Some media reports called it a Valentine’s Day gift to Wall Street. When Federal Reserve chairman Ben Bernanke appeared before Congress on February 14 and 15, he gave an upbeat view of inflation and the economy, setting off a strong rally in stocks. The Dow Jones industrial average rose 87 points to 12,741.86. Bernanke told Congress that the economy seems to be moving to a slower but more sustainable rate of growth, which suggests that the Fed will hold short-term interest rates steady at 5.25%, where they have been since last summer. Will stocks continue to perform strongly? Knowledge at Wharton talked to Wharton finance professor Jeremy Siegel, who predicted in his last podcast that the Fed was unlikely to raise interest rates anytime soon.
Knowledge at Wharton: So, you were right. When Ben Bernanke went before the U.S. Senate Committee on Banking, Housing and Urban Affairs last week, he said that the Fed would most likely hold interest rates steady for some time. Did you agree with his overall assessment of the economy?
Siegel: Oh yes, I think that Bernanke gave a strong presentation. Even the Democrats, who wanted to needle him a little bit on some of the issues, some of them said that he did very, very well. Again, this is his first appearance before a Democratic Congress, and it looks like that might be the case for some time. So, he’s going to have to get used to those sorts of questions.
No news is good news; no “new” news is good news. This followed exactly what the Fed had been saying. [Bernanke] really is following in the footsteps of Greenspan. Again, he’s a quick learner. He knows how to handle the political constraints that he is under. More and more, I am impressed with him and think that he was certainly a most excellent choice for the Fed.
Knowledge at Wharton: What, in your view, is the outlook for stocks? Will they remain strong?
Siegel: We’ve had an unbelievable run. It was reported, I think a couple of weeks ago, in USA Today actually, that it’s been over 50 years [since] we have gone such a long period without the Dow Jones Industrial Average having at least a 2% reaction. It’s really been incredible since July; it’s just been straight up.
And, those things break one time or another. The interesting thing is that it can break upward as well as it can break downward. I think that the trends are still intact for an upward movement. We’re getting some softness — we may talk a little bit more about that later. But, as long as interest rates come down and stay down with that, stocks can remain firm.
Knowledge at Wharton: Like stocks, bonds also rallied last week. In fact, you wrote in your newsletter that housing starts have come in much lower than expected, industrial production is slower and retail sales are softening as well, and that with inflation under control, this triggered a bond rally. Is that likely to continue?
Siegel: I think so. I think that we are getting some softness in the indicators. Last week, jobless claims, industrial production, even consumer expectations were on the weak side …. We’re going to get, in the next couple weeks, some more indicators, to see whether this slow-down is going to be sustained or move forward.
Most people still think that this quarter is going to be 2.5% to 3%. The big news is that last quarter, which was originally at 3.5%, looks now like it’s going to be revised all the way down to around 2%. So, we’re sort of stuck in a 2-2.5% range, which is below what the Fed considers long-run potential. That eases capacity constraints, eases pressure on the labor market, and I think that this could probably lead to lower interest rates.
Knowledge at Wharton: So, is there anything in the economy that is worrying you? Are you concerned about the trade deficit or about jobless claims?
Siegel: I’m not worried about the trade deficit. I’ve said that there are long-term reasons why that will be in deficit. Actually, last quarter was almost a turnaround quarter; we may start to see a little bit of an improvement there. I also don’t think that a housing situation is going to snowball into a severe downturn.
Yes, housing starts were lower, but we’re also seeing some fascinating news from the world-class cities, such as Manhattan and London, that prices have started up again and have sometimes even surpassed the peaks that they reached a year and a half ago. So, there is a lot of underlining demand. I’ve talked to realtors who say that once you reduce the prices, you do get demand. I think that we’re going to stabilize around 1.4 million as a housing start and work off the excess inventory.
Knowledge at Wharton: I wonder if you could talk about the international situation a little bit. In our last podcast, you had told us about your concerns with the Chinese stock market. More recently there have been reports — in fact, The Economist had a cover story about this — that India was getting overheated. What do you think will happen with India?
Siegel: Yes, I did read that. I don’t know if I agree wholeheartedly with them. What they are talking about is that they do need a lot of infrastructure change [in India] and there is worry about moving too fast on some fronts and not on the others. But, my experience is that happened in China, too. Different parts move at different paces. I think that both China and India can move forward.
[The Economist] threw out a number — 7% — as what they thought was sustainable growth [for India]. Of course, China is 8% to 10%. But for India, they didn’t explain how they got that. There are a lot of underemployed, unemployed resources in both China and India that can be brought into play to keep that growth at a rapid pace for a while. Yes, infrastructure has to be done. I think that everyone recognizes that there are some reforms that have to be done. But, I’m not sure that will really slow the pace or whether they’re in a bubble that is unsustainable.
Knowledge at Wharton: On February 8th, Fortress Investment Group became the first U.S. hedge fund investment manager to go public. Considering that the stock shot up dramatically on the first day of trading, do you expect more hedge funds to go public, and will this make hedge funds any more transparent?
Siegel: I think part of their mystique is that they’re not transparent. Maybe if they told us what it was, they wouldn’t go as high as they do. You know, when there’s only one thing around as a play, it will go to a premium — a new thing like this — because people will want to hold it and they’ll want to trade it. There’s liquidity there, and it will move to the premium.
Ultimately, it [depends on] what kind of returns they deliver. My feeling is that the fee structure on hedge funds is, although justified for some — there are very good people out there, there are some not-so-good people out there — they’re not going to justify some of those fees. And when you read of a few disappointments, that will knock the premium out.
We don’t know when that will happen. It could be in a week or two, or it could be in six months, or a year. But my feeling is that this sort of excitement about investment media is very cyclical.
Knowledge at Wharton: A little bit more on hedge funds. There’s been a lot of talk about the need to regulate them more. But there have also been some very interesting reports recently that hedge funds are becoming very actively involved in financing the campaigns of the various presidential candidates.
In fact, speaking of Fortress Investment Group, I believe that John Edwards used to be a consultant to them, until he resigned after he declared his candidacy. Do you think that with all of these efforts that the hedge funds are making, that it’s going to make it harder for them to be regulated in the future?
Siegel: Well, I am not a big fan of the regulation of hedge funds. I’m not too certain that they represent a threat to the financial system, even if they’re all on one side of the market or not. I’m one of those people that are very caveat emptor. You have to have a certain amount of wealth to get into them. You’ve got to understand the risks, and my feeling is that you take the risks and you have to suffer with the consequences.
Could they precipitate a crisis? Not with the Fed on top of it. The Fed can diffuse any crisis. If everyone gets on one side of the market and things are out of control, the Fed is the ultimate source of liquidity. I think that they can prevent that from spinning out of control. So at this particular point, let people follow those paths that they think are most profitable.
Knowledge at Wharton: Let’s end with our usual question: Considering everything that’s going on, what is the best strategy for investors in the coming weeks?
Siegel: Well, again for the long-term investors, I would stand pat. I still like stocks, I still like international stocks. I might shade down a little bit with REIT’s. The Real Estate Investment Trusts have had an incredible boom. I’m not saying that they are going to bust particularly, but if you have some good capital gains in those, I would sort of spread them towards international stocks and big cap stocks, which I still think give good value and are positioned for good returns for investors.
