The economy seems to be sinking toward recession, with new home sales at their lowest since the early 1990s. Many other indicators are falling as well. Legendary investor Warren Buffett says the country is already in a recession, and that it will be worse than most people expect. But at the same time, inflation is picking up. Some Americans are paying $4 for a gallon of gas, and they are coming home from the supermarket with sticker shock.

All this puts the Federal Reserve in a tough position. By cutting interest rates, the Fed can stimulate the economy. But cutting too much can make inflation worse. At the same time, the financial markets are all atwitter. Investors wonder whether the credit crisis will ever end.

With the market this nervous, the spotlight on the Fed is especially intense. Today, the Fed deemed recession the bigger worry and cut short-term interest rates by a quarter of a percentage point, from 2.25% to 2%. Was this the right choice? How will it affect the financial markets, and will it help the economy or hurt it? Should investors bet on a stock market rebound or should they hide on the sidelines. Knowledge at Wharton put these questions to Wharton finance professor Jeremy Siegel, author of The Future for Investors.

Knowledge at Wharton: The Fed reduced interest rates by a quarter of a percentage point, not very much. What does that mean?

Siegel: Frankly, I was a little disappointed. I was hoping that they would come down harder on the inflation. The market certainly expected them to cut a quarter of a percentage point; it was about a 4 to 1 odds, as calculated from the Futures Market, that they would. I would have preferred them giving a little “shock therapy” to break the inflationary psychology in the bubble that we have in commodity markets, by holding firm.

Absent that, I would have preferred a stronger statement that the cumulative reductions that have taken place, over the last six to eight months, which has certainly been more than 3 percentage points, was sufficient to stimulate the economy — and that any further cuts would run the risk of higher inflation. They gave some hints to that in the statement – but I would have hoped that that statement would have been stronger.

Knowledge at Wharton: So you think that inflation is a bigger concern than it was a few months ago?

Siegel: I think that inflation is now the bigger concern to the economy. I think that with the rebate checks going out, with some normality coming back to the markets — housing is still in the tank, to be sure — but, as we heard this morning, the GDP in the first quarter was positive. Most economists think that there will be positive growth also for the second quarter. The risk now is that runaway energy prices will offset the stimulatory affect of the rebates. I think that if the Fed had been a little firmer, they could have broken all of those speculators that are running into commodities and running out of the dollar — both of these things are happening at once and I think are exacerbating the inflationary psychology.

Knowledge at Wharton: The commodity prices have just been soaring. Anyone watching oil or going to the gas pump knows that, and supermarket prices are going up. We’re reading stories now about food prices that are going up all around the world and there are even food riots in some places. A lot of people attribute this to demand from China and India and other developing economies. Are high commodity prices something that we’re just going to have to get used to, or is this something that will come down?

Siegel: We don’t really have world markets in many of these commodities. There are so many restrictions that are put on by governments. Recently, seven or eight governments have blocked many exports to try to keep commodities within the countries. There is a whole network of subsidies, taxes and quotas. And so, sometimes, you just don’t get the right amount of food to the right place in these markets.

That being said, there is increased demand around the world. With the inflationary psychology and all the money saying, “Hey, I’m going to chase whatever trade is out there that I can touch and feel, like food and gold and particularly energy,” you have a psychology there of hoarding; you have a psychology of upward prices. That will eventually come to an end, but it could inflict some substantial damage before it finally winds down.

Knowledge at Wharton: You mentioned earlier new home sales or the home market in general. We saw some numbers the other day, that prices tumbled nearly 13% in the last 12 months, according to one of the surveys. How important is the housing pullback to what’s going on in the economy and the financial markets?

Siegel: It’s very important. I’ve been down in Florida, three or four times, just in the last month, and, boy the devastation there is just something to behold  in terms of prices going down much more than the 12% -15% national average. In many cases, we are talking about 25-30%, and there are even stories of banks selling foreclosed properties for 50% and even more off of previous prices.

Then again, there is a lot of regionalityto it. Florida is particularly vulnerable. So are Las Vegas, Southern California and Phoenix. Other areas, particularly Philadelphia… we got the news today that we have among the lowest foreclosures in the entire country. There hasn’t been much of a bubble. Portland is holding out well, Charlotte is holding out well. There are a number of areas that aren’t affected.

But where there had been a lot of speculation – that has certainly hurt. And, combined with the psychology of higher gas prices — these are two visible things for the consumer — we are getting consumer expectations and sentiment at nearly record lows. It was surprising that real consumer spending actually rose by 1% in the first quarter. I’m hopeful that it will do so in the second quarter. But again, this negative psychology will make it a very, very tough pull. 

Knowledge at Wharton: When investors find that their stocks have fallen by 10% or 15%, they are usually told to just “suck it up and live with it — and wait for them to rebound and that that is what life is like for investors.” Many people, in the last few years, have been treating their homes as investments rather than as homes. Why is it so much more devastating for them to see a 10% or 15% drop in a home price than it is in their stock or mutual fund portfolio?

Siegel: This is because they have never seen that before. The average American has not experienced a decline in his or her home values. The truth of it is this has happened in the past. Actually, Los Angeles had a 25% to 30% decline from 1989-1990 all the way to 1995 — and then it began soaring again. Most people consider their home to be something that was rock solid and that would not go down.

The shock of that … you buy a $300,000, $400,00 home — most people don’t own that much in stocks — so a 10% decline hurts an awful lot more because of the huge amount of equity and levered equity. Many people might have lost everything if they had rolled over their equity into a higher priced home – and now with the declines. some of them have had their equity wiped out. This is very difficult.

Knowledge at Wharton: We haven’t seen that kind of thing in the stock market since the margin rates changed after the Great Crash. Is that right?

Siegel: We did see a 50% decline actually from the peak of the bubble in March of 2000, all the way to October 2002 and it hurt those people speculating in the Internet [companies]. We all know that a number of people were badly hurt there. But they retreated to their home as something that this couldn’t happen to and they failed to realize that we were in a bubble on the home prices also and that it was unsustainable. This was obviously fed by the fact that the lenders were able to give loans against this. So you had a whole medley of problems that came together at once to make this much worse.

Knowledge at Wharton: Lots of people are worried about the falling dollar. It’s been falling for some time and it’s making oil and other imported goods more expensive for Americans. But on the other hand, it’s good for U.S. exports. We hear. “Well, that’s the other side of the coin.” Which is more important? Which way should we be rooting?

Siegel: There are some people who definitely love the low dollar. If you’re an exporter, you love the low dollar. If you’re a multi-national, taking in many or most of your sales abroad, you’re taking the foreign currency and translating that into dollars — that’s very good. It’s interesting, through the first quarter, we now have most of the earnings of the S&P in. Outside of the financial sector, it’s been very good. And again, the multinationals are getting double digit gains from a year ago, despite the fact that we’re virtually at a GDP stall in the economy.

But, to answer your question: net, we’re all consumers. Although there are some firms that gain and there are exporters who gain, we all consume energy, we all consume food and we all consume imported goods to one extent or another. Those are all going up in price, and economists will tell you that the negative from that outweighs the positives such as what comes from earnings and exports.

And so, netwe would prefer to have a strong dollar. It does not help us net to have the weak dollar. And, I think, I’m not one that says that you should peg it in exchanged markets. But I think that the Fed should have acknowledged that problem — [the falling dollar] along with the rising commodity prices — to try to bring about a reversal of the inflationary psychology that is being accompanied with these Fed moves.

Knowledge at Wharton: Tomorrow is the beginning of May and, according to the government, the rebate checks from the stimulus package will start flowing. People will have $600 or $1,200, or even more if they have children, to spend. Is this going to have the stimulative affect on the economy that the proponents thought that it would?

Siegel: I think it will have a stimulative effect, although I sometimes think that it is all going to go to gasoline, due to increasing gasoline products and maybe not into any other products — if we see some of these recent gains continue. Most economists are talking about a gain in consumption that will give us a growth of maybe 2% to 2.5% in GDP in this current second quarter and third quarter.

The problem is that those checks are going to stop. And then you wonder, will the economy get on its legs a bit for the fourth quarter? I’m optimistic about that and I think there will be factors that will bring about a stronger economy. But there will be a negative shock coming late into the third quarter and fourth quarter from these. It turned out, you know, we economists often say, “Oh, fiscal policy, this is never timed right, there’s too much of a delay.”  Interestingly enough, this is coming at the right time. Congress acted relatively quickly and the economy is still weak. So,, this stimulus package is coming at the right time and, when combined with the Fed package, should really help stabilize the economy.

And as soon as we — as I think is going to happen — get our hands on these write- downs and the housing prices, this will bring about a base for recovery in the second half of the year.

Knowledge at Wharton: Do you think that we’ve heard most of the bad news from the credit crunch, these write-downs and those types of things, or is there a lot more to come?

Siegel: I think the official write-downs are around $350 billion of all the banks everywhere. We have the IMF talking about losses of $1 trillion, although, it seemed like that was home losses as well; it wasn’t all in credit instruments…  In March, April, May and June, it’s going to be bad and we’re going to get reports on that. But a lot of people seem to say that right now, with the interest rates going down and if the recession doesn’t grow worse, that this will produce a bottom somewhere toward the middle and end of the year.

In fact some shrewd observers are talking about write-ups in the second half of the year, that some of the credits might actually improve in value a bit. And that will certainly help the financial sector, which has been so beaten down. So, I think yes… if I were to answer the question — ‘Is the worst over?’ — I would say yes. Even though we’re going to get a few write-downs, in terms of actually thinking towards these financials, we’re going to get some smart money beginning to move into these depressed assets and instruments.

Knowledge at Wharton: Lots of investors look at the ratio between stock prices and corporate earnings for a general measure of the risks of the stock market. What are those price to earnings ratios telling us now?

Siegel: They are telling us a couple of things. If you look at reported earnings which include all of the write-downs of the corporations and the financials — we’re 18 to 20 on a price range ratio, which is on the high side, not prohibitively and certainly not as high as we had in March of 2000, where we reached 30, 40 and in the technologies sometimes 100 times earnings. So we’re not any where near as inflated as we were back then.

On the basis of normalized operating earnings which eliminate the write-offs, we’re at a very conservative 14, 15 times earnings. So if one thinks that the financial firms, after the write-downs are over, will recover most of their earnings power and therefore supply a boost to the S&P — we’re at an extremely reasonable price to earnings ratio. I think that is one reason why you see a stability in the market today. It is that people realize that at these very low interest rates, even with the depressed earnings, you have real value there in the stock market.

Even Warren Buffett, though he thinks that a recession is certainly here and that it’s not going away soon, said that he has found that there are more values today in the market than he has [seen] in the recent past. 

Knowledge at Wharton: What do you expect to see in corporate earnings for the second quarter?

Siegel: I think that again, basically, what we are seeing is good gains outside of the financials. There will be a few more write-downs in financials, but I think that they are going to be over by the end of the second quarter. Then you are going to see the financials recover quite a bit. If gasoline prices continue to rise and all prices rise, consumer discretionary [spending] might be hurt a bit going forward. It’s my own feeling that the biggest threat is still going to be rising energy prices. I think that the housing story has mostly played itself out. That’s why I think it’s so important that the Fed pursue policies that will help bring down the energy prices and pop the commodity bubble and the inflationary psychology that has been so pervasive over the last several months. 

Knowledge at Wharton: I’d like to get to the usual final question. We’ve seen a little bit of a boost in the stock market recently, recovering some of the losses that it has had this year. For long-term investors, people saving for their kids’ college or for their own retirement, they may still be pretty nervous. What should they be doing?

Siegel: Well, I guess as author of the book Stocks for the Long Run, I’m still optimistic long-run. [That’s] because again, not only are prices reasonable, with respect to earnings, but with respect to alternatives out there. Bonds offer no value to me. I think that they are risky going forward. We’re getting yields of 1% over inflation and that’s on long-term; on short-term, less than inflation. There’s no competition from fixed income. I think that real estate still has a way to go. Generally, commodities are very high priced.

So, looking at long-term values, I really think that stocks stand alone in being valued at or near their long-term historical values which in today’s market is very attractive relative to the other asset classes. It’s interesting … we hear about the market, the market is only down about 8% or 9% from its all-time high last October. It’s hard to believe it was down almost 20% and it has come back more than half that way. It wouldn’t have reacted so well if a lot of people didn’t think that there is still true value there in the market. I think that they are right.

Knowledge at Wharton: You have been arguing for a long time that Americans should be diversified worldwide in stocks, talking figures as high as 40% of the stock portfolio. What’s your view of that in today’s market?

Siegel: Well, again, more than half the world’s equity capital is outside the United States. I tell all long-term investors “Don’t worry about the dollar.” The dollar might show some strength and we might be at a bottom. But in the long run, just buy where the world’s equity is. We know that more and more, the equity is going to be outside of the United States. I still recommend 40% there and just as a matter of diversification.

If you try to outsmart the dollar and say, “I’m going to wait until the dollar goes up 10% or 20%” — you’ll find yourself never going into the international market because you’ll always be worried about the dollar. My feeling is that this is as good a time. In fact, Europe is more reasonably valued than the U.S. with 11 and 12 PE ratios. The emerging markets — with China coming down and India coming down — are also quite reasonably valuednow.

Knowledge at Wharton: Well, a lot of optimistic advice from you. Thank you very much Professor Siegel.

Siegel: Thank you.