WWGADD?

The S&P 500 stock index is up more than 70 percent since its cyclical low in March 2009. After such a tremendous rally, investors find themselves in a predicament. Will the economy continue to recover and push stocks higher? Or will economic growth stall toward the end of the year as the effects of the stimulus wear off, dragging stocks down?

On the one hand, consumers seem to be coming back to life and spending more, but the national unemployment rate is still very high and consumer confidence is anything but robust. What’s an investor to do with such an uncertain economic outlook?

One approach to uncertainty can be found in the teachings of Benjamin Graham and David Dodd. Who are these guys? Graham and Dodd are best known as the fathers of value investing. They co-authored the book Security Analysis in 1934, and a revised edition in 1940.

Don’t let the bland title fool you. Security Analysis is still regarded as the fundamental text for the analysis of stocks and bonds. Warren Buffett, one of Graham and Dodd’s students at Columbia University, calls the book “the bedrock upon which all of my investment and business decisions have been built.”

Facts, Not Expectations 

The Graham and Dodd method of evaluating securities was honed during the Great Depression, a time of unprecedented economic and market volatility. Their approach didn’t put much emphasis on forward-looking estimates, such as forecasts of revenue and earnings, because forecasting during times of high uncertainty is akin to guessing, and has the same low probability of being accurate.

In fact, Graham and Dodd had harsh words on the subject: “As for the new-era view, which turned upon the earnings trend as the sole criterion of value, whatever truth may lurk in this generalization, its blind adoption as a basis for common-stock purchases, without calculation or restraint, was certain to end in an appalling debacle.”

Think of the dot-com boom of 1999 and 2000, when for a time it seemed that there was no price too high for tech stocks. Many investors simply chased ever-climbing growth rates. We all know how that ended. In fact, the Nasdaq Composite Index is still down more than 50 percent from its high in 2000. An appalling debacle, indeed.