The U.S. economy may be getting stronger, but that doesn’t mean interest rates will go up when the Federal Reserve meets next week on January 31. According to Wharton finance professor Jeremy Siegel, interest rates should hold firm at their current level for quite a while, and “the big question for the market is whether there will be any drops at all this year.” He believes there is “a balance in the economy between strength and moderate inflation,” and the Fed is unlikely to move interest rates up or down unless something surprising happens.

If that is true, what strategy should investors adopt in the coming months? In an interview with Knowledge at Wharton, Siegel says he is still “positive about stocks … though the edge of stocks over bonds is not as great as it was three months ago. Anyone planning a longer portfolio preference should still be in equities, and 40% of these should be internationally based.” He warns, however, that investors should be very careful because some areas — such as emerging markets — are now too hot. “China looks like a bubble,” he says. “Shanghai has doubled in just a couple of months.”

Knowledge at Wharton: As the recent announcement of the University of Michigan Consumer Sentiment Index showed, the economy is getting stronger and consumers are noticing that. What is likely to happen at the Fed meeting on January 31st? Do you think that the Fed might raise interest rates? And, if so what will be the affect on stocks?

Siegel: It’s way too early to think about raising interest rates. No, they’re going to hold firm on January 31st. The big question for the market is will there be any drops at all this year, and might there be a rise? We got a rise from Bank of England that was unexpected.  The economy is getting stronger.

My feeling is that we’re going to hold at this rate for quite a while. I think that there’s a balance going on in the economy between strength and yet moderate inflation so that the Fed is not going to act up and down in this and make a very surprising announcement. It won’t be January 31st; it probably will not be until the summer or later.

Knowledge at Wharton: In his testimony before the Senate Budget Committee last week, Fed Chairman Ben Bernanke warned of the dangers of the looming deficits in Social Security and Medicare. Although these comments largely echo the sort of issues that Alan Greenspan often raised when he was the Fed Chairman, are these issues likely to influence the Fed’s decision on interest rates?

Siegel: These are exactly the same long-term issues that Greenspan spoke so frequently about. The Federal Reserve does not want to be in a position where it’s facing huge budget deficits that it’s having trouble financing. Right now the deficits are moderate and the financing capacity is very great.

But in 15 or 20 years, when the baby-boomers retire, the deficits are going to be much more extreme and there may not be the sources of financing. And they don’t want to be in the position of having to finance that debt. That’s very inflationary. So this is standard Central Bank warnings, it’s way in the future. I don’t think that we’re going to get Social Security reform until the next Congress. So, it’s a back burner issue now.

Knowledge at Wharton: Talking about burners, oil has been quite inexpensive. The prices have come down to the 50s — quite a change from the prices that we had earlier last year. What’s your outlook on energy prices? And what do you think their impact will be on the stock market?

Siegel: Yeah, in fact we saw it dip below $50, into the 40s for a few seconds, last week. This is very good news for the consumer. In fact, my feeling is that the lower oil prices are sustaining the economy, in spite of the housing decline. We’re going to speak about that later.

Basically lower oil prices are almost like a tax cut. It increases the disposable income of consumers; it is keeping consumer spending on target. It is very important. It doesn’t have to be in the 40s. I’d like to see it stay in the 50s, and in the low 50s for the next six months or eight months. That could keep the economy on track. Oil is very, very important for the economy.  

Knowledge at Wharton: Since you raised the point of the housing market, is it bouncing back? You expressed surprise in your recent newsletter about the fact that it came in at 1.64 million units, which I guess was 120,000 units more than the previous month.

Siegel: Right, it was a surprise. It was concentrated in multi-family construction mostly, which is five units or more, rental units as well as condominiums. Actually, single family home starts were down. But nonetheless we’ve had two months now of increase. It’s not like anything we had last year. But it suggests that we’re not falling off the biggest cliff in the world — that there might be a bottom soon.

But I don’t think that we’re going to see any — housing is certainly not going to add anything to GDP. It’s a question of whether it’s going to subtract any more than it already has. It has been subtracting, most economists estimate between 1 and 1.5 percentage points from GDP growth. My feeling is that the lower oil prices have been basically adding that back to keep us on a 3% growth.

We’re going to get that growth next January 31st and most estimates that I’m seeing out there are between 3 and 3.5%, which is actually at or even slightly above the average for the last two years. This is pretty surprising again during this housing decline, but not so surprising because we’ve had a concurrent oil price decline and energy price decline.

And, again it’s not just gasoline; it is even more importantly heating oil, natural gas and those derivatives that can be very expensive for people in the winter months.

Knowledge at Wharton: Turning now to the stock market, Tech stocks have been [performing] well above expectations. This is so much so that you recently wrote in your Newsletter that even good news seems to be sort of bad news. What is going on there?

Siegel: Right, the expression is “They are priced to perfection.” Everything has to be right; not only the number itself, that’s got to be at or above, preferably above several cents. The revenues have to be at or above. The forecast has to be at or above. The margin has to be at or above. Everything has to be right.

What is happening is that they’re really taking down these stocks, if any one falls short. They’re being very critical. Part of the run up, I think is the buzz words that the fourth quarter was going to be better than a lot of people expected and it is coming in fine. This week of course is a big, big earnings week. We’ve only gotten maybe 15% of the S&P reporting.

We don’t have a complete picture. They’re coming in all right, but not quite as good as all the rosy expectations. This is particularly in Tech, which has done better than the market recently. We’ll have to see how that comes out — in the next two or three weeks we’ll get the bulk of those. Again, this is no disaster what so ever. This is just a little bit of over expectation and particularly on the Tech stocks causing some problems with them.

Knowledge at Wharton: Last week was an interesting week for politics, with Hillary Clinton and Barack Obama announcing their intentions to form exploratory committees for potential presidential runs. What are the chances of either of them winning the White House, and what will that mean for the markets?

Siegel: It’s hard to predict two years in advance. I mean yes, the election is gearing up, as you know. For the first time in many decades … there’s no natural candidate that can step into this position and so the field is wide open. And, given what the democrats did last November, everyone feels that they have a chance.

Does Hillary have a chance? Does Obama have a chance? Certainly. But it’s way too early to make a call to see how they’re going to come out as candidates. If you remember we all thought that Howard Dean was going to be the candidate. He made a few mistakes and then he was totally out. And then John Kerry rises from the ashes, which no one thought he could have four years ago, and becomes the candidate.

I think that so many people have been burned; I don’t want to say who is going to be the candidate. I do think that the Democrats have an advantage, certainly with Congress. It looks like they’re going to keep Congress two years from now, unless something really [very] bad happens to them or something good happens to the Republicans.

And, we’re getting more and more people who are saying that they will vote for a Democratic president rather than a Republican. But, when you name a few of the Democrats, they’re wary. I mean there are strong feelings about Hillary and strong feelings about Obama. So, in a way, in abstract, you can pick the party but once a face is connected with it, it can be very different. It’s going to be a great race — I think probably the most exciting politics that we have had in many, many years.  

Knowledge at Wharton: I quite agree with you that it’s way too early to predict anything two years out. But, it’s also very interesting that people like Warren Buffett and George Soros have come out in support of [I think] Obama. Are there any immediate signs in the market that you saw in response to these announcements, and how do you read those signs?

Siegel: I saw no real response. Of course, we know that both Buffet and Soros are Democrats. Obama is very attractive in many ways — he’s a new face. People want a new face; they don’t want the same old thing. They want someone really new — that may look at things a different way, that is solution oriented rather than sticking to the old party lines. And so I think that there’s definitely that sort of an outsider look there. Again, it’s going to be exciting.

I think the biggest thing is the fact that the stock market did not respond to the Democratic sweep in November. There was probably two hours of selling the next morning and then it was back up and then subsequently it went too high. They were saying “I don’t like everything about the Democrats, but I can live with them”.

I don’t predict that they are really going to go anti-capital and as far as the market’s response, we don’t have to worry. They may be wrong on that eventually. But that’s what the smart money is saying at the present time and basically I will have to go with it. I think it was a change, not so much against capital and against the markets but against the Iraq War and the way certain policies were handled.

Knowledge at Wharton: Finally, the question the question with which we always end. As we get well into 2007, what is the best strategy for investors in the coming months?

Siegel: Well I’m still positive about stocks and international … for bonds, interest rates have come up. There’s a little more competition right now. I think the edge of stocks over bonds is not as great as what others said it was three months ago, or six months ago. But it still is definitely there.

My feeling is that anyone planning any kind of longer portfolio, preference should still be on equities and international. As we talked about 40% should be internationally based. They have done extremely well. There are some hot areas that are too hot. I would be very careful about emerging markets now.

We have China, which looks like a bubble; even the Chinese officials said that it might be a bubble. They might be coming in to try to regulate that market in Shanghai, which has doubled just in the period of a couple of months. So you have to be very careful. Don’t run after these, but if you set reasonable long-term allocations, I think you will be rewarded in your investments.