After months of anticipation, on March 30 the Dow Jones Industrial Average closed at more than 10,000 for the first time in history. On April 2,
After months of anticipation, on March 30 the Dow Jones Industrial Average closed at more than 10,000 for the first time in history. On April 2,Jeremy Siegel, professor of finance at Wharton and author of Stocks for the Long Run, spoke to Knowledge@Wharton and analyzed the implications for investors.
Knowledge@Wharton: Three and a half years ago the Dow hovered around 5,000. On March 30, it cracked the 10,000 barrier. What does this mean for investors?
Siegel: It’s truly remarkable. Even optimists like myself didn’t expect three or four years ago that the Dow would crack 10,000 before the turn of the century. The major lesson is that returns of that magnitude cannot be repeated in the future.
Knowledge@Wharton: Why not?
Siegel: My long-run studies have shown that the after-inflation rate of return on stocks is about 7% a year. What we’ve had for the past four years is a return of more than 20%. That has never been sustained through history.
Knowledge@Wharton: Is the cracking of the 10,000 barrier really significant or is it largely a symbolic, psychological event?
Siegel: It’s certainly largely symbolic and psychological. In many cases, it’s also arbitrary. We know that it all depends on what stocks Dow Jones includes in its average. Had the company put Intel and Microsoft in the average—and by the way, many recommended it in the past—we would be way above 10,000 today. And furthermore, when the Dow closed above 10,000 on March 30, had the markets waited just 15 minutes more for the announcement of Coke‘s poor sales, the Dow would never have hit 10,000. So it’s arbitrary to the minute in terms of when you take the prices of the stocks. But all that aside, I don’t deny the tremendous psychological impact of the Dow getting into the 10,000 area. It is the world’s most famous average. It’s the way people think about stocks and conceptualize the market. As a result, it has tremendous pyschological import.
Knowledge@Wharton: In this market, where should investors look for opportunities? And where do you see risks?
Siegel: The market will always have risks. My feeling for quite a while has been that investors should hold widely diversified portfolios—I’ve always liked index funds, and of course they’ve done extraordinarily well. Dow 10,000 should not alter anyone’s plans in the market. People should not say that the market has gone too high so we should sell, or that it has cracked this level so it will only go higher. Whatever plan they had decided on before this event, they should carry it out.
Knowledge@Wharton: OPEC has curtailed oil production, and prices are starting to inch up at gas stations around the country. Should we be worried about inflation?
Siegel: No, we shouldn’t be worried about inflation, but it does drive home an important lesson for those who believe we might be entering a deflationary period. I for many years have not believed that to be the case. The rise in oil prices actually confirms the fact that if you look toward the future, we are not going to have a lot of inflation in the next few years. But I also don’t think we are going to continue to see a decline in the inflation rate towards zero or even below, the way a number of forecasters had feared. Actually many people view going back to $15 a barrel as something good because the collapse in oil and other commodity prices would put tremendous pressure on the world’s resource-supplying countries. This price increase gives them a little bit of a boost. A continued rise toward the $20 range, however, would be more of a concern. I am not worried about $15 to $16 a barrel, but at $20, it does introduce a note of caution.
Knowledge@Wharton: What will happen to interest rates?
Siegel: Forecasting interest rates is almost as difficult as predicting the stock market. In some ways it is even harder. I don’t think the economy is going to be that strong in the second half of the year. And since I don’t see a big increase in inflation, my feeling is that bond rates will stay stable or actually go down. In fact, I’ve been sticking my neck out and saying that the next move of the Federal Open Market committee would be to lower rates rather than raise them. Most people are now talking about raising rates; I’m a bit of a contrarian here. I think low inflation and some softening in the economic data may actually cause the Fed to lower rates in the future. So I don’t see long-run rates moving substantially higher. I’ve always said, however, that if long-run rates do move up, that is a concern to people in the stock market. The biggest competition for stocks is bonds. If bonds are more attractive to investors, then stocks will be less attractive. Although that effect may not be felt right away, it will definitely be felt eventually.
Knowledge@Wharton: Do you see any signs of that happening?
Siegel: Yes, I see concern about higher inflation and a tightening effect in the bond market. That does give me some concern. Again, if stocks ignored these warnings, that would not be good. My feeling is that as more data comes through, that will allay fears of the tightening and the Fed will not tighten things further. So we need not worry about that scenario, although it certainly is a possibility.
Knowledge@Wharton: How do you see the global situation? Could another Russian or Brazilian crisis affect Wall Street’s performance?
Siegel: The world situation, economically, looks better than it has for a couple of years. Asia appears to be recovering, more so the non-Japanese Pacific Rim countries which have been devastated over the last two years. We see signs that Japan may be turning the corner, although that might still be premature. Latin America has done remarkably well in light of the Brazilians’ devaluation of the real. The Brazilians have taken monetary policy in hand, they are not increasing money supply, the real has stabilized and in fact has increased in value from a month ago. I have been very impressed with the Mexican response, and that market has been up. Yes, there are some trouble spots in Latin America. Equador is one. Chile has been hurt by the copper price fall. But nonetheless, Latin America has stood up remarkably well to the problems in Brazil. Russia is always a problem, but the market has pretty well discounted that. The Russian market has recovered a little, although from extremely depressed conditions. Europe now looks like it is the world’s softest area. Clearly the enthusiasm about the Euro was overdone, and we have seen a substantial fall in Euro currency prices. I think that may be near an end. They have discounted a lowering of European interest rates, and inflation is very, very low. My feeling is that 106 or 107 may be the low point of the Euro.
Knowledge@Wharton: Won’t that depend on what happens in Kosovo? That has had an effect on the Euro.
Siegel: That has had a temporary effect on the Euro, but not a large one. Currency traders are more concerned about interest rates and economic growth. Although we don’t like what’s happening in Kosovo, at this point the market’s opinion is that it won’t turn into a larger crisis that could lead to greater economic disruptions.
Knowledge@Wharton: You spoke earlier about Microsoft and Intel not being in the Dow average. We have also seen a huge run-up in the stocks of Internet companies. For example, Amazon.com has annual sales of $150 million but a market capitalization of more than $20 billion. Is this a bubble? And if it bursts, what could be its impact?
Siegel: I am concerned that this is a bubble. I have tremendous respect for the market. I don’t like to question prices, because prices are generally set with a lot of intelligence. But I still don’t understand the pricing of the Internet stocks, and that concerns me. If the bubble bursts, what effect would it have on the market? That is difficult to ascertain. My feeling is that at this point, the bubble bursting would not have lasting effects on the market. Only one stock, AOL, has substantial market value that is owned by institutions. So when we talk about individuals who hold mutual funds and so on, their only exposure is to AOL, not to the other Internet stocks. So they will not be hurt if the bubble breaks. A lot of the activity involves day trading and speculation, and that is a removed segment from where most of us do our investing. Nonetheless, any bubble breaking does have negative effects. I don’t think the market would be totally immune from it. The question is whether the effect would be limited or not. At this point, my feeling is that it would be limited, but you clearly have to see how developments occur.
Knowledge@Wharton: Warren Buffett says that people should celebrate when stock prices fall rather than when they rise because that is what creates good buying opportunities. What is your view?
Siegel: There is a lot of truth to that. It depends on your horizon. If you are a long-term investor and relatively young, you are better off if prices decline. You can reinvest and buy shares at lower prices for the long run. But if you are elderly and living off the money, a decline in stock prices would certainly be more harmful to you. So for many investors, a decline in prices could actually be beneficial for their portfolios. Even though we think of a stock market decline as being negative, it is not always.
Knowledge@Wharton: Wall Street has seen a long bull market. As we approach the new millennium, will stocks still be good for the long run?
Siegel: Yes, I think so. Clearly, the returns of the future will not match those of the past. But I don’t see any reason why future returns should fall substantially below what they have been in the long term. In the long term, they have dominated all the other assets in the system. My reading of stocks, bonds and fixed income still gives the decided edge to equities in one’s long-term portfolio.