Though stock market volatility continues to rattle investors’ nerves, the future looks bright for equities in the U.S. and many emerging markets, according to Wharton finance professor Jeremy Siegel. That’s not so for bonds, which could become money-losing investments as rising interest rates drive bond prices down. In an interview with Knowledge at Wharton, Siegel says that investors should think about reducing their bond holdings, buying more stocks and keeping just enough cash for a rainy day and other liquidity needs, since interest rates on cash are near zero. With the housing market — so critical to the U.S. economy — clearly improving, anyone who has held off buying a home should think about buying now while prices and mortgage rates are low, Siegel adds. 

An edited transcript of the conversation is below.

Knowledge at Wharton: There’s been a lot of volatility in the stock market in the last few days. I wonder if you could give us a quick assessment of what’s going on.

Siegel: Well, that seems to be the description of the market over the last five years — periods of volatility. We have the uncertainty with the sequester [and] the developments in Italy, which are really more surprising and shocking to the market. That’s thrown a little scare in it. I still think that the fundamentals are very strong and that they will overcome these negative risks.

Knowledge at Wharton: Let’s talk about the sequester. It’s coming up very soon, a couple of days. Does that really matter? Is it as important to the real economy as people say it is? And how would that be reflected in the stock market?

Siegel: There’s a lot of scare stories about what’s going to happen. And it’s hard for me to get the amount of actual dollars, which the experts say is probably going to [add up to] $50 billion this year…. It’s a tiny, tiny fraction, really, of GDP. Most of the forecasters I’ve seen say if the full sequester this year takes effect, we’ll see probably a quarter or a half a point off of GDP. Although that’s not insignificant, we have momentum going in our economy — and particularly with the housing market, which I think is the key to the recovery — that I think could more than overcome that deficit from the sequester.

Knowledge at Wharton: Europe and the problems in Italy and the broader problems we’ve been seeing for some time in Europe — how much are those affecting us?

Siegel: I’ve been on record saying that the euro is way too high. When it got up to 137 it was sort of crazy. It’s down now to 130. But I think that [European Central Bank president Mario] Draghi is going to have to both talk down the euro and lower those interest rates, because Europe is in trouble. It’s going to be slow growth for a long time. So, we’re going to see more stimulus from the European Central Bank here. Draghi has pledged — and I believe him — to prevent any general banking crisis. He’s going to step in and provide that liquidity. So that big fear that really dominated the market last year and even the year before, first with Greece and then with Spain, is mostly gone. [We’re dealing] with very, very slow growth. That’s mostly been factored into the market. I think stimulus by the ECB in terms of a lower euro and lower rates will help that situation somewhat, so it won’t be a drag on U.S. markets.

Knowledge at Wharton: Now with U.S. markets, I read the other day that although the big indexes, the S&P and the Dow, are getting back close to their highs of about a decade ago, some of the fundamentals are looking pretty good, better than they did back then, like the price-earnings ratio. What are you seeing there?

Siegel: Exactly. And by the way, some of the other indices, the small stock indices, the Russell 2000, the mid-cap indices are at all time highs. So it’s not just a few stocks that are really driving this market. I think what’s really important is a couple of things. We hit the all-time high in October 2007, and it was almost the same as where we were in January of 2000, 12 years ago. The huge difference is that 12 years ago, we were selling at 30 times earnings. Now we’re selling at 15 times earnings and actually, looking forward, 14 times earnings. That’s a world of difference. Earnings are at all-time highs.

Dividends … were cut dramatically during the financial crisis by the financial firms and others…. Financial firms haven’t come back to the levels they were before, but other firms have raised their dividends so much that in the last quarter and this quarter, we’re at the all-time high in dividends. So, the fundamentals supporting this market, this high, are so much stronger than what we had in 2007 or in 2000.

Knowledge at Wharton: And let’s look at the bond market. Of course it’s been very generous to people in recent decades. But now interest rates are so low it’s inconceivable [they could] go much lower, and the risk of rate increases and price declines seems high. Or is that too pessimistic?

Siegel: Well, I will admit that I thought the bond market would turn around last year and the year before. But when we look back at July, when we got down to 1.39, I think, on the ten year note — I was giving a lecture yesterday, and I said that years from now, we’ll look back and say July of 2012 was the low on those interest rates. And we will also say, “How did it ever get so low?” And what that means is there’s definitely risk in the market for long-term bond holders. It’s going to affect the treasuries the most. But high-grade corporate bonds, any long-term instrument, mortgage bonds, will be affected. So the future there, to me, looks not good.

It is a — what should we call it — a risk asset that people like to hold when everything else is in tumult. It’s an insurance policy. But I describe it as one of the most expensive insurance policies you can now buy. And I don’t think it’s worth the price. It’ll be a huge drag on your portfolio if you hold long-term bonds.

Knowledge at Wharton: You wonder whether you’re just as well off putting your money in a bank account with FDIC insurance.

Siegel: Better in a bank account because you won’t get the capital loss. But we know banks are yielding a half a percent or less. So cash is not attractive. What I think is going to be happening is that people, seeing that the world is not ending — and of course there were so many fears of that the last three years — are going to get their feet wet in the stock market again, into dividend-paying stocks that are offering 2%, 3%, 4% and more in some cases, because they need income. We need income, portfolios need income. And you can’t get it from the bond market with the risk there. And certainly cash is almost zero now.

Knowledge at Wharton: Do you think that at these valuations in the stock market, the risk of buying dividend-paying stocks for income is acceptable?

Siegel: Absolutely acceptable. The good thing about the dividend-paying stocks is, first of all you have stocks, which are real assets if we have some inflation. I think we’re going to have 2%, 3% maybe 4%. That’s a sweet spot for stocks. Corporations do well with that. It gives them pricing power. Their assets move up with prices. I’m not fearful of that inflation. What I don’t like is inflation at 5%, 6%, 7%. I don’t think we’re going to get that. So this sort of mild inflation is really the ideal environment for people to go into those dividend-paying stocks because those dividend payments over time — and we have a lot of evidence — have risen one to 2% above the inflation rate on average over the last 60 years.

Now I will admit, if you find one that’s 10%, be cautious. It probably will not be able to maintain its dividends. But one thing is very interesting. The percentage of S&P firms paying dividends is rising now. For years it was falling. It was a sign you didn’t have anything better to do with your money. Now, when the demand for those [dividends] are there, we see a rising trend. So we have about 350 to 400 dividend paying stocks in the S&P 500. We have about 200 that are paying 2.5%, 3% and more. You can get a very diversified portfolio. And if you want to go abroad, they’re even much more dividend paying than they are in the United States. They pay out a much higher fraction of their earnings as dividends. So go international.

Knowledge at Wharton: You have been an advocate of going international for a long time, holding a fairly large percentage of your portfolio in stocks from around the world. Is that still the case? Is it on the risky end of the spectrum or the safer end of the spectrum right now?

Siegel: I think really worldwide stocks are a buy. I was cautious about Europe. Europe is selling at 10 and 11 price range ratio, so a lot of risk is there. If you stick with the exporters, those companies that have a global reach, and the euro goes down, they’re going to be helped because they’re going to become much more competitive. So there are definitely values in Europe. And as you know, I’ve been a big fan of the emerging markets. Right now, the PE ratios of most emerging markets are 10 to 15. You have a few in the high teens, but that’s a very reasonable price historically to pay for the type of growth that they have engineered over the last five and 10 years. Honestly, I still think they’re going to be the engine of growth over the next decade.

Knowledge at Wharton: Investors for a long time have been told that one of the keys to success is asset allocation — the mix of stocks, bonds and cash and the subcategories. But with stocks at fairly good valuations, as you say, and bonds looking very risky and yielding almost nothing, and cash yielding almost nothing, should people be adjusting from those sort of standard guidelines of asset allocation?

Siegel: Most definitely. People say, “Jeremy, do you hold any bonds?” And I say, “The only bonds I’ve held over the years and years and years is junk bonds.” And even they’ve become a little expensive, but you know, I just roll over and reinvest my interest there. That’s the only bond part of my portfolio. I always have some cash, just for liquidity purposes. But as for an investment purpose, outside of a little chunk that rolls over in junk bonds, no extra bonds. I’m very enthusiastic about stocks. I’m not enthusiastic about gold because I think gold is priced for either hyperinflation or the end of the world. Neither of those two eventualities, in my opinion, is going to happen. I think commodities are expensive. Oil is expensive.

So really, stocks, properties — now, you know, there are some good values in real estates. REITs are very high, but they still should be part of your portfolio. In some investment properties, if people want to go into the liquid sides, it’s fine. And of course if anyone is waiting to buy that home and lock in that mortgage rate, now is the time, and definitely that would be an advisable purchase to make. But as far as the liquid part of your portfolio, the vast majority should be in stocks now.

Knowledge at Wharton: The housing market has been a big drag on the economy for years. But we’re seeing just an endless cadence now of good news. And the latest Case-Shiller news yesterday was quite positive. I think it was a 7% gain or something like that for a year.

Siegel: Almost 7%, year over year, which is the most since the crisis began. We had some metropolitan areas like Phoenix rise year, 20% to 25%. Now, that’s a lot of bottom feeders, investors that went in picking up foreclosed and auctioned properties at very low price. But there is no question the bottom has been reached. The trend is up. And I think the trend on home prices will continue quite strong over the next year. And I think that’s going to be one of the biggest pluses in the economy. We get through the sequester, and there might be some negotiations there to actually lessen the impact. We get through the European crisis, and again, the second half of this year could be much stronger than most people expect.

Knowledge at Wharton: The money that people are reluctant to put into bond investments, would it make sense to put that into your home or a new home, a bigger home or paying down your mortgage or any of those strategies?

Siegel: Well, right now you should probably think of refinancing, if you haven’t yet, from a higher rate. If you always wanted a second home and have the wherewithal, here’s the time to get it and finance it. In terms of buying properties, you’re off the bottom; if you know a lot about properties and you want to put some dollars there, I certainly wouldn’t object. But I still think those opportunities are going to be in the stock market.

Stocks are earning 6%, 7%, 8% off their capital base. And that’s a great earnings rate in a zero interest rate world. In fact, I find that the average price-earnings ratio of stocks when you’re in a low to moderate interest rate environment, or still in an extremely low interest rate environment, is 19. So you know, being a PE ratio of 14 or 15, depending on how you measure, is still well below the average valuation in a low to moderate interest rate environment. So I still think the opportunities are there in the stock market.

Knowledge at Wharton: So let’s just wrap up with a question: What do you think the stock market is likely to do for the rest of this year? And then over five and ten years?

Siegel: I stuck my neck out early last year and was on record saying that I thought by the end of 2013, the Dow would reach and exceed 15,000. And a chance of 17,000.

Knowledge at Wharton: And it’s a little below 14,000 right now.

Siegel: Yes, just skirting around 14,000 right now. I still feel very confident about the 15,000. 17,000 might be a stretch, but not out of the question. I mean if some of these clouds begin to part and people finally say, “Hey, now there’s still value in the market,” I can see it between 16,000 and 17,000 by the end of the year. I mean, that would be a great year. But I think we will have a good year this year.

Knowledge at Wharton: And you see good times rolling on after that in the next five years?

Siegel: Yes. [Stocks are] not overpriced, and I think we’re going to get an economy that’s going to go from subnormal growth of 1% to 2% to good growth of 3% to 4% by the end of this year and into 2014.

Knowledge at Wharton: Well, let’s hope it all transpires that way. Thank you very much.