Jeremy Siegel – The Market is “Fairly Valued” But There are Two Big Risks
Jeremy Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania and a senior investment strategy advisor to Wisdom Tree Funds. His book, Stocks for the Long Run, now in its fifth edition, is widely recognized as one of the best books on investing. It is available via the link on this page. He is a “Market Master” on CNBC and regularly appears on Bloomberg, NPR, CNN and other national and international networks
I spoke with Jeremy on Wednesday, November 20th.
In our interview last year on November 20, the S&P 500 was at 2,641. Yesterday it closed at 3,119. That's a gain of 18.1%. Last year you said the market was below fair market value based on current earnings. So your forecast was very good, given that the average annual return has been about 9.8%. What is the fair value of the S&P 500 now? And what's your outlook for the coming 12 months, including December of this year?
Last year's stock market forecast turned out very well. As I looked through that commentary, I said the earning increases in 2019 will be much less than expected, most likely 4% to 5%. Last November, analysts projected a 12% earnings increase in the S&P 500 earnings. Now it is estimated to be about 5%. . That's close to the increase I expect for 2020 – about 5% from this year’s level.
By the way, I use S&P operating earnings in my calculations, which are a little more conservative than firm-reported earnings calculated by Bloomberg, Thomson-Reuters and others. Warren Buffett has said that he uses S&P’s estimates for judging valuation.
Based on 2019 data, the market is selling for about 19-plus-times earnings. I said last year that fair market value for the S&P is closer to 17- to 18-times earnings. I'd notch that up a little bit because interest rates are much lower than they were a year ago, particularly long rates, which are so important for equity valuation.
Last year I thought that interest rates on the 10-year would fluctuate between 2.5% to 3.5% in the coming years. Now I think the range will be 1.5% to 2.5%.
Lower interest rates mean higher market capitalization. Price-earnings ratios of 18- to 19-– and you could argue even 20 – are very reasonable in this environment. Given that last year I said we were a bit of below fair market value, I'd say we're at fair market value now.
This means that by the end of 2020 we should expect 7% to 8% nominal return that includes a 2% dividend.
Warning: We all know that the standard deviation of one-year returns is about 20%, so a point estimate for one year has a high margin of error. But barring a serious recession, a 7% return is quite reasonable over the next 3-5 years
Last year you said there was a 50% chance of a recession in the next two years. Given that unemployment has remained very low, consumer spending is still very strong and the stock market is doing so well, what are the recession odds now?
I love predicting 50%. You can't be wrong!
I am a bit more confident that we will avoid a recession over the next two years than I was last year. But there are definitely rocky shoals that we have to maneuver.
The two biggest threats to the economy and to the stock market are an all-out trade war and a Democratic sweep that includes not only the presidency but the Senate. I assume the Democrats will keep the House.
Neither of those events are likely, but certainly not impossible. Trump cannot afford a trade war if he wants to be reelected. And odds makers now see the Senate staying Republican at 2 to 1 . If there is no trade war, I would say the odds are 3 to 1 or higher. But those two events could push us into a recession in the next couple of years.
Despite the above possibilities, I'm going mark down my recession forecast from 50% to 40% because I believe other factors, such as a rising labor market participation rate, can extend our expansion for a number of years if we don't have a trade war or a Democratic sweep.
When we spoke last year, the 10-year Treasury was 3.06% and you said then 3.5% might be the peak for the 10-year in 2019. It's now at 1.75% and it was as low as 1.46% in September. Why are rates so low and what is your forecast for the 12 months ahead?
I was wrong on my interest rate prediction, like everyone else. The biggest surprise of 2019 was the collapse of long-term interest rates. I scarcely know anyone who could have dreamed that rates would go down to 1.5% and below on the 10-year bond without a serious recession.
I've come to the following conclusions about interest rates: The dramatic fall of interest rates is due to factors that go well beyond central banks. The biggest reason for the drop in long-term interest rates that our long-term Treasury securities have become ideal “negative-beta” assets. They have become hedges to risk assets (equities) unlike their behavior during most of the post-World War II period.
There are statistical studies by several very well-known economists that have confirmed this. A week ago, Richard Clarida, who is a vice chair of the Fed, delivered an excellent paper in Zurich. It details the reasons for the drop in interest rates and Clarida maintains that this negative-beta quality of Treasuries is an “underappreciated reason” for the fall in rates. I urge investors to read it. We're all very fortunate to have such a learned man in such a powerful position, second to Jay Powell at our Federal Reserve.
There are other economic reasons for the fall in rates, including the slowdown in economic growth, low inflation and the increase in risk aversion. As populations age, investors tend to get more conservative and tend to invest in bonds rather than equities.
People are living longer, they're saving for retirement, investing in “target retirement funds” and depressing term premiums. We will see a much flatter term structure of interest rates in the future. That will keep long-term interest rates low for quite some time.
You mentioned inflation being low as one of the factors that is holding down interest rates. Why is it low and will it remain low?
For those of us who lived through the 1970s and early 1980s, did we ever dream that inflation wouldn't be a problem in our future economy? But it certainly is not. I see no problems on the horizon. I said a year ago that 2% looks like a reasonable forecast and I maintain the same forecast today
This stability of inflation has a lot to do with the inflation targeting by central banks who have stated clearly that 2% inflation is an important goal. Since economic agents believe central banks will set rates to achieve 2% inflation, that level becomes a self-fulfilling prophecy. Individuals set their contracts and their expectations to 2%, and this reinforces that level.
Look at oil, for example. It was $60 a year ago and it’s $60 today. Oil prices were a major reason for high inflation 40 years ago, but not today We've already had peak oil demand in the developed world; only in the emerging world is demand increasing. We have made tremendous progress on renewable energy, bringing down the price of renewable power and lowering the demand for oil into the future. Take a look what's happened in natural gas over the last 10 years in the United States. The fracking revolution has been dramatic in terms of reducing heating costs for those who live in colder climes.
The CRB commodity index is actually below where it was a year ago. To be sure, we're not in deflation, which you would only expect in a very weak economy. But we have ample supplies of raw materials and energy sources
Furthermore, I am not as fearful as I was last year that our labor markets are tightening so much to cause excess wage increases. We've seen a very good rise in the labor participation rate in the United States, hitting a 7-year high. US participation rates have fallen behind many other developed countries, but we are catching up. This is very good for the economy
Let's talk about the trade war, which you mentioned earlier. How heavily is that weighing on the U.S. economy? How and when do you expect it to be resolved?
It is now the major issue facing the stock market and the economy. As we speak, there is a rumor coming out of the White House that we're not going to get a deal this year with China. The stock market fell 200 points in a few minutes. This is what has been happening recently. As I said last year, the market wants a trade deal. It would love a “great deal”, but it will happily accept any deal. It does not want trade disruption.
If things go south and Trump puts on 25% tariffs in the middle of December, as is now scheduled, not only would we have a bear market in stocks, we risk an immediate recession. I don't think it's going to happen because, politically, it would be deadly for him next year. But it is the major issue.
I don't think that Trump will be able to get all he wants from China. But he didn't get all what he wanted on the U.S.-Mexican trade accord and yet he came out with a deal. I expect the same type of settlement to be negotiated with China.
Turning to politics, you have said previously that any reasonable Democrat would beat Trump. Is that still the case? You talked earlier about the chances that Democrats might take control of the Senate. Where do you see the odds resting now in both the presidential election and the Senate elections?
I'm going to make the same statement. Any moderate Democrat will likely beat Trump next year. Who do I think are not moderate Democrats? Bernie Sanders and Elizabeth Warren.
The race for Democratic nomination has tightened dramatically in recent weeks. Elizabeth Warren scampered far ahead in the betting markets just a month ago. Now these markets say it is basically a three-way tie between Warren, Biden and Buttigieg.
As far as Congress is concerned, the betting odds are 65%, about two-to-one, that Republicans keep the Senate but the odds that Democrats will keep the House are 76%. I see virtually no way that Republicans can retake the House.
If we can avoid trade war and a recession, it's going to be a close election even if a moderate Democratic runs. It is extremely important that the Senate stay Republican an anti-business candidate like Warren takes the presidency. In that case none of her programs has any chance of passing a Republican Senate.
One thing that has been part of Warren's and Sanders' platform is a wealth tax. What are your thoughts on a wealth tax? In terms of the broader question, should we address income inequality in any sort of policy framework?
This is what I find so deeply disappointing in the Democratic Party: bashing billionaires and those who created wealth. Many of those are giving back to society in major ways, heading huge philanthropic organizations. Almost all our charities and non-profits are supported by those people who have done extremely well.
If we want to reduce income inequality in the United States, we need to bring up the bottom, not bash the top. We need to improve our schools, whether public or private. We have fallen behind dramatically in the way we educate our children. We are not educating them for 21st century jobs. Their skill sets are low.
Why aren't the Democrats talking more about these issues? Since I graduated high school, the national SAT average scores for high school students have fallen almost 200 points. Children are not learning what they did. Over 50 years we should have been able to improve performance, but we're not.
A wealth tax is just punishing the rich, and pretending as it is going to do something for the poor. I'm very disappointed that so many Democrats are pushing for it.
It’s not just the wealth tax. Elizabeth Warren wants to raise capital gains and dividend taxes to 50% and higher. If you do the math, that results in a negative return after inflation returns on stocks even with my optimistic projections.
How are you going to encourage capital formation if you're going to get a negative rate of return on your investment? It is punitive. It's targeting the wrong problem. Are these billionaires the ones who are causing the problem? Are they the ones who causing other sectors of our society to not do as well as they should be?
This wholesale bashing of businesses, corporations and the rich is counter-productive for the Democratic Party and certainly for the U.S. economy.
Going back to last year, you said the most attractive valuations were in emerging markets for investors with at least a five-year time horizon. Emerging markets are still cheap relative to the U.S. on a P/E basis. They're about 12 compared to 17 or 18, depending on how you measure it, for the U.S. Are you still sticking with that call or are there are better opportunities elsewhere?
I've been making that call for a couple of years and admit that the foreign markets have still lagged. They haven't matched the U.S. market’s performance. Does that mean you should abandon them? No. If you go through the history of valuations, when sectors become relatively more attractive, then you should up your bet.
The question is: Are value stocks are going to turn relative to growth stocks I believe we’re nearer to that time than ever. I base that partly on the fact that, with interest rates permanently lower, investors are never going to get the income they need out of bonds, bank accounts or CDs.
The S&P is yielding 1.9%. Dividend-paying stocks in the S&P are yielding 2% to 2.5% on average, and many are yielding 3% to 5%. Dividend-paying stocks could be the “new bonds.”
The dividend yield in emerging markets is 4% to 5%, and the earnings yield is 7% to 9% and higher. Europe's stocks are priced at 15-times earnings, nearly 25% cheaper than the US. I believe that three to five years hence, you will find that the non-U.S. portion of your portfolio will be the outperformer. I'm feeling more confident than I have in the past that that will be the case.
We will revisit that prediction in our interviews in the years ahead. What are the biggest risks that advisors and their clients should be concerned with? Last year you were worried about the corporate tax cut and deregulation in the event that President Trump might not be reelected. You talked about the trade war earlier. Is there anything else?
The trade war is a big threat, but I don't think it's going to happen and the market doesn't either. That's why if it does happen, I believe there will be a big selloff.
Losing the corporate tax cut could happen only if the Democrats sweep the elections. That’s not out of the question, but the markets are saying that's an unlikely event.
Trump is going to be impeached, but the Senate will not remove him from office.
If we can keep the economy and the market reasonably strong, people are going to look at the election and say, "Listen, I may not like everything that Trump is doing, but he got a trade deal. I’d rather keep him than risk Warren or some left-winger who really might change the parameters of the game."
Bob, when we talk again a year from now, we will know the outcome of the election and the answers to some of these questions.
We will. Thank you very much.