Jeremy Siegel on Why Stocks are Undervalued

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A video of this interview appears here.

Jeremy Siegel

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 fourth edition, is widely recognized as one of the best books on investing.  It is available via the link above.  A regular columnist for Yahoo Finance, he is frequently quoted in the financial press and is considered by many today’s preeminent market historian.

Dan Richards interviewed Siegel at his office at the Wharton School in Philadelphia on July 8.

Some would suggest that the last 10 years have undermined some of your findings about the long-term returns on stocks.  How do you respond to that?

It's been a tough 10 years to say the least.   

You have to remember that when we look back over the first decade of the 21st century, we will look back and see that we started that decade at the top of the technology bubble where I and many other people said that technology stocks were overvalued, as were many other stocks. 

We had two incredible decades of stock returns prior to 2000.  Never before had we had double-digit gains in two consecutive decades prior to that.  In my analysis that brought us 50% to 60% above the trend line. 

My research shows that there is reversion to the mean, which means that eventually that trend line is going to dominate – the trend line is eventually going to bring the market back.  Unfortunately, often it brings it back with a vengeance.  It actually goes below the line, which we have just experienced with the bear market. 

My analysis suggests that the market is about 25% and maybe even 30% undervalued by long-term trends.  But basically what we have done over the last 10 years is gone from a very overvalued market to an undervalued market – which is not unprecedented.

How do you arrive at that 25% to 30% undervaluation today?

Basically, there are two methodologies.  One is looking at the long-term trends of after-inflation stock returns.  I've done a lot of econometric analysis.  My analysis confirms that there is reversion to the mean, which means that whenever you are outside a boundary you tend to go back.  When I draw that line over 200+ years of return data, I find we are about 25% to 30% under trend.

But trend lines are only one aspect of it. There has got to be a valuation behind that. That is very much what supports the position that stocks are undervalued.  When I look at earnings going forward on the S&P 500, for instance projections for 2010 and 2011, we are looking at either 13-times earnings this year or 11-times next year's earnings.  In this interest rate environment, that is unprecedented and, again, demonstrates around a 25% or 30% undervaluation in the market.

So the norm would be historically more like 15- or 16-times earnings?

Absolutely.  The very-long-term norm of price-earnings ratios is 15.  That also adds single digit P/E ratios that occur whenever you have double-digit inflation.  We couldn't be further away from double-digit inflation than we are today with very low single-digit inflation.  Once you are into that low single-digit inflation, P/E ratios of 16 and 17 are more common, and we are well below that level, even below 15.

I have heard three concerns articulated.  One is a concern about a double-dip recession, and whether those earnings will materialize.  There are also concerns that we may face a lower economic growth rate as governments reduce debt.  Finally, I want to talk about the valuation metric that Robert Shiller of Yale uses.

So let's talk first about the concerns that the US may be heading into another recession and will potentially drag the rest of the world with it.

I rate the probability of a double-dip recession well under 20%.  But it's not impossible.  Nothing is impossible. 

What I see is a slowdown.  I see growth going from 3 1/2%, 4%, even 4 1/2% down for a quarter, maybe two quarters, to 2 1/2% to 3%. 

Of the forecasters that I look at, none of them have negative growth rates for GDP.  In fact, none of them that I respect, and I look at a lot of them, are even below 2%.  To have a double-dip you really have to have at least one quarter of negative GDP growth.  So when I look at all the data and all the forecasters, I am very convinced that we will not have a double-dip.  This is a slowdown, which I think by the end of the year will move into a reacceleration of 4% growth.