Permanently High Plateau

Throughout the nineteenth century, stocks were deemed the province of speculators and insiders but certainly not conservative investors. It was not until the early twentieth century that researchers came to realize that equities might be suitable investments under certain economic conditions for investors outside those traditional channels. In the first half of the twentieth century, the great U.S. economist Irving Fisher, a professor at Yale University and an extremely successful investor, believed that stocks were superior to bonds during inflationary times but that common shares would likely underperform bonds during periods of deflation, a view that became the conventional wisdom during that time.

Edgar Lawrence Smith, a financial analyst and investment manager of the 1920s, researched historical stock prices and demolished this conventional wisdom. Smith was the first to demonstrate that accumulations in a diversified portfolio of common stocks outperformed bonds not only when commodity prices were rising but also when prices were falling. Smith published his studies in 1925 in a book entitled “Common Stocks as Long-Term Investments”.

In the introduction he stated:

These studies are a record of a failure—the failure of facts to sustain a preconceived theory, . . . [the theory being] that high-grade bonds had proved to be better investments during periods of [falling commodity prices].

Smith maintained that stocks should be an essential part of an investor’s portfolio. By examining stock returns back to the Civil War, Smith discovered that there was a very small chance that an investor would have to wait a long time (which he put at 6 to, at most, 15 years) before being able to sell his stocks at a profit.

Smith concluded:

We have found that there is a force at work in our common stock holdings which tends ever toward increasing their principal value. . . . Unless we have had the extreme misfortune to invest at the very peak of a noteworthy rise, those periods in which the average market value of our holding remains less than the amount we paid for them are of comparatively short duration. Our hazard even in such extreme cases appears to be that of time alone.

Smith’s conclusion was right not only historically but also prospectively. It took just over 15 years to recover the money invested at the 1929 peak, following a crash far worse than Smith had ever examined. And since World War II, the recovery period for stocks has been even better. Even including the recent financial crisis, which saw the worst bear market since the 1930s, the longest it has ever taken an investor to recover an original investment in the stock market (including reinvested dividends) was the five-year, eight-month period from August 2000 through April 2006.

The Influence of Smith’s Work

Smith wrote his book in the 1920s, at the outset of one of the greatest bull markets in our history. Its conclusions caused a sensation in both academic and investing circles. The prestigious weekly The Economist stated, “Every intelligent investor and stockbroker should study Mr. Smith’s most interesting little book, and examine the tests individually and their very surprising results.” Smith’s ideas quickly crossed the Atlantic and were the subject of much discussion in Great Britain. John Maynard Keynes, the great British economist and originator of the business cycle theory that became the paradigm for future generations of economists, reviewed Smith’s book with much excitement.

Keynes stated:

The results are striking. Mr. Smith finds in almost every case, not only when prices were rising, but also when they were falling, that common stocks have turned out best in the long-run, indeed, markedly so. . . . This actual experience in the United States over the past fifty years affords prima facie evidence that the prejudice of investors and investing institutions in favor of bonds as being “safe” and against common stocks as having, even the best of them, a “speculative” flavor, has led to a relative over-valuation of bonds and under-valuation of common stocks.

Common Stock Theory of Investment

Smith’s writings gained academic credibility when they were published in such prestigious journals as the Review of Economic Statistics and the Journal of the American Statistical Association. Smith acquired an international following when Siegfried Stern published an extensive study of returns in common stock in 13 European countries from the onset of World War I through 1928. Stern’s study showed that the advantage of investing in common stocks over bonds and other financial investments extended far beyond America’s financial markets. Research demonstrating the superiority of stocks became known as the common stock theory of investment.

The Market Peak

Smith’s research also changed the mind of the renowned Yale economist Irving Fisher, who saw Smith’s study as a confirmation of his own longheld belief that bonds were overrated as safe investments in a world with uncertain inflation.

In 1925 Fisher summarized Smith’s findings with these prescient observations of investors’ behavior:

It seems, then, that the market overrates the safety of “safe” securities and pays too much for them, that it overrates the risk of risky securities and pays too little for them, that it pays too much for immediate and too little for remote returns, and finally, that it mistakes the steadiness of money income from a bond for a steadiness of real income which it does not possess. In steadiness of real income, or purchasing power, a list of diversified common stocks surpasses bonds.

Irving Fisher’s “Permanently High Plateau”

Professor Fisher, cited by many as the greatest U.S. economist and the father of capital theory, was no mere academic. He actively analyzed and forecast financial market conditions, wrote dozens of newsletters on topics ranging from health to investments, and created a highly successful card-indexing firm based on one of his own patented inventions. Although he hailed from a modest background, his personal wealth in the summer of 1929 exceeded $10 million, which is over $100 million in today’s dollars.

From “Stocks for The Long Run” by Jeremy Siegel.


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