Jeremy Siegel almost never gives a one-year forecast for stocks, but last week he predicted that U.S. equities will end the year with gains of as much as 10%. That may seem meager for investors who have benefited from double-digit gains in seven of the last nine years, but Siegel said this year will be far better for stocks than it will be for bonds.
Siegel is the Russell E. Palmer professor of finance at the Wharton School of the University of Pennsylvania in Philadelphia and author of the book, Stocks for the Long Run, originally published in 1994 and now in its fifth edition. He spoke on Thursday at the TD Ameritrade LINC conference for advisors in Orlando, FL.
Siegel has been unabashedly bullish on stocks during the post-crisis period and, unlike those analysts who have warned of overvaluation, his predictions have been vindicated. Indeed, he said that his 2018 forecast was the most bullish of those recently appearing on CNBC. Despite losses last week, stocks have gained approximately 5.6% this year, so he is poised to continue that record.
He provided some context for his bullish outlook based on the long-term performance of stocks versus other major asset classes.
Going back to 215 years to 1802, Siegel showed the degree to which stocks have outperformed bonds, bills, gold and the dollar itself. “Over the long run it is the most stable asset,” he said. “It’s not really a random walk. It is mean reversion.”
He said that stocks have returned 6.8% annually on a real basis, implying that they double every 10 years. Those returns have been very constant, he said, even over various sub-periods. Bonds have returned 3.5%, bills 2.6%, gold 0.5% and the dollar -1.5%.
Inflation, he said, has been evident only since World War II and has not hurt stock returns. “That should be the case because they are real assets,” he said.
Siegel presented data going back 115 years on international stocks based in U.S. dollars. In every country in the world, he said stocks “slaughtered” fixed income. The U.S. equity market is number three; number one is South Africa, because it had the lowest starting P/E ratio. Across the world, stocks have returned 5% to 5.5%, he said.
Global valuation
Siegel was not overly concerned about inflated equity valuations.
The average P/E ratio for the S&P since World War II has been 17.02, he said. Now it is slightly greater, about 21-22. He said there have been sub-10 P/E ratios only when there was double-digit inflation. P/E ratios are normally 18-20 when rates are low, as they are now, according to Siegel. The highest P/E was 30 in March 2000, when the technology sector had a P/E ratio of 90. The rest of the market was at 20, he said. The P/E of the NASDAQ was 600 at the peak of the dot-com bubble, he said, adding that bitcoin is in a similar bubble and will meet a similar fate.
“I don’t believe that stock prices are driven by quantitative easing (QE),” he said, or their gains would have reversed during once the Fed began shrinking its balance sheet last year. “They are really driven by earnings and interest rates.”
Siegel distinguished between frim-reported earnings (which he said are the most liberal, because companies can include or exclude what they want), S&P operating or “core” earnings (where companies can expense certain things like pension costs) and GAAP or reported earnings (which are the most conservative, because it requires assets to be written down, which he said is overly conservative). Siegel uses S&P operating earnings for his analysis.
Siegel said that the earnings yield, which is earnings divided by price (the reciprocal of the P/E ratio), is the best predictor of long-term performance. Over 150 years, the average E/P is 6.7%, which he said is very close to the long-term historical real return for equities.
Stocks are priced at 22.5-times 2017 estimated operating earnings or 19.2-times this year’s earnings. Being conservative, using an estimate of 20-times 2018 earnings, he said stocks should return 5%. That 5% return consists of 2% from dividends, 2.5% from stock buybacks and 0.5% from capital expenditures and growth.
“That is my prediction for real returns on stocks over the long term,” Siegel said.
A 5% real return is not a historical anomaly, Siegel said. Until fairly recently it was impossible to hold an index portfolio of U.S. stocks. He said it would have cost 150 basis points. The actual return was 5% on a real return of 6.5% from the index.
Europe is priced at approximately 15 on a P/E basis and Asia (excluding the Nikkei) is priced at 17-18, he said. China and Australia are valued similarly to Asian equities. Emerging markets are priced at a mid-teen P/E ratio.
“Everywhere else in the world will outperform the U.S. in the next three to five years,” he said.
Don’t be fooled by the CAPE ratio
As we have noted previously, Siegel has been critical of the Shiller cyclically adjusted price-earnings (CAPE) ratio.
The Shiller CAPE ratio has an R-squared of 33%, Siegel said, meaning that it explains only a third of the variation in future equity performance. He said the CAPE predicts 1.9% real returns over the next decade.
The mean CAPE ratio was 16.62 over the last 100 or so years, he said, but for the last 30 years the CAPE has been above average. As a result, the actual 10-year return has been higher than what CAPE projected. In May 2009, when the Dow was at 8,500, the CAPE signaled overvaluation. It is now 26,000. “That’s not a good prediction for the CAPE ratio,” Siegel said.
What went wrong? Siegel said that Shiller uses a measure of earnings that had a big spike down in the financial crisis. But that spike was because the FASB changed its definition of GAAP earnings, forcing companies to use mark-to-market to value assets. He said that the 2009 spike was the result of AIG, Citibank and the Bank of America having to take unrealistically large writedowns on assets. Siegel prefers to use the operating earnings corroborated by NIPA that don’t include those writedowns.
“That change in definition caused all this bearishness,” Siegel said.
Interest rates and inflation
Siegel noted that the 10-year TIPS yield peaked in March 2000 at 4.4%, when the P/E ratio on stocks was 30 (and the E/P was 3.3%). Bonds were poised to return more than stocks and there was an inverted risk premium.
“Nothing like that is going on today,” he said, with a P/E of 20 and TIPS at 0.5%.
Low interest rates are not because of QE by central banks, Siegel said. “They are caused by low inflation, low growth, a high private and regulatory demand for liquid assets, increased risk aversion from older investors and the negative beta of long-term Treasury bonds.”
Siegel said that once the 1970s inflation was “wrung out of system,” bonds became a good hedge against poor stock performance, which is why he called them a negative beta asset.
“That is a source of huge demand and why rates have not gone up,” he said, “despite huge deficits. The demand for this hedge asset is almost insatiable.”
But, he said, if inflation spikes then bonds will lose that property.
If we are stuck in a low-interest rate world, investors will want dividend-paying stocks, Siegel said. He presented data showing that cash dividends have outpaced the CPI during high and low inflation periods. He said that cash dividends are the strongest since the financial crisis.
What about the yield curve inverting? It has been a reliable signal of recessions, Siegel said, and the yield curve has been flattening. But the average spread between two- and 10-year Treasury bonds has been lower than it is now, according to Siegel. He predicted a higher yield on the 10-year Treasury, but said the yield curve will not invert.
Siegel said there will be three or four Fed rate hikes in 2018, bringing the Fed funds rate to 2% or 2.25%. But, he said, that is dependent on jobs gains of 200,000 to 250,000 per month.
The long bond will hit 3.25% this year, Siegel said, which will be “somewhat of a challenge for stocks.” The yield curve will be “flatter but not flat,” he said, and there will be no recession in the next 12 months.
The recent gains in the equity market were due to the excitement of the tax cuts, he said, but those cuts are “front loaded,” because they allow for the expensing of capital equipment.
“It is a possible for a correction,” Siegel said, adding that the losses during the week he spoke came as rates were moving higher.
Read more articles by Robert Huebscher
Jeremy Siegel almost never gives a one-year forecast for stocks, but last week he predicted that U.S. equities will end the year with gains of as much as 10%. That may seem meager for investors who have benefited from double-digit gains in seven of the last nine years, but Siegel said this year will be far better for stocks than it will be for bonds.
