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Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up:

Knowledge@Wharton
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Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest
Rates Will Go Up
Published : January 06, 2010 in Knowledge@Wharton

U.S. stocks boomed in the last nine months of 2009, but remained well
below earlier highs. Indeed, many people referred to the first 10 years of
the 21st century as "the lost decade," because stocks returned virtually
nothing while investors had been conditioned to expect 10% a year.
Meanwhile, bonds and commodities experienced a stunning run. Have the
rules of investing changed? What's ahead for 2010?
Knowledge@Wharton talked with Wharton finance professor Jeremy
Siegel, who sees some hazards, especially for bonds, but expects a good This is a single/personal use copy of
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Knowledge@Wharton: Stocks have had an incredible run in the last
nine months, giving 2009 a pretty good gain. Is this what we can expect for the future? And what
has caused this?
Jeremy Siegel: It shouldn't be a surprise. We dodged a very severe bullet when the financial crisis
hit worldwide. It started out very much like the Great Depression in the early 1930s. But in
contrast to the Great Depression, central banks around the world rallied to the cause, providing
enough liquidity to prevent a collapse of the financial system. It was doubtful whether they would
be able to do that earlier last year, which is why we saw the stock market down some 58% from its
high. Now that we avoided [a repeat of the Great Depression] -- and I can say that with about 98%
confidence -- the market has moved up substantially -- and justifiably -- from the abyss we were
looking into.
Knowledge@Wharton: When you look at the indices -- for example, the S&P 500 -- and at data like
price-to-earnings (PE) ratios, what are they telling you right now?
Siegel: We had a severe hit to earnings. Certainly, the financial sector was a major cause of that.
Before the recession, in 2007, we had earnings on the S&P 500 that were in the $90-per-share
range. That fell to around $30 a share at the bottom. Most of that was due to the financials, which
had severe, multibillion dollar losses. Those minus signs cancelled out a lot of the profits in other
sectors.
We are looking forward to much better earnings this year. Consensus forecasts are around $70 a share on
the S&P 500. I think it might even be higher. Take, for example, a PE ratio of 15, which is the long-run
average -- and we can talk about whether that's appropriate or not. Fifteen times 70 is 1,050. We're at
1,100, or a few points above that. So we are now in the range of an average valuation for this year's
earnings.
Knowledge@Wharton: Is a 15 PE ratio still appropriate? Or have things changed?
Siegel: My research shows that when interest rates and inflation are as low as they are now, the
average post-World War II PE ratio has been 18 to 20. One might say that as long as we don't get a
sharp increase in interest rates, the fair valuation of the stock market is higher than what we see
today. A second very important factor is that 2010 is just one year out from the most severe
recession in the post-war period. It's nowhere near what I would even consider normal earnings. If
we go back in history, we have usually matched, if not surpassed, the previous peak in earnings
after four years or so. As I mentioned, in 2007 we had $92 a share. That won't be hit in 2010. It
might not even be hit in 2011. But history tells us that by 2012, we should be in the $90 range or

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might not even be hit in 2011. But history tells us that by 2012, we should be in the $90 range or
even above. So, if you apply normal ratios -- 15 or 16, let's say -- to $90 a share, you still end up
considerably higher than we are today.
Knowledge@Wharton: If you add on top of that a ratio of 18, you would go even higher.
Siegel: That's true, if interest rates stay low. As I'm sure we're going to discuss later, I don't think
they're going to stay as low as they are now, although I don't picture a severe ratcheting up of rates.
Knowledge@Wharton: Let's discuss it now. One thing many people have commented on is the great
run that the bond market has had in recent years. A lot of that has been driven by the price gains
caused by falling interest rates. What do you see happening with interest rates and bonds?
Siegel: That bull market ended in the first quarter of last year, when we got the long bond [rate]
down to 2%, which was crazy but it was a depression hedge rate. In other words, people were
saying, "I need this. I want my treasuries in case the world collapses." Now that the world has not
collapsed and is recovering, we see the long bond moving toward 4%.
It was a good decade for the long bond, to say the least. But 2009 was a bad year for Treasury bonds. I
don't see it being a good year in 2010 either, because the Fed will be forced to raise interest rates sooner
rather than later. We will see bond rates move higher.
Knowledge@Wharton: Is this good news for people who are fixed-income investors or retired, or
care about interest earnings?
Siegel: It is. We all know we're sitting on our money funds, and earning infinitesimally little
income. We're not going to experience the double digits, or even high single digit interest rates, that
we did in the 1970s. But we don't want that. That was associated with very high inflation. We're
going to move toward normal interest rates, which is going to be very good for savers. For
borrowers, it's going to be tougher.
Knowledge@Wharton: Higher yields are wonderful as long as you're not losing out to inflation.
What is inflation going to do?
Siegel: Inflation is going to be under control this year and probably into 2011. However, we will
have an upward tilt to inflation, which means the longer-run trends point to a 2%-to-4% range of
inflation rather than zero to two, which unofficially is what most central banks and the Fed have
targeted. So we're going to have low to moderate inflation, not double digit or even high single digit.
The scaremongers, who worry that the ton of money the Fed created to fight off the crisis is going to fuel
the next [period of] inflation, are wrong. At the same time, we will have a slight upward tilt in our
inflation rate from what we've had over previous years.
Knowledge@Wharton: But the 2%-to-4% range is standard over the long run, right?
Siegel: It's not. I remember when I was studying economics, we talked about what a victory it
would be if we could get down to between 2% and 4%. We've been spoiled with very low rates.
Most central banks use zero to two. They come closer to two.
We'll move closer to between 2% and 4%, particularly in the United States, given the large deficits that
we have and the liquidity that was created. But just as Bernanke acted very responsibly in providing the
liquidity necessary to prevent [a repeat of] the Great Depression, he is also an excellent enough economist
to know that money is what fuels inflation. The Fed is really solely responsible for inflation. He will not
let it go above five, and probably not even four. He will raise interest rates to whatever level is necessary
if inflation starts running into the mid-single digits or higher.
Knowledge@Wharton: When we talk about inflation, we also often talk about commodities. There
has been a pretty good run in some commodities, especially gold. What do you see happening there?
Siegel: The commodities cycle has followed the world economy. It had hit its low very close to the
same time the stock market did. Everyone was looking at a very severe recession that could get

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worse and commodities -- except maybe gold -- are dependent on economic activity, particularly oil,
which is the most important one. Now that the world markets have recovered, we see oil has
recovered. I wish [the price per barrel] could have stayed down in the 60s. It has moved up to the
80s, partly because of the very cold weather we've been having in the northeast [in the U.S.]. It's
boosting demand for fuel. I would love to see it in the $70-to-$80 per-barrel range.
I believe commodities are fully priced. Gold ... is priced for an inflationary scenario that is much worse
than will be realized. Those who fear that all the paper money and liquidity that have been created will
fuel hyperinflation have been moving into gold. Speculators have moved into gold. The trends are up.
But gold is a risky investment now.... Gold is not going to be a good investment throughout 2010 and the
longer term.
Knowledge@Wharton: Looking at the economy and the financial markets as a whole, what are the
big dangers that could derail things?
Siegel: I worry about commodity prices getting out of hand. I would be disturbed if oil got to $100
[a barrel] or above. That would put a dent in our recovery, but not squelch it entirely. At this
juncture, I don't fear over-regulation. Not that I like everything that's happening in Washington,
but I don't see anything on that front that is really going to squelch the recovery.
Over the Christmas break, I was in China and Hong Kong, and Asia is very much back on the road to
recovery. That [region], of course, has been the major driver of economic growth around the world over
the last several years. So this recovery has a very sound basis. It is really a worldwide recovery in the
economy. It will continue into this year.
Knowledge@Wharton: The China story is especially intriguing. It seems to have rebounded
wonderfully. Of course, their system is very different from ours, and I'm wondering whether there
are lessons that the West can draw from China.
Siegel: There are a lot of differences. One of the differences is they have over $1 trillion in the piggy
bank and we don't have anything. China has such high savings ratios that it can start spending. We
spend with deficits, and then worry about deficits and rising interest rates. China has a lot more
flexibility. When it saw foreign demand dry up, it boosted domestic demand and infrastructure,
which it is still building apace. It has the flexibility to move.
When you have the size deficits we have, you just don't have as much flexibility, because every dollar the
government spends means a dollar of extra deficit and future taxes, which scares investors and consumers.
China doesn't have that situation. As a result, it was able to withstand the world recession better than most
other countries.
Knowledge@Wharton: In the U.S., the deficit is the elephant in the room. How important is it that
we tackle the deficit, and how soon does that have to be done?
Siegel: Two-thirds of the deficit is caused by the recession. As the recession wanes, tax revenues will
bounce back. Some spending will decline -- unemployment insurance, etc. We will move to a more
manageable deficit as a result of the economic recovery. The big 800-pound elephant in the room is
really Medicare and, to a lesser extent, Social Security, which aren't [addressed] at all in the long
run. They amount to multitrillion dollar liabilities, which unfortunately I don't think Obama's
health plan has really tackled. But the big multitrillion dollar liabilities were here in 2007, when we
were at the top of the boom. They were here in 2005 and earlier.... The problem is that although we
are able to run this size deficit in a recession, as the recession wanes, we can't run this size of deficit.
Such deficits will drive interest rates way too high, and the government will be forced to pull back. For
the long run, unfortunately, we haven't solved our problems. But for the short run, this deficit isn't
something that will derail the expansion, because we've had a tremendous decline in domestic credit
creation. The increased savings by consumers has to go somewhere, and it's going into the government
debt.
All this government deficit, which is over $1 trillion, is being very easily absorbed, because there's been
no private credit creation. As the economy improves and there's more private credit creation ... the

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Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up: Knowledge@Wharton
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government deficit won't be able to be absorbed as easily. But as the economy improves, fortunately, the
size of the deficit itself will go down, because tax revenues will rise. So the big 800-pound elephants in
the long run are still there, but I do not believe this deficit is going to derail the economic recovery.
Knowledge@Wharton: Coming back to stocks, a lot of people have been calling the first 10 years of
this century "the lost decade." I'm wondering if comparing prices today versus 10 years ago is fair.
There's quite a big difference in PE ratios from 1999 to 2009. If we were to do a 10-year span
starting a couple years later, it would be an easier comparison to make. What is the best way to
gauge the long-term performance of the market? Should it be over 10-year, or longer, periods?
Siegel: Unfortunately, we hit the bubble peak in the first quarter of 2000. I'm going back 10 years
ago to the technology and Internet boom. This decade got measured from the very top. The Dow
Jones peaked in January 2000, the S&P in March 2000. And, by the way, the 1990s followed an
extraordinary decade of the 1980s. The reason why the last 10 years have been bad is that we had
two decades of extraordinary record returns. Usually a very good decade is followed by a less good
decade, back and forth. We had never had two double-digit return decades as we did in the 1980s
and 1990s.
The result was that the market simply got way too high. The last decade has offset the excesses reached in
the 1990s. It shouldn't be viewed as a template for what's going to happen as we get into this new decade.
We're back to normal. My analysis shows we're even slightly below normal [since] this decade has been
so bad. [This decade was] slightly worse [for stocks] than the 1930s. When we look at the long run, we
are much more confident that we're back into the normal range of equity returns. Long run [equity returns
are] 6% to 7% per year after inflation. With this decade correcting the excesses of the 1990s, there's no
reason why we can't be back in that zone of normal returns.
Knowledge@Wharton: When we look at the stock market, we tend to look at the S&P 500 and the
Dow. But there are lots of other indices. I'm particularly interested in small company or mid-sized
stocks and foreign stocks. Do you have any thoughts on the health of those?
Siegel: I've been a big fan of international, and I still am. I'm a big fan of emerging markets. You
should be in international, emerging and U.S. stocks. The revenues and profits of much of the S&P
500 -- in excess of 40% now -- come from overseas. You've got to take a global view on equities. A
broad index I like to look at is the Russell 3000, [for the 3,000 largest, most liquid stocks traded in
the U.S.].
Small stocks have done very well in the last month. They had a very good December, and they have held
out well. They often do very well early in recoveries. They should not be ignored. You've got to take a
global, comprehensive approach to your stock investing.
Knowledge@Wharton: How much of an American investor's portfolio should be devoted to small
and foreign stocks?
Siegel: My feeling is that you should have about 40% of your investment in foreign stocks. I
wouldn't mind it split between the EFA [shares in countries in Europe, the Far East and
Australasia] and emerging markets. One adviser asked me what I thought about him having his
clients in one-third U.S., one-third EFA and one-third emerging markets. I said it's very aggressive,
but I like it. Over half the world's equity capital is outside the United States. That fraction is
growing. You have to take a global view.
Knowledge@Wharton: That 40% -- that's of the equity portion of a portfolio, not the entire
portfolio, which also includes bonds?
Siegel: This is the equity portion. People ask me about what fraction [of a portfolio] stocks or bonds
should be. I don't recommend that because it varies with each individual's financial circumstances.
You can't generalize. It depends on your age, your other assets, what kind of income and
pensions you're expecting.... You have to talk to your financial adviser about what [your allocation]
should be. Let me just say that given the low interest rates and what I see for the recovery and
earnings for stocks, stocks are going to be much more rewarding over the next few years than the
fixed-income part of a portfolio.

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Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up: Knowledge@Wharton
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Knowledge@Wharton: That takes us to our usual final question, asking for a bit of forecasting.
What can we hope for in 2010 in the stock market, and are stocks still the best bet for the long run?
Siegel: We're going to have a good year. The main factor that stocks are going to deal with is that
the Federal Reserve, in my opinion, is going to be forced to raise interest rates earlier than the
consensus now expects. Many people are talking about no increase in 2010, all the way into 2011. I
don't think that's going to happen. The recovery is going to be stronger than expected. The Fed is
will have to act sooner. At first, this [will lead to a] kind of panic among stock investors. There will
probably be a correction in the market.
But then, investors will say, "Just a minute. They're only raising interest rates because the economy's so
good, and profits are better" -- and [stocks will] regain their footing. So it will be another positive year in
stocks. I'm not saying it's going to be as good as the 22% or so that we had in 2009. But I see no reason
why we can't have another 10% gain in equities.
Knowledge@Wharton: And bonds?
Siegel: I don't think bonds are going to have a good year. The risk premium has gone down a lot. I
did like corporates, and risky corporates a little bit better. But those risk premiums have shrunk
dramatically from where they were earlier last year. I don't think any long-term bond portfolio
looks to get good returns in 2010.
Knowledge@Wharton: Stocks are still good to hold for the long term?
Siegel: Stocks are going to be the place to be, not only in the long run, but also over the next 12
months.

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