Wharton finance professor Jeremy Siegel says the drop in U.S. stock markets that began last Friday is a temporary correction, largely in response to events in China and unusually large, downward revisions in U.S. corporate earnings expectations. But while the correction so far has hovered around 10%, he warns that such downward movement often generates a rebound, which is already is underway, followed by a further drop. In this Knowledge at Wharton interview, Siegel says he thinks the Dow ultimately could drop 15% from recent highs before recovering to around 19,000 by year-end. What’s happening now is a correction — not the beginning of a bear market — which would be a drop of around 20% or more, he notes.
An edited transcript follows.
Knowledge at Wharton: I want to welcome Jeremy Siegel, a finance professor here at Wharton, and we’re going to talk about the recent turmoil in markets around the world.
Just as a quick context, I want to note that U.S. stock futures are up, pointing to a positive opening today. Stocks seem to be rebounding from the big drop on Monday, when they saw the biggest drop in four years. European stocks had their worst day in seven years. I would also note that commodities are at a 16-year low, and on Tuesday in China, it was a down market day as well. The Shanghai index was down about 7%. What’s going on out there?
Jeremy Siegel: China is a major story, and the decline in China, which everyone believes is far worse than they officially have admitted to, is really putting downward pressure on commodities and on oil and I think that’s important to note. Many people said, “Yeah, but Jeremy, we’re an importer of oil. Don’t lower oil prices help the United States?” And the answer is yes, it does.… So yes, the U.S. economy is helped, but many of these oil suppliers and owners of the reserves are going to be hurt.
“If you look at the history [of stocks], when there’s a sharp decline and then a rally, usually you’ll get another downward leg that will test that decline.”
The slowdown in China, the drop in oil prices and the tremendous rise in the Dow [Jones Industrial Average] have put tremendous pressure on the earnings of corporations. In fact, the earnings revisions downward this year in 2015 have been the steepest I have ever seen outside of a recession — down about 10% to 15%. So three weeks ago, I looked at this market and I said, “It isn’t going anywhere. I think we’re going to finally have the first real correction in four years.” And indeed, with yesterday’s drop, we breached the 10% limit of a correction, and we have one.
Knowledge at Wharton: Is this a correction, which is usually thought of as a drop of 10%, or is it going all the way to a bear market, which is 20%?
Siegel: I don’t think it’s going to get to a bear market. I think we’re going to see maybe a 15% [decline] — and by the way, we all know how hard it is to actually say how much it’s going to be. I predicted about 12% to 15%. This morning will be less than 10% with a rally, but , when there’s a sharp decline and then a rally, usually you’ll get another downward leg that will test that decline. So if you’re a short-term trader — and it’s very hazardous to be one — I don’t know if this rally is going to last that long before we test the lows. But as far as a bear market is concerned, since I don’t see a recession in the United States, I don’t think we’re going to have a bear market.
Knowledge at Wharton: So what would your advice be for investors given your outlook?
Siegel: Definitely long run, I’m favorable. In fact, when I gave that bearish prediction on CNBC several weeks ago, I said the fourth quarter could be very, very good [once] we get September out of the way. Of course, three weeks ago everyone thought September was going to be the date the Fed was going to move [to raise rates]. Now that probability has gone way down, although not to zero. There’s still almost a month until that decision is to be made, but I said that once that is out of the way and if we could get stability in oil and in the Dow, we could see a very good fourth quarter that in fact could bring us to new highs in the market. The two other years that we had corrections — in 2010 and 2011 — we actually saw very, very good fourth quarters develop after that.
Knowledge at Wharton: You mentioned at the outset that China is central to everything that’s happening, so what do you think is happening in China? What are the implications for the U.S.?
Siegel: One of the problems for world investors today is they’ve lost confidence in the Chinese government’s ability to control and guide their economy. It was always thought [that] when there was a downturn, the Chinese would pour money in one way or another and things would get straightened out. But they’ve been [caught] left-footed and awkward with the stock market. They first talked it up above what it should have been, and then it started going down, and then they made some desperate attempts to repair it.
“One of the problems for world investors today is they’ve lost confidence in the Chinese government’s ability to control and guide their economy.”
They’ve now cut the reserve [requirements for banks] and lowered the interest rate. They have some silver bullets in their holster, in contrast to the U.S., Europe and Japan, who have interest rates down to zero. Their interest rates are still 5% and they have a lot [of room to] cut … to actually encourage the market. But there has been this feeling that they have just not done this well, and there’s a loss of confidence in China and its ability to control the markets and I think that is perhaps just as important — if not more important — than the slowdown in economic activity.
A lot of people think that China is really only growing at 3% or 4% right now instead of the official 7% that came out in the last quarter. Something else that’s a little disturbing about China is that in the earlier years, China would grow because of … tremendous growth in productivity. Now they seem to have to build bridges and dams and all the rest. They want to stimulate consumer [spending], but the only way you’re going to stimulate the consumer is with productivity [gains]. They’re trying to get the consumer to buy more, and he and she is not doing that, so they’re sort of doing a last-resort type of stimulus. All these things are adding to this idea that China — which is either the biggest economy in the world or the second to the United States, we’re just about co-equal — is faltering, and that obviously is going to effect world outlook.
Knowledge at Wharton: Well, it’s interesting you say that people are worried that the Chinese authorities may have lost control. Does that mean China may be going more capitalist?
Siegel: There was talk of a move towards a yuan or renminbi that would be more flexible, although believe it or not, all they’ve done after the 2% devaluation is they fixed it again versus the Dow. They haven’t really freed that up. I thought their restrictions on short sales [did not make sense as well]. You don’t want to invest in any market that will prevent you from selling when you want. Liquidity, if they knew anything, is one of the prime reasons people like to buy assets — and if they don’t have liquidity, they’re going to be discounted. This idea of “we’re not going to let big holders sell; we’re going to prohibit short sales” and all those restrictions … was the wrong prescription … and also engendered a loss of confidence in Chinese management.
Knowledge at Wharton: Is what’s happening in global equity markets to some extent recognizing that markets got overbought too far ahead of what global fundamentals are? We know that China’s growth is slowing, and emerging markets have been slowing a lot as well.
“Emerging markets are in bear market territory. There’s just no question about that.”
Siegel: Certainly, we’ve had an incredible sell off. Emerging markets are in bear market territory. There’s just no question about that. … Right now, people who have the guts to go in — and there could be more volatility — are going to be pleased because the currencies have been battered as well as the stock markets.
The best performing economy is now India because it’s not commodity-based. Because China has gone down, every emerging market that has commodities as a major part of exports is being hit, and of course there’s even some developed countries like Australia — or take a look at Canada; take a look at the Canadian dollar, which has depreciated almost 30%. It’s basically a petro currency now. The Australian dollar is down and the Australian stock market is down, because so much of the minerals and the mining and all those raw materials that China used to build up its infrastructure are down. But if you take a look at India, which has had some quarters of 7% growth and they are importers of oil and raw materials, they may be the new leader in the next four, five, six years in emerging markets. They have more people in the world than any other. They don’t have the GDP that China does, but they certainly are now the one country that is holding the banner for the emerging markets.
Knowledge at Wharton: In addition to India, which countries would you recommend people invest in, and which sectors?
Siegel: I haven’t been one generally to recommend countries or … sectors because I like to look at the macro approach and my belief is that the broader your portfolio is in the long run, the better off you will be. Take even the Chinese economy. With the decline that it has suffered, its price-to-earnings ratios are now back to 12, 13, 14. Not unreasonable at all. The emerging markets are selling for about 13, 14 times earnings as a group.
“My feeling is that we definitely could get to Dow 19,000.”
Brazil has been battered badly. It could, again, turn around even though they have problems. Remember, if you play individual countries, [you don’t buy ones] that have the best story but those who have had the worst story that everyone now is giving up on. Brazil is probably going to come back. They’re in maximum tension now with the raw materials situation and politically with the corruption that’s going on there. They could be a winner in the next three to five years. [But again,] I don’t pick countries.
There are many emerging market funds that you can diversify in — and yields to emerging markets, by the way, are very, very good. You can get 3% to 4% yields on diversified portfolios — I’m talking about dividend yields. I think they are attractive now. I’m increasing my allocation in general to the emerging markets.
Knowledge at Wharton: Where do you think the Dow will be at the end of this year?
Siegel: My feeling is that we definitely could get to Dow 19,000. It certainly seems like that’s far away but we’ve had 20% increases from the sell-offs in late August and September. Don’t forget, late August and September are historically weak months. … Summer is over; we’ve got all these bills. The kids are going back to school, we have no liquidity, the days are getting shorter. … September is the only month that has negative returns, including dividends, going all the way back 100 years. It’s the worst month in the market, and that has sort of moved to August because everyone now fears September. They start selling at the end of August.