U.S. stocks ended 2018 skimming bear market territory. In the new year, the market has bounced back somewhat but remains volatile. This week, Wharton finance professor Jeremy Siegel joined the Knowledge at Wharton show on SiriusXM to discuss the market outlook, Fed rate hikes and the impact of the U.S.-China trade war. He is also co-host of the show “Behind the Markets” on Wharton Business Radio every Friday. Siegel was joined by Gad Allon, who is director of the Jerome Fisher Program in Management and Technology at Wharton and also professor of operations, information and decisions.
An edited transcript of the conversation follows.
Knowledge at Wharton: As we continue our 2019 look-ahead series we are going to focus on the markets, which have been on a rollercoaster ride the last few months. The Dow Jones Industrial Average ended up seeing a decline of more than 10% last year. Both the Nasdaq and the S&P 500 saw declines as well. The factors that led to some of this uncertainty are still in place including the U.S. trade war with China, and President Trump’s open disagreement with the Federal Reserve’s decision to raise interest rates, among other things. So what should we expect in the markets in 2019?
Jeremy Siegel: Now let’s review last year. I predicted zero to 10% return on the market, and during almost all of the year people said, ‘Jeremy, you are far too pessimistic.’ Then all of a sudden, bang, we had that near bear market. It didn’t quite get down to that 20% on the S&P from top to bottom. But I think it overreacted.
Let me say that I do think the last hike of the Federal Reserve was a mistake. I wouldn’t have [done it], but it’s not a fatal mistake. It was a close decision. But I was very encouraged, as the market was, by last Monday’s employment report [for December], which certainly dispelled any sort of immediate worries. Now the employment report is what we call a coincident indicator; it is not a leading indicator. So it is not predictive of weakness, but it does show you that we certainly didn’t end 2018 on what we would call a recession.
Given all of that, the market is selling for about 16 times last year’s earnings. That is the S&P 500. So even if earnings don’t increase at all — which is well below expectations — 16 is a very reasonable multiple, especially in a low-interest rate environment. And I don’t think the Fed is going to be tightening at all this year, or only if the economy turns out to be very strong, and only at the end of the year.
Knowledge at Wharton: That has been the question, whether there potentially could be two increases in rates or even whether there would be none.
Siegel: I wouldn’t have done the December [rate hike]. Will they take it back? Only if there is a lot more weakness. Otherwise they will be on hold — and again, they may be on hold for the whole year.
But my feeling is that the bond market, which is really where so much of the important sentiment is located, has told the Fed: ‘You tightened enough, if not more than enough.’ So it is saying ‘you’ve got to slow down,’ and I think now [Fed Chairman Jerome] Powell and the Fed are going to listen to that.
Knowledge at Wharton: Also joining us is Gad Allon, professor of operations, information, and decisions here at the Wharton School. Give us your thoughts on what you saw on Wall Street and the performance of some companies in the last few months of 2018, and maybe where we’re headed in 2019.
Gad Allon: I am not an expert on the financial markets per se, but as I look at the tech firms, specifically how in the last few years the tech firms were really the main engine that was driving the S&P, and I am worried about some of these firms — specifically after I look at the last few months, and even more so the last few days, and some of the indicators that we saw there.
For example, I am terribly worried by the last announcement by Apple [cutting projections on sales and earnings]. I think it has long-term implications – on firms doing business in China, selling in China, and having a supply chain heavily skewed towards China.
The entire tech supply chain in many ways is powered by the consumer side, but if you go downstream and you see firms like [chip designers and manufacturers] Qualcomm and Applied Materials, [they could be affected too]. So I am a little bit less optimistic than Prof. Siegel on what is going to happen in the future, primarily because I am looking at some of these firms, and I am worried about the implications.
Siegel: The saving part about that is that Apple is not priced like Netflix or Amazon. It is priced at a very reasonable P/E ratio. It is almost priced as not really a tech firm, but almost like a consumer discretionary firm.
I agree, the slowdown is serious. [Apple CEO Tim] Cook should have warned earlier. There were signals that they were not going to make their projections there and I think a lot of the smart money began to know it, and that is why Apple was under pressure for so long even before that announcement. But right now, at today’s multiple, you don’t need it to become another super growth company. It is selling at a really reasonable [multiple] times earnings.
Now some of the other firms you mentioned are really leveraged in this slowdown, and I agree with you, there is a source of concern there. But I mean maybe Apple has another 10, 20 points on the downside but I think there is innovation at Apple. I was listening [to the news] this morning and someone said, ‘Clorox only has a 3% expectation of growth and it is selling for 20 times earnings,’ and Apple is at 10 [times earnings]. So in a way it is selling almost like a consumer stock.
Allon: That brings me to the point of why I am maybe not worried about Apple per se, but I am worried about the entire market — the worry is deeper than just one firm. I think one implication of what we see, and if you read a little bit into the announcement [by Apple], is the fact that many firms are building [their business growth] off of the discretionary spending of the new middle class in China. If in the past they were running to buy brands … we don’t see similar behavior there now.
Siegel: But don’t you think that is partially [due to] the tensions between China and the U.S. and maybe [the Chinese consumer] telling Trump, ‘We don’t necessarily need American goods?’ Do you think there is some of that in the slowdown?
“I do think the last hike of the Federal Reserve was a mistake. I wouldn’t have [done it], but it’s not a fatal mistake.” –Jeremy Siegel
Allon: There might be some of that. There might be a little bit of deciding to change purchasing behavior. For a long while, there were many U.S. brands that … did better in China than in the U.S. KFC does really well in China. One thing might be that. The second thing might be that people [might now think], ‘We don’t need any more brands, period. We actually need to spend on things that [lead to a] better quality of life. We do see much more spending on vacations, for example, in China than in the past.
Knowledge at Wharton: If there ends up being a new trade deal between the U.S. and China, what impact is that going to have on Wall Street? The expectation is we are going to see a quick pick up. Is that your expectation as well?
Siegel: I think the market expects a deal. However, if a deal is reached it doesn’t mean the market won’t go up. It does mean if a deal isn’t reached and tariffs get heightened it is going to really go down again. So, I mean that is going to be a relief rally, and with a slowdown in China there is a feeling that Trump maybe has more leverage than he had a right to have expected a year ago, or six months ago, in terms of this negotiation.
But it seems to me that with the slowdown in China, [President] Xi wants to come to some agreement, and that we expected an agreement to be made. Also, the fact that if Powell doesn’t hike anymore then it is on Trump to keep the stock market up. If he escalates a war on tariffs and the market goes down, he has only himself to blame.
Knowledge at Wharton: Gad, how confident or pessimistic are you about these “negotiations” moving forward, especially in the next few weeks?
Allon: I am with Jeremy on that. Both [sides] have realized by now that unless there is some change we are heading into a slower market, and both have nothing to [gain] from that. … I definitely don’t think that Trump realizes how entangled the two economies are.
You cannot just say, ‘Let Apple move the production to the U.S.’ [because] otherwise we will have a $5,000 iPhone. I think most of us depend so much on the supply chain that crosses [countries]. In one of my classes I show the life of a DVD player. It is such a commodity, but it takes nine countries and [crossing borders] five times … to manufacture something like that.
These are deeply long supply chains that are built on top of each other. So I cannot see [an outcome] where they both will decide not to negotiate or decide to just get entrenched into their current positions.
Knowledge at Wharton: Gad, with you following the tech sector the way you do there is also interest coming up in the markets of a couple of IPOs expected in 2019, such as Uber and Lyft.
“I am maybe not worried about Apple per se, but I am worried about the entire market — the worry is deeper than just one firm.” –Gad Allon
Allon: We have these three: Uber, Lyft, and Slack. These three are probably the most anticipated in the last few years. Just to talk about Uber for a second, in my opinion Uber is probably one of the biggest experiments ever in using VC money to fund a winner-takes-all [firm] in a market that is not a winner takes all, with the belief that sometimes in the end, one can actually take all of these subsidies and all of these payments and actually create value.
… I mention Lyft as well because it is clear that it is not a winner-takes-all market. So the question is how do you value these two firms when the entire market until now was built on the fact that they can dominate their specific markets?
I add Slack to that. While we see firms like Google and Facebook absolutely dominating the consumer markets, more and more interesting firms are coming into the B2B market, and Slack is probably the most interesting player in that [space]. It will be interesting to see how the market will value them.… [B2B is] unlike the consumer market, which is the much more predictable market, with much more predictable growth. But [in B2B] they are fighting against a Salesforce and Microsoft. Again, reading the IPO [performance] will tell us a lot about what are the expectations in terms of the market in B2B versus B2C.
Siegel: I agree. I am glad for Lyft that Uber isn’t a monopoly. That is what we need everywhere. I like the fact that there is another firm that provides competition. And it’s needed. Although certainly I think Uber is several times Lyft. Lyft is there and people do use it; it’s a few dollars cheaper. You may have to wait a little longer, but some people’s time is less valuable than others and they are willing to do that.
Some people have ideological reasons for using Lyft rather than Uber. And I sometimes wish we had that competition for Facebook or Google in the same way. I mean, there have been attempts at it. I am not an expert in the tech area, but I am just sort of an observer. And of course, it also falls to the very important question about whether — and Gad, I’d like your opinion on this — you expect any antitrust action could ever be taken or severe restrictions being placed by the U.S. Congress on Google or Facebook as a result of their near-monopoly positions.
Allon: If you ask me what is the next, the other important trend that is going to happen in the next year or two is definitely much stricter regulation on Facebook and Google. You have a new Congress that leans one way, you have a Senate that leans another way, and the only thing that they agree on is the fact that the other side is better represented on social media.
I expect also a little bit [more scrutiny] with respect to Amazon, even though I should say the public perception of Amazon is much more positive than maybe [that of] observers of the market in general. But all of these firms I think are going to have much higher scrutiny.
Siegel: Actually, President Trump has been the one who has been negative on Amazon more than Facebook or Google. But because of privacy and other issues, Congress talks more about Google and Facebook than it does about Amazon. But Amazon certainly has threatened a lot of small-core sellers, and … caused disruption. Trump gets on them every so often, although I think we all love the convenience of it. I do.
Allon: Exactly. So that is the thing that will be interesting. When it comes to Facebook and Google, most of us in the tech industry have understood for a long while how they make money and how they actually can have such an amazing engine, and why it is so hard [for others] to compete. But the reality is that the main person that uses them doesn’t really know how it is being monetized.
From the hearings in Congress, it is clear our congressmen and women don’t know how they monetize their data. They very seldom sell it per se, but they monetize it in many other different ways. And any attempt to curb and regulate that is definitely going to hurt their long-term valuations.
With Amazon I think [the issue] is more about the actual scale. When you get a firm at this scale that by now controls Whole Foods, and starts to produce private label [products] to compete with firms that sell on their platform, we are going to see some [regulatory] scrutiny on what does bigness mean, what does scale mean. What type of firms do we allow, and how big do we want them to be?
Now you made a really great point, which is why do we see a competitor to Uber and we don’t see competitors to Facebook and Google? We did see early competitors but not anymore. Some of that is because Uber from the first day had to fight against regulations, usually very local regulations. In different cities, they were not allowed to operate. Having that friction resulted in the emergence of competitors that were vital. In China, they had to leave, in Malaysia and Tunisia they had to leave. In the U.S., they do well in some cities, but not in other cities.
Facebook and Google really had no friction whatsoever once they reached a certain scale.… And now it is too late. If you think about the time where Facebook was allowed to buy Instagram or buy WhatsApp — these are the kind of things that probably would not be allowed these days.