Listen to the podcast:
After delivering an extraordinary 32% return in 2013, the U.S. stock market has had a shaky start in the new year. But in an interview with Knowledge@Wharton, Wharton finance professor Jeremy Siegel says corporate earnings are strong, and the U.S. economy is likely to grow at a healthy rate in 2014. According to Siegel, stocks are not overpriced relative to earnings, but bonds are a risky play as interest rates rise.
An edited transcript of the conversation appears below.
Knowledge@Wharton: It’s late January, and everybody’s getting their year-end statements from 2013 and seeing the stupendous gains they made in the stock market, and they are getting ready to pay taxes on them. And now, all of a sudden, we seem to be falling off a cliff. The S&P 500 is down about 3% year-to-date, after being up 32% last year. What is going on?
Siegel: It shows you how used to gains we are. After being up 32%, we call being down 3% “off a cliff.” I regard it as a little bump. No bull market goes up in a straight line. We haven’t had a correction — which is defined as a 10% decline in the market — for at least two years, which is pretty remarkable. I don’t think this current reaction is going to move that far. In fact, many technicians say it’s healthy for a bull market to have this [kind of] correction, because it blows off the excess bullishness that sometimes accompanies rising prices.
Knowledge@Wharton: What has triggered this now? Why not a month ago or a month from now?
Siegel: Ostensibly, it was the [trouble in] emerging markets…. The [Federal Reserve] “tapering” was announced in December. So, if markets are at least even partially efficient, why is it reacting four weeks later to something that we knew in December? Well, we [also] had a very disappointing labor market report. Earnings are coming in so-so. Actually, the percentage [of companies] that are beating earnings, at least at this point, is actually a little bit more than average. But the [beating of analysts’ forecasts] is a little less, and some of the forward [earnings] guidance isn’t too good. That’s been a little disappointing, because we know that the second half of 2013 had better economic growth than the first half. Many of us thought that maybe the fourth quarter would surprise us more on the upside. But it’s still early. Let’s wait until we get more data on that.
“I don’t think this bull market is over. I still think there’s room to grow.”
Knowledge@Wharton: In some ways, it seems like people are looking for an excuse to sell and take some of those immense profits from last year.
Siegel: Yes. People talk about the bullishness of the market. One of the indicators that I look at that monitors market sentiment is called Investors Intelligence, which for 50 years has been looking at bulls and bears. And indeed, my indices recently reached 20-year highs. Right after January, when everyone was saying, “Hey, there’s nothing in the way of this bull market” — you’ve got to get a little worried when we get to that particular point. Because historically, bull markets have climbed the wall of worry. There’s always, “Oh, I’m worried about this, I’m worried about that. That’s one reason I’m out of the market.” I don’t think this bull market is over. I still think there’s room to grow.
Knowledge@Wharton: We’re beginning the tax season. And a lot of people, of course, are sitting on big gains from last year. I’m curious: Is raising cash to pay for taxes a factor in this?
Siegel: Only if they sold. If they didn’t sell, one of the nice things about capital gains is that you can let them ride until you want to. So, it has to do with how much was sold. I don’t think so. Taxes are really due in April. Of course, if you pay quarterly, you had to come up with that January payment already. I think it’s more just the fact that it got a little bit overbought, a little bit over-optimistic. And [investors are] using the… problems in Argentina, Venezuela and Turkey as more of an excuse than anything to take some profits.
Knowledge@Wharton: When you open the hood and look inside at things like the price-to-earnings ratio, and other gauges like that, what do you see?
Siegel: What I see is that our traditional gauge, which is using the S&P 500 earnings against its level, is very close to its historical average — very close to the average of the post-World War II period: around 16 or 16 and a half [as a ratio of stock prices to earnings]. Yes, on the basis of 2013 earnings, we’re at around 17 right now, although it has come down a little bit. It’s a little bit above. But it has been my thesis for more than a year now that this market is going to go above its historical mean. And the reason for that is the low interest rates. With so little competition from other asset classes [such as bonds and cash], in my opinion, that would lead to a somewhat higher valuation. So, I think this bull market is going to 18 to 19 times earnings, which is another probably 10% to 12% [gain] in prices.
Knowledge@Wharton: Higher than they are today?
Siegel: Higher than they are today, yes.
Knowledge@Wharton: By the end of the year?
Siegel: Well, I say that. Of course, [only a] fool predicts the short run in the market. Again, we could even go much higher. I remember [once saying during an interview that the Dow Jones Industrial Average] could go to 20,000. And [the response was], “Dr. Siegel, are you predicting 20,000?” No, that would be overpriced unless we have a gangbusters economy in 2014 and 2015.
Knowledge@Wharton: You mentioned tapering [the reduction of the Federal Reserve’s bond-buying program to stimulate the economy]. And of course, this debate over tapering has been going on since May, I believe…. But now it has begun. And I’m wondering what effect you see there. The argument was that all of this money from the Fed is propping up stocks. Take it away, and stocks will fall.
Siegel: I have maintained that the biggest myth of the market in 2013 was that the bull market, the 30%-plus gain, was all due to the [Federal Reserve] pumping money into the economy. QE [quantitative easing], in other words. I said, “Hey, guys. You know, on the basis of earnings alone, and valuation relative to alternatives, I can completely attribute this rise in prices. I don’t need QE.” [QE] certainly doesn’t hurt. I’m not going to say it hurts. But I think its contribution to the great bull market that we’ve seen over the last two years is way too over-emphasized.
[Stock gains are attributable to] the fading of the fears of another collapse that 2008-2009 brought on. As the years go on, we see these risk premiums go down. “Oh, you know, there isn’t going to be a currency collapse, a municipal collapse, a commercial mortgage collapse.” I mean, all of a sudden, people are saying, “You know, the economy may not be great. But I don’t have those primal fears that so dominated the market in 2009, 2010, and 2011.”
Knowledge@Wharton: The Fed’s plan to reduce its bond-buying program is a pretty slow process. And it will be well done before they get around to actually raising short-term interest rates. Are you comfortable with the pace at which these things are planned?
“[QE] certainly doesn’t hurt…. But I think its contribution to the great bull market that we’ve seen over the last two years is way too over-emphasized.”
Siegel: Yeah. I am. And even that pace isn’t set in stone. I expect them to continue [cutting bond buys by $10 billion a month] at this week’s meeting, despite the bad employment report that we had. However, let me say, if the markets go down further, and we get some further poor data, surprisingly low data, I would say that there’s a very good chance at the March meeting…. for them to halt the tapering. Now, I don’t expect that to happen. I think we’re going to see a re-acceleration of the recovery. But again, no one should think that this pace is in stone. It isn’t. It can respond any way to what actually happens in the economy.
Knowledge@Wharton: And we’re just days away from the hand-off at the Fed from Ben Bernanke to Janet Yellen. Is that a significant event? It is for them, obviously. But does it matter to the markets?
Siegel: Well, I think the markets have now reconciled themselves [to the change in Fed leadership]. Certainly, they’re factoring that in. I think Janet Yellen is very competent. I think she is a very, very good choice. I do think she’s on the dovish side. I think there’s no question [about] that, when push comes to shove. But she’s also a good listener, and she’s a very smart woman. And… she knows that the Fed has an inflation target, and it’s not going to violate that inflation target by any significant amount.
She is only — just like Bernanke, and Greenspan before him — one vote of 12 on the open market committee. And there’s no veto power. Certainly, [the chairman] holds sway — their argument and their position is certainly important. But, I think the bank presidents, who have had no qualms about speaking out when they are concerned about inflation or over-stimulus, will certainly have their voices felt if they think that Yellen is moving too much to the dovish side.
Knowledge@Wharton: How does the economy look to you? Is it getting stronger, as it seems to be to the rest of us?
Siegel: I still think so. Despite the fact that we, again, had that poor employment report for the last month, in December. I think we have a chance for 3.5%-plus … GDP growth for 2014 [given] the better [financial] markets, the better … balance sheets of the consumers, the rise of the housing market and the rise of the stock market. And that should give a boost to consumer confidence. That could also boost business capital spending, which has been also very, very sluggish. And with housing moving up to, I think, over a million units sold… I think that that has the capability of giving us a 3.5%, or [more, economic growth].
Now, again, that certainly may not happen. And I have been overoptimistic on economic growth over the last two years. But, I think the stars are better aligned for such an acceleration this year.
Knowledge@Wharton: One of the elements in consumer confidence, of course, is jobs, and whether you think you’re going to lose your job, or your chances of getting one, if you have [lost one]. Do you think the job situation will improve?
Siegel: Well, I think the fear of losing your job has been going down for five years. We’ve seen the unemployment rate go down from 10% to 6.7%. And we have seen net hiring by firms. It’s always going to be present, and there are always firms that are going to be cutting back. But, you know, 200,000 jobs [created per month] — and in the private sector — actually, the job growth that we got over the last 12 months, even with the poor December report, has been fully as much as we had in 2003, 2004, 2005 and 2006 — before the crisis occurred. It’s a little bit less than we had in the booming 2000 period, the 1990s to 2000 period. But still, the growth has been decent. So, I think the labor market is going to be fine.
Knowledge@Wharton: And that’s the private market. One of the problems is, government cutbacks have been hurting these overall numbers, is that right?
Siegel: Oh, there’s no question about it. I mean, this is the first time, really, ever, that we’ve had a sustained — actually slightly negative on average — balance of government numbers. Government was always adding…. If it wasn’t the federal [hiring], it was the state and local [hiring], boosting it. Bernanke has made that point in some of his speeches … toward the end of his term, saying, “This recovery, given the contraction of government [employment], has actually not been that bad.”
And so, if we assume that the government’s contraction is going to be gone, that would neutralize the government as being a decidedly negative factor [in job creation], and let the private sector carry the economy forward.
Knowledge@Wharton: Unemployment upwards of 6% is the kind of thing that we used to look at with absolute horror. I suppose many still do. But if you break down the number, it’s not that bad among those with college degrees. It’s really people with less than a college education and less than a high school education who are making up the bulk of that excessive unemployment figure.
Siegel: You know, that has always been the case. The better educated, the much lower the unemployment rate is. The Fed now regards about 5.5% — 5.3, 5.5 — to be the long-run [normal] unemployment rate. Now, if we’re talking in the 1960s, we’d probably say it’s 3.5% to 4%. But various factors have raised that over time. So, I’ll say 5.5%. So at 6%-7%, we’re only between one and one and a half percentage points above what the Fed thinks the long-term unemployment rate [ought to be].
“It’s a dynamic economy. But the old factory job, even with manufacturing stabilizing, the old manual labor job … is probably not coming back.”
Knowledge@Wharton: Are the people with less education who lost their jobs en masse during the crisis ever going to get those jobs back? Will those segments of the workforce continue to be worse off?
Siegel: You know, the job market is changing. It’s changing even for some trained people, with the rise of technology being able to substitute for [certain jobs]. The low-skill jobs I don’t think are coming back. There are just too many people around the world, and with technology and communication being so easy … they can take over those low-skill jobs, and produce the goods, and [companies can] ship them [around the world]. Or even do the services by remote telephone centers that we have in the less-developed countries. All sorts of services are going to be outsourced…. There are always areas where the people who are gaining from the [rise] in technology are going to want to spend their money. I mean, there has been a restaurant boom. Younger people are enjoying going out. These are the types of service areas that are expanding [and cannot be moved offshore]. And there will be others.
So, again, it’s a dynamic economy. But the old factory job, even with manufacturing stabilizing, the old manual labor job, except maybe in the health care area where people might have to have some personal assistance, is probably not coming back.
Knowledge@Wharton: Let’s switch for a second and look at the bond market. And of course, when interest rates go up, people don’t want those older bonds that pay less. So you can lose money on your [older] bonds. Is that something we need to worry about today? How does that work into an investor’s thinking about asset allocation in a portfolio?
Siegel: Well, think of what happened last year: We had a bad bond market, rising interest rates and a really good stock market. Now, I think the stock market will be good this year. Not as good as last year, but that was certainly spectacular. I think we can see a 10% to 15% return at the end of the year for stocks. I still think you’re at big risk with bonds, even though this first two or three weeks [of 2014] have been great for bonds. They bounced back from just over 3% [yield] on the ten-year [Treasury note], down to 2.7% with this little bit of a pullback [in investor’s embrace of risk]….
Knowledge@Wharton: So, ending with something practical. The investor who has just finished 2013 with big gains in the stock portion of his or her portfolio is thinking now about reallocating — rebalancing, as they say. Should that investor be looking to get back to his or her original [asset-allocation] goal, or should he or she be saying, “The bond market is a little too scary, so maybe I won’t allocate as much to bonds?” What do you do?
Siegel: I still don’t think bonds are going to be offering really positive returns…. I still think it’s going to be negative returns for bonds. We know it’s zero for money markets…. And … if you want income, as we’ve been saying for so long, there are very good dividend-paying stocks that are yielding 3% or 4%. There are many dividend-paying mutual funds, exchange-traded funds, etc., that specialize in that.
And [with dividend-paying stocks] you’re going to get that growth [in principal as well], because dividends are growing 10% to 12% to 14% a year. [This is] one of the strongest dividend-growth [periods] we’ve actually seen…. And most analysts that I talk to expect it to continue in 2014.
Knowledge@Wharton: So, you’re basically optimistic about the economy, and basically optimistic about the stock market. Not too keen on bonds. That summarizes it?
Siegel: Yes. And that was pretty much [the situation in] 2013. But again, I’m always reminding [people]: No bull market goes up in a straight line. You have to get through these corrections. That will always be part of the stock market.