Jeremy Siegel: His Bet Is Still On StocksPublished: March 19, 2001 in Knowledge@Wharton
During an interview March 12 amidst the stunning sell-off that plunged the S&P 500 officially into bear market territory, Wharton finance professor Jeremy Siegel was no happier about stock losses than anyone else. But he was satisfied, he said, that the forces that make stocks the investor’s best long-term bet are still dependable.
"I still think they are a good bet for the long run," he said. "In fact, they are probably a better bet now than they were a year ago. You can buy them at cheaper prices."
Siegel’s well-known 1994 book, and its 1998 update, Stocks for the Long Run, inspired investors with its thoroughly documented argument that over long periods stocks have dramatically outperformed bonds and cash. From 1926 through 1997, the broad market, measured by gauges such as the Standard & Poor’s 500, returned an average of 7.2% above inflation, despite short and long periods of losses. The chief investment alternative, bonds, while often safer over short periods, returned just 2% above inflation. Cash, such as bank accounts or money market funds, will generally offer no real return once inflation is taken into account, though cash investors are well protected from losses.
Some commentators have argued that Siegel’s book helped sustain the bull market by convincing legions of baby boomers to put their trust in stocks and stay the course during setbacks.
But that strategy is being tested today, as the ever-rising stock prices that investors became used to in the 1990s turned into a string of losses in 2000 and 2001. "In my lifetime I’ve seen worse bear markets," Siegel said March 12. "But I’ve never seen one major sector take off like technology did and then crash."
On March 12, a 4.3% drop took the S&P 500 officially into a bear market, with losses exceeding 20% from the March 24, 2000 peak. Also on March 12, The Dow Jones Industrial Average closed down 12.9% from its January 14, 2000 record. And the Nasdaq Composite Index was down a stunning 61.9% from its March 10, 2000 high, more than erasing the 86% gain that index made in 1999.
Almost exactly a year earlier, on March 14, 2000, Siegel had written a column in the Wall Street Journal arguing that many major technology stocks that dominate the Nasdaq were ripe for a devastating downturn. The reason: Investors had bid share prices far higher than could be justified by those companies’ current or projected earnings. Investors were betting on extraordinary earnings growth in the future, or were hoping other investors would continue to demand stocks at ever-higher prices even if such growth seemed unlikely.
Nine of the 33 stocks with market capitalization over $85 billion traded at price-to-earnings ratios in excess of 100, more than five times the long-term average for stocks in the S&P 500, Siegel wrote. Even if these companies met analysts’ optimistic earnings growth projections, P/Es would remain in the 80s after five years and fall only to the 40s after 10 years. History suggested that P/Es would return eventually to normal levels of 15 to 20, which could only be accomplished by an inconceivable earnings growth or a devastating price decline.
Now, a year later, Siegel’s prediction has come true. Yahoo!, trading at 623 times earnings a year ago, has fallen 92%, from over $200 to about $16. Yet it still trades at an extraordinary high P/E of about 136. Many other tech stocks have fallen similar amounts.
"This has been a fascinating year," Siegel said March 12. "Certainly, we’ve seen a resurgence of the traditional tools of valuation of equities – earnings and cash flow. Profits have become extremely important again."
Inflated prices were the tinder; the economic slowdown was the match. The slowdown has brought a string of corporate "profit warnings" and disappointing quarterly reports, making it clear to investors that the extraordinary earnings growth needed to justify high stock prices would not come to pass.
Today, a record number of Americans own stocks, either directly or through mutual funds, tightening the link between the stock market and the "real" economy. In the late ‘90s rising stock prices fed the wealth effect, causing consumers to buy more and thus propping up corporate results. Now falling stock prices could have the opposite effect, Siegel said.
"I am worried that if the market goes down much more, Americans may decide to start saving, which sounds like a good thing to do," he said. "But the flip side is they may stop spending, and then it is going to be very hard for us to stay out of a recession. We’re just skimming above the recession level right now."
So far, low interest rates have helped prevent a recession and have kept stocks from sinking even further, he said. "The good sign is that we are going into the slowdown with a very strong banking system and a very strong real estate sector." At the start of the 1990-‘91 recession, in contrast, conditions were worse because a sagging real estate market saddled banks with a surge of bad loans.
"The crucial question is consumer confidence and whether consumers are going to pull back [spending] as a result of the stock market. That is the big wild card I see out there that could tip the economy into recession."
While investors have a gloomy view of the stock market these days, conditions are not universally bad, Siegel noted. "What I’ve been impressed with, actually, is how well the market has held up despite the collapse of the Nasdaq." Had he been asked a year ago, he would have predicted that if the Nasdaq sank below 2000, as it did March 12, the Dow would be at 9000, he said. Yet the Dow remains just over 10,000.
Of the 500 stocks in the S&P 500, 420 stocks were trading March 12 at prices higher than they were a year earlier, Siegel said. It is the other 80 stocks, most of them tech issues, which have caused the devastation. Since the S&P 500 gives more weight to large-capitalization stocks, a few big-company stocks can skew the entire index.
"It really pinpoints that the problem is the technology sector," Siegel said. Some other sectors have done quite well. Over the past 12 months, the Dow and S&P utilities indexes are up more than 40%, the Dow transportation index is up 24% and the Nasdaq insurance index is up about 30%. For investors, those results underscore the value of diversification, Siegel said.
Can the market sag further? Yes, Siegel noted, since P/E ratios in many areas are still above the long-term average of around 15. Despite the deep decline, tech stocks are still risky. "I would not overweight technology issues," he said. "I would not put more than 20% [of a portfolio] into technology today."
The perennial problem in valuing stocks is that while current prices incorporate investors’ expectations about profits years down the road, accurate forecasting is limited to a few months in the future, Siegel said. Thus it’s impossible to predict when the current bear market will end.
"One good thing about bubbles is that once you have one, you don’t have another one for quite a while," he added. "But history also tells us it does not turn around very quickly." It would be easier to conclude that stocks have hit bottom if there were very large volumes of trading coupled with crashing prices, but so far this hasn’t happened, he said.
So are stocks still a good bet for the long run?
Yes, Siegel said, so long as the investor plans to hold them for many years – ideally, a decade or more. Because of the short-term risks, stocks must continue to provide better returns than more stable investments like bonds. Over long periods, he said, stocks should provide average returns of 5 to 7 percentage points above inflation – handily beating bonds and cash.
Bear markets and recessions are part of the game.