Can stocks in the future deliver the fat returns that investors got accustomed to through the 1990s? It's easy to get in an argument on that question, but you would be hard-pressed to debate it with anyone as knowledgeable as Jeremy J. Siegel.
Author of the widely lauded Stocks for the Long Run (published by McGraw-Hill, which also publishes BusinessWeek) and finance professor at the University of Pennsylvania's Wharton School, Siegel spoke with me recently about market sentiment, current valuations, technology stocks, and what may lie ahead for investors in the "post-bubble" economy. You can listen in on part of our conversation, or read through the edited excerpts of our conversation below:
Q: Where is the stock market headed?
A:I would be surprised if this was a banner year for stocks. There will be more disappointments in earnings than are expected, or certainly built into, the estimates now. But they're going to hit against the lower interest rates, and I think the [Federal Reserve] is going lower. So, a kind of standoff is going to develop.
Basically, for the next six months, I don't really see any dramatic returns. In fact, I think that the market may be pretty flat...with the normal caveat that our ability to predict the short run is extraordinarily limited....If we're going to get improvement...it would really have to be in 2002.
Q: But investors don't seem to be acting that way.
A:I'm somewhat surprised that the market seems to hold up as well as it does. I mean, at this particular juncture, it seems like [investors] just are totally brushing off any bad news. It's like [they're thinking], "It's going to turn [because] the tax cut and the Fed cuts are in place. And it's going to turn and I don't care how bad the news is right now." That seems to be the attitude of the market.
My studies have shown that there's a very tight period, four to six months, between the bottom of the market, which I put at late March or early April, and the actual bottom of the economy. And if we add five months to April we get September, and it's basically saying that September is going to be the turnaround and we are going to start up from there.
Q: That might be the time, too, when corporations begin to see slightly easier earnings comparisons.
A:They'll begin to. Obviously, it's the first quarter [of 2001] that's going to be the easiest, the fourth quarter [of 2000] also. Third quarter, I guess, it was still somewhat strong, depending on what sector you were looking at. But basically we would have to see economic activity head up by September. If it doesn't then, you know, you would have to say the market is premature in its celebration.
Q: And, in any case, isn't the market's price-earnings ratio still high by any historical standard?
A:There is no question that p-e's remain high by historical standards. There is [also] no reason why the p-e should go back to 15 just because 15 is the average over the last 50 years. There are a lot of favorable factors that justify a p-e in the low 20s rather than the mid-teens.
But then there is also the question about whether from current levels the stock market can generate those 7% real returns that have marked the long-run [historical] average.... My feeling is that we could see actually 5% to 7% real [returns].... But...suppose we have 6% real returns? Those are still considerably more than the TIPS inflation-indexed bond, so you are still getting a premium. It's just a smaller premium than what has been the historical norm.
Q: What would an investor these days get in real terms from TIPS?
A:TIPS are now 3½%.
Q: Do you subscribe the idea that high valuations in the stock market reflect what many people call the New Economy -- that higher productivity resulting from advances in information technology are a support for higher stock-market valuations?
A:I'm skeptical. You know, the problem is that a lot of these information gains are also making [the business] environment much more competitive. And people are ignoring the fact that when we see rises in technology, only for a very short term does it fall to the bottom line of the firm. Very soon afterward, it's competed away and gives way to lower prices for consumers.
...Certainly on a theoretical basis, there is much to question....So, [as for] extra productivity growth, I am not saying that's bad for earnings. But I think it's too convenient and sometimes too easy a rationale. Actually, I like to point to other factors leading to higher valuations, including much lower transactions costs...[and] the very favorable capital gains taxes that we have now. I like to point to the fact that firms are turning taxable dividends into lightly taxed capital gains [by] buying back their shares....Low inflation is also a very positive factor because our tax system is not indexed to inflation on capital gains. That can be a very strong effect. [Also] a more stable macroeconomic setting, despite the [current] slowdown.
Q: Given all of this, what strategy would you advise individual investors to follow?
A:I still think equities offer an edge over bonds [in the long run]. I think the edge is smaller, clearly, than it has been over the last 50 years. You should only count for, you know, two or three points above [bonds' return].
Q: And what about the short run?
A:In the short run, I think there still might be a little bit of edge given to value [stocks] over growth [stocks]....And I think there is a lot of worry about how good the quality of the earnings are, particularly in the tech sector. [Because of that worry] I think there might be some movement toward the sectors where they're very sure of their earnings....
There are definitely growth opportunities out there still. Biotechnology still holds tremendous promise, and even in technology -- well you have to just realize that there's a lot of competition out there.
Q: It sounds like you might underweight technology stocks?
A:I'm still skeptical....The truth of the matter is that technology hasn't been a good long-term hold...it surprises people, but had you bought IBM stock after 1958 you would have fallen behind the S&P, even [if you still held it] today. People don't realize how tough it is in tech. Now you can make a lot of profits if you just move right in at the right time and get out, you know, when everyone is real excited about it.
Q: What have you been focusing your research efforts on now?
A:Some of the issues we've been talking about: What are the right p-e's for the market given the current situation? [To do that] I'm looking at tax structures...transaction costs...the stability of the economy.
I'm also going to be writing a book, actually, on investment strategies in, I guess you could call it, the post-bubble economy.... And I'm going to be talking a lot about the communications revolution, the biotechnology revolution.
Q: What do you think would surprise readers of your earlier work most about your coming book?
A:Probably that you could believe in the New Economy and yet find it real tough to make profits in the market. I mean some people think, "New Economy. Higher productivity is a slam dunk. Market is up 10% to 15% a year," and I don't think so. I think it's going to be very tough. There will be "first-mover" advantage, but it won't be long-lived.
Q: What's the biggest positive you see for the stock market and what might pose the greatest danger?
A:The biggest positive is the injection of liquidity by the Fed....The biggest negative [would be if] this recovery doesn't come when it's expected....As I say, the market expects September/October to be the turning point. And if it doesn't [happen] at that point, we could see another leg down that would challenge those April lows. I'm not ruling that out.
Q: Anything else?
A:[If people just believe] the worst is over and the Fed is going to fix things. And I just want people to realize that the Fed started easing from a p-e ratio of 25 and my calculations have been that over the post-War period, when the Fed start[ed] easing the average p-e ratio had been 13. And that's one reason why things worked out so well. You were starting from a much lower level of prices.
And the market had often been beat up badly because of high interest rates before the Fed started easing. And they had p-e ratios of 8,9,10, and it's not hard to get good returns after that. So...when the Fed started easing in January, the p-e of 25 was nearly twice as high as the average p-e when it started easing [in the past]. And that's why I'm not convinced that you're going to have as much of a push from the Fed as appeared to be the case in past expansions.
By Robert Barker
Edited by Patricia O'Connell