A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

ERA III: THE AGE OF
EXUBERANCE
Let us now turn to the third era—the golden age of financial
asset returns, from 1982 through early 2000. At the start of
the period, both bonds and stocks had fully adjusted—
perhaps even overadjusted—to the changed economic
environment. Stocks and bonds were priced not only to
provide adequate protection against the likely rate of inflation
but also to give unusually generous real rates of return.
Indeed, in late 1981, the bond market was in disgrace. The
Bawl Street Journal
, in its 1981 annual comedy issue, wrote,
“A bond is a fixed-rate instrument designed to fall in price.”
At the time, the yield on high-quality corporate bonds was

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around 13 percent. The underlying rate of inflation (as
measured by the growth of unit labor costs) was then about 8
percent. Thus, corporate bonds provided a prospective real
rate of return of about 5 percent, a rate unusually generous by
past historical standards. (The long-term real rate of return on
corporate bonds has been only 2 percent.) To be sure, bond
prices had become volatile, and it was therefore reasonable to
suppose that bonds ought to offer a somewhat larger risk
premium than before. But panic-depressive institutional
investors probably overdiscounted the risks of bond
investments. Like generals fighting the last war, investors had
been loath to touch bonds because experience over the past
fifteen years had been so disastrous. Thus, the initial
conditions were such that bond investors could expect very
generous returns in the years ahead.
What about stocks? As I mentioned above, it is possible to
calculate the anticipated long-run rate of return on stocks by
adding the dividend yield of the average to the anticipated
growth of earnings per share. The calculations I performed in
1981 suggested a total expected rate of return from common
stocks of more than 13 percent—a rate well above the core
rate of inflation and very generous by historical standards.

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Common stocks were also selling at unusually low
multiples of cyclically depressed earnings, at below-average
price-dividend multiples, and at prices that were only a
fraction of the replacement value of the assets they
represented. Small wonder that we saw so many corporate
takeovers during the 1980s. Whenever assets can be bought in
the stock market at less than the cost of acquiring them
directly, there will be a tendency for firms to purchase the
equities of other firms, as well as to buy back their own
stocks. Thus, I argued that in the early 1980s we were
presented with a market situation where paper assets had
adjusted and perhaps overadjusted to inflation and the greater
uncertainty associated with it. The following table shows
how returns developed during the 1982–2000 period.