Even more impressive and important are the circumstances behind this rise. Never has the stock market anticipated recovery from a recession so confidently, or discounted future earnings so optimistically. By the autumn of 1958 the market’s sheer exuberance baffled almost everybody, including the professionals. Financial columnists said the market was out of touch with reality, and blamed its unreality on, among other things, investors’ “quiet desperation” about the “coming inflation.” Corporate earnings were still below their 1956 peak, though it looked as if they might get back up there during 1959. But the Dow-Jones average had long since anticipated even such earnings. By the end of 1958 it hit 584, about sixty-three points or 12 per cent above its 1956 and 1957 highs. At this price, the average was selling at more than sixteen times the $36 Dow-Jones earnings then expected for 1959, to yield less than 3.5 per cent in cash dividends. This yield is less than the yield on long-term corporation bonds, and even less than on long-term government bonds. Only in eight of the past thirty-nine years have stocks sold so high in terms of dividends. Only for short periods in 1929, 1930, and 1933 have stocks yielded less than government bonds.

It has been practically an article of faith in the U.S. that good stocks must yield more income than good bonds, and that when they do not, their prices will promptly fall. Late in 1958 and early in January, 1959, accordingly, some of the Street’s best-known advisers adopted the view that the market was precariously high, and that a severe “correction” might lie ahead.

But the stock market remained insolently strong. The “breadth” indexes, which measure the degree to which the market as a whole is participating in the rise of the Dow-Jones average, never looked more encouraging. Customers were buying warily and even reluctantly, but they were buying. Every time the market sold off, somebody or some fund with plenty of money jumped in to take advantage of the lower prices and promptly forced them up again. “Paradoxically,” observed Joseph Mindell of Marcus & Co. toward the end of January, “the most bullish thing about this market is that so many people are bearish on it. When everybody is throwing caution to the winds and rushing to buy up to the hilt, that’s the time to get cautious. But when everybody is cautious, and yet the indicators are all strong, you needn’t fear a bear market.”

Are stocks sounder than bonds?

One reason for the continued strength of the market early in January was the prospect of better earnings still. Toward the end of December, 1958, indeed, it began to look as if corporate earnings before taxes in 1959 might rise to a dazzling, record-breaking rate of $50 billion, compared to the 1956 high of $45.5 billion and the 1957 figure of $43.4 billion—equivalent to, say, about $40 a share on the Dow-Jones composite industrial average. In other words, it could be argued that the Dow-Jones average at 584 was no higher in relation to corporate profits now anticipated for 1959 than the 1957 high of 521 was in relation to 1957 corporate profits. Given $50-billion earnings and the expectation of greatly increased dividends in 1960, a Dow-Jones average price of 600 began to look more than reasonable to some optimistic investors.

A more basic reason for the market’s strength was the phenomenon largely responsible for its unprecedented rise in the fall of 1958: a growing belief that the time had at last arrived when quality stocks, because they appreciate in both intrinsic and market value, should normally sell to yield no more—or even less—income than bonds. The result was a big movement into equities, led by knowledgeable institutional investors. Not even the most enthusiastic equity partisan, to be sure, denies there will always be a bond. Hundreds of institutions and companies and thousands of individuals will always want a security readily convertible to cash at or close to its face value. The doctrine that equities should be valued for more than mere yield, furthermore, is by no means new. It was the subject of a much discussed book published in 1926, Edgar Lawrence Smith’s Common Stocks As Long-Term Investments, and it was a doctrine that helped whoop up stock prices to absurd levels in 1929.

But the abuse of the doctrine in the 1920’s, the prophets of revaluation argue, does not necessarily invalidate its arguments today. An investor’s equity in a healthy, growing company, as everybody knows, can double or triple in value while the real value of a bond issued by the same company, owing to inflation, may decline greatly. And in recent times the case for good common stocks has been reinforced by progressive income taxes. People in high tax brackets vastly prefer the capital gains that can flow from a “growth” stock, which are taxable at no more than 25 per cent, to the fixed income from a bond, which is taxable at regular rates (except income from tax exempts).

It is also true that over the years quality stocks, as investments, have already demonstrated a marked superiority to bonds. It is almost a cliché in the financial community that the Dow-Jones stocks, if “dollar-averaged” or bought in fixed dollar amounts at fixed intervals beginning even in 1929, would have returned the investor an average annual yield of close to 7.5 per cent.

The catch with even the best of common stocks, of course, has been that their value has fluctuated widely even in “normal” times, and declined steeply in recession or depression. It is to offset this volatility, as one financial adviser puts it, that “risk premiums have been built into conventional price-earnings stock ratios… But suppose,” he goes on, “that investors cease to fear massive declines in earnings. This risk premium is then clearly unnecessary, and stock prices can be bid up to much higher price-earnings ratios.” What happened in 1958 was that more and more investors ceased to fear massive declines in stock earnings. Therefore they did not hesitate to bid up stock prices to much higher price-earnings ratios.

Investors ceased to fear a massive decline in earnings because the American economy since World War II has seemed to demonstrate that a recession need no longer snowball into a major depression, that the excesses of inflation are not necessarily followed by the equal and opposite excesses of deflation. This phenomenon was evident in 1953-54, and confirmed in 1957-58. Owing to the “built-in stabilizers” like social security and unemployment insurance, owing to the government’s use of monetary and fiscal policy, and owing to labor’s power to resist wage cuts, consumer demand declined very little and inventory liquidation ended rapidly. Business took advantage of the opportunity to cut costs and increase productivity, which later meant improved earnings. Confidence began to rise. As corporate and individual liquidity rose, money gravitated to the market, which once again anticipated recovery long before it was obvious to most people.

“We quit being conservative”

What this meant to sophisticated investors is well put by the officer of one closed-end investment trust. “Toward the end of May, 1958,” he says, “we awakened to the fact that the time had come to quit being conservative. Something new was happening. Business was plainly not heading for another round of liquidation. The specter of economic catastrophe that has haunted the U.S. since the 1920’s now appeared to be only a bogeyman.”

The instant and enormous success of Lehman’s One William Street Fund, founded on May 29, 1958, this officer notes, demonstrated beyond all doubt the rank and file’s yearning for stocks—and its ability to buy them. “In the old days,” he goes on, “common stocks were regarded as speculation even when they were not. But we decided the time had really come for the revaluation we had talked about. Later on, in September, 1958, we worked out for ourselves a kind of tentative revaluation. Since the Dow-Jones average had sold at a maximum of 14.4 times earnings in 1957 and at 15.4 times earnings in 1956, we figured that a little less than seventeen times earnings would be about right in 1959. If the Dow-Jones would earn $35 in 1959, a modest enough estimate, that would put the average at about 600. This assumption justified our holding earlier purchases, and the continued purchase of common stocks on an investment basis rather than for a temporary speculative play.”

Since then, as noted, corporate earnings in 1959 have given promise of rising to perhaps $40 on the Dow-Jones average. If this promise remains strong, an average of 680, by this fund’s method of reckoning, might not be too high for 1959.

The value behind the price

No one yet seems to have worked out a full rationale for judging the new level of stock earnings vis-à-vis bond earnings. Some analysts are attempting to put a specific value on the ability of a growing company to offset inflation, and on the earnings that corporations do not pay out as dividends but plow back into growth. Some are trying to appraise precisely the declining risk of recession. And many are paying attention to the great increase in corporate cash flow, related to earnings per share.

Under present law, corporate depreciation has been increasing faster than actual replacement of assets, and has given many companies extra cash to plow into growth. Thus a company that only a few years ago was paying, say, $3 of its $6 earnings per share as dividends and reinvesting the other $3 in itself, now finds, because of the more liberal treatment of depreciation, that it has a dollar or even two dollars per share more to plow back than it had a few years ago. Its reported earnings may still be $6, but it is now able to reinvest not $3 but $4 or $5 a share. If its stock was a good buy at twelve times $6 earnings, or $72 a share, it might now be worth fourteen times earnings, or $84 a share. And if the value of growth, of protection against inflation, and the declining risk of recession are appraised in similar fashion, many technicians might decide the stock is worth seventeen times earnings. This kind of analysis, when the earnings of the Dow-Jones average are around $40 a share, could mean a further upward revaluation of earnings.

Institutionalized bull market

Probably the most important reason for the scarcity and high price of “investment grade” equities has been the great and growing demand for them by institutional investors—above all the pension and mutual or open-end funds, but also corporate profit-sharing funds and life-insurance companies and savings banks.

In 1957 institutions and individuals in the U.S. bought a total of $3.7 billion worth of stock net (total volume of stock traded was in excess of $37 billion). Of this $3.7 billion, the funds accounted for no less than $2.3 billion, or 62 per cent; $1 billion was spent by pension funds, $800 million by mutual funds, and $500 million by life-insurance companies and others. Although all these organizations together hold about $30 billion worth of equities, or only some 10 per cent of all the stock outstanding in the U.S., they have been increasing their share of the total rapidly. What is more to the point here, they have become a dominant force in the stock market. For not only are they accounting for more than half the net purchase of equities, they buy only quality stocks for the long pull, they have embraced the policy that appreciation is more important than yield, and they set an example for hundreds of thousands of individual investors, who closely follow the announcements of the latest additions to the funds’ portfolios. In short, the funds have created a “scarcity” of equities that has inevitably meant higher prices.

The most portentous of all stock-buying institutions are the private non-insured pension funds, whose assets, according to Vito Natrella of the SEC, have increased from about $5.6 billion in 1950 to about $22 billion today, and are expected to rise to more than $50 billion by 1965. In 1950 they invested less than 10 per cent of their assets in equities; today the figure is close to 30 per cent. The proportion may well continue to rise even more steeply than the assets themselves. About 32 per cent of the assets of General Electric’s pension fund is already invested in stocks, about 70 per cent of Bethlehem Steel’s, about 84 per cent of Sears, Roebuck’s. And when, last fall, A.T. & T. decided to put 10 per cent of its huge $2.8-billion pension fund into common stocks, some of the most conservative pension funds succumbed to the trend. “If Bell is doing it,” they told themselves, “so can we.”

“The way some of them buy!”

Pension funds, it is true, do not have to go on increasing their investments in stocks. Many of them are now going easy, “waiting for good buys.” But the fact remains that they can afford to pay high prices for stocks with relative impunity. Over the long run, which is what the managers of pension funds are paid to think about, the main consideration is the growth of the economy, and the only problem is to buy stocks embodying this growth.

Even more avid for good stocks than pension funds have been the 151 leading open-end mutual companies. Most of them have sold themselves to the small investor—and sold themselves very well—as the most profitable and safest mechanism for putting money into stocks. As of January 1, 1959, they had assets of more than $13 billion, or $4.5 billion more than a year earlier. In 1958 they sold $1.7 billion worth of shares in themselves, and redeemed about $511 million worth. (Redemptions as well as sales have been rising with stock prices, apparently because many fund stockholders want to play the market for themselves.) They invested, net, about $1.1 billion, most of it in stocks. Committed as they are to equities, they found it almost as hard to hold back in a vigorously rising market as A & P would find it to refrain from buying coffee in a rising market. Since several thousand shares, for many of them, is hardly more than an odd lot, they also had to buy actively traded stocks.

“The way some of them buy!” exclaimed one investment adviser. “I would have gone broke years ago, buying as they have to. They just bull through and average prices out.”

Although a few of the funds became wary late in 1958, several of them, in their hunt for acceptable “new areas” of values, took up the “cyclical” and once “semi-speculative” issues like paper, metals, and railroads, and upgraded them to “investment status.” The better rails, which for so long went begging when they could have been bought for seven or eight times earnings, were commanding as much as twelve times earnings.

Life-insurance companies began to get into stocks in a notable way about 1949, when a few of them, particularly John Hancock and Prudential, decided that common stocks were not only a logical hedge against inflation but, at the yields then prevailing, excellent sources of income. Prudential, largest stock owner among insurance companies, now has a portfolio of about $275 million—as yet only about 2 per cent of its assets. But it operates on the principle that the value of stocks has undergone a revaluation, and it is the policy of Carrol Shanks, the Prudential’s inflation-conscious president, to invest more of the company’s assets in good stocks.

All this institutional buying “for keeps,” to repeat, has been a major factor in the “shortage” of stocks, particularly stocks of “investment grade.” What intensified the shortage is that corporations are issuing relatively little new stock because they still find bonds, whose interest is tax-deductible, a source of cheaper capital than stocks. (If stock yields stay low, the issue of new stocks may well be stimulated.) Individual investors with large paper profits, moreover, found themselves “locked in,” reluctant to sell their holdings and pay as much as a quarter of their gains in taxes, and this further intensified the “shortage.”

Yes, but—

That many investment counselors and analysts look at such developments with wariness, not to say skepticism, should surprise no one. Many believe that investment psychology can easily change, especially if earnings prove disappointing, to favor bonds again. J. Eugene Banks, of Brown Brothers Harriman & Co., for example, agrees that stocks have been undergoing what looks like a revaluation for some time, and he himself is optimistic about the market. But he points out that the market has always alternated between periods of over-optimism and over-pessimism. The present, he feels, is simply a time when investor psychology happens to favor stocks over bonds. “There are always good reasons,” he says, “for believing the going state of affairs will become permanent, otherwise investors would not pay fantastically high prices at one time and sell at ridiculously low prices at another.” The current optimism appears likely to continue for a while, he concedes, but sooner or later something will happen either in domestic or world affairs to swing investor preferences the other way—as it always has in the past.

Anthony Gaubis, investment counselor, has little time for theories about a new kind of market. He maintains that inflation is not so “inevitable” as it is cracked up to be, that bonds should by nature yield less than stocks, and that the present market is headed for a major readjustment. Partly because of what he regards as the arrant overpricing of equities, he predicts that equities will soon give up most or all of the gains they made during 1958 and early 1959.

On the other hand, Alan Greenspan of Townsend-Greenspan Inc., financial advisers, thinks the market will soar, and that’s just the trouble. “A sharp secondary liquidation of goods and securities was avoided in 1958,” he argues, “by an artificial liquidity in our financial system. This excessive liquidity could conceivably power an explosive speculative boom.” Before World War I, he explains, the periodic “over-exuberance” of the financial community was held in check or brought up short by the automatic forces of the market. Stock prices could not get too far out of line with real values because the supply of credit for the market was automatically constricted by a limited money supply. The ensuing corrections, however sharp, were short lived.

Once the Federal Reserve was set up, Greenspan reasons, the money supply never really got short. With one eye necessarily cocked on politics, the Fed has always maintained a more than adequate money supply even when speculative booms threaten. The Fed, furthermore, has recently been boxed in by a huge and partially monetized federal debt, which tends to produce an addition to the money supply, whose size is unrelated to the needs of private business. The immediate effect of this “insensitive” liquidity is to keep the economy in an artificially buoyant state.

Because the penalties for over-expansion and excessive credit do not materialize, says Greenspan, investors get over-confident. Unless the Federal Reserve rations credit severely enough to paralyze business itself, this over-confidence finds exuberant expression in a bull stock market. So Greenspan is worried lest stock prices take off in a steep rise. Once stock prices reach the point at which it is hard to value them by any logical methodology, he warns, stocks will be bought as they were in the late 1920’s—not for investment, but to be unloaded at a still higher price. The ensuing break could be disastrous. Panic psychology, Greenspan believes, cannot be summarily altered or reversed by easy-money policies or any built-in stabilizers.

The variable: confidence

But the partisans of revaluation remain undismayed. It is true, they hasten to note, that the human propensity to overvalue or undervalue the price of stocks is just as great as it ever was. If anything is sure in this world, it is that equities will sell off from time to time because they have been overpriced and rise because they have been under-priced. By the time this is published, indeed, the “correction” that some analysts anticipate may well have occurred. Nobody knows, or can know, what a “normal” price level is because that in the last analysis depends on confidence, and confidence is never the same from time to time. But to the extent that the past dozen years have raised confidence in the economy’s ability to shake off recession and endowed corporations with new values, the equity partisans argue, the revaluation of stocks is a fact.

*In 1954 the Dow-Jones industrial average rose more steeply than in 1958, but it started out from a level 55 per cent higher in 1958.