Chapter 3: A Century of Stock-Market History: The Level of Stock Prices in 1972
Graham used indexes, the S&P 500 its with wide breadth of companies, and the largest companies in the Dow Jones Industrial Average, to analyze the over-all performance of the market. As well as indicators with the broadest reach; earliest available records going back in time.
Graham condensed the data into annual rates of advance or average compounded rate of advance (may or may not include dividends); averages of entire periods following a characteristic trend.
He mentioned the "Rule of Opposites" when the market was low, that the time was ripe for another bull market, and was skeptical of advances that "it may have been overdone".
Graham also condensed the data into decades figures; including over-all earnings of corporations on invested capital. He kept a weary eye on the trend of "net losses" posted by companies, the number of those being "financially troubled" as indications of the end of a boom era.
Thus Graham also watched the P/E ratio of indexes, as well as the dividend yield on the indexes. He also had his eye on interest rates of high grade bonds.
Prices, earnings and dividends were key indicators in the market, and interest rates of high grade bonds.
Graham, like everyone else, had difficulty gauging the market, outside of his value judgements. Even if the market was historically high in relation to values, and Graham recommended a conservative stance, it was merely a beginning of another great advance and "it was not a particularly brilliant counsel." And it continued to advance even more. And even in a bearish stance, the market advances again. Graham was sure of one thing, that it will collapse and such "heedlessness" will not go unpunished.
He urged that if unsure, the investor must follow the side of caution:
1) No buying of stock on margin/borrowed money.
2) No additions to investments on common stock.
3) Reduction in equity holdings "where needed" to a maximum of half of the portfolio and reinvested into bonds and savings accounts.
Investors with a dollar-cost-averging plan may decide to continue or stop his periodic payments.
Graham urges investors to follow a "consistent and controlled common-stock policy" rather than guessing the over-all direction of the market, beating the market or picking winners.
It is also wise to keep an eye on the attractiveness of other alternatives to common stock investment such as bond interest rates, illustrating this with his bond-yield/stock-yield ratio.
Commentary by Jason Zweig
Long-term record of stocks cannot guarantee it's future movement. The one who believes so is an ignoramus.
"The value of an investment is, and must always be, a function of it's purchase price."
The rule of opposites is that the more enthusiastic investors are in the long run, the more probable it is that they will be proved wrong in the short run.
A valuation approach of Yale Finance Professor Robert Shiller, inspired by Graham, is that stock markets tend to do better below a P/E ratio of 10, and tend to do poorly shortly after going higher than a P/E of 20.
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