The government’s rescue of Fannie Mae, Freddie Mac and AIG demonstrated clearly that the financial turmoil continues on Wall Street. In an interview with Knowledge at Wharton, Wharton finance professor Jeremy Siegel says there are some positive signals in stocks and corporate earnings, but it’s too soon to say the market has hit bottom. Siegel also talked about inflation and commodities. An edited transcript of the conversation follows.
Knowledge at Wharton: The financial crisis continues on Wall Street and stocks are in turmoil. We asked Wharton finance professor Jeremy Siegel about the key factors driving today’s market and what’s ahead. Welcome, Professor Siegel.
Siegel: I’m happy to be here.
Knowledge at Wharton: Well, the markets are just crazy. A few days ago, they were down 500 points, the biggest drop since 2001. And, yesterday, they were up 140 points; though the Fed decided not to cut interest rates. Why is it that the Stock Market can’t decide which way to go?
Siegel: Yesterday, it was much more important that AIG get solved than whether the Fed cuts 50 basis points. And, that is basically why it did actually fall during the day at about 100 points, when they didn’t lower it. But, then when there were rumors of the deal coming through on AIG, it rallied at about 200, 250. It was much more important to salvage the liquidity of the financial system.
But, the news is fast and furious. Which is the next one to go? What do these balance sheets look like? I mean with so much news coming in, it’s not surprising that we are getting all of this volatility.
Knowledge at Wharton: When you look at the markets, there’s an endless blizzard of statistics. I mean when you look at the employment numbers, the inflation numbers and on and on and on. What figures or data should we really be focusing on?
Siegel: There is the economic data and then there is the financial data. The economic data indicates a mild recession. And in fact, some might not really think it is a recession — certainly a slow down, but we have had much more severe ones than this. The financial data has been unprecedented because of what we have had — with some of the biggest investment banks in the world having taken leveraged positions with assets that they believed were safe and sound and they were not.
We never had a real estate bubble to the extent that we have had over the last two or three years — and never did the financial industry go as heavily into that bubble as they did. And, that combination combined with excessive leverage has proved toxic.
Knowledge at Wharton: Is it your sense that we are closer to the end of this drama or are we still somewhere in the beginning, or is it that we just can’t tell?
Siegel: People are asking “Which inning are we in?” and others are saying “Just a minute, we’re in a double header.” It just keeps on going. I honestly had thought that last July we had seen the worst of it and probably even with Bear Stearns. The question is: How many of these financial institutions have these bad assets on their balance sheets? Now, again, the bad assets so far are still confined, by and large, to real estate.
What happened with Lehman Brothers was that not only did they have bad mortgage backed securities, they actually had real estate. They were trying to flip real estate. They bought some of it at the peak and they thought that they could get rid of it. So, in some cases, it was not just the mortgage backed securities; it was a very leveraged position in an overblown real estate market. And, until you really know to what extent other financial institutions have gotten involved in this, it’s hard to know which firms are going to be in trouble next.
Let me say however, the firms that have kept their head and did not get involved in this, they are going to do very well – and are doing very well.
Knowledge at Wharton: This would be Goldman Sachs, for example.
Siegel: Goldman Sachs was lucky enough to offset some of its purchases of the mortgage backed securities with a short position that offset it and it has survived. And, there are other banks that did go into it, but in a much more minimal way, like JP Morgan and several others. Wells Fargo increased its dividend. And that was good… California Bank… it was very tempting to go into this… mortgage-related assets, so the question is to what extent you bought and leveraged the mortgage backed securities and real estate. One of the problems is that the claims are so complicated for these tranches of these mortgage backed securities that they are all being discounted in the marketplace, even the good ones and even the performing ones.
If you call yourself a tranche of a mortgage backed security, you’re going to go at a 20% to 30% discount, even if you’re paying perfectly. Now, that will be rectified in time; but right now of course, no one wants to touch these. We see the imperfections in these and as a result, we’ve got hundreds of billions of dollars that are probably discounted below their true economic value.
Knowledge at Wharton: We always look at the S&P 500 as the chief gauge of the stock market. And, the big number is that it’s down, I think something like 16% this year.
Siegel: 25% actually from the all time high and this was actually just touched last October.
Knowledge at Wharton: Right. However, there are a lot of stocks in there. Can you just talk a little about looking inside it? There are different sectors of it. Are there certain sectors who are weighing it down and others that are doing well? Do you get a different picture of its health when you look at in detail?
Siegel: Certainly the financial sector has been the poorest performing, by far. Interestingly enough, energy had been doing extraordinarily well, we’re talking about 8 weeks ago, on July 15th, oil hit $147; yesterday, it dropped below $90. All commodities have come down. Actually, I was looking at the energy component of the S&P 500 — it was actually down more than the S&P as of yesterday. There’s been a little bit of a bounce in oil today. But, yes there is a big difference.
Health care which has been hammered a lot on expectations that a Democrat-strengthened Congress is going to bang health care, has actually started performing relatively well. But, all sectors are basically down. Energy was bucking the trend and now with energy down basically all sectors are low. I mean consumer staples are always a little bit more stable and they are holding their own a little bit better. And, as I said health care is now doing a little bit better. But, when you are in a recession, really virtually all firms fail.
The S&P 500 as you know holds the top firms; it’s the top 75%-80% of market value. So, there is still the Small Stock Index which has been holding up fairly well. It’s down on the year, but not down as much. So, if you are holding both small stocks and mid-sized stocks along with the large stocks, you’ve cushioned yourself a bit from this bear market.
Knowledge at Wharton: Corporate earnings are always essential to stock prices. What do you see happening with corporate earnings over the next quarter and in the next year or so?
Siegel: What’s interesting about the S&P 500 earnings, and certainly they’re going to be way down this year, is that there are only two sectors that are down year to date and that is of course financials, way, way down and consumer discretionary earnings. Now, the interesting thing about consumer discretionary earnings is that they are down and this is because of two companies, Ford and GM, taking huge losses. If you take out these two companies, consumer discretionary is up.
Nine of the ten sectors have higher earnings to date in 2008 than they did in 2007. But, with the financial sector being virtually crushed, I mean down 70%-80%, you know overall earnings are going to be down. But one has to be aware of that. There is a lot of distortion now in earnings.
And, by the way, it’s a statistical property and that is when there’s greater dispersion, when you have a few firms with huge losses and other firms that are doing all right, those losses get added into the gains and it looks like the P/E ratio gets really high, but it’s only because of the statistics of how actually aggregate P/Es are computed. So again, it’s a mixed message. Stocks are down across the board pretty much. But it’s only the auto makers and the financials that are really suffering earnings wise.
Knowledge at Wharton: What’s happened to the P/E ratio?
Siegel: P/E ratios, if you take out the financials, which have been discounted a lot, are very reasonable. If you add all of the losses of the financials then you will get P/E ratios that are 18 to 20. And, people will say “Oh, that’s not cheap.” You know, 10 is cheap.
But again you get this distortion because you are adding a few firms over here like Fannie Mae and Freddie Mac, AIG and Lehman Brothers. I mean these companies have virtually no market value; and they have tens of billions of dollars of losses. And, they are going to scoop out the earnings of all of the good companies that are in the S&P and this makes you look like you don’t have a lot of aggregate earnings.
But, when you separate it out, you actually find that the P/E ratio is really quite reasonable. It’s really at 14 or 15, if you do the separation. If you look in Europe, P/E ratios are 10 to 11. Even in Japan, which has for years been at a way too high P/E ratios, is down to the 15 to 18 range. Emerging markets are now down to reasonable levels. Again, once you take out these distortions, and especially compared to what interest rates you can get on the outside of these very risky mortgage backed securities and several others, you have what I think is a very attractive comparison of equities versus bonds.
Now, I’ve said that before at Knowledge at Wharton and I just think that it’s getting even more stretched at the current time. I mean, one thing is very important; there is beginning to be discrimination among the financials. The big commercial banks are actually up any where from 30%, to 40% to 50% from their July 15th low. They’ve taken their hits, they have access to the Fed, and they are going to grow bigger.
Because of the folding of Merrill Lynch and the Bank of America — we are going to see the commercial banks getting bigger. They have access to the Fed and the Fed is going to lend to them at 2% and the spreads are enormous now. So, any bank that doesn’t have this toxic real estate — I think they are going to have a field day coming up in the future. And, I think that some of the smart investors realize that. And, that is why you see a lot of selective buying that is moving into some of these stronger commercial banks. The investment banks that have done all of this leveraging, I mean clearly, they are the ones that are in trouble.
Knowledge at Wharton: Speaking of spreads, yesterday the yield on the London Interbank offered rate just jumped. Can you tell us what that’s all about?
Siegel: Well, again, there’s fear of… you know London Interbank is….what are banks lending each other to? And, if there’s going to be a crisis that extends to the banking system and then overnight, you’re not sure whether you’re going to get the money back; so you add what is called a risk premium on top of that — and that shot up the London Interbank rate.
What’s good is that the Federal Reserve and its responsibility in the U.S. is that the interbank rate of borrowing is actually much closer to the Fed funds rate, which is the rate that banks lend to each other. And, the Fed added $50 billion in reserves to keep that Fed funds rate at 2%. I heard that the ECB (European Central Bank) also tried to pump in some reserves to get the rate down on that.
So, the central banks are now going to flood. And, in there, with liquidity, whenever there’s this uncertainty — we saw the spike in July, we saw the spike in March again when Bear Stearns went under. We’re seeing the spike now with the problems with AIG. Actually, the spread between the Libor rate and the Fed — and what is called the OIS [Overnight Index Swap] actually had stabilized for a long period of time before this latest flare up.
So, there was actually some hope that they were getting their hands on these premiums that are being developed. But, this is really what the central bank is for: Short term interest rates and making sure that there’s enough liquidity in the bank to get those interest rates down. I’m not overly concerned that that’s going to cause a major crisis. This is because that’s something that the central banks can act on much more directly.
Knowledge at Wharton: Now, we have the government takeover of AIG, essentially overnight. And, on the other hand, the other day, they did not help out with Lehman Brothers. So, what is going on here? Are they picking and choosing? Or, is it that they can’t decide what to do?
Siegel: There are a lot of things going on. Actually, the interesting comparison is Bear Stearns and Lehman Brothers because they were more similar. Why did Bear Stearns get it? Because it was early on and there was a lot of panic then when Bear Stearns was going… They can also make the argument that with Lehman Brothers that they had the primary credit borrowing facility in place. It had just been put in place almost the week-end before and Bear Stearns didn’t have a chance to access it. Lehman Brothers did have the chance to access it.
Actually, Lehman could have gotten short term borrowing if they were losing….trading and counter parties. But, the problem with Lehman’s balance sheet and this was also true with Bear Stearns, although Bearn Stearns also had a run on the bank, so to speak–and the problem was that they were involved in real estate and direct holding of real estate that they had bought trying to flip a year ago and now it’s on their balance sheets, and they wrote it down just a little bit. Dick Fuld [Lehman Brothers] said “Oh yeah, we wrote it down.” They didn’t write it down enough and when people really knew what that stuff was worth and how levered they were on that they just said “Hey, there’s no net worth left over here.”
Knowledge at Wharton: Then, AIG is just another case of too big to fail?
Siegel: AIG is much bigger to the markets than Lehman Brothers was. AIG was involved in what is called the default swap market. This was a big strong insurance company that was actually selling insurance against the risks of other corporations who were going to default on their debt.
So, here you’re with an insurance company and all of a sudden, you’re worried about… just a minute, “AIG was the strongest one and they may not come up.” Think about the panic if it’s an insurance company, if you think that it’s going to go under and that it’s not going to pay off. And, the credit default market is absolutely huge. Now, maybe it should have been brought under some regulation or not. But, we’re talking about trillions of dollars of credit swaps. Now, not all of that was AIG.
But when the Fed took a look at that market worldwide — they saw systemic risk and this as being a real problem. I’m not surprised. Actually, I was predicting yesterday morning that AIG is going to have to be taken over. They can let Lehman go, but AIG has to be taken over. And, by the way, when you talk about bailing out, it’s really important to make clear that AIG is selling for what, a couple bucks.
Really, the shareholders and all of this shareholder equity is being gutted. The government is going to get anything if anything is left. So, it’s not like “Oh boy, they’ve bailed us out and everything is okay.” We’re talking about a huge… you know this was a $100 billion equity plus company that now has equity of you know $1 billion or $2 billion, even if it survives — and it might not even have that. And the government is taking 80% of the upside. So, in a way, they’ve gutted it out. It’s not a free pass to AIG.
Lehman Brothers, clearly that’s dismantled and parts of it have been absorbed by Barclays and elsewhere. Similar things could happen to AIG and also Bear Stearns; you know they got bought by JP Morgan. Again, technically, they were bailed out but all of these are in a very… you know they’re just being stripped of whatever their earnings assets are. There is really very little left in terms of the original shareholder equity in the firms.
Knowledge at Wharton: When we’ve talked over recent months, you’ve often expressed some concern about high oil prices and high gasoline prices and how that could affect consumers. We are now heading toward the holiday season which is critical to consumer spending and yet, we’re seeing oil below $100 and gasoline below $4. Is inflation a worry? Is consumer spending likely to pick up or what?
Siegel: Well, this is the good side of the global slowdown. It’s this bubble in commodities which I had thought was a huge threat. It has broken and that is a huge factor because I did some calculations that suggested that if oil stayed at $135 a barrel it was going to shave 2 percentage points off of GDP and that is huge. Now that it’s back down to $90, we’re going to get back to 1 to 1.5. Now, again this is on top of all of the financial market turmoil. But, this is a cushion economically that we have.
As for inflationary expectations, we saw the CPI actually lowered. It’s going to be lower again probably by the end of the year. I really don’t think that that’s a concern anymore and that’s very, very important. The Fed could have moved down on inflation circumstances. They want to save their ammunition in case there’s another problem. Basically, that is I think, one reason why I think they wanted to keep a few more bullets in their holster, yesterday.
And, they knew that with AIG… they were working out the AIG data, with Ben Bernanke that was the major thing. If they feel that they have to go down from 2% to 1.5% in an emergency meeting, then they don’t have to wait until the October meeting; they can do that at any time. But, this is the good side – the fact that world energy prices are moving to more reasonable levels.
Knowledge at Wharton: Well, what is your bet for the stock market for the rest of this year and in 2009?
Siegel: I think that what’s important again is that the chaos we see in the market, as a result of bad investments that I-banks and some commercial banks and insurance companies had made, in the past, this doesn’t reflect that people aren’t buying their services. I mean Merrill Lynch, all of their brokerage services and investment advice and everything like that — we think of this as the reason for going bankrupt- because no one wants to buy what they have for sale. But, that’s not what’s causing the problem.
So, as I had mentioned in Tuesday’s Op-Ed piece in the Wall Street Journal, the financial landscape is changing, but the demand for financial services is going to survive. The names are going to change and they made really stupid mistakes. But again, looking forward, financial services are going to be important in our world in the next ten years, even more so than in the past. Worldwide capital flows and everything, I mean once we get over these bad real estate investments, I think that the future looks good.
Knowledge at Wharton: And, the S&P 500 is it going to be up?
Siegel: Well, I don’t think that it will be up this year unless we have a tremendous rally from September to December. Calling a bottom, I think that right now, we are going to be forming a bottom. But, no one can predict and you know I thought that July 15th was the bottom. We went a little bit below it yesterday and it looks like this morning we are too. But, it’s searching for a bottom and with low interest rates and lower energy prices and once that people see that it is not spreading; all we need is a few weeks of calm to return and I think that we have a very good base for a rally in the market. I won’t make an absolute prediction there but, I think that the long term values are definitely there.
Knowledge at Wharton: And so, the final question, as always,for the small investor is sticking with stocks for the long run still the strategy to follow?
Siegel: As some say, it’s too late to sell. One thing that I think is also important is again, this is a bear market, but not a huge one. You know we had a 50% bear market from March of 2000 up to October of 2002. This is 20% to 25%. Some people think that it is getting worse and I don’t. Listen, it’s part of the 200-year history of the U.S. Stock Market. And, if you go back 200 years, has it been right to sell in the bear markets? The answer is no. You take the pain, you hold your position, and you will be rewarded in the future.
Knowledge at Wharton: Well, we know one thing, it will change a lot in the next few weeks and we’ll be back to talk about it. Thank you very much.
Siegel: Thank you too.