Market Update: A Real Recovery, or a False Start?Published: March 14, 2012 in Knowledge@Wharton
The Dow has hit its highest level in years, loan rates are at record lows and the U.S. economy appears to be gaining momentum. Even the housing market is starting to look inviting. But is this a real recovery -- or a false start like last year's? Wharton finance professor Jeremy Siegel and Scott Richard, a Wharton practice professor of finance, think the economy is showing signs of a true rebound and predict that stocks should do well in the next 12 months. But bonds, they warn, are in dangerous waters, and economic growth will be in jeopardy if oil prices keep rising and the European credit crisis worsens.
An edited transcript of the conversation follows:
Knowledge@Wharton: Let's start with you, Professor Siegel. Looking at the signs of the economy, it does seem like things are improving. On the other hand, we had somewhat of a false start a year ago, and I think a lot of people were burned by that. So, should we believe there is an improvement, or should we not believe it?
Jeremy Siegel: [Last year,] it was a head fake. Things were going up in April.... I think things are far more real now. The employment numbers are much better; the private payroll expansion is much better. Remember, [last year we had] the tsunami and earthquake in Japan. And then Europe got much worse. We can talk about Europe later. No one can say that couldn't flare up again, but there have been a lot of measures taken that have stifled the recovery that was proceeding at the beginning of this year.
Take a look at even home building, because that has been the most depressed area. [Figures from the] National Association of Home Builders are suddenly moving up. That was dead last year. In today's Wall Street Journal, I saw an article about a revival of real estate in Phoenix.... It was one of the worst [areas,] and all of a sudden they see a recovery there. So, I think these green shoots are much stronger now than what we had a year ago.
Scott Richard: I completely agree with that. We are in the beginning of a serious recovery, both in jobs and in output. And I expect stock prices and bond prices will react accordingly, with the bond market going up in yield and down in price.
Knowledge@Wharton: But you think it's more solid this time than it was a year ago?
Knowledge@Wharton: Well, let's zero in on the stock market for starters and then we'll talk about the bond market. Professor Siegel, we've talked a number of times about the gears and levers inside the market that you look at to see what's going on -- things like price-to-earnings (PE) ratios and that sort of thing. What are you looking at now?
Siegel: I think ... the two things that are important are cash flows and the discount rate -- which for stocks are earnings, basically, and the interest rate environment in which you find those earnings. It was very favorable last year. Actually, it is more favorable, to me, this year because interest rates are a lot lower now -- especially those long-term interest rates -- than they were a year ago. So the PE ratio is about the same as a year ago: 12 to 13, as we had last year.
Knowledge@Wharton: That's forward looking?
Siegel: Yes, that's the forward looking in the next 12 to 13 months, which is lower than the long run average of 15, and in [what is] in some ways a record low interest rate environment. So the question is, [what about] those alternatives out there that are not attractive at all. A lot of people tell me nowadays, "Well, Jeremy there's not just bonds out there. There's all these other assets that they talk about, and commodities and private equity and venture capital and all the rest."
But you shouldn't be fooled. I'm sure that Scott will agree that fixed income is still the biggest asset class that you have to compare [these alternatives] to. They're not on all equal footing in terms of size. Fixed income is the big comparison there, and the comparison is, I think, extraordinarily favorable.
Knowledge@Wharton: So with PE ratios low, the risk level of stocks looks relatively low, and you can make nothing in bonds or anywhere else.
Siegel: Of course when I say risk level in stocks, I mean they could go lower. The bears like to point out, "Well, Jeremy, we had PE ratios of seven and eight back in the late 1970s and 1980s." And I say, "Yeah, and that's when interest rates were 15% and 20% and there was a lot of competition there." There isn't any competition. So to see a PE ratio of 13 in an extraordinarily low interest rate environment is really extraordinary.
Knowledge@Wharton: And that's a positive sign?
Siegel: Extraordinarily positive going forward. I think people are beginning to put their toes in the water and buy a little.
Knowledge@Wharton: Given what the market has done over the last few years, would it be a good period to look back at to compare how stocks are doing?
Siegel: Well, I actually think that this period is not unlike the 1950s. In the mid-1950s, we had very low interest rates and low valuation of stocks. People were very frightened then. They still had memories of the Great Depression and the tremendous stock collapses that happened. They didn't believe the post-war recovery was real because so many economists were talking about a relapse into another depression. The fear was there. And if you remember, that was one of the best times to start accumulating stocks and one of the worst times to start buying bonds.
Knowledge@Wharton: So it would be risky to be sitting on the sidelines now?
Siegel: I think you're missing out on great values in stocks, even in terms of the dividend yield. This is the first time since the 1950s that the dividend yield on the S&P 500 has been higher than the 10-year government bond. And stocks have growth and inflation hedge properties that the bonds don't have. If you want the inflation hedge properties in the bonds and you go to TIPS (Treasury Inflation-Protected Securities), their yields are negative -- incredibly so, in my opinion. So there's really no yield there at all. So again, stocks are really the only real game in town for yield going forward.
Knowledge@Wharton: So a person who is, say, in or near retirement, should really consider dividends as a source?
Siegel: Good blue chip dividend paying stocks, low PE dividend paying stocks -- I think that's going to be your best answer.
Knowledge@Wharton: I know some of the telephone stocks are paying over 5% these days.
Siegel: I wouldn't stay with any one or two. I would try to be as diversified as possible. I don't pick sectors or stocks, but if you are diversified towards a value portfolio that is dividend tilted and dividend weighted, I think that will perform very well going forward.
Knowledge@Wharton: For people who look back or read the stories about "the lost decade" -- not referring to Japan but referring to the U.S. stock market -- would that be too short a perspective or a misleading perspective?
Siegel: Well, remember, we started that [so-called] "lost decade" in 2000, with a PE ratio of 30 on the market in March of that year. When you start with 30, you're not going to have a decade. Japan started in 1989 with a 90 PE, and they did not have a good 30 years after that.... People say, "Can't this next decade be lost?" And I say, "Not starting from these PE ratios."
Richard: There's one other class you might want to look at, which is real estate. Clearly, cash is absurd with single digit yields -- I mean, in basis points, 10, 12, basis points. And then bonds: I don't understand why anybody in their right mind wants to lend the U.S. government money for 10 years at under 2%. It makes no sense to me at all. So if you rule out cash, you rule out bonds, stocks are very attractive, as Jeremy said. But real estate also has a lot of attractive attributes right now.
Knowledge@Wharton: You're referring to real estate investment trusts (REITs)? Or actually going out and buying an investment property?
Richard: Either one, especially if you have the nerve [to invest] in some of the sand states where things have really been crushed. The rental markets already are reflecting this: Rents are up nationwide. But we've never seen more affordable prices on single family housing since the records have been kept. Between the low mortgage rates and the low prices, this is the best opportunity we have seen in 40 years.
Knowledge@Wharton: Talking about real estate, when people are considering their own home, they've historically been told, "Well, you've got to stick around for four or five years to break even, given the cost of buying and selling, title insurance, things like that." If one were considering an investment property, how long a holding period would they have to commit to, do you think, at minimum?
Richard: Depends on the market, of course.
Knowledge@Wharton: But it's not a six month, flip-buy-and-flip kind of market?
Richard: Never. For the one who occupies a consumption good, it's not an investment. If you're not collecting rent, it's not an investment; you are consuming the house property. And as for rental properties, that's just a straight forward present value calculation. How much is the rent I can collect versus the cost of carrying the house -- the principal and interest, the insurance and the taxes. And I think that you'd have to be fairly foolish,, as we've all learned, to invest on the capital gain that you're planning to get out of that house.
Siegel: I do agree with Scott here. But the REIT index has totally bounced back. It's within, I think, 10% or 15% of the high that it reached before the crisis.
Richard: So is the stock market.
Siegel: And the stock market is also within that. In some of these individualpropertiesyou're talking about, I do agree the affordability index is at a record high. And U.S. real estate is unbelievably cheap on an international basis as well. So again, the REITs themselves have gotten a good bounce. I still think they are probably okay as an investment. But if you can get into the rentals in particular places, I think you might score very well.
Knowledge@Wharton: But again, that's a multi-year proposition.
Siegel: That's multi-year. It requires a little bit more specialty in terms of being able to do that.
Richard: And no liquidity. There's no liquidity there, as opposed to stocks.
Knowledge@Wharton: Professor Siegel, you mentioned the foreign markets in real estate, and there are also of course foreign markets in stocks. In the past, you've been quite a strong advocate of people having pretty substantial holdings in international stocks. How have things changed? Is that still a good idea?
Siegel: I think it's still an excellent idea. There was more growth abroad.... Countries such as Japan and [those in] Europe have moved into a slow growth period to be sure. But the emerging markets have bounced back. And not only have they bounced back, but their valuations for rapidly growing countries and firms are still extremely reasonable. I was just looking at the Shanghai composite selling 10 to 11 times this year's projected earnings. And even with the comedown of the squeeze in the Chinese market, Hong Kong is around 12, and Singapore is at 15. They're all 15 to 16, which I think are very good valuations.
People say, "Are these emerging markets for real?" I think we definitely know the answer is "yes," because we had the biggest economic shock in 2008-2009 since the Great Depression in the 1930s. If it was going to knock anyone out, it would have been the emerging markets. They've come back much stronger than any of the developed markets in terms of their economies. Some of their stock markets are not quite back, but their economies are now well over the peak of what they were in 2007.
Richard: I have data since 1972 looking at corporate values, including both the stocks plus the corporate bonds. That's grown about 1% faster than nominal GDP.... [One reason] is we are participating in a global expansion.
The U.S. companies themselves, without diversifying globally, give you global diversification. Now, clearly they can't keep growing 1% faster than the economy, or they become the economy. Sooner or later, they are going to have to level off and grow at the rate of the economy. But I don't see that happening, myself, in the short run because of the increasing and continuing globalization.
Siegel: I definitely agree. People look at the ratio of stock market value to GDP. It's not appropriate anymore. I mean, 45% of the profits of the S&P 500 are now coming from abroad. So, you need to look at world GDP, which is growing faster than U.S. GDP. That is, I think, the most important criteria, and why I think that divergence can go on for an awfully long time.
Knowledge@Wharton: Before we switch from stocks to bonds, I just want to ask one last question, which is what worries you the most? If something were to derail all of this, what would it be?
Siegel: I'm not happy about rising oil prices.... Any sort of war in the Gulf that could send oil up to $250 a barrel is obviously a threat out there. A longer-term threat is -- and I don't see this happening -- if the emerging markets stop growing. Political things [could happen], and the growth of the emerging markets is very important for us economically. They are the new middle class that is going to be buying so many of the goods as the baby boom population retires over the next 20 years. And they're going to be the demanders of goods and grow much bigger than the middle classes that now exist in Europe and the United States. If something disrupts their growth, that's a longer-term issue. I don't see that happening. Short run, it is probably the oil question and war or attacks on Iran.
Richard: I think this is going to be the century of wealth creation. You have two billion people in the last 20 years who have come out of abject poverty into the cash economy and huge growth in the middle class in India and China. That's nothing but good news. I don't see anything that will cause that to derail, unless their governments adopt very bad policies. A government can always do that, and then there's nothing you can do about it. But both the Indian and the Chinese governments seem to have ... embraced market economies, and we should see quite a bit of growth continuing out of those countries.
Knowledge@Wharton: Let's talk about bonds a little bit and the interest rates. It just seems like it's been years that we've been saying, "Well, interest rates are more likely to go up than down." Have we ever seen a period where rates have been so low for so long?
Richard: Not since the great depression.... We've seen low rates ... but never cash this low, fed funds this low, for this long. And Fed chairman [Ben] Bernanke has announced that he intends to keep it there through 2014. The markets seem to be buying this.
Knowledge@Wharton: That was quite a remarkable announcement, very unprecedented. How did the markets react? Has it calmed them down? Are they just ignoring it?
Richard: I think nobody in the markets ignores the Fed. They are the 800-pound gorilla.Long [-term] rates are just averages of short [-term] rates. So you have to be looking at the Fed. Now of course the Fed has much, much more control of the front end of the yield curve than they do over the long end. So the reaction in the market is that we have very steep yield curves. The rates are not all that high, but the curve is very steep. And the forward rates are even steeper....
As the economy strengthens in the coming years, the Fed is going to be holding down the front end of the curve. The only way the curve can go is to move up, is to steepen. And that's what the forward rates look like. That's what I expect will happen. Whether the Fed changes its mind and then eases before the end of 2014, I think will ... depend on what happens to the unemployment rate and inflation....
[As for inflation,] they may have printed a lot of money. I don't know whether they're going to be able to reel it back in time to [prevent] inflation. In past years when the economy was stronger, if they had printed anything like this amount of money -- this huge easing they' have gone through in the last few years -- people would be very worried about inflation.
Knowledge@Wharton: So does it look like rates will come up in the next few years?
Richard: In my view. And that's what the market's forecasting as well.
Knowledge@Wharton: I'd like to just note that it's always difficult for laymen to remember this relationship between the interest rates and bond prices, and how a rising rate can cost you money if you've bought a bond earlier that pays less. That's a danger for people who are looking at bond mutual funds and think they are safe. How would you gauge that danger these days?
Richard: You can buy bond mutual funds in all sorts of flavors. [For example,] you can go for the money market fund, which probably is safe.
Siegel: But yields zero.
Richard: Yields zero. Well, no free lunch. [There are also] short bond funds which are yielding something like 1% and are relatively immune to interest rate movements. And then you can go on out to longer bond funds, five years, where what you say is very true. When yields go up, eventually these funds are going to suffer. Offsetting it will be some spread tightening as the economy recovers. The corporate spreads are not all that wide right now, nor are mortgages.
Knowledge@Wharton: So, should the investor who wants a portion of their portfolio in bonds assume that this is going to even out over time -- the turnover in the fund will get new, higher yielding bonds, and it won't matter? Or should they be worried about it?
Richard: I would expect to earn your yield right now. I don't think you're going to get some coupon, and I expect capital losses to come in against the coupon. So that's what I mean by earn your yield; if you hold it to maturity, that's about the best you're going to do.
Knowledge@Wharton: Should be wary of the bond market right now?
Richard: I would be very wary of it, and I would not be a bond buyer at these yields. Like I said, why do you want to lend the U.S. government money for 10 years at 1.75 percent when they're running trillion dollar deficits?
Knowledge@Wharton: Now of course we're constantly hearing about the situation in Europe, the debt crisis in Europe. It's a little bit mystifying to many of us how that affects us. We know vaguely everything's interconnected. But how does it affect us? What's sort of the mechanism in which troubles in Europe affect markets in the United States?
Richard: They're a huge trading partner. And if they go through these serial defaults, like I liken it to a bank run. [After] Greece's default, I imagine the market is going to turn its attention to Portugal next. Portuguese spreads are already very wide and have been widening. These [countries] are less worrisome because they are small [in terms of] GDP. But if they start to fall, then the next one is Italy or Spain -- and those are big and real. The joke about Italy is it's too big to save. If its economy becomes compromised, these are people who buy a lot of goods and services from the United States. That's going to hurt, that's going to hurt everybody who exports, from farmers to manufacturers. So that's the mechanism. Trade is really the mechanism.
Knowledge@Wharton: Do you feel that they're getting a grip on this situation in Europe, or not?
Richard: Truthfully, no. I think that they're moving in the right direction, but for a currency union to work, you need several things. We have a currency union in the United States. We have 50 states and one currency. We have a lot of labor mobility. That's what makes our currency union work. They have very little labor mobility in Europe .... so they don't really have a mechanism that's going to allow huge differences in labor productivity across Europe to equilibrate. The normal way of doing that would be -- for example, with Greece, they would have had a drachma. And the drachma would have fallen in value. Then everybody's labor productivity per unit of currency would have worked out. So the euro would have stayed strong, the drachma would have weakened and the Greeks would have been competitive in the European market.
The same thing is true now of Portugal, Spain and Italy.... Their unit labor costs are very high compared to Germany's, and they don't have a mechanism for adjusting. That's what worries me.
Knowledge@Wharton: Do you think that going to the euro was a mistake? Is that what all this is pointing to?
Richard: Going to the euro was perhaps not a mistake. What was a mistake was going to the euro without having a mechanism in place to make sure that unit labor costs across the eurozone were going to remain competitive...
Knowledge@Wharton: You mentioned that it would make no sense to lend the U.S. government money for earning nothing.
Richard: Well, I wouldn't lend it to them.
Knowledge@Wharton: But there are other opportunities in the bond market. There are corporates or municipals and there are junk bonds, or "high yield," as they like they say. Across that spectrum, what looks appealing or unappealing, or more dangerous or less so?
Richard: I don't see anything awfully appealing in the bond market at all, across the whole sector. And that's because I'm worried about rates going up. If you hedge out the rates, then the question becomes: Are any of the spreads attractive? Mortgage spreads are a little bit wide, not tremendously wide. Corporate spreads are a little bit wide, not tremendously wide. A lot of the value in corporations, if you had the nerve [to invest], was available a year ago. But they've tightened in a lot. So, I don't see any real great values across the whole bond market.
Siegel: I tend to agree. Interest rates are going to go up. Again, they're at zero on the short term. I personally do not think that Bernanke is going to be able to hold rates until 2014. I think the economy's going to improve and/or inflation is going to increase enough that he's going to have to pull the trigger on that.
A lot of people ask me, "What's going to happen in the stock market?" I say that it will be a shock when that happens, but if you go through history, the early phases of fed tightening are not bad for the stock market. Stock rallies continue. It's only at the end when they really squeeze -- try to slow the economy that's getting out of control in terms of inflation and resource utilization -- that you really begin to see the bear market beginning. So I'm not saying that on the day when Bernanke says, "We're now thinking of withdrawing the accommodation," there will not be a short term shock there. And I consider that a buying opportunity because history shows us that often times stocks recover very quickly from that and continue on to the new highs as long as earnings are growing.
Remember, there are two things that affect the stock market -- interest rates and earnings. The bond market is only the interest rates. If the economy's going to be stronger, you're going to do really well on the earnings side. That's going to be able to bring the stock market up where bonds can't go.
Richard: Some sectors of the bond market, like the banks, are very attractive right now. But that's a view that the financial sector is healing and not going down the tubes.
Knowledge@Wharton: There's one other sector I wanted to ask you about because of your background in the mortgage securities market, and that is, am I correct that the private securitization market is still pretty much dead?
Richard: Moribund, absolutely.
Knowledge@Wharton: And does that matter? Is there something else? I guess Freddie and Fannie have stepped in to fill that breach. Is it important that we have a private securitization market? And if it is, what will it take to get it going again?
Richard: Those are great questions. Fannie and Freddie can only securitize a loan up to a congressionally set ceiling... which under special circumstances is now up to about 6.25. But the actual ceiling is about $200,000 lower than that. And there's a lot of political pressure to return it to the actual ceiling, to not make it a jumbo loan securitizer. There's essentially no jumbo loan market. How important is that? Well, if you're the average person who's buying, the average home price in the United States is a couple hundred thousand dollars, and it's not important at all because there are lots and lots of Fannie and Freddie conforming loans available. If you're buying a jumbo loan or if you live in an expensive market like California or New York, it's very important because you can't buy a house -- which means that the person trying to sell you the house can't sell it to you. Even though rates are low, people can't get the loans.
So what's it going to take to get that going? I'm think you're going to have to see house prices return to some strength so that the underlying collateral, the house price, looks good enough for people to be willing to lend against it. In the Wall Street days there was an expression, "Don't catch a falling knife." That's what people look at the housing market as, a falling knife. Now we have some signs like Jeremy mentioned about Phoenix turning. And we may see other cities turning. But I believe that the mortgage lenders and the bond market are going to take a wait-and-see attitude. They're not going to get in front of this.
Knowledge@Wharton: A year from now, what do you think things are going to look like in the economy and the markets that you're following?
Siegel: Well, since I believe this recovery is real, we're going to see a stronger economy. I think the stock market's going to be higher -- [maybe] 15%, or even more. We know one year projections are so uncertain. I think the interest rates on treasuries will be substantially higher. I think within a year, Bernanke's going to have to bring forward the tightening date, and that announcement could very well be made in the next 12 months. And the rising economy, as Scott said, I think will stabilize the home price situation ... [and] start lending in that market. We will be healing in the economic sense in the next 12 months.
Richard: The big unknown is the elections. We have a very, very big tax hike built in at the beginning of next year, [when] the rates return to the pre-Bush tax cut rates. If we're split among Democrats and Republicans, it could be that it's impossible to do anything about that, and I think that will not help. That will slow the recovery, [by adding] a big tax hike right in the middle of [it].
Siegel: But you know, I've always been saying that you're not going to get an agreement until the elections.... As Scott said, if we go back to those [tax hikes], that will be a fiscal hit that [will derail] any recovery. So my feeling is at that particular point, this is our strength. These are our negotiating points. And they're going to [have to] come to a deal.
Knowledge@Wharton: Okay, so we're optimistic, but there are a lot of big "ifs" out there.
Richard: Well, whenever there's an election year, there's a big "if."