Dive Right in, Siegel Says, the P-Es Are Fine

Thanks to the stock market's big bounce around Columbus Day, being Jeremy J. Siegel just got a lot easier. The Wharton School finance professor is the high priest of investing in equities, thanks in no small part to his 1994 bestseller Stocks for the Long Run, now in its third edition.

Siegel is just as bullish now as he ever was, insisting that investors can confidently expect to make an average of 5% a year after inflation over the next 20 to 30 years. The main reason? Today's buyers are getting in at prices more than 40% lower than in March, 2000. That matters because the five big market busts of 40% or more over the last century were followed by above-average annual real returns of 8.6% over the next five years. "You're starting from a much lower base," says Siegel. "I don't consider this market to be dirt-cheap, but it is a good, if not better-than-average, time to buy equities."

How so? First, as of Oct. 15, stocks were about 20% lower than they would have been had they simply matched the average 6.7% annual returns since 1801. This is the first time the market has been significantly below that trend since the end of 1994. By contrast, at the end of 1999, the market was 70% overvalued. Furthermore, argues Siegel, stocks now deserve a price-earnings ratio in the low 20s--vs. an historical average of around 15--because inflation, taxes on capital gains, and stock trading costs are all significantly lower than they typically have been.

Current low yields on Treasury bonds are making the call for stocks easier as well. T-bonds have just completed their best 20-year run in a century, running up compounded annual returns of 8.5%, after inflation, from 1981 to 2002. But the recent 4% nominal yield on taxable 10-year Treasuries now makes them "the world's worst investment," says Siegel. Inflation will likely eat up more than half the yield, he says.

Of course, plenty could go wrong with Siegel's rosy scenario. For one, what he calls "irrational despondency" could break out: That's when investors dump stocks again and again for fear of new losses. Indeed, Robert J. Shiller, author of Irrational Exuberance and a Yale professor specializing in behavioral finance, believes investors will become a lot more pessimistic about stocks. "I wouldn't be surprised if we fell below the average p-e of 15, maybe to 10," says Shiller. "That would halve the market again."

Failure to clean up scandal-ridden accounting practices could also prove fatal to solid stock returns. Unless businesses consistently report earnings that can be compared against past performance and peers, stocks won't be worth 20 times earnings, Siegel concedes. Nor will equities do as well as he expects if terrorists attack again in the U.S. Says Siegel: "If what happened in Bali happens in the U.S., then the bets are off."

Despite those considerable risks, he doesn't think stocks will go as low as they did in 1982, when p-e ratios of less than 10 heralded the start of an 18-year bull market. "As much as everyone is discouraged about stocks, I don't think investors are going to let the market get as cheap as it has in the past," says Siegel.

That's why he foresees real gains of 5% a year in the future--a lot better than recent performance, but still nearly two percentage points less than the average real returns over two centuries. In other words, because future stock buyers won't get shares at prices as cheap as in the past, they won't get returns as rich as in the past, either.

Keep in mind that when Siegel says long run, he really means it. Stock investing, he insists, needs to be carried out over a full 20 to 30 years. And that's a time frame that easily outstrips most investors' patience.

By David Henry in New York

Before it's here, it's on the Bloomberg Terminal.