propelled nominal stock prices justifiably above their previous, noninfla-
tionary trend. Those who used trend-line analysis and who failed to ana-
lyze stock prices in real, instead of nominal, terms would have sold in
1955 and neverreentered the market.^4
But there is now another justification why the channel may be pen-
etrated on the upside. Stock indexes record only capital appreciation, and
they therefore understate total returns, which must include dividends.
But firms have been paying an ever-lower fraction of their earnings as
dividends. More of the return is being pushed into capital gains through
stock buybacks and reinvestment of earnings. Since the average dividend
yield on stocks has fallen 2.88 percentage points since 1980, a new chan-
nel has been drawn in Figure 3-1 with a 2.88 percentage point higher
slope to represent increased capital gains. By that measure the Dow level
at the end of 2006, although at a peak, was within 1 standard deviation of
the mean.
VALUE-WEIGHTED INDEXES
Standard & Poor’s Index
Although the Dow Jones Industrial Average was published in 1885, it
was certainly not a comprehensive index of stock values, covering at
most 30 stocks. In 1906 the Standard Statistics Co. was formed, and in
1918 it began publishing the first index of stock values based on each
stock’s performance weighted by its capitalization, or market value.
This technique is now recognized as giving the best indication of the
overall market, and it is almost universally used in establishing market
benchmarks. In 1939, Alfred Cowles, founder of the Cowles Commis-
sion for Economic Research, constructed indexes of stock values back to
1871 that consisted of all stocks listed on the New York Stock Exchange
using Standard & Poor’s market-weighting techniques.
The Standard & Poor’s stock price index began in 1923, and in 1926
it became the Standard & Poor’s Composite Index containing 90 stocks.
The index was expanded to 500 stocks on March 4, 1957, and it became
the S&P 500 Index. At that time, the value of the S&P 500 Index com-
prised about 90 percent of the value of all NYSE-listed stocks. The 500
stocks contained exactly 425 industrial, 25 railroad, and 50 utility firms.
Before 1988, the number of companies in each industry was restricted to
these guidelines.
42 PART 1 The Verdict of History
(^4) For a related situation in which a long-standing benchmark was broken because of inflation, see
the first section in Chapter 7, “An Evil Omen Returns.”