Does Wharton's Jeremy Siegel Have Alan Greenspan's Ear?

The economics professor makes a case for high market multiples

The performance is just staggering. In less than four years, the stock market has shot up more than 150%. Yet rather than bask in prosperity's glow, investors seem uneasy. What accounts for the market's lofty valuations--economic fundamentals or irrational behavior?

Like all of us, the Federal Reserve Board wants to know, and for good reason: Any collapse in the stock market is bound to crimp the economy. And there have been calls for the Fed to hike short-term interest rates, not so much to dampen potential inflation as to cool the market. But if Fed governors were swayed by a recent presentation from Wharton economics professor Jeremy J. Siegel, the author of the highly influential book Stocks for the Long Run, the nation's central bank will turn its back on that advice.

Every six months, the Fed invites a group of luminaries from academia, Wall Street, and the corporate world to discuss economic questions. The latest conference was held on June 15, covering front-burner issues like the Asian economic crisis and the health of the U.S. economy---and Siegel's favorite topic, stock market valuation. These discussions can be influential. For instance, on Dec. 3, 1996, economists Robert J. Shiller of Yale University and John Y. Campbell of Harvard University argued that investors had driven the stock market to unsustainable heights. Two days later, Fed Chairman Alan Greenspan rattled markets worldwide when he asked rhetorically whether "irrational exuberance" was building in U.S. stocks. "I never used the term `irrational exuberance,"' says Shiller. "But I did say `irrational."'

The market shrugged off Greenspan's remarks, rising more than 2,600 Dow points since then. Despite that rise, Siegel maintains that the market is quite rational. True, based on historical benchmarks, the market looks overvalued--perhaps by as much as 25%. But those benchmarks are suspect now, says Siegel. "When we say overvalued vs. history, we have to ask, is this period like history?" he says.

QUANTUM LEAP. Conditions are a lot different now, says Siegel. For one thing, the demand for equity investments has taken a quantum leap. Millions of workers setting money aside in retirement savings plans have gotten the message that equities are the best-performing long-term investment. It's a mantra long associated with Siegel, especially since the publication of his book in 1994. For another thing, corporate earnings are less volatile than before as swings in the business cycle have moderated over time. In addition, with most nations embracing market capitalism, it's hardly unreasonable for investors to anticipate higher growth rates at home and abroad.

Still, the core of Siegel's argument rests on how the dynamic forces driving the U.S. economy affect the stock market. In his Fed presentation, Siegel compared the top 20 companies of the Standard & Poor's 500-stock index in 1998 with the top 20 in 1964, a year in which the overall S&P index sold at price-earnings ratios near those of today (table). In 1964, the index was dominated by smokestack companies and oil giants. Earnings had grown by an average of 8% over the previous five-year period. Only five of the big companies were considered growth stocks.

In sharp contrast, the five-year earnings-growth rate for 1998's top 20 companies is nearly twice as high--15.2%. But the p-e ratio for these companies, 30.4, is only 50% higher than it was in 1964. Many of today's companies are leading-edge global competitors, and 15 are considered growth stocks. Microsoft Corp. Chairman William H. Gates III was still in elementary school back in 1964 and Intel was not yet incorporated. Heck, Cisco Systems Inc., didn't even ship its first product until 1986.

When comparing today's stock market to 1964's, the p-e ratio seems more reasonable. After all, on top of the relative stability of corporate earnings, the growth rate for the S&P 500 as a whole is 41% higher. "Overall, I said there was a sound basis for putting high valuations on the market," says Siegel, referring to his Fed talk. "Of course, the earnings may not be realized, or they may disappear."

As important as today's top companies may be, they play a smaller role in the market and the economy than their mid-'60s cousins. In 1998, the S&P 500 comprises 67% of total U.S. stock market capitalization, and the leading 20 S&P companies account for 29% of the index. In 1964, the S&P comprised more than 90% of total market cap, and the top 20 made up nearly half of the S&P. In that year, General Motors Corp. was ranked second, with 7.3% of the S&P's market capitalization. Microsoft now ranks second--but with only 2.4% of the S&P. Today, GM is far from the top 20 list, at No.53. "General Motors workers are on strike, and it's not that big a deal anymore," says Sung Won Sohn, chief economist at Norwest Corp. "In the 1960s, people would be saying that a GM strike would lead to recession."

At his Fed presentation, Siegel may have helped reinforce Greenspan's growing belief that markets aren't as irrational as he may have once thought. In recent testimony and talks, Greenspan has cautiously noted how Corporate America's productivity gains are fueling stronger-than-expected profits and therefore higher stock market valuations. "If, indeed, we end up with a wholly new type of high-tech international financial environment," said Greenspan following a speech before the American Society of Newspaper Editors on Apr. 2, the expectation of ongoing productivity gains from massive spending on technology could mean that "the markets are appropriately priced." He added that, as a central banker, "I always have great skepticism about new eras and changing structures of the way the world functions. But...I'm not wholly alien to that particular view."

Of course, Siegel's positive take on the stock market is hotly debated among academic economists. Yale's Shiller remains sure that investors are behaving irrationally, and he can readily rattle off anecdotal evidence to support that conviction. Shiller and Campbell recently published an article based on their Fed testimony of two years ago. Their conclusion: "There may be special circumstances now that will change the historical relations between the valuation ratios and subsequent stock market performance. But there have always been special circumstances, circumstances that are adduced every time the ratios have been at extremes, and that have in the past allowed people to fail to heed the message of the ratios."

Even those more receptive to Siegel's view are a bit wary. "I think there are good reasons for saying valuations should be higher than at any point in our history," says Mark Zandi, chief economist at Regional Financial Associates Inc. "But the valuations are still beyond what changes in the economy support."

Sure, at today's levels, the market is vulnerable to bad news. Still, Siegel made a strong case that the stock market is anchored to the fundamentals of higher productivity and a long economic expansion. And he may have convinced the Fed to let the bull run.