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 Jeremy on Monday, November 30th.
In our interview on November 24 of last year, you said the fair value of the S&P 500 was approximately 2,300. On that day the S&P closed at 2,064 and on Friday it closed at 2,090, which is a 1.2% gain. Now that’s short of your forecast, but in fairness, the consensus at that time was considerably more bearish than you were forecasting. What happened that you did not expect?
Outside of a recessionary period, I have never seen a shortfall of earnings relative to estimates as sharp as we have had this year. We had a total collapse in earnings.
At this time last year, the estimates for S&P 500 operating earnings were between $120 and $125. Now, those earnings are coming in at approximately $106 to $107. This is an unprecedented decline. It happened because of the collapse in oil prices and the strength of the dollar. That has taken $15 off of S&P earnings.
No one thought oil would go down so far. When people ask, “Well, isn’t lower oil good for the U.S?” The answer is, “Yes. Lower oil is good for the U.S. In fact, even a higher dollar, everything equal, is good for the U.S. It increases purchasing power. It lowers the price of imports and it helps the consumer.”
But the problem is the S&P is not just a U.S. Index. With 40% to 45% of its profits earned abroad, a heavy energy sector and an industrial sector that supplies to the energy sector, anything that pounds energy is going to pound the S&P. That’s why the return on stocks fell so sharply from what I had predicted.
Can we expect a bounce back next year? What is the fair value for the S&P 500?
S&P 500 operating earnings estimates are about $125. That was way too bullish a year ago. I think that’s still probably too bullish. But I don’t think $120 is necessarily off the table because outside of the energy sector we did have a good 7% to 8% growth in earnings. All we need is for oil to stabilize at the $40 to $50 level and the dollar to stabilize at $1.05 to $1.10 for the euro for us to get a nice snap back in the earnings.
If we get an earnings recovery, then we will have a one-year delay of my forecast last year. Reaching 2,300 for S&P 500 is definitely a possibility by the end of 2016.
The drop off in earnings was to some degree offset by an increase in PE multiples.
Yes, P-E ratios have risen because of the anticipation of a bounce back in earnings. We have PEs that are pretty elevated. Based just on this year’s operating earnings, we are at about 19. As I did last year, I’m going to say that in the low-interest-rate environment we are in, a multiple of 18 to 20 could be considered a fair market value. If you apply that multiple to an earnings bounce back you get 2,300 for 2016 on the S&P.
I want to be clear that you are using operating earnings and not reported earnings.
That is correct. You and I have discussed which is a better measure, operating or reported. S&P operating earnings are extremely conservative and they are much lower than the IBES estimates of earnings. Actually, S&P operating earnings are about the most conservative operating earnings out there. At 2015 estimates of $106, that gives us a PE multiple of about a 19.5.
You’ve got a lot of write-downs, especially in the energy sector in this year’s earnings. But when I say 18 to 20 times earnings, I’m talking about a conservative measure of the operating earnings such as Standard and Poor’s uses.
The question that all investors are asking is whether the Fed is going to increase interest rates when it meets in December. You said last year that you believe we are in a permanently lower interest-rate environment. Has your view changed at all on rates?
No it hasn’t.
I said last year that if oil prices continue to go down, the Fed hike would be delayed until possibly the end of this year. It is a virtual certainty that we will have our first hike in December. But we will still have permanently lower rates. Last year, I said we are going to see an average 10-year TIPS rates at 1.5% in the next several years and average Fed funds rate of 2%. That was way below estimates last year, but now is becoming a much more accepted forecast.
The minutes of the last FOMC meeting started out by indicating that The Fed staff thinks that the “new-neutral” Fed funds rate is going to be 2%. That is a huge change from what they had been anticipating. They had been saying that the long-term Fed funds rate is going to be 3.5%. So the Fed staff believes that we are in a permanently low interest-rate environment. Now the Fed staff is distinct from the FOMC members who make decisions, but the staff’s research is very influential.
Last year you also said that the new long-term yield on the 10-year Treasury bond would be 3.5%, but you didn’t say when we would reach that level.
If you take the 1.5% in TIPS projection and if the Fed hits their 2% inflation target, then when you add the two together you get my 3.5%.
But we are not at 2% inflation, and we are not at 1.5% TIPS yet. The 10-year TIPS right now is at only 60 basis points. We can expect some increase.
What is your forecast for inflation? We have been seeing some fairly positive news on the job-creation front, but we still have depressed commodity prices.
Yes, very depressed.
Last year I said one of my worries was whether we would get job shortages that might force up the price of labor. Unemployment is down to 5%, which is the realm at which the Fed says is long-term full-employment level at which wages do begin rising. We’ve seen some increase in wages but nothing scary yet. I am not worried about inflation next year. I don’t see any big blow up. But if we are going to see some price pressures, it will be on the wage front.
I said last year that I hoped we would see an increase in the participation rate. Well, we certainly have not. We are seeing declines in the participation rate. We are adding to the labor force only 50,000 to, at most, 100,000 people a month and we are creating nearly 200,000 jobs. This is what is causing the decline in the unemployment rate and will ultimately put pressure on labor costs.
One more question related to equity valuations. What is your take on what has been going on with share repurchases? How does that factor into valuations?
I’m a fan of share repurchases. It gets a bad rap in the press.
Let’s face the facts. Firms don’t need to put their earnings into expanding their plant and equipment and capacity. They are easily selling all that they can produce. There are no shortages. So what are they going to spend their earnings on? There is no persuasive new technology that they have to acquire. So I say return it to the shareholders.
Given our tax system, which mitigates against dividends as opposed to capital gains, share buybacks are a very tax-efficient way to return value to shareholders. It is much better for companies to repurchase shares than waste the money buying other firms or plunging into some other activity or investment that isn’t in their core competencies.
I would love firms to pay more dividends. And we have seen dramatic increases in dividends this year, many more than 10%. But firms say, “I want to get this money back to the shareholders. Dividends are taxed at 23.8%, but I can do it with share repurchases, which are deferred capital gains that have a lower effective tax.”
Does it concern you that a lot of those share repurchases have been funded through debt?
Much that is funded through debt does not have it be. One of the reasons is that, because of our tax system, money earned abroad is not being brought back.
With interest rates so low, companies are taking out debt. Look at the basic facts. Let’s say the PE is 20, and therefore we are earning 5% on our equity. Of that, 2% is goes to dividends. At most, 1% goes to expanding plant and equipment. So 2% is from buybacks – from free cash flow. The average firm does not need to float debt to buy back shares. They may be issuing debt for tax reasons, but that debt is not the ultimate source of the cash needed for buybacks. We are largely financed by the cash flows of the corporations.
Do you expect the dollar to remain strong against the currencies of our trading partners?
Yes, although some people think the dollar will experience a huge appreciation because European policymakers are sending their interest rates lower while we in the U.S. are moving in the opposite direction. But a lot of this is already built into the exchange rate. The dollar is pretty high now. I went to Europe in September, and it was the first time ever that that Europe was “cheap.”
Last year you said that China, Russia and the emerging markets would reward investors over the long term.
I was clearly too early with that call. A lot of the decline in EM equities is, of course, tied to the unprecedented commodity price collapse. Who would’ve believed that oil could be $40 or lower? And it is not just oil. Look at copper and many other metals. Unfortunately many of the emerging markets are tied to those raw materials.
But one country that definitely is not is India. It is growing at 8% and stands to benefit from lower commodity prices. But the collapse of commodity prices has really hurt other countries.
Commodities have likely gone down as much as they are going to because there is so much bearishness in this area. I believe that emerging markets do have value. Three to five years out that sector is going to be rewarding. Yes, I said that last year, and I know 2015 wasn’t rewarding at all. But we know that these markets are volatile in the short term.
Again, we don’t need oil prices to go all the way back up; we just need them to stabilize to give value to many of these stocks.
Is the weakness and commodities driven primarily by China? Has China lost control of its economy?
A lot of the weakness is driven by China, but to say China “has lost control of its economy” is pretty extreme. China’s growth is going to be at least in the 3% to 5% range. Forget their 6% or 7% forecasts. But even 3% is still twice the U.S. level and three times the European level. But yes, the decline in commodity demand is primarily driven by China.
The other factor leading to the commodity price declines is the general strength of the dollar because oil and other commodities prices are quoted in dollars.
The China slowdown plays directly into why oil is so cheap. Automobiles are the major source of oil demand, and automobile sales in China have been way below estimates. The U.S. has had a tremendous increase of four million barrels a day during the last four or five years from fracking, which was impossible to predict several years ago. You add four or five million more barrels from the U.S. to a sharply slowing China demand and with no one in OPEC cutting production, it is not surprising oil is $40.
You said that a further drop in the price of oil would cause you to be more bearish. Are there other things that you worry about that would cause you to be more bearish, particularly with respect to U.S. equities?
As I said, we have to watch for tightening in the labor market. Another thing that I mentioned last year and is now getting everyone’s attention is the very distressing productivity collapse that we’ve seen. I was one of the first to point out that we’ve been having basically zero productivity growth over the last several years – way below estimates. We don’t know all the reasons for it.
There could be some mismeasurement problems involved. Prices may be falling faster than we think. So many things are “free” and bundled today -- camera and GPS services, information retrieval, etc. The GDP statisticians don’t know how to get those freebies into their data. There is lots of work to do to understand this productivity decline.
I’m also disappointed that the labor-participation rate hasn’t increased. We have near-full employment, and we’re creating almost 200,000 new jobs a month and people still don’t want to go into the labor force to search out work. This is a disturbing trend.
However, I do not believe these worries will be the major factors driving equity prices next year. The major driver of equity prices will be the bounce back in earnings. If we don’t see some bounce back in earnings, we are not going to have a good year in stocks.
Stepping back, what guidance would you offer to financial advisors who are looking to construct portfolios for clients, particularly those clients who are in the early stages of their investing lifetimes and are taking a long-term view towards growing their wealth in their portfolio?
A lot of advisors as well as investors have been avoiding dividend-paying stocks because they said, “It’ll look like I’m crazy if I invest in a yield-based strategy on the eve of the Fed hiking for the first time in nine years.”
But once the Fed does hike, as I think they will on December 16, it will be a different story. Advisors will look around and find the world has not ended, and the yield on the 10-year is still very tame. They are going to start saying, “You know what? Maybe we should be going into some of these really great yielding stocks because, very honestly, we are not going to find yields in the fixed-income area.”
Despite permanently lower interest rates, we’ve had approximately a 10% increase in dividends in the S&P 500 this year. Dividends have increased despite a terrible year for earnings. That is where the opportunity lies. Once the Fed hikes, we could see a very nice rally in those value stocks that have been under so much pressure this year.
Read more articles by Robert Huebscher
