Thoughts for the long run

Business Times - 03 Jun 2009

This crisis is not going to turn into a Great Depression as in terms of GDP, it will be similar to those of the 50s, 60s, 70s and 80s

OVERVIEW

JEREMY Siegel is a teacher and scholar who holds an endowed chair at one of the world's leading business schools, the Wharton School of the University of Pennsylvania. Yet, he is best known for his book Stocks for the Long Run. First published in 1994, the book is a financial bestseller and is now in its fourth edition. The Washington Post placed it on its list of the 10 best business books of all time.

Dr Siegel appears frequently on CNN, CNBC and National Public Radio. He writes a regular column for Kiplinger's and Yahoo Finance and has contributed articles to The Wall Street Journal and the Financial Times as well as other leading business publications. He spoke with Citi's chief investment officer Jeff Applegate and took questions from listeners in an April 8 conference call for investment professionals.

Mr Applegate: Reports have come out that stocks don't have nearly the advantage over bonds over the long term as often thought, and that there are long periods in which bonds outperformed stocks. Can they be right?

Dr Siegel: Well, if you calculate the 40-year return on stocks and bonds as of the March 9 low, government bonds did outperform. That's not true any more with the rally we just had in the stock market. Over the long term, stocks have about a three-percentage-point edge over bonds.

If there is a bubble going on right now, it's in US government bonds, which are sure to fall in value. This is absolutely the worst time to make the comparison between the returns on bonds and stocks.

Mr Applegate: Do you think March 9 was the low for the stock market?

Dr Siegel: I tend to believe that - but, certainly, I can't make that guarantee. If we assume it's the low, then the market was down more than 50 per cent from the peak. Once you've declined 50 per cent, investors are generally looking at 10-12 per cent gains a year, going ahead three to five years and sometimes much more. Now that the market has moved up, many will give up, saying: 'Gee, I already missed the first 25 per cent.' Don't feel bad about that! There's a lot more to go. And, actually, you're not out of the bear market until we've broken through a previous rally high, about 940 on the S&P 500.

Mr Applegate: Would your remarks about US equities extend to global equities as well?

Dr Siegel: Yes. We've all been amazed at how correlated world markets are. They're moving in sync. This happened in 1987, too. In a crisis, you don't get the benefit of diversification.

In terms of recovery, I am most optimistic about Asia. I'm least optimistic about Europe. The Europeans are saying this is a US problem and have been reluctant to lower rates as much as the US has done. I believe that they will come around and get their rates down to our level. Still, the fact is that they've delayed - meaning it's going to take longer to get out of the recession.

I'm optimistic about the emerging markets. They had become way overblown and got hit badly, but they've rallied nicely. They're up year to date, and we're not. China and India are not falling apart. Their currencies have stabilised after an initial decline, and their stock markets have stabilised, too.

Mr Applegate: You've written recently that the way in which earnings for the Standard & Poor's 500 Index is calculated distorts the picture. Can you explain?

Dr Siegel: When S&P computes aggregate earnings, it adds dollar for dollar the losses of any company to the gains of any other, without any regard for the market value of these companies. On its website, S&P says it looks at the S&P 500 as 500 divisions of a single company, and the losses of one cancel out the gains of another.

That is absolutely wrong. Clearly, the losses of one firm don't cancel out the gains of another if they're separate firms. AIG had a 2008 loss of US$95 billion that was more than twice the total profits of Exxon Mobil. AIG had a market value of US$15 billion while Exxon Mobil was almost US$400 billion; yet, S&P says that all Exxon Mobil's profits are cancelled out. If you held a market-weighted portfolio of both those stocks, 95 per cent of your money would be in the oil company, yet S&P would say your portfolio didn't have any earnings.

The point of this is that if you correct S&P earnings for market value of the companies reporting those earnings, you don't get anywhere near the terrible earnings that you do when you add all these financial losses together with the gains. AIG shouldn't even be in the S&P 500 anymore. If you took it out, S&P earnings would go up by US$10 a share.

Mr Applegate: Many people believe all the money that is getting pumped into the economy will cause inflation. Do you agree?

Dr Siegel: No, because I do believe that the Federal Reserve will pull back as necessary when the economy recovers. The board members understand their charge, which is to keep prices within a stable range. They must also prevent deflation because, when we look back at the 1930s, it was, in fact, the tremendous collapse in prices - the Consumer Price Index went down 35 per cent between 1929 and 1934 - that essentially bankrupted everybody who was in debt. In real terms, debts rose by more than one-third.

Of course, the Fed is also working to prevent a breakdown of the banking system - which did collapse in the 1930s when the Fed did nothing to prevent it. That is equally as important as preventing deflation.

All these policies are the reason why this tremendous financial crisis is not going to turn into a Great Depression. In terms of GDP (gross domestic product), this recession will be similar to those of the 50s, 60s, 70s and 80s. The problem is that everyone got used to the light recessions of 1990, 1991 and 2001 and thought we were in a new world of very low economic volatility. That is one of the factors that, in fact, encouraged all the risk taking that led to this crisis.

Mr Applegate: Is there anything that can be done if you are worried about inflation?

Dr Siegel: Get a home and lock in your 30-year fixed-rate mortgage at less than 5 per cent. If you pay a reasonable price now, you have hedged yourself and your investment against all that liquidity that we see going forward.

Mr Applegate: So you think real estate prices have bottomed?

Dr Siegel: Very near. It's still got farther down to go, but not too much. There are two prices now, there's the buyer's bid price on a lot of stuff and then there's the ask price by the sellers. Sellers are slowly coming to the realisation that if they want to sell, they're going to have to get much closer to those bid prices.

Look at the Affordability Index that is put out by the National Association of Homebuilders. It measures the degree to which the average family can afford to buy the average home - given their income, given the price of homes and given the interest rate. By this index, real estate has rarely, if ever, been more affordable for the average family to buy the average home. That is, in large part, due to the very low interest rates.

The interview was first published in May issue of Citi Private Bank's 'The View'. Opinions expressed herein should be regarded solely as general market commentary, and may change without prior notice. Past performance is no guarantee of future results.