In 1994, an economist from the Wharton School at the University of Pennsylvania published a book in tune with the times. Called Stocks for the Long Run, it became the bible of the bull market. The author, Jeremy J. Siegel, had painstakingly researched stock prices over 200 years and concluded — as the title suggests — that investors who put their money into equities, over the long run, wind up ahead. His data showed that in their worst 20-year period, stocks rose more than 20 percent (adjusted for inflation) whereas bonds fell by 60 percent in their worst 20 years.
Although the book might have helped convince new investors to put their faith in stocks, Siegel was not a cheerleader for the bull market. Indeed, in March 2000, Siegel warned that the tech darlings that were pushing the indices to new records were vastly overpriced. In 2002, McGraw-Hill published a third edition of his book ($29.95). In it, Siegel dissects the 1990s bubble, includes material on the rise of exchange-traded funds and behavioral economics and makes the case that the bull market from about 1998 to 2000 was, in fact, restricted to the tech sector.
Recently, Siegel sat down with Registered Rep. Editor David A. Geracioti to discuss the market. Siegel's most important message? That there must be a new approach to calculating the “right” price-to-earnings multiple for large stocks. “I conclude that the historical average of 14.5 is no longer appropriate, and that a significantly higher ratio is now warranted,” Siegel says. He thinks that the p/e multiple should be at around 20 times normalized earnings because of efficiencies in the market and favorable taxes. But, he says, the market will continue to be under pressure until faith in earnings is restored. And that is the basis for Siegel's second main message: Congress, by altering our tax system, should actively encourage dividends.
Rep.: First of all, let's just get to the question that you always get asked: Are stocks still the best bet for the long run?
Siegel: Definitely yes. What's your alternative? Look at the bond market right now. The 10-year government bond is yielding 4 percent — that's taxable, there's no growth possibilities, and no protection from inflation. I would say that hands down the stock market is going to beat those bonds over the next 10 years.
Rep.: Is this bear market unlike any other?
Siegel: Yes. The bull market was unique also in the sense that it was heavily concentrated in technology stocks. If you look outside the tech sector, you didn't have much of a bull market, and non-techs haven't suffered much of a bear market.
Technology became more than one-third of the market value of the S&P 500 index at the market peak, and when tech stocks collapsed, of course they hurt the S&P's performance. But if you take the technology sector out of the S&P, you will find that the bear market would be classified as being relatively mild. In the past, the big bull markets had virtually all sectors participating, while this time, it was almost entirely concentrated in the technology stocks.
Rep.: Was it really just tech?
Siegel: Look at the bull market in the late 1990s. There was much excitement with the new economy, the new technology and the Internet. And Internet trading hyped up many of these stocks. Many thought we were entering a new age. In fact, if you remember, old economy stocks were being abandoned as the techs soared. Anything that did not smack of being a part of the new economy was sold. Real estate investment trusts were way down. Retail outlets were considered old economy, and it was thought that the Internet was going to put most retailers out of business. All the old industrial firms were being sold. It was a very distorted picture of reality.
Rep.: So, non-tech stocks didn't play on the way up, but didn't get hurt so badly on the way down?
Siegel: Yes. The old Dow stocks, that is before they added Microsoft and Intel in late 1999, were sold down to 9,700 in March of 2000, as the Nasdaq hit 5,000. Now that old Dow group of stocks is at 8,500, down less than 15 percent. But the S&P is down by about 40 percent. This shows where the bear market is concentrated.
Rep.: You take a long view of the markets. Does the Internet bubble look like the 1920s, when radio and the mass production of the automobile signaled another “new era?”
Siegel: The optimism of the 1920s was different. First of all, the Federal Reserve had been established a few years earlier, and people thought it would somehow be able to control the economy. Many proclaimed that there were going to be virtually no more business cycles. Peace seemed to reign everywhere. They even started using the phrase “new era,” one marked by stability. All stocks would go up.
The 1990s were different. This was just a fascination with technology, and the non-tech stocks went down. They did not share in the new economy.
Rep.: What lessons can our readers — brokers and financial advisors — draw from the market over the past few years? How can they help investors benefit from and/or protect themselves from the madness of crowds?
Siegel: I sympathize with every broker and financial advisor and thank goodness I was not a money manager during that time. I would have probably lost all my customers, because I would have kept my clients out of tech stocks and, as a result, would have woefully underperformed the averages. Everyone would have told me to get into these stocks, and I'd say, “I don't want to, I think they're overpriced.” And they would take their money away. What are you going to do? You're eventually shown to be right, but can you win your old clients back? Maybe not. This goes way beyond just economics. You're entering the area of psychology and marketing.
Rep.: Tell us more about the bear market.
Siegel: First of all, there are two phases of this bear market. The first phase was the technology bust. Then came the question of the quality of earnings. It's not just corporate scandals; it is the quality of the earnings. The fact that the dividend yield has dropped to such minuscule levels means there's no longer the tangible evidence the firm is making money. And there's no longer any cushion on the downside provided by the dividend that used to cushion stocks in prior bear markets. Without the dividend, the trust in earnings becomes paramount. And when firms begin to cook the books or stretch their definitions — that's what caused the second leg of the bear market.
Rep.: But wasn't there always some fiction in reported earnings?
Siegel: The truth of the matter is that many years ago firms would say I have $4 in earnings and they almost always had it. They could give you a $3 dividend, and that other dollar they could actually use to reinvest in the firm. Now, they're saying they have four dollars, and it's not clear they do. I think this is worrying the market.
Rep.: But people have been yelling about this for a long time, even before the bear market.
Siegel: There was a lot of criticism of accounting in Internet and tech stocks. What really happened, I think, is that manipulation spread to the blue chips — stocks that were formerly untouchable such as GE and even IBM. All of a sudden firms that looked like they were doing really well suddenly were found to be cooking the books to some extent. And I think that's really taken a terrible toll on the market in 2002.
Rep.: So if you're an investment advisor, what should you be looking for?
Siegel: What drives stock prices? I've always said the two big things are, and always will be, earnings and interest rates. Now, interest rates are very favorable, but earnings are not. Earnings are very troublesome and are now more of a concern than potentially higher interest rates in the future. I don't think the potential war with Iraq is a major factor, at least not yet.
Rep.: Where are there good values in this market?
Siegel: My feeling is that there's still a premium for companies that have been honest in their reporting, that pay a good dividend and that return profits to the shareholder. I think that's going to become even more important in the future. Now there are some firms that might have been unfairly tarnished by the scandals. If these firms can prove that they really do have those earnings, they will recover. So there are a few that you should be on the lookout for.
But investors must be careful because a lot of people in the early stages thought that Tyco wasn't tarnished, and it ended up that it was. Often new companies tend to have more trouble than some of the companies that have been around a long time, although that's not always true. General Electric has been around over 100 years, it's about the oldest company in the Dow Jones Industrial Average, and yet to keep the earnings rolling at a steady pace, it looks like Jack Welch did a bit of manipulation. So even the older companies are not immune. And that is what really has hurt a lot of stocks this year.
Rep.. What about valuations?
Siegel: My feeling is that the right p/e ratio for the market is in the low 20s — that is, priced on earnings that we really can trust — and not the 15 that has been the historical average.
Rep.: Why should it be higher than the historical norm?
Siegel: Because [now] we can avoid crises such as banking collapses, great depressions and double-digit inflation. We also have a much more liquid market. Transaction costs are much lower. We have a favorable set of taxes on equities. These factors are very favorable and lead to a higher valuation in the equity market.
Rep.: So you're not a value guy.
Siegel: Not exclusively. In fact, in one of the chapters of my book I said that growth stocks are actually worth 40 times earnings. That was considered almost heretical back [in 1994], when few money managers would pay more than 25 or 30 times earnings.
Rep.: So you might be a buyer of large-cap growth stocks now?
Siegel: Certainly. At 100 times earnings, as they were three years ago, that was ridiculous, and I said that emphatically in print and on the air. Right now, 40 times earnings is what a good growth company should be selling for. And a value company should probably be selling closer to 15 times earnings, I would say.
Rep.: Don't stocks themselves move from one category to another?
Siegel: Yes, and that is important. Historically, large value stocks have a small edge over large growth stocks. In small stocks, the advantage of value seems to be much more certain, but on big stocks it is not. I think you do really well with growth stocks if you avoid some of the really overpriced ones. When you get over 50 or 60 times earnings, those stocks very rarely live up to investor expectations.
Rep.: As brokers look for opportunities now, what else can they learn from past bull-bear cycles?
Siegel: I have a chapter in my book on the Nifty Fifty of the 1970s, and I show that, as a whole, those stocks did pretty well if you held them for the long run. But those that were selling over 50 times earnings definitely underperformed.
Rep.: Did well from when to when?
Siegel: From the peak of the market in 1972 until today.
Siegel: Believe it or not, yes. It was quite an eye-opening study.
Rep.: People usually bring up the Nifty Fifty with derision. Why do they have it wrong?
Siegel: Because they looked at the short-term performance and not their long-term performance. You had Pfizer, you had Proctor & Gamble, you had Philip Morris. They became huge winners in the long run. They were all part of the original Nifty Fifty.
Rep.: I guess diversification is always the key.
Siegel: That's it.