant reactions regarding intle- a are probably more the pesult of the stook-narket action that they bave recently “‘tasertonced. than the eause GE'Tts Consequently there is great danger of Investores giving inflation too imck weight vhen the market advances end ignoring it extirely, ‘ss they did in 1945-9, ven the market declines, ais hae actually been the bistory Of inflation and stock market behavior ever eince 1900. ‘me problen of price fluctustions, or market fluctuations, is a very real one for investors as well as speculators, tlthough there has been « tency in Wall Street to deny that Zor a number of years in the past anf even currently. Actually, ‘the real probien is not whether price fluctuations are important to the investor; i te rather the opposite, that ie to find some good vorkable distinction between the dovestor and the apectlator in common stocks, Ag vill be painted out leter that distinction has alnost vanished from Wall Street, a fact which nas caused a great eal cf trouble in the past and will omige « great deel of trouble in the future. Yet only last year, although 1t seems « long tine ago--narket fluctuations, fas evidenoad by a declige in the Dov Jones Average from 135 0.535, €id loom as extrenely important to investors and speculators alike. This fall of sbout 27% in the Dow Jones Average vas accompanied by declines af betwean 50 and 90 per cent for wore in ost of the nev securieties that had been issued in the preceding tro yours and had played such « spectacular part in the stock market activity of that period. At that tine then, in May 1962, the concept of « one-way market, which could go only upvards vith very small reactions, seemed to be abandoned for good. Hovever, Wall Street has a very short mesory, and ov the majority of fiumeial authorities een to be slipping back to the concepts af 1960 and 1961. They are returning to the idea that for the suart investor the question of stock market Fluctuations doas not have to be considered to ay great extent. There in « tvoufold emphasis here, which slurs over the reality of stock market fluctuations. The first i the general conviction that the market can de counted on ‘to advance so emphatically through the years that vistever declines take place are comparatively unisportant; hence if you have the true investor's attitude you don't have to concern youreelr with them, fhe second claim 1s denial that the “atock market” axiets at all, meaning thereby that what the market averages 40 18 of no real inportance to the’ intalligert, vell-advieed investor or eyeculator. It yas to be a ruling tenet of Wall Street that if you practice the proper Kind of selectivity in investaeate you don't have to worry about viet the stock market does fas a wncle, as shown by the averages,tor at all tines the good stocks vill be going ‘up and the bad ones vill be going dow and all you need to do is pick the good stocks forget about the stock-warket averages, Tow valid are these tyo axgusente? Tue firet one-- the ergunent thet comon favocks are and always vill be attractive, including the present tine, because of / tas excellent recom since 1949-- involves in those terns a very funtusental and / smportant fallacy. ‘This ie the idea that the better the past record of the stock market as such the more certain it is that comon stocks are sound Snvestuente for ‘the future. Now we all know that if a corporation hae had a very good record over the past years that is a fair iniiostion (but no guarantes) that ste recor’ 4s Likely to be goo! in the future, because it hes certain business alvantazes Which in most cases ought to coutiaue, But you cannot aay that the fact that the stock marist bas risen continously (or slightly irregularly) over « long period in the pas is a guarantee that it vill continue to act in the sane way in the | future. As I ens it, the real truth ts exactly the opposite, Zor the higher the \ stock markSt advances the more reason there is to alstrist Ste future action i? \you are going to consider only the market's internal belavior. We all knov thatBaas 5 Gor macy decades the typical history of the stock market has been a succession of large rises, 42 gool part apeculative olloved inevitably by substantial falls. Coasaquentiy, the substantial upeveeye of the past have alvays carried vith then ‘warning sigels of usbapzy consequences to cose. Tt does not necessarily folloy Ghat a large rise in the price of « individual stock or in the market everages mast be colloved by © daoling; but the only reason to view with confidence the Zutire reice cf a security that hag alzpady advanced substantially in the presence ‘of srternal seasons, other than the actual price movenent iteelf, which vould justity wish coat idence. dence a lange advance in the stock market is basically « sign for ousttion and not a reason for confident Tat us diesuns the market's possibilities from present levels in teras first cof theoretical xessoning and then in terns of some practical considerations. I would like to presant thee possibilities} undoubtably there are a great nazy nore. One possibility, which 1s a very popular one in present thought, ia that the rise Ghat bas taken Place #ince 19s0-- from about 163 n the Dov Jones Average, to 750 at the present tine-s reflects a aev and a marvelously improved character of common Stocks, and therefore can be expected to continue more oF less at the sane rate in the future, Only such « point of View can make sense out of the prevalent practice of ‘caloulating the gains thet investors could have made in mtual-fund shares or in similar purchases over the last lt youre ay « basis for trying to parauade thea to Duy guch securities af thety present advanced prices. As you knoy, this kind of cal- culation Sa dont all the tine by mtual-tund aglegmed'to impress investors. The Suc requires it to be accompanied by a perfunotéiy statenent that the caleulstion ‘carries no varrantly for the future, but I doa't think very much emphasis is placed ‘upon that qualification. =" The second ponaibilsty is that a good yart of the rise I spoke of vas an ad- ‘Justannt from an undervalued level in 1949 to a proper level on some nev basis of yaluation, If that ia #0, © good part of the 1989-1963 rise could not be expected Yo be repeated from @ level whic is nov a corrected one, Hovever, vo could have = satisfactoy advance on the average, say 4% per annum, from vhetever level turns out to be about right for totay. If 750 te about the right present level then the in- yestor might possibiy expect a more or less standard M4 advance frou this level, year by year, subject to moderate dovmvard fluctuations. ‘But the thisd possibility i that the nature of the mnket hes not changed ‘from ite earliest tims, as shom in our recoris that go back at least to the South ‘Seas Bubble in 1720, pratically 200 yaara. WE have also very detailed data on in the United States since 1872, which vere incorporated in the Covlé Pe ost recext axample of sxcessive prssinion is the very period which vas a starting fone fer this narket. During 19h9-50 the market had the lovest peace-tine price- earnings vatio in its history. Stocks sold at only sbout 7 tines their earnings, Sn the market averages Tam talking aboxt, as compared with about 20 tines at the presect tine. The implication here is that just as stocks vere evidently under- Valued at seven tines their earnings they aight very well be overvalued at twenty ‘ines earnings or at some higher multiplier that vill be established later in this market and vill represent « level of excessive optimien. My ova opinion about these three choices ta thet the first possibility 1s really out of the quasticn. It ig agt in the nature of economic reality to perait et gains at the shovn rates from iysy to O3-~ something like 14 per annum in cluding the divident zeturne-- to comtime iniePinitely-a the future. We just don't hava a financial and econoste aysten that can operate on that basis. If ‘that vere true nobody would have to vork for a living. I renesber very well thePAGE ‘nusber cf people tn the late 1920's vho got a corresponding view of the stock market, gave up their joba and plunged into Wall Street to take advantage of its vonderful fubura. The second possibility-which ie thet the market will advance pretty stead- Ady from approxivately the present level, but vill not have the advantage of starting frou a vary low level-~ is admissible in'theory. But the grext problem, one thet I Vil talk about inter, 48 hov cen you deteraine the proper nev basis for common stocks valustions ant therefore hov can you determine the mare.or less stoper-Zevel for nest’. I discussed this question in « paper read to the Anericen Pinence Ave’, in December 1961, and caid then that the market ves really adrift on a sea of tn. settled stasiaris. The old standards of value, which had been well established for Gecedes and perkays generations, no longer seen to be tensble, as mich too con- srvative; but the proper nev standards of valle could certainly not be worked out either by somebody's inner-conscioumness ox by mathematical caletlations. We ‘shall have to walt, probably for « considerable length of tine before we can, detarsine depeniabie nev standards. In the mean tine it seened to me that the stock market vill have to carry on ita celoulations by a process of trial snd error, Waich ootld lead to large flustuxtions around what in the end vill tur out to be te new central value. I think vhat happened since Deceuber 1961 bears out his inter- pretation to sone degree. Cartainly the big decline in 1962 represented « sbarp fluctuation of cne Kind, and the impressive recovery since June 1962 aay represext a fluctuation of the other Kind. Ho doubt you would be interested to know whet I nean by the terms “old and new standards of value" as applied to the stock market level. The old standards of value--viieh vere pretty well accepted up to aay 1955 ware reached by © nuaber of afferent approaches based on reasoning or experience. The one T like dest of course vas uy ovn, viich has been knova as the "Grahan.” Tt vas derived fron the Gantra Vaitis avefage earnings of the 30 stocks in the Doy Jones Industrial Average for ten years past, capitalized at tice the interest rate on high grade ‘onds. For exenple at the present time the average earnings for the last ten years sare about $33 on the Dov Jones unit and the present sate on bigh grede bonis iv ha} per cent. if you capitalize $33 at8.Gf-- vhicn 1s « multiplier of about 12 you ‘would get a central Value on the old basie af about 360, as compared with the present price of about 750. Zp early 1955 vhen I testiciea before the Pull Committee the stock market yas then spout 400, my central value vas also around $00 and the valuations of otner “experts” using other wethoda all seemed 20 cone to about thet level, The action of ‘the stock market ilbe then vould appear to denonstrate that these metio’s of val- uations are ultra-consarvative and mch too lov, although they did vork out extrene- ly well through the stock market fluctustions from 1871 to sbout 1954, whlch ts an ‘exceptionally long period of tine for a test, Unfortuately in this Kind of vork, where you are trying to determine relationships based won past behevior, the lnost invariable experience 1s that by the tine you here bad a long enough period Yo give you sufficient confidence in your form of easurenent Just then nev cone itions suparssde and the neamzenent ie no longer dependable Zor the future. We had to deal with this problen in the fourth edition of "Security Ansiyeis” published last year, and to recognize tha probability thet stocks should be valued ‘nore Liberally nov than in the past, our chief reason for thet, incidentally {» 2ot Decause the governnent's commitnent to prevent large scale depressions has changed ‘the climate of corporate earnings from woat it was prior to the Zaployment Act of 1946, We think this nev 2 against a very severe Zalling off in the arnings of corporations generally would Justify a higher valuation of these ‘earnings than in forser years. Henge ve have added an arbitrary 50 per cent to ‘the valuation based upon our Old method. That vould give us nov a value of about19 for the Dov Jones Average, and a corresponding value of sbout 56 for the Standard Poors 500-stock average. Let me point out that the two avevages stand 40 close to- wether on ten-tomone asia in their price level, dividenis and earnings,thet you can use the tro figures almost interchangeably for purposes of description or an~ alysie, You must recognize that this level of 570, vhich ts derived from an arbitrary ‘mark up of 50K from the old level, has no special authority behind it. Tt waa nerely the best Judgnent that we could give on a situation which does not sdait of aay veally dependable calculations. ‘Asa matter of fact if one te wufficiestly optimistic and adroit it is quite possible to develop & method of valuation waich sounds plausible enough and would justify the presext level of 750 for the Dov Jones Average. Let me shov you hov that could be done. You say first that tne Tastors vould Like to get an over-all return of 7H on their noney in future years, ‘Taat ‘a what common stocks have returned on the average- in dividends and price spprectation-ever since 1671, as shown by the Covles and Molodoraky studies, ow if ve can expect rate of grovth of aaraings and dividends of Hak a year then all ve eed ts a dividend return of 36 to make up the desired 72% total, Since the Dow Jones sai Staniard Poor's dividend return is Just a Little more than 36 right now on the arket price, ve could buy these at the present level with confidence, es we vould then get «3% return in dividends and a Hf anneal return in grovel Maay people might think that even less than an overall 7if should suffices All that sounds fine but if you reflect that by some chance the future grovth rete vould be 328 instead of |f— and 344 vas about the actual anmal grovth in dividends in the last ten years-- then you get quite a difterence. For if nov you are expecting & 338 grovth rate, you will needs if dividend retum to make up the required TH. On that basis the Dov Jones Average is vorth just about the 570 which we exbierarily rave to ite There is & lot of juggling with figures thet om be done now as alvays; but none of these nethods in itself gives « dependable remult. To a grest exvent the figures selected are detersined by the general attitate cé the man vho is selecting ‘them, and that general attitude is very often determined in turn by vist the stock barket has been doing. When the stock market ia at 750 you take an optinistic attitude and use sone favorable figures; but if it should have a severe decline Rost pecple vould jump dack to the older and more conservative evaluation methods. st me nov point out a striking area in vhich the uncertainty of the proper Yaluation of comon stocks 1a brought to the fore, That is thie Yery question cf ‘the relationship detween dividend return on stocks and the interest rave on bonds. For fifty years or more st van a tenet in wall Street that stocks should yield, considerebly sore than bonds. In speculative marketa stocks aigt rise util their yield decane less than that af bonis, But this very developaert vas a sure eign ‘hat you vere in a dangerous market-- one heading for a bad fall. A frien ef mine, hhead of a2 important brokerage house, vas so enasored of that idea he used i=. constantly in his market letters. More than that he actually had the relation” ship between stock yields and bond yields printed in «nice chart-design on neck ‘thes imported fron Paris, which he distributed to bis friends incluting we. Por svhile I vore this tie at sone of ay lectures, and auld that this vas ¢he fizet ‘ine that anybody had analyized the technical position of the stock market tres Bis necktine. Well, since 1958 stocks have been yielding considerably less. than douds vith no sign Gf a return to old relationships, Hence my broker frienis found thet thie concept increasing hard to tick te, About two years ago, actual- Ay not very long before the big sarket break, in a huge newspaper edvertisensnt ‘be abandoned thin concept completely, said 4¢ was all dosh to talk about stock yields a the baste of evaluation, clained the main thing vas the peychology and attitude of the public; and asserted this factor vas strongly bullish and justified,AGE 6 contident bwing of stocks. My chief retson for mentioning this incident 1a that T liad Jast epeat « lot of tine stulying the weekly analyses of the stock market by one of our oldest Pismctal services walsh started so 1909 and 1 ound the identical experience took place just 30 years before in this service (whose name I also won't tention.) For many years they talked thost the standard relationsniy between otock Yields and bond yieids, and they ued St to deteraice the probable top levels for tne stock market advances, In the greet bull merce’ of the late 960%» tna pelts Honship proved to be very unreliable ts a short-tera santet forecester. 30 they too, inva spectactlar stevenene uring Alsoet the sear Language, vurned dhefe back completely on the comparison of stock yielis and bond yields aid said that the sarket's paychology waa the best basis for forecasting. Tet lagpened toasting in'1928, tnd they atick to this viewpoint vo the great Green of 1359. ‘Toe present relasionshty gives conascerably Lover yields on stocks than on bonds.” High grade bonis Yield about Ago per cent valle the stocks averages Yield a little Dit ore than Jf. Becase that relationship hee esievad for te inst five youre does it represent a permanent relstlonhip for the fueuey or it Teonly an indication that the stock sarket has Seen clearly Crervalued for five yours, in the sane vay that {6 vas clenrly unervaiuel duriie the period 1949-19541 Tate de the aanj-billion-daliar question, Youwon't te able to get the anmver to that by aathenstice) you von'e De abis to get it from an expert such en ae GF mayboty else; s0 you'll have to answer that question for yourself. [But the thought at the stock sarket may save deen cvercrained” in the last Fave years, just au {© vas undervalue! fisteen youre ago, trings us to the third Jostbility viton I enuerated, nanely that ve tre stil going to have vide fluctua / tions in the future, This I consider the wort gesbetle ose, hough It le far free J certain, Ny reason for thinking that ve shell have these wide fluctuxtionss of watch J seinaa"s caave'in 1962, in bay gartioulariys da tost't don't see aay cnange is huaas Batures viswecvis the atock market whlch is sufficient to estebiion nore festrelute 4p the public vetavior than St shoved over so eaty decaies in the pasts) The ectioes cf the public with respect to loe-arede rv ‘antes distng the 1960-01 axtravagenen in ‘hat £1014 are an indication of tor inberent issk of revireist, You ought te Feneaber #150, that oany of ‘tie highest grads como stock iemies were foroed up fovexcessive ievels by « market anthortagn wich Teodiced large subeeyuene declioe et ne. give you some exaupiest The most foprensive to ay aint van cate of Teter ational Business Hackiaes vhich ia ceaoubeabiy the Leading common stock in the ative uarest, Speculative enthupiann pushed. it ay to 607" ts Deceaber 1961, frou \, Sitch st"aeckinea to 300 tn dune S9ear~'a rain ce tore thin SOf isthe aporé period of 6 sonthe, Genera Slectric, which ie the oliert nigh grade snvestamnt omen |\ stock, declined from «high of 100 in 1960 to 5h in 1962." Dow Chemical, one of our \ beet cuesical cospentes, Zeit from a high of 101 to a low of 0, ant 0.3, Seeel which \ pan ola ieaaery’ shrank from 309 in 1959 to a iow af 38 in 1902." These very fide svings underline the fact that the stock market {s basically the sase nov as it ‘Rivas vas, in the sense it ia still gubject to very substantial over-evalustion at \sonetines and undoubtebly substantial under evaluations at others. Wy basic conclusion ie that investors as well as speculators mist be prepared in their thinking and in their policy for vide price novenenta in either direction. They showla not be taken in by soothing atatenente thet « real investor doess't nave ) to worry about the fluctuations of the stock market. Z Tt is tine nov to say what Little I can say aboct the probable course of the stock market from the present level. No doust that ia the point which vould interest ‘the audience most and on which I can be the least enlightening, In ay view there is an important difference betveen the presert stock market and the mrket at sore or less the sane level in December 1961, At that time I had no hesitation about predicting that then there would have 29 be a fairly near-term collapse of the nev- Asue market, vhich had passed all bounde in apectlative excesses, And if thet-PAOE 7 collapsed it vould surely effect in soue serious way the general level of stock prices, it alent possibly usher in the bear market vhich Invardly T have been ex- pecting for soma time past. The nev iague collapse case per schedule and it aid have a najor averse effect on the rest of the market. Sut « recovery begen in ‘= comparatively short time, and it has carried the sarket averages to nev heights, Which were contrary to ay invard expectations but not to any specific predictions Vhich I mde, I would like to point out thet the last tise T mde any stock market gredictions vas in the year 1914, vhen ay firm Judged se qualified to write thelr ‘market letter, based On the fact thet I bad one month's ax perience in Vall Street, Since then I have given up making predictions. ‘The important point nov is that the current high levels of the market are ‘not accompanied by Encas excesses in the nev-iaaue market and in sone other direc~ ‘tions which mie it appear so vulnerable in 1961. It is the general view in Wall. Street that such characteristic abuses mst develop again before the stock market can have ancther collapse,--or before « true bear sarket can begin (if it ian't against the lay to use the dixty vords "bear market"). These abuses vould include Large public participation by small people who don't imoy vhat thay are doing, high borrowings on margin, the reneval of the nev-iasues apres and #0 on. Now this con tention sounds plausitle enough based on experience, and 40 one aight guess thet ‘the market could well continue generally upvard for quite a vhile. But let we point out "for the record” that it is not impossible in theory that the market's high level ‘lone could scorer or later precipitate « collapse without the7necessity for these ‘technical weaknesses to ghov thenselves. The collapse might be triggered ty some luntovard economic or political development, But if things do happen that vay it will be the firgt tine in market history, Z believe, thet ve would have the end of 1 bull market without the excesses and abuses of the sort Ihave mentioned. But Shere 1a always = first vine for evesythiuse My opinion then regarding the present market level must be rather incon- clusive, and I shall Baby ay later prescription of policy on the assumption that investors cannot have a dependable View on the aarket's future action in the next Year or so, dut that a large and disturbing decline is Likely to take place again Sonetine-in the future, ant that ve should be prepared in thought and action for it, is a necessary sasumption for investors to uake, and for sensible apeculaters too if there aravany such. ‘The second claim vhich is that thare is no real "stock market” but only, as the atl Street people ike to aay, only "a market of stocke”-- deserves & moment oF ‘evo of aiscuasion. “What they ean by saying this is that investaent results depend only on what happens to individual securities, sose of which vill go up and others don, ant that it is illusory to talk about viet Eappens to the market as a vbole fs having © najor bearing on hoy the investor fares. I disagree with that point of view on three grounds. The Tire is that T doubt that the market is really #0 mich different in thie respect from what it alvaye vas in the past. I have sone recollection of the mar- et in 1928 and 1929, and I am sure that the disparity and diversity of stocks Detween those that acted well and those that acted poorly was alnost as great then fs ve see nov. But despite that fact it was essential for investore to be guided by a view as to the general level of the stock market, Tt is suprising to ne that Wall Street people haven't taken the time to make a study cf the spread in price Rovenents betveen individual stocks in racent years as compared vith what happen- ed in former years. (I have a student at UCLA who 1s going to mike thie study, ‘and it may prove quite iliuminatory), ~.the secon reason is that there is actually a considerable underlying con- sistency in the stock market it you measure ite aoveuents by comparing ‘vo averages Which seen to be quite different. One of them is the Dov Jones Industriel Average, which consists af only 30 stocks, and the other ie the Standard & Poor's Cot posite Average which consiste of 500 stocks. You might vel aasune that if there