The collapse in U.S. stock prices and the scandals in executive suites have sent waves of fear and loathing throughout capital markets around the world and caused many investors to lose faith in U.S.-style capitalism. They also have led to a decline in the dollar, forced the Bush administration to postpone a push for Social Security reform, and prompted Congress to develop new rules to curb corporate malfeasance and restore investors’ confidence.
But the worst is probably over, according to Jeremy Siegel, Wharton finance professor and author of the best-selling book, Stocks for the Long Run. In a wide-ranging interview with Knowledge@Wharton, Siegel says that the market has probably bottomed out, that the U.S. economy is sound, and that this is a good time for long-term investors to consider adding equities to their portfolios.
Knowledge@Wharton: Have stocks reached a bottom?
Siegel: It is likely. I’m hopeful that July 24 was a bottom. No one can ever call a bottom, like no one can ever call a top. But the capitulation in all sectors, extreme volatility and the fear that gripped the market is very characteristic of a market low. I think we’re going to bounce around with the S&P 500 between 800 and 900 because there’s always volatility at the bottom of a bear market. But it’s my belief that the S&P has probably hit a low. Whether NASDAQ has hit a low or not I don’t know. [On July 24, the Dow Jones Industrial Average declined in the morning to 7532.73, a low not seen since September 1998. But the Dow then soared to close at 8191.29 – a gain of 488.95 points, or 6.4%, from its July 23 close. On July 24, the Standard & Poor’s 500 rose 45.72 points, or 5.73%, to close at 843.42.]
Knowledge@Wharton: Have small investors stayed in the market?
Siegel: By and large, the public has held.
Knowledge@Wharton: Does that surprise you?
Siegel: It pleases me. But I think another dip – if stocks drop below their levels of July 24 – would more likely lead to panic and liquidation by the public. The public can only hold on so long. I hope very firmly that we have seen the lows so that this does not happen.
Knowledge@Wharton: Anecdotal evidence suggests that some investors have given up on stocks. Are they right to do that?
Siegel: No. Stocks’ long-term return looks better now than at any time over the last four to five years. This is the time you want to go in. You should abandon stocks at the top, not at the bottom. But anybody who needs money in the next few years should not be in the stock market. Anything can happen to the stock market over short periods of time.
Knowledge@Wharton: Was the collapse in stock prices inevitable?
Siegel: The collapse of the technology sector was inevitable. In fact, the bubble that we saw in the last few years was actually quite unusual in the sense that it exclusively pertained to the technology sector. The non-tech stocks really never were in a bubble. Up until the last two months, the Dow Jones Industrial Average, which is basically a non-tech, “old-economy” average, was about the same level as it was in March of 2000 when NASDAQ was over 5000. That’s important to keep in mind. There most certainly was a bubble on Internet stocks, but it differed from the bubbles of 1929 and 1971-72. All stocks didn’t participate in the recent bubble.
Knowledge@Wharton: What role have the corporate scandals played in the drop in stock prices?
Siegel: My feeling is that the scandals played some role, but not a decisive role. Basically, stocks fell because the recovery in corporate earnings was not responding as quickly as most analysts had anticipated.
After the terrorist attack, we had a recession. Everyone thought we would have a weak economy through the first half of 2002 and then gain momentum in the second half. Well, it turned out we had a gangbuster first quarter. Second-quarter data will be out soon and it’s going to show a considerable slowdown. But the bottom line is the first half turned out quite strong and earnings were OK, but they weren’t great. Now it looks like the second half might be weaker than the first half, and that was supposed to be the time when earnings were going to shoot upward. So all of a sudden, the market began to say ‘Oh, oh, we thought we had big earnings increases built into the second half of 2002 and the first half of 2003, but now it looks like earnings are not going to be that strong.’
Knowledge@Wharton: President Bush, Treasury Secretary Paul O’Neill and Federal Reserve Chairman Alan Greenspan have said the economy is sound. Do you agree?
Siegel: Yes. We’re on the road to 3% to 4% growth in the second half of this year. If the decline in the stock market isn’t arrested – if the market doesn’t stabilize – it will damage consumer sentiment. But if we don’t go to new lows, my feeling is consumer confidence will hold up well enough so that the economy will be strong in the second half.
Knowledge@Wharton: Do you think the bill dealing with corporate governance and oversight for the accounting industry that Bush signed July 30 is a good piece of legislation?
Siegel: None of those provisions [in the bill] particularly bother me. But my feeling is the discipline is going to be coming from the market, not from Washington. Right now the market is saying, ‘If you don’t tell us the real story (such as expensing options, pension gains, all debt obligations, etc.), we’ll just sell your stock down the drain.’ That’s the most powerful incentive CEOs have to shape up. Yes, we want penalties for corporate misgovernance, and they should be stiff. But ultimately, it’s the market that will be applying the pressure. Let’s hope the bill causes companies to slow down the rate at which they issue stock options to executives. Companies should use other performance-based measures [to compensate executives] rather than highly leveraged stock options.
Knowledge@Wharton: The market decline reportedly has prompted the Bush administration to reconsider its plans to overhaul Social Security and create private retirement accounts.
Siegel: It’s the wrong time to start talking about it. A guaranteed income sounds pretty good to the public right about now. The only way to sell Social Security reform in this environment is to give people a choice about private accounts. But to force people right now into private accounts is not a politically good thing to do.
Knowledge@Wharton: But isn’t this the time for long-term investors, like those in the Social Security program, to be buying stocks?
Siegel: It’s a good long-term position. But if you try to tell people right now that your future is in the stock market, people will just be nervous. It’s just the wrong time politically, even though it’s the right time financially.
Knowledge@Wharton: Merrill Lynch and some other brokerage firms have simplified the categories their analysts use for stock recommendations – buy, neutral and sell. Is that a good idea?
Siegel: I think they’re fine. Yes, they need to balance “ratings inflation” where almost all recommendations are buys and almost none are sells.
Knowledge@Wharton: How much credence do you put in what analysts say?
Siegel: I listen to them. Do I invest on the basis of what they say? Almost never, because it’s just not clear that their track record is all that good. I don’t own many individual stocks. Most of my [holdings] are in funds.
I’ve always said to small investors, ‘Don’t try to pick individual stocks.’ It’s a risky business and analysts’ advice can be tainted. Diversification sounded boring two years ago, but it was the key to avoiding the problems that many investors have today. You would never have suffered a meltdown in your portfolio [if you had been diversified].
Knowledge@Wharton: Will some CEOs or other top executives have to go to jail if investor confidence is to be restored?
Siegel: There is a strong public desire that someone’s got to go to jail or be punished in a real way for the fraud that has been committed. Whether the government is going to make an example out of someone, I don’t know. But, yes, there is sentiment out there that some of these CEOs – I think of Ken Lay [the former chairman of Enron] as the primary one – who should spend some time in jail. I’m not a legal expert. I’m not saying whether he should or should not go to jail given the laws in effect at the time. It’s a very complex issue. But you can hear the public’s cry for justice and feel that some of these guys responsible should suffer some real penalties.
Knowledge@Wharton: Some observers have said that recent events suggest there is something inherently wrong with capitalism. What do you think?
Siegel: CEOs are human beings like everyone else. In the 1990s there was a temptation to idolize these CEOs. Everyone is subject to failings in various degrees, to the temptations of money, to greed, and to committing to less-than-honest actions to save their reputation. We know government officials and athletes have also given in to these temptations. No one is perfect. A higher number of CEOs succumbed more than we would have liked during this bull market. But they’re human beings and most have performed admirably. I still think the system works. The wealth produced by the U.S. and its capitalistic system is still supreme in the world.