U.S. stocks boomed in the last nine months of 2009, but remained well below earlier highs. Indeed, many people referred to the first 10 years of the 21st century as “the lost decade,” because stocks returned virtually nothing while investors had been conditioned to expect 10% a year. Meanwhile, bonds and commodities experienced a stunning run. Have the rules of investing changed? What’s ahead for 2010? Knowledge at Wharton talked with Wharton finance professor Jeremy Siegel, who sees some hazards, especially for bonds, but expects a good year for stocks.
Knowledge at Wharton: Stocks have had an incredible run in the last nine months, giving 2009 a pretty good gain. Is this what we can expect for the future? And what has caused this?
Jeremy Siegel: It shouldn’t be a surprise. We dodged a very severe bullet when the financial crisis hit worldwide. It started out very much like the Great Depression in the early 1930s. But in contrast to the Great Depression, central banks around the world rallied to the cause, providing enough liquidity to prevent a collapse of the financial system. It was doubtful whether they would be able to do that earlier last year, which is why we saw the stock market down some 58% from its high. Now that we avoided [a repeat of the Great Depression] — and I can say that with about 98% confidence — the market has moved up substantially — and justifiably — from the abyss we were looking into.
Knowledge at Wharton: When you look at the indices — for example, the S&P 500 — and at data like price-to-earnings (PE) ratios, what are they telling you right now?
Siegel: We had a severe hit to earnings. Certainly, the financial sector was a major cause of that. Before the recession, in 2007, we had earnings on the S&P 500 that were in the $90-per-share range. That fell to around $30 a share at the bottom. Most of that was due to the financials, which had severe, multibillion dollar losses. Those minus signs cancelled out a lot of the profits in other sectors.
We are looking forward to much better earnings this year. Consensus forecasts are around $70 a share on the S&P 500. I think it might even be higher. Take, for example, a PE ratio of 15, which is the long-run average — and we can talk about whether that’s appropriate or not. Fifteen times 70 is 1,050. We’re at 1,100, or a few points above that. So we are now in the range of an average valuation for this year’s earnings.
Knowledge at Wharton: Is a 15 PE ratio still appropriate? Or have things changed?
Siegel: My research shows that when interest rates and inflation are as low as they are now, the average post-World War II PE ratio has been 18 to 20. One might say that as long as we don’t get a sharp increase in interest rates, the fair valuation of the stock market is higher than what we see today. A second very important factor is that 2010 is just one year out from the most severe recession in the post-war period. It’s nowhere near what I would even consider normal earnings. If we go back in history, we have usually matched, if not surpassed, the previous peak in earnings after four years or so. As I mentioned, in 2007 we had $92 a share. That won’t be hit in 2010. It might not even be hit in 2011. But history tells us that by 2012, we should be in the $90 range or even above. So, if you apply normal ratios — 15 or 16, let’s say — to $90 a share, you still end up considerably higher than we are today.
Knowledge at Wharton: If you add on top of that a ratio of 18, you would go even higher.
Siegel: That’s true, if interest rates stay low. As I’m sure we’re going to discuss later, I don’t think they’re going to stay as low as they are now, although I don’t picture a severe ratcheting up of rates.
Knowledge at Wharton: Let’s discuss it now. One thing many people have commented on is the great run that the bond market has had in recent years. A lot of that has been driven by the price gains caused by falling interest rates. What do you see happening with interest rates and bonds?
Siegel: That bull market ended in the first quarter of last year, when we got the long bond [rate] down to 2%, which was crazy but it was a depression hedge rate. In other words, people were saying, “I need this. I want my treasuries in case the world collapses.” Now that the world has not collapsed and is recovering, we see the long bond moving toward 4%.
It was a good decade for the long bond, to say the least. But 2009 was a bad year for Treasury bonds. I don’t see it being a good year in 2010 either, because the Fed will be forced to raise interest rates sooner rather than later. We will see bond rates move higher.
Knowledge at Wharton: Is this good news for people who are fixed-income investors or retired, or care about interest earnings?
Siegel: It is. We all know we’re sitting on our money funds, and earning infinitesimally little income. We’re not going to experience the double digits, or even high single digit interest rates, that we did in the 1970s. But we don’t want that. That was associated with very high inflation. We’re going to move toward normal interest rates, which is going to be very good for savers. For borrowers, it’s going to be tougher.
Knowledge at Wharton: Higher yields are wonderful as long as you’re not losing out to inflation. What is inflation going to do?
Siegel: Inflation is going to be under control this year and probably into 2011. However, we will have an upward tilt to inflation, which means the longer-run trends point to a 2%-to-4% range of inflation rather than zero to two, which unofficially is what most central banks and the Fed have targeted. So we’re going to have low to moderate inflation, not double digit or even high single digit.
The scaremongers, who worry that the ton of money the Fed created to fight off the crisis is going to fuel the next [period of] inflation, are wrong. At the same time, we will have a slight upward tilt in our inflation rate from what we’ve had over previous years.
Knowledge at Wharton: But the 2%-to-4% range is standard over the long run, right?
Siegel: It’s not. I remember when I was studying economics, we talked about what a victory it would be if we could get down to between 2% and 4%. We’ve been spoiled with very low rates. Most central banks use zero to two. They come closer to two.
We’ll move closer to between 2% and 4%, particularly in the United States, given the large deficits that we have and the liquidity that was created. But just as Bernanke acted very responsibly in providing the liquidity necessary to prevent [a repeat of] the Great Depression, he is also an excellent enough economist to know that money is what fuels inflation. The Fed is really solely responsible for inflation. He will not let it go above five, and probably not even four. He will raise interest rates to whatever level is necessary if inflation starts running into the mid-single digits or higher.
Knowledge at Wharton: When we talk about inflation, we also often talk about commodities. There has been a pretty good run in some commodities, especially gold. What do you see happening there?
Siegel: The commodities cycle has followed the world economy. It had hit its low very close to the same time the stock market did. Everyone was looking at a very severe recession that could get worse and commodities — except maybe gold — are dependent on economic activity, particularly oil, which is the most important one. Now that the world markets have recovered, we see oil has recovered. I wish [the price per barrel] could have stayed down in the 60s. It has moved up to the 80s, partly because of the very cold weather we’ve been having in the northeast [in the U.S.]. It’s boosting demand for fuel. I would love to see it in the $70-to-$80 per-barrel range.
I believe commodities are fully priced. Gold … is priced for an inflationary scenario that is much worse than will be realized. Those who fear that all the paper money and liquidity that have been created will fuel hyperinflation have been moving into gold. Speculators have moved into gold. The trends are up. But gold is a risky investment now…. Gold is not going to be a good investment throughout 2010 and the longer term.
Knowledge at Wharton: Looking at the economy and the financial markets as a whole, what are the big dangers that could derail things?
Siegel: I worry about commodity prices getting out of hand. I would be disturbed if oil got to $100 [a barrel] or above. That would put a dent in our recovery, but not squelch it entirely. At this juncture, I don’t fear over-regulation. Not that I like everything that’s happening in Washington, but I don’t see anything on that front that is really going to squelch the recovery.
Over the Christmas break, I was in China and Hong Kong, and Asia is very much back on the road to recovery. That [region], of course, has been the major driver of economic growth around the world over the last several years. So this recovery has a very sound basis. It is really a worldwide recovery in the economy. It will continue into this year.
Knowledge at Wharton: The China story is especially intriguing. It seems to have rebounded wonderfully. Of course, their system is very different from ours, and I’m wondering whether there are lessons that the West can draw from China.
Siegel: There are a lot of differences. One of the differences is they have over $1 trillion in the piggy bank and we don’t have anything. China has such high savings ratios that it can start spending. We spend with deficits, and then worry about deficits and rising interest rates. China has a lot more flexibility. When it saw foreign demand dry up, it boosted domestic demand and infrastructure, which it is still building apace. It has the flexibility to move.
When you have the size deficits we have, you just don’t have as much flexibility, because every dollar the government spends means a dollar of extra deficit and future taxes, which scares investors and consumers. China doesn’t have that situation. As a result, it was able to withstand the world recession better than most other countries.
Knowledge at Wharton: In the U.S., the deficit is the elephant in the room. How important is it that we tackle the deficit, and how soon does that have to be done?
Siegel: Two-thirds of the deficit is caused by the recession. As the recession wanes, tax revenues will bounce back. Some spending will decline — unemployment insurance, etc. We will move to a more manageable deficit as a result of the economic recovery. The big 800-pound elephant in the room is really Medicare and, to a lesser extent, Social Security, which aren’t [addressed] at all in the long run. They amount to multitrillion dollar liabilities, which unfortunately I don’t think Obama’s health plan has really tackled. But the big multitrillion dollar liabilities were here in 2007, when we were at the top of the boom. They were here in 2005 and earlier…. The problem is that although we are able to run this size deficit in a recession, as the recession wanes, we can’t run this size of deficit.
Such deficits will drive interest rates way too high, and the government will be forced to pull back. For the long run, unfortunately, we haven’t solved our problems. But for the short run, this deficit isn’t something that will derail the expansion, because we’ve had a tremendous decline in domestic credit creation. The increased savings by consumers has to go somewhere, and it’s going into the government debt.
All this government deficit, which is over $1 trillion, is being very easily absorbed, because there’s been no private credit creation. As the economy improves and there’s more private credit creation … the government deficit won’t be able to be absorbed as easily. But as the economy improves, fortunately, the size of the deficit itself will go down, because tax revenues will rise. So the big 800-pound elephants in the long run are still there, but I do not believe this deficit is going to derail the economic recovery.
Knowledge at Wharton: Coming back to stocks, a lot of people have been calling the first 10 years of this century “the lost decade.” I’m wondering if comparing prices today versus 10 years ago is fair. There’s quite a big difference in PE ratios from 1999 to 2009. If we were to do a 10-year span starting a couple years later, it would be an easier comparison to make. What is the best way to gauge the long-term performance of the market? Should it be over 10-year, or longer, periods?
Siegel: Unfortunately, we hit the bubble peak in the first quarter of 2000. I’m going back 10 years ago to the technology and Internet boom. This decade got measured from the very top. The Dow Jones peaked in January 2000, the S&P in March 2000. And, by the way, the 1990s followed an extraordinary decade of the 1980s. The reason why the last 10 years have been bad is that we had two decades of extraordinary record returns. Usually a very good decade is followed by a less good decade, back and forth. We had never had two double-digit return decades as we did in the 1980s and 1990s.
The result was that the market simply got way too high. The last decade has offset the excesses reached in the 1990s. It shouldn’t be viewed as a template for what’s going to happen as we get into this new decade. We’re back to normal. My analysis shows we’re even slightly below normal [since] this decade has been so bad. [This decade was] slightly worse [for stocks] than the 1930s. When we look at the long run, we are much more confident that we’re back into the normal range of equity returns. Long run [equity returns are] 6% to 7% per year after inflation. With this decade correcting the excesses of the 1990s, there’s no reason why we can’t be back in that zone of normal returns.
Knowledge at Wharton: When we look at the stock market, we tend to look at the S&P 500 and the Dow. But there are lots of other indices. I’m particularly interested in small company or mid-sized stocks and foreign stocks. Do you have any thoughts on the health of those?
Siegel: I’ve been a big fan of international, and I still am. I’m a big fan of emerging markets. You should be in international, emerging and U.S. stocks. The revenues and profits of much of the S&P 500 — in excess of 40% now — come from overseas. You’ve got to take a global view on equities. A broad index I like to look at is the Russell 3000, [for the 3,000 largest, most liquid stocks traded in the U.S.].
Small stocks have done very well in the last month. They had a very good December, and they have held out well. They often do very well early in recoveries. They should not be ignored. You’ve got to take a global, comprehensive approach to your stock investing.
Knowledge at Wharton: How much of an American investor’s portfolio should be devoted to small and foreign stocks?
Siegel: My feeling is that you should have about 40% of your investment in foreign stocks. I wouldn’t mind it split between the EFA [shares in countries in Europe, the Far East and Australasia] and emerging markets. One adviser asked me what I thought about him having his clients in one-third U.S., one-third EFA and one-third emerging markets. I said it’s very aggressive, but I like it. Over half the world’s equity capital is outside the United States. That fraction is growing. You have to take a global view.
Knowledge at Wharton: That 40% — that’s of the equity portion of a portfolio, not the entire portfolio, which also includes bonds?
Siegel: This is the equity portion. People ask me about what fraction [of a portfolio] stocks or bonds should be. I don’t recommend that because it varies with each individual’s financial circumstances. You can’t generalize. It depends on your age, your other assets, what kind of income and pensions you’re expecting…. You have to talk to your financial adviser about what [your allocation] should be. Let me just say that given the low interest rates and what I see for the recovery and earnings for stocks, stocks are going to be much more rewarding over the next few years than the fixed-income part of a portfolio.
Knowledge at Wharton: That takes us to our usual final question, asking for a bit of forecasting. What can we hope for in 2010 in the stock market, and are stocks still the best bet for the long run?
Siegel: We’re going to have a good year. The main factor that stocks are going to deal with is that the Federal Reserve, in my opinion, is going to be forced to raise interest rates earlier than the consensus now expects. Many people are talking about no increase in 2010, all the way into 2011. I don’t think that’s going to happen. The recovery is going to be stronger than expected. The Fed is will have to act sooner. At first, this [will lead to a] kind of panic among stock investors. There will probably be a correction in the market.
But then, investors will say, “Just a minute. They’re only raising interest rates because the economy’s so good, and profits are better” — and [stocks will] regain their footing. So it will be another positive year in stocks. I’m not saying it’s going to be as good as the 22% or so that we had in 2009. But I see no reason why we can’t have another 10% gain in equities.
Knowledge at Wharton: And bonds?
Siegel: I don’t think bonds are going to have a good year. The risk premium has gone down a lot. I did like corporates, and risky corporates a little bit better. But those risk premiums have shrunk dramatically from where they were earlier last year. I don’t think any long-term bond portfolio looks to get good returns in 2010.
Knowledge at Wharton: Stocks are still good to hold for the long term?
Siegel: Stocks are going to be the place to be, not only in the long run, but also over the next 12 months.
