Jeremy Siegel: Sit Tight During the Sell-Off

U.S. stock markets are in a tizzy. The Dow Jones Industrial Average plunged 311 points on July 26, and most media companies interpreted this to mean the end of the buyout boom. Buyout firms such as the Fortress Investment Group and the Blackstone Group were hit especially hard. How long will the turmoil continue? Could the trouble spread overseas to international markets? What is the right strategy for investors in these times? In an update to the podcast that Knowledge@Wharton published on July 25, Wharton finance professor Jeremy Siegel offers his insights on these questions. In the earlier podcast, he discussed the continuing crisis involving sub-prime housing loans and other issues — including economic growth in China and the impact of the strong Indian rupee — with Knowledge@Wharton.

Knowledge@Wharton: The stock market plunged 311 points on July 26, and most media reports say this spells an end to the leveraged buyout boom. In your newsletter, though, you describe the sell-off as an over-reaction to the sub-prime crisis. What’s going on?

Siegel: Over the past few months we have seen waves of fear and anxiety that the sub-prime crisis is going to spread to the rest of the economy, and in particular to the leveraged buyouts that we’ve been seeing increasingly over the last few months. I think it’s important to realize that the bull market in stocks does not depend on this buyout boom. There were only a few stocks that were actually bid for. This boom was a signal that a lot of buyout firms saw stocks in the public markets are cheap.

So, it’s not an over-priced market that suddenly is going to collapse because we’re not going to have as many buyouts. Yes, we’re not going to have as many buyouts as before. But, I think that stocks stand on their own feet — that the earnings are coming in at or above expectations, and the economy is still growing. We had a 3.4% GDP growth last quarter; expectations are 2.5% for the current quarter. The economy is not falling apart, despite the sub-prime crisis. And, as a result, my feeling is that this was a very strong over-reaction in the market to the increase in these risk spreads.

Knowledge@Wharton: The reaction did spread to other global markets as well. How do you expect them to behave over the next few days?

Siegel: Well, predicting any market over the next few days is always very, very difficult. What we do know are two things. First of all, markets are connected around the world more than ever before. So, we’re going to see very strong correlations: We saw that what happens in New York goes to Europe and Japan and everywhere else. You’re not going to get independent movements from these markets.

The second thing we know is that volatility breeds more volatility in the short run. So, we’re going to see a lot of sharp movement — probably both up and down — in the markets. But I think that they’re going to sort themselves out in the sense that there are a lot of positives now for stocks. The Fed, for example, as well as other central banks, have a lot of room to ease if indeed sub-prime does spread to the rest of the economy.

So, we’re not out of options. Even if credit woes spread, there are good things out there for investors to look forward to. Yes, there will be volatility in the short run — but I think that spells opportunity in the long run.

Knowledge@Wharton: More specifically, hedge funds have been hit hard in the current sell-off, and there’s talk about whether Kohlberg Kravis Roberts, the giant private equity firm, should withdraw its IPO. How do you expect hedge funds to fare in the coming months?

Siegel: We don’t really know how hedge funds are doing. We certainly know that the big buyout firms like Blackstone and others certainly have been hit; Blackstone is now way below its IPO price. There is no question that buyouts are going to be far below the level that we saw before. And, that’s going to hurt those firms. But those firms were making a lot of money even before the buyout splurge. They’re going to be pinched a little bit, but most of the big ones will survive.

Now, hedge funds: There are thousands of them out there; they haven’t reported their last quarter or their last month. We’re going to see how they do, and that’s going to be very interesting because if they’re really hurt by this volatility, we could see money flow back into the equity markets

Remember, we have over a $1.5 trillion worth of investment funds in the last five years that has flowed to these hedge funds and out of the equity market, looking for better returns. If investors are convinced that better returns are not in hedge funds, we may see some of that come back to the equity markets. So, there’s actually a silver lining to this volatility: It may mark the return of funds to the public markets. That could certainly mean continued good returns in equities.

Knowledge@Wharton: Considering that, what is the right strategy for investors in these times?

Siegel: In these times, the right strategy is always to stand pat. For everyone who has resisted the temptation to sell, and certainly for those who follow the market closely, I understand there’s a sinking feeling in the pit of your stomach when you see 300, 400, 500 point declines. But everyone who has sat tight during those times has been rewarded in the future.

And, by the way, I think that if this decline goes much further, or even if it doesn’t, this is a good opportunity for anyone who has been sitting on the sidelines to start putting some funds back into the market. This is because right now — given the level of interest rates and earnings — we’re seeing a fairly cheap stock market. 

Knowledge@Wharton: In the U.S., where do we stand in the sub-prime mess right now?

Siegel: Well, it’s definitely a mess. In the sub-prime market, we are seeing in the last couple of days risk spreads widen outside of the mortgage industry — not dramatically yet, but there are the first signs that it’s happening. So there are still fears in that industry. The big question is how much it is going to spread to the outside.

I still go with those who are optimistic and say that it’s going to be contained in the mortgage industry. It’s a mess for those people who invested in mortgages, but it will not be horrible news for other credit instruments. But there is no question that this cools down the economy, because we already see a cancellation of buyouts; borrowing is getting tougher.

We’re seeing a return to probably more realistic risk spreads in the market as a whole. Again, I think that it’s going to be contained. It isn’t going to spiral out of control to cause a crisis. But it is going to keep that industry down for a while.

Knowledge@Wharton: Why have markets continued to climb, and how likely is it that the Dow will climb over 14,000 again and stay there?

Siegel: I think that it is going to go back there. The earnings so far — and we’re right in the thick of earnings as we talk — are mixed, slightly below the average amount of firms beating expectations. The average is around 62% to 63%; I think we’re at about 58%.

But earnings are coming in between 5.5% and 6% above a year ago — not as good as the first quarter, but still very respectable. And with interest rates low — we got that 10-year now below by 5% — there’s been a little bit of fleeing to treasuries as the credit spreads are widening. That’s still the benchmark by which you look at the stocks, and I think a 10-year bond under 5% is still quite doable for stocks.

Knowledge@Wharton: The dollar has been falling. Is that good or bad for stocks?

Siegel: Well, it’s always the conundrum. As the dollar falls for foreign holders, that’s bad; but once it gets down, it’s good. So you have to get through some pain to get to a good point. I actually think that a low dollar net is favorable for stocks. It makes stocks look cheap internationally; it boosts the earnings that get translated into dollars from abroad. Yes, it does raise inflation a bit for imported goods, which is not good for stocks. But I think, on balance, it’s a positive for the stock market.

Knowledge@Wharton: Emerging markets have been going straight up; is it time to get out?

Siegel:  Yes they have, and it’s looking a little “parabolic” as we now say. There are great things going on in the emerging markets. I would say that I’m still positive, but I’m now watching them more closely. We’ve talked before about the Chinese market, and in my opinion it’s too hot and overpriced. I looked at some of the other emerging markets. They’re getting pretty fully priced for optimistic scenarios — not unrealistic at this particular time, but one has to recognize that things have to go right. So I would say, don’t get out, but I wouldn’t start buying in those markets at this particular juncture.

Knowledge@Wharton: Bernanke testified before Congress last week. Where does the Fed stand now on interest rates?

Siegel: His testimony was very much as expected. The minutes from the meeting in late June were very much as expected. That’s what the market likes — a predictable chairman — and I think that’s what they have at the present time. Where does the Fed stand? Right in the middle: They have really balanced forces going up and down.

Inflation, on the core level, is coming under control. They like that.

The economy has recovered a bit, but it’s not overheated. They like that. There are some risks in sub-prime spreading; they believe, like I do, that it will not be a major cause of a slowdown in the future. So, basically, they like the outlook. They’re not near to either a tightening or a loosening. And more and more experts are now saying that the Fed is going to be on hold through the end of this year. 

Knowledge@Wharton: Speaking of risks, what do you think about oil? It seems to be an important risk out there.

Siegel: It is. It was actually very encouraging, I think yesterday, [when] we had some OPEC officials saying that they are also worried about the price getting too high. It’s in the mid to upper 70s right now. They actually mentioned a price in the 60s as where they’d prefer it, which I think is good. And we’ve seen oil come down for a couple of days.

That is a risk, and with the dollar going down it’s more of a risk on the upside, because when you quote it in dollars it looks more to the Europeans (in euros) that it hasn’t gone up that much. But to the Americans (in dollars) it has. I’m encouraged by the OPEC sentiment. We think that it is in their interest not to let oil get too high, because if it gets too high then all sorts of measures to conserve and curb imports might ultimately hurt them.

They want to keep it high, but not so high that governments will take extreme measures to reduce consumption. So, I hope that we see a peak here, but it’s something to always keep your eye on.

Knowledge@Wharton: China’s economy has expanded at 11.9% in the second quarter, its fastest growth since 1995. This follows 11% growth in the first quarter. Can this pace be sustained, and should it?

Siegel: Certainly not forever, but for a long time. I’ve been a bull on the Chinese economy as it’s catching up to, you know, even semi-Western standards — levels like South Korea or Taiwan…. It can grow 8% to 10%, even 11% and occasionally 12% a year. People were telling me that it was getting overheated at 8%; I didn’t see it. Yes, inflation is a little bit higher in a couple of places. But, my feeling is that they are not reaching constraints that will cause it to slow down.

Again, when I say that 8% to 10% sounds more normal, you have one blip up on to the 11% to 12% scale, but still very rapid growth, I think, for years to come.

Knowledge@Wharton: The Chinese government has in fact said that it would take some actions to slow down the rate of growth. So they’re thinking that it’s a little bit scary for them. They raised interest rates last week for the third time since March, part of which reflects the continuing attempts, as you mentioned, to slow inflation, which rose 4.4% in June. A lot of that was due to inflation in the food area. What else can the government do to ensure orderly, rather than chaotic, growth?

Siegel: Actually, the government is more worried right now about the stock market overheating than they are about the economy overheating. Yes, there’s been some pressure on food prices, but I think that really they’re not comfortable with maybe 11% or 12% — but they are comfortable with very rapid growth. My feeling is that their priority is not to let the stock market get overheated. It probably already is, but not to let it get more overheated and then turn into a severe downturn that really could harm the economy.

Knowledge@Wharton: If in fact the stock market is overpriced, as you’ve said, can you predict when there might be a rough landing?

Siegel: No one knows when a bubble will break — that’s the thing. The history of bubbles is they always go longer than you think…. You know, the popping of the Chinese bubble has been declared many times, and it hasn’t happened yet. That’s what they are worried about. They don’t want things to get so out of control.

You don’t want to go like Japan, which had the Nikkei going up to 40,000 in 1989 and then fell to one-quarter that level. Of course, it was a very different economy than China, but they don’t want a bubble. And my feeling is that raising interest rates [and] raising taxes is all that they’ve tried to do to slow it down, and I think that they will. They will start raising rates to slow it down, and if it slows down the economy a little bit, that will be all right because they don’t want to face the consequences of a burst bubble.

I think they can stop it. They’ve got to balance the economy — they don’t want to harm the economy too much, but given how strong it is, they wouldn’t mind a little slowing on that side, and they could do a lot [yet] to keep the stock market under control. So I don’t think that it’s an out of control situation for them. That’s what they’re eyeing now.

Knowledge@Wharton: Part of the growth story there is the huge jump in China’s trade surplus, which increased 85% over a year ago. The U.S. continues to urge China to revalue the yuan and import more U.S. goods, especially agricultural products which would help with food inflation. What are the chances that Beijing will let the yuan appreciate more quickly going forward?

Siegel: Well, that’s a tug of war. As you know, I’ve never been real sympathetic with aggressive moves towards China to force them to revalue the yuan. I think that actually could harm the U.S. more than it would help the U.S. They have been a little more flexible in their revaluation of the yuan. It’s been going a little bit faster; that’s all I think they’re going to do. Maybe just a little bit faster — I do not think that they’re going to give in. They’re very scared that if they just let this yuan float in the market, it’s going to go to about 4 to 5 to the dollar and just tremendously disrupt the prices of their exports. Yes, the Chinese consumer is going to be well off… they’re going to buy all of these consumption goods and name brands at much cheaper prices, but they’d prefer to have orderly trade in pricing. So my feeling is that we’re going to continue to make noises, and they may go a little bit faster. But there’s not going to be a radical change in their yuan policy.

Knowledge@Wharton: There was a time when the India rupee was about 47 or 48 to the dollar. In recent weeks the Indian rupee has appreciated to 40 rupees to the dollar. What do you think are the implications for the global competitiveness of Indian firms?

Siegel: This is painful. It’s been the strongest appreciation of the rupee in over 30 years as I look back at some of the data. Basically, they have a big cost advantage. It’s just gotten a little smaller, which is good; it means that they’re going to have to continue to watch costs on exports. I think that they should use this appreciation of the rupee to lower prices to consumers and to encourage the middle class.

This is because everything that they import is 10% to 15% cheaper than it was before. I think even oil has even gone down, perhaps in rupees, over the last 6 months. So, there are good things that come of it for the consumer. My feeling is that India should not move against this. The exporters have had it really good. Let’s give the Indian consumer a break and continue to make sure that the exporters are going to have to stay on their toes as far as competitiveness is concerned.

Knowledge@Wharton: You know the exporters — especially the IT companies, many of which earned dollar-denominated revenues — have been complaining about the impact on earnings. Are there any things that these companies can do to hedge their earning potential?

Siegel: Well, obviously there are hedges that they can put into a foreign exchange market. It’s interesting in that it’s kind of a reflection of what is going on in the U.S. — because of the dollar depreciation, we are getting more for foreign earnings. Their dollars have turned into fewer rupees and they’ve got to pay in rupees. So, again you see the reflection that’s going on here. 

And, by the way, it’s just not India. It’s many of the developing countries in the world. Thailand, in fact, tried to stop the capital from flowing in — that’s a major reason for the appreciation — when they put the big stock tax on about six months ago. And that backfired with a terrible reaction in the market. They then took it off.

The Philippines have had a very strong currency. [India] is not alone; it’s happening to other Southeast Asian countries. Again, the only thing that can be done is to watch your costs very, very carefully and continue to push for efficiency.

Knowledge@Wharton: Should the Reserve Bank of India or the commerce ministry intervene? What is the appropriate role for the government at such a time?

Siegel: My feeling is no, they should not intervene because my historical studies showed that a lot of the 1997 crisis was because currencies did not appreciate. That was during the era of fixed exchange rates in Thailand, Taiwan, Indonesia and the Philippines. And by not letting them appreciate, they actually attracted more capital. By letting it appreciate, people are a little bit more cautious because it looks a little more expensive now. And all of the capital that came in — they couldn’t deploy it favorably, and the result was over-consumption, deficits and then finally devaluation.

So, this is actually, as I say, a much better way. It is painful for the exporters, but look at the other side of the coin — the consumers. Try to emphasize that as a [net] gain: A strong currency is good for a country, it’s not bad for a country. They shouldn’t just be beholden to the exporters. They should listen to the consumers, who are going to gain undoubtedly because of the strong currency.

Knowledge@Wharton: So, just as the exporters are hurt, which sectors of the Indian economy do you think would benefit from the strong rupee, and what would be the right way for India to manage this trade-off?

Siegel: Well, again, the consumer is going to be helped. And you’ve got to make sure that you open up those import markets, that you allow prices to be flexible and give the consumer a break. Balanced growth requires not just pushing exports, but also developing your middle class. And you develop your middle class by passing on some of those price gains that you get through strong currency, to lower their cost of living.

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