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 below. He is a regular columnist for Kiplinger’s, a “Market Master” on CNBC and regularly appears on Bloomberg, NPR, CNN and other national and international networks
I spoke with Siegel on Monday, November 24th.
In our interview on November 29th of last year, you said that investors could expect a 10% to 15% return on the S&P 500 this year. On that day the S&P closed at 1,815 and on Friday it closed at 2,064, which is a 13.7% gain. Congratulations.
Another good year. You wonder about how long a streak like that can continue.
Well, that’s my first question. What do you consider the fair value of the S&P 500 to be today?
I consider the fair value of the S&P 500 to be approximately 2,300. That is not necessarily a forecast for the end of this coming year, but I believe we are in a permanently lower interest rate environment, which supports higher than historical valuations for equities. I still believe P/E expansion is in the cards. An 18 to 20 P/E ratio is appropriate given what Bill Gross dubbed the “new neutral” interest rates that we are likely to see in the coming decade.
What would cause you to be more bearish?
Of course there are always isolated bearish events – terrorist attacks, pandemics, things like that. What we saw with Ebola a little more than a month ago is representative of them.
But as far as structurally bearish events, I worry about a tightening of the labor force that brings about an inflationary rise in wages, meaning that we cannot continue at the 200,000 monthly pace in the non-farm payrolls that we’ve had. We are not adding to the labor supply enough to absorb it. We are not even increasing the labor force enough to offset the increase in the payrolls, and that is why the unemployment rate is going down so rapidly.
Ultimately, we are going to come across a constraint where the demand for labor exceeds the supply, putting inflationary pressures on wages, forcing the Fed to tighten more than I anticipate at the current time.
One of the big disappointments that we have seen in the U.S. is productivity growth. It plunged in the first quarter of this year. GDP growth was way, way down that quarter, but it didn’t snap back in the second and third quarters to anything that is exciting. It’s disappointing in this internet-connected world where there are so many laborsaving devices that we haven’t sparked productivity increases.
Some economists claim there is always a lag between the introduction of new technologies and actual productivity growth. That is one of the reasons why GDP growth has been so disappointing in the face of technology advances. Even though we have had good labor-market growth since the financial crisis, we haven’t been able to get the normal boost in productivity that would get us to the 3% or 4% GDP growth that we experienced during most of the postwar period.
The key variable to watch is the labor participation rate, which unfortunately has been declining. It is a very disappointing response to the excellent employment growth and decline in unemployment.
So one risk is that we will hit a constraint that will cause the Fed to tighten prematurely
I am not too concerned about Europe, China or Japan. They are going to get through their slow growth. China is on a lower growth path than it was before the financial crisis, but 6% to 7% growth a year is still extremely good.
As far as Japan is concerned, Shinzo Abe has to make some progress with the “third arrow” of his tri-part economic plan, which, besides monetary easing, includes labor-market and other structural reforms. I don’t think monetary expansion alone can spark prosperity for the Japanese economy.
On the European front, I believe that Draghi will move to take down the euro even more. My interim forecast is $1.15 for the euro, and if there is no economic pickup at that level, perhaps even lower. He may engage in quantitative easing, but lowering the price of the euro would be probably more effective.
Demographic factors in Europe and Japan are working against economic growth. Labor-market rigidities are somewhat related to the aging of the workforce, because people who have the jobs – the older generation – don’t want to lose them and yet they want all their benefits.
Where does the U.S. stand with respect to those types of structural reforms?
It’s not easy to get structural reform. The US and Europe need to put their entitlement programs on a long-term solvent basis. These entitlement programs are going to dog the developed countries in the world in coming decades.
Nevertheless, there is no deficit problem in the US over the next five years. The long-term problems with entitlements don’t really kick in until about 10 years from now, so we are not going to need imminent reform on those programs.
The big question that faces us in the United States is whether we need a crisis to get reform. I would hope not, but given the political stalemate, that might happen. Nevertheless there is no fiscal crisis that I foresee over the next five years.
Last year you predicted a 3.5% annual GDP growth for this year, which is above where we are year-to-date.
My forecast was too optimistic. We only have had 2% GDP growth in the first three quarters. Part of that, of course, was that terrible first quarter, which was weather-related to some degree. We are really running below-trend GDP.
I, the Fed and almost all forecasters were too optimistic on the GDP side. And yet we were too pessimistic on the unemployment side. The reason for that was the productivity growth being so disappointing as I remarked earlier.
The early read for this fourth-quarter is not great. Most estimates that I see are between 2% and 2.5%. I am hoping that the drop in oil prices, which is a very significant economic event, could boost growth this quarter and through 2015. But we will have to wait to see how the GDP data come out on that.
When we spoke last year, the Shiller CAPE ratio was approximately 25. Now it is nearly 27. I know that you’ve introduced an alternative approach using the NIPA data. Looking at either the Schiller or NIPA data, how worried are you about overvaluation?
There have been a couple of important developments. You should read Jason Zweig’s interview with Bob Shiller that appeared in October 10 edition of the Wall Street Journal. In that, Shiller actually sounded like he’s read my work (The Shiller CAPE Ratio: A New Look, posted on jeremysiegel.com) and agreed with it. He said a number of things about the CAPE being overvalued according to its long history, yet asked, “How do we know that history hasn’t changed?”
Of course, I say that what changed is that reported earnings are calculated very differently now than they have through most of this 143 year series. That big earnings declines that occurred in 2002 and 2009 are distorting his CAPE data.
He’s also come up with two alternative CAPE measures in a working paper with Oliver Bunn from Yale University. He hasn’t put those new CAPE ratios on his website yet, but these measures show much less overvaluation in the market and take into account some of the criticisms that I have made.
I want to stress that it’s not Bob’s fault that CAPE has been far too pessimistic over the last decade. I’m not attacking his CAPE methodology. I’m attacking the data that is being fed into it. When Shiller invented the CAPE in 1996 or 1997, these were not issues. The FASB rulings that came into play over the next 10 years mandated tremendous write-downs to corporate earnings in recessions and are distorting his CAPE data.
If you use the CAPE methodology and make the corrections I recommend, using the NIPA (National Income and Product Account) data instead of S&P reported earnings, valuations are virtually at the historical mean. I am not worried about stock valuations at these levels.
One forecast you made last year that wasn’t as accurate as the others was for interest rates. You had projected a 3.75% for the 10-year.
I thought there was going to be better GDP growth and that was going to spur higher rates. This is one area where my closer look at the economy convinces me that we will have a permanently lower interest rate structure than we have seen in most of the post-World War II data. I believe we are going to see the average TIPS 10-year rate of about 1.5% and an average Fed funds rate at approximately 2%.
This doesn’t mean we are not going to go above those levels if we are at the top of the business cycle. I believe the new average 10-year Treasury rate will be about 3.5%, but I don’t necessarily think we are going to get their next year.
I reason for my interest rate shift is a better recognition of the slower growth forces that impact our economy. The CBO predicts only 1.5% to 2% GDP growth in the U.S. over the next 10 years. That’s a very sobering forecast I was clearly wrong on that interest rates. I’ve now shifted my opinion – not that rates won’t rise, but not nearly as much as I had thought.
You talked about Japan earlier. Do you see the potential for any spillover effects in the U.S. from the aggressive quantitative easing that they are undertaking now?
No. Obviously to the extent that their QE spurs Japan’s economy, that’s good for the U.S. But I believe we are done here in the U.S. with QE, absent a very unexpected shock caused by factors that neither I or the Fed sees now.
Nevertheless, if oil prices continue downward – far more than we’ve experienced so far – that would put a long pause on the Fed raising rates. Yet I don’t think that there’s much stomach here to reintroduce QE. There would have to be some very negative GDP or labor-market developments that would spark resumption of QE.
One of the negative scenarios worrying some analysts is that there could be a recession in Europe and Japan, along with a slowdown in China that you talked about earlier. This could actually trigger deflation in the United States. Is that something that you consider at all possible?
Oil prices are coming down. In the next few months, the headline inflation CPI and probably the PPI indices will be negative. But the core CPI is not negative. With the labor markets tightening, I don’t think wage deflation is in the cards.
Given that labor is much more important than commodity prices in terms of determining the cost of the goods sold, without deflation of wages it’s hard to see overall deflation. If oil prices continue very weak and the headline CPI is negative, that would only delay the Fed raising interest rates from midyear to the end of next year. But it would not spark another round of QE. Another round of QE would have to arise from some very unexpected negative development.
What would you consider your best investment idea for the next five years?
Valuations in emerging markets have been beaten up, in particular in China and Russia. In both those countries, you are being paid generously to take those risks.
Emerging markets as a group, which has lagged the U.S. and Europe in terms of performance over the last two or three years, are very attractive and will reward investors three to five years from now.
And obviously you consider U.S. equities still a good buy.
I still think they are a good buy. Lower long-term interest rates, which are the denominator of every asset-valuation model we know, have to be favorable for the valuation of stocks.
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