Jeremy Siegel on the Dow Reaching 11,000
"You've still got upside. . . ."
The Dow has closed above 11,000, the European Union is bailing out Greece and the U.S. economy seems to be perking up. Is the future as bright as it looks? In fact, it looks pretty good, says Wharton finance professor Jeremy Siegel. While the Dow's 11,000 close doesn't mean much to professional market watchers, it can give ordinary investors a psychological boost, and it focuses attention on the stock market's fine showing over the past year. According to Siegel, the U.S. economy is in a self-sustaining recovery, no longer dependent on government stimulus -- and while the housing market could take years to make up recent losses, the economy should do well. With interest rates likely to rise, it's a risky time to invest in bonds, but stocks could end the year 8% to 10% higher than they are today, Siegel said in an interview with Knowledge@Wharton.
An edited transcript of the conversation follows.
Knowledge@Wharton: The Dow surpassed 11,000 for the first time, it seems, in ages. Is this something that matters?
Jeremy Siegel: It doesn’t matter in a real economic sense, but more in a psychological sense. Obviously, these are just arbitrary points. But this is the highest position since September 2008, when the crisis really broke out. More illuminating than just looking at the number 11,000 is that the market is only about 22% or 23% off from its all-time high, which was reached in October 2007 when the Dow was over 13,000. We went down 58% and now we are back within a little more of 20% of the high. That shows you that there has been a very significant recovery.
Knowledge@Wharton: You hear about these big numbers like 11,000, 10,000 and so on, and we know mathematically 11,000 is not much different from 10,999. But the analysts are always talking about psychological barriers. Is there any evidence that investors behave differently, that they are encouraged, when you break through one of these ceilings?
Siegel: It does hit the news. It might cause a few investors to say, “Hey, you know what? I think the worst time is over. Maybe I should dabble in stocks again.” Professional traders don’t put any stock in it at all -- although there are a few traders who love to place little bets on whether [the Dow] is going to close above or below [a certain level], and they may push the market around a little bit to try to get their way. But, again, it is mostly a psychological barrier. It sort of causes us to step back and take stock in how far we have come back. That sort of reflection is good for the market.
Knowledge@Wharton: Another item in the news is the recession, and the panel that calls the beginnings and ends of recessions -- always far after the fact -- decided recently that it was too soon to decide whether the recession has ended. Again, is this something that matters, or are the markets way beyond this question?
Siegel: Yes, the recession has definitely ended. What they were more uncertain about was what month it ended, but that is quibbling about history. My feeling is that it was July or August of last year. But there is no question that we are out of it. In my opinion, we are not going to have a double dip. It is just a question of whether we are going to come out of this with moderate growth or surprisingly rapid growth.
The National Bureau of Economic Research [NBER] is, as you say, notoriously late at calling the turning points. I was listening to Jim Poterba, who is the new head of the NBER, saying they are not a forecasting group; they just look at data and try to pick when the turning points of the economy have taken place. Again, I don’t think we should take too much stock in that. The more interesting argument is how strong the recovery is. Of course, there are pessimists out there still who believe we are going to have a double dip. You heard the term “sugar high” being applied so much late last year -- that it’s only the stimulus keeping our economy afloat, and that when it is withdrawn, we are going to sink back into a serious recession.
Knowledge@Wharton: Another item is Greece. There has been a lot of worry in recent months about the economic conditions in Greece. Now Europe has come forward with $40 billion to help, at a relatively low interest rate. Yet the markets didn’t seem to go crazy over the news. Is this, again, something that matters?
Siegel: Greece is a serious drag on the European economy. It really goes beyond whether they are going to default on their debt because the peripheral countries that joined the EU, and particularly Greece, had sudden inflation in their cost structure. Their wages went up. A lot of capital came in. They thought they were rich. They spent a lot. The truth is that the Greek worker did not increase his or her productivity anywhere near in line with how much wages increased. What does this mean? Greek labor and industry are at a very severe cost disadvantage, which is going to drag down the Greek economy for years to come. As I have often said, if they had the drachma, their old currency, the solution would be easy.
It’s not easy, but it’s apparent. You devalue your currency and you become competitive again. Of course, the cost is that imports are more expensive. Laborers don’t get the real income they would have otherwise. But now what you have to do, since everyone is in the euro, is ask the Greek worker not to hold wages constant, but [bear] outright cuts. Some experts are talking about cuts of 20% to bring back competitiveness. When I look at the news from Greece and I see the strikes and demonstrations, this is not about cuts. This is about freezing wages or benefits or reducing some of the overly lavish pension provisions. I doubt whether they can ever achieve the type of wage reduction that many believe would be necessary to bring them back to competitiveness. This may be a problem for not only Greece, but also Portugal and Spain. Spain has an unemployment rate of 20% once again and is in a serious recession.
The big difference is that there isn’t labor mobility in Europe as there is in the United States. When one region is somewhat depressed [in the U.S.], there are jobs elsewhere. Americans move. In fact, we have the most mobile worker group of large countries in the world. We just move where the jobs are. The Greeks are not going to move to Germany, where jobs are, or to France or Belgium. There are cultural and language differences. That lack of mobility makes it even harder for them to make the necessary adjustments.
Knowledge@Wharton: To laymen, it looks like Greece is not that big of a country and we can’t really understand why it is infecting all the countries around it. What is the mechanism that makes that happen?
Siegel: There is a group called the "PIIGS," which is Portugal, Italy, Ireland, Greece and Spain. Ireland is doing some necessary things and it is going to succeed. But we are talking about more than just Greece. Even if Greece is forced to leave the euro, that is terrible. It is unprecedented to leave a currency.
What is also very important -- and this is good for the U.S. dollar -- is that the Chinese and [other] Asians, who have most of the world’s foreign exchange reserves, were accumulating euros over the previous five years because it has been a strong currency, and certainly strong relative to the U.S. dollar. They may now have many second thoughts about accumulating euros. That would probably make them more comfortable with the U.S. dollar. That has a lot of significance, but is mostly a positive for the United States.
The negative, of course, is that if the euro goes down in value, European exports are going to become more competitive and … when we translate euros into U.S. dollars, we will get less and there will be a little less profits. But [the euro] will rise against the U.S. [dollar], which is still the world’s primary reserve currency, to a more solid position in the future.
Knowledge@Wharton: Let’s look at the U.S. One of the areas we dwell on an awful lot these days is the housing market. Some news is good and some news is bad. What do you see happening there, and how is that affecting the broader economy and financial markets?
Siegel: Housing is still extremely sluggish. We are going to get housing starts at the end of this week, but the monthly reports [show] half a million starts on an annualized basis, which are one quarter of what we had during the boom years of 2004, 2005 and 2006 -- a 75% reduction. We have had stability in home prices. In fact, the Case-Shiller [home price] index has been up marginally from the lows it reached around six or seven months ago. There is a lot of debate. I have a little bet with one of my colleagues about whether it is going to go back down another 10%. It probably hit its bottom, but I don’t think it is going to recover for a long time. It could be 15 or 20 years for housing to get back to the level it was during the boom year of 2005.
That said, we can have a fairly strong economic recovery without housing going back into a boom period. Housing is going to be weak for a long time and prices, even if they stabilize, are not really going to go up. There are good values there for first-time homebuyers and that is very positive. But I don’t see a boom in that industry any time soon.
Knowledge@Wharton: There has been some talk recently about whether improvements in the stock market and economy are due to the stimulus efforts from the federal government. What is your view?
Siegel: What we have seen over the last three months are the first signs of a self-sustaining recovery. What I mean by that is that in the first quarter of the year, we did not get any direct fiscal stimulus. There were no tax cuts. There were no rebates. The "Cash for Clunkers" program and even the housing credit expired. Yet, when at the end of April we get the real growth most experts are looking for -- 3% to 3.5% in consumption, which is really quite good -- we don’t have to rely on fiscal stimulus for that positive GDP growth. The economy is beginning to repair itself on its own.
We could argue about how quickly it is repairing itself on its own and how quickly it needs to repair itself to bring down the unemployment rate, but right now I believe -- and many colleagues and fellow forecasters I follow on Wall Street and otherwise, even some who had been skeptical believe -- that we have seen a self-sustaining expansion.
Knowledge@Wharton: Interest rates are very low by historical standards, but are inching up. Mortgage rates have gone up a little over 5% and the 10-year Treasury has been up over 4% -- not every day, but some days. What do you see happening with interest rates?
Siegel: We are going to trend up. But it is interesting. It poked above 4% and then came all the way down to 3.8% again. There is still a lot of demand for bonds and the safety of U.S. securities. I mentioned earlier that foreign central banks are looking a little bit askance at the euro and continuing to buy government bonds. That said, the Federal Reserve by the end of the summer is going to have to start notching up rates, and the 10-year Treasury rate will go above 4% and could be 4.5%. Some experts are even saying 5%. I wouldn’t be surprised to see that.
One should also say that although that’s high from the standard of the last two years, it is still a very low rate if you look over the last 20 or 30 years. Mortgage rates, even though they poked above 5%, are still very good rates -- 30-year fixed up to 6% are good rates. I remember when I was young and thinking of [buying] a house, [a 6% mortgage] would have been a dream. They were 9% and 10% or higher. So we can stand higher rates and still have a healthy economy. But I think the Fed will have to start raising rates.
Knowledge@Wharton: What about investors? A lot of people like to own bonds for safety or as part of a long-term diversification plan. Is it a dangerous time to be in bonds with rates threatening to rise?
Siegel: Certainly with long-term bonds, it is because you are going to get capital losses on them if you are stuck in a 3.5% or 4% bond and interest rates go to 5%. You are going to take a 10% or 15% loss. If you hold it to maturity, you will get it back, but you are stuck for 10, 15, 20 or 30 years in a low-yielding instrument. I do not believe bonds are an attractive investment going forward. It is precisely because I think a stronger economy will bring a rise in interest rates.
Knowledge@Wharton: This week we are entering the earnings reporting season for the first quarter. What are you expecting?
Siegel: A good quarter again. We had two knockout quarters in the third and fourth quarters of last year, with the percentage of firms beating their estimates being at or near highs. Most analysts believe this will be another quarter in which the percentage of firms beating their estimates will be above average, but not maybe quite as strong as the previous two quarters. Nonetheless, as economic growth becomes self-sustaining and the economy becomes stronger, I look at not only the past quarter, but also projections for 2010 earnings. Virtually every week or two, I see an upgrade of those earnings estimates. Earnings estimates are on the upswing, and that is certainly positive for the market.
Knowledge@Wharton: Stocks have had a terrific run in the last 12 or 13 months and have done quite well so far this year. Are the earnings you are talking about already built in to stock prices, or do they have farther to go?
Siegel: They have farther to go. They are beginning to be built in, but there is still a lot of skepticism out there. As I mentioned, a very important indicator of valuation is the price-earnings ratio. Right now, stocks are selling at around 15-and-a-half times projected 2010 operating earnings. Many people say, "Isn’t that about the average?" The answer is yes. But coming out of a recession, that is actually a very low valuation. I did a study about the average price-earnings ratio of the market for the next full year out of a recession and it turns out to be 18 and a half. We are about 15% or 20% discounted from the average price of stocks coming out of a recession. That’s why I still think there is room for stocks to run up.
Knowledge@Wharton: Let’s look briefly at [non-U.S.] stocks, which you have long argued should be a sizable portion of an investor’s portfolio. How do they look? Safe? Encouraging? Frightening?
Siegel: I have been a fan of emerging markets and they have done very well. In fact, they have come back the best of all countries, even outside of China, and are now just about back to their peak levels of GDP. I am still a fan of emerging markets and think they will out perform. Now, people ask me about Europe. Don’t give up on Europe.
First, the low euro gives them a little bit of extra competitiveness. Second, many of them sell internationally and not to Europe itself. Third, European stocks are selling at the cheapest levels now relative to their earnings. They are selling at 10, 11 or 12 times earnings, which is cheap enough given the euro's problems. If you listen to the first part of this podcast, you would be saying, "A minute ago, you were telling us about all the problems there," and I’m saying, "You are getting paid for those problems right now. You are getting them at a discount of maybe 20%." That’s enough to not shun those European stocks.
I am still in favor of global diversification. Probably the only area I am not enthusiastic about is Japan. But Europe still deserves to be held. Emerging markets are going to be strong and they could be over-weighted. And, of course, I think American stocks are going to do well.
Knowledge@Wharton: Regarding American stocks: How far do you think the S&P 500 could go from where it is now?
Siegel: We are at just about 1,200. The high was around 1,450, if I recall. Getting to 1,300 is another 8% this year. We can get there. We have already had about a 5% or 6% run. I was thinking in terms of 10% to 15% this year. It would be on the upper part of my estimate but given some of the recent data, I am very encouraged about consumer spending. The recovery could be even stronger than what I anticipate, which would lead to the upper ranges of my estimate on returns this year. We can get to 1,300 this year. In a couple of years, we will surpass the high, maybe sooner, maybe later. Standard & Poor’s has already come out with its 2011 estimates. On operating earnings at least, it expects to surpass the high. That might be a little bit over-optimistic as those operating earnings are. But it begins to show you that we have moved a long way toward recovery from the severe recession.
Knowledge@Wharton: Fifteen percent in any 12-month period is something to be happy about. Stocks are still the things for the long run in your view?
Siegel: Absolutely. People worry. They say, "I’ve missed it. It is up 80% from a year ago." I’m saying, "No, you’ve still got upside. Don’t feel you’ve missed it all." I wouldn’t use that as a reason to say, "It is too late. I’m not going to go into stocks."
Published April 19, 2010
Originally published April 14, 2010, in Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania. Republished with permission.