Ben Graham sat before the Committee on Banking and Currency to testify about the stock market.
This was 1955.
The stock market had risen significantly in the past few years. The government wanted to know why.
The Chairman finished up Graham’s testimony with a simple question:
The Chairman: Well, it does not matter. One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – advertising, or what happens?
Graham responded with a classic non-answer answer:
Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.
I doubt the Chairman liked the answer despite its truth – all stock prices eventually move toward value over time.
The Dow was up 56% from September 1953 to March 1955. The Chairman feared, as he put it, “a final orgy of buying.” I guess someone was worried about a repeat of 1929. A few people were looking for ways to prevent it.
Graham’s entire testimony meanders across a number of subjects, thanks to the Chairman’s broad line of questions. However, Graham explained the mysteries further in his prepared statement (emphasis mine):
The true measure of common stock values, of course, is not found by reference to price movements alone, but price in relation to earnings, dividends, future prospects, and, to a small extent, asset values.
Present concepts of common stock valuation turn largely on estimating average future earnings and dividends and applying thereto a suitable capitalization rate or multiplier. Since these elements are all matters of prediction or judgment, there is room for a wide difference of informed opinion as to the proper value for a single stock or group of stocks at any time. Uninformed or speculative opinion will, of course, cover an even wider range as the market swings from the depths of pessimism to the heights of optimism.
As a guide to identifying the present level of stock prices in the light of past experience, I have made 2 sets of comparisons – 1 related to the Dow-Jones industrial average, the other to General Electric, a component of that average and an outstanding blue chip issue. I have related the present prices and the high prices in 1929, 1937, and 1946 to earnings of the preceding year, the preceding 5 years, and the preceding 10 years. This information, together with certain other data, appears on the appended table.
The Dow Jones industrials are now at a lower ratio to their average earnings in the past than they were at their highs in 1929, 1937, and 1946. The same applies to General Electric as an individual stock. It is clear that the issues referred to – which may be considered as reasonably representative of the larger industrials as a whole – have a considerable way to go before reaching the ratios shown at their former tops. It should be pointed out also that high-grade interest rates are now definitely lower than in previous bull markets except for 1946. Lower basic interest rates presumably justify a higher value for each dollar of dividends or earnings.
Much has been made of these relationships as indicating that the market is still on safe ground. However, such comparisons fail to take into account the extent of the subsequent declines from past bull market highs. Since the Dow-Jones average lost 90 percent of its price from 1929 to 1932, it is evident not only that 381 was much too high in 1929, but that the market had entered dangerous ground at a point far below that figure…
…As to reasons for the market rise since September 1953, in general I agree with the answers by President Funston, of the New York Stock Exchange, to question 1 of the committee’s questionaire. However, I should like to emphasize more than he did the role of investment and speculative sentiment in determining the wide variations in stock market prices.
In my view, the fundamental reason for the rise was the swing from doubt to confidence – from emphasis on the risks in common stocks to the emphasis on the opportunities in common stocks.
There has been no change of importance in the earnings of the Dow-Jones industrial average since 1949. Actually, however, earnings of most secondary companies fell a great deal in 1953-54 from the levels of the previous 5 years. But prior to 1954, the public was expecting a substantial setback and was braced for a large falling in earnings when business turned down after the middle of 1953. It was the mildness of the shrinkage – especially in gross national product and disposible incomes – that reversed the tide of sentiment and gave currency to the view that we no longer have to fear deep depressions.
This change in sentiment produced a change in the public’s valuation of stocks, especially in what it considered suitable multipliers of current earnings. In effect, the multiplier advanced from about 8 for the Dow-Jones industrials in 1948-50 to 10 in 1953, and to a current 14, which is slightly less than the 1936-40 average.
My studies have led to the conclusion that sentiment alone, not supported by any visible change in value, will produce a swing on the order of 100 to 250 or 100 to 300 in price. It is interesting to note that while American Telephone & Telegraph has paid a uniform dividend of $9 since 1922, and while its earnings have fluctuated comparatively little, its price advanced from 115 in 1922 to 310 in 1929, declined to 70 in 1932, and since then it has fluctuated between lows of about 110 and highs of about 200.
Source: Stock Market Study – Hearings Before the Committee on Banking and Currency, United States Senate, Eighty-Fourth Congress, First Session on Factors Affecting the Buying and Selling of Equity Securities, March 1955