Jeremy Siegel: The Excessive Bearishness is Great for Equity Investors
Jeremy Siegel is the Russell E. Palmer Emeritus 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, just published its sixth edition, is widely recognized as one of the best books on investing. It is available via the link on this page. He is a “Market Master” on CNBC and regularly appears on Bloomberg, NPR, CNN and other national and international networks
This is my 15th annual interview with Jeremy, which in the past we have done just before Thanksgiving. He has been one of the most prescient forecasters among those featured in Advisor Perspectives. You can access our prior interviews here: 2021, 2020, 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, and 2008.
This interview is an abridged transcription of the opening keynote session of the Investment Insights Summit on December 13. You can watch that session here.
We spoke on November 24 last year, so this is a little bit more than a year since our last interview. The S&P 500 closed at 4,689 then, and yesterday it closed at 3,991. That is a decline of 14.9%. In our interview last year, you correctly predicted that the market would react badly to inflation and unexpectedly high CPI reports. You correctly said that you would not be surprised to see a correction of the magnitude that we have seen. But you also gave a target of 5,000 for the S&P 500, which would have been a gain of 6.7%. What is the fair value of the S&P 500 now, and what returns do you expect for the next year?
I was a little too optimistic. We got within 4% of my target on January 1, and I thought that maybe I was too low! But the Fed got very aggressive. We did enter bear market territory. I was sure about NASDAQ would be in a bear market. I didn't know that S&P would, but it did.
It was not a bad bear market, but I believe that the October is going to be the low, unless that Fed becomes over aggressive.
I have never seen so much bearishness in the market, which is a great sign for stock investors. I've never seen a recession so imminently called for. That is also good for investors. It's the unexpected, good events, not the expected bad events, that pull down stock prices.
I'm on record as saying that the stock market is undervalued. I would say it's 10% to 15% undervalued. It could run more. I would not be surprised to see 4,600 or higher by December of next year, on the basis of the following: The P/E of the S&P should average 20. The historical average has been about 16, but the trend is upward. I'm not going to go into all the reasons. I do in my book, and I've written on this subject.
What are we forecasting for next year's earnings? It is $238/share on the S&P. But what happens if there's a recession? You have to be careful. Do not put average P/E ratios on recessionary earnings. It's never been right. It isn't right now. The non-recessionary earning level is $240; if you put a 20 P/E on that, you get 4,800.
I'm not forecasting that. That would be a 20% gain from current levels. It's going to take longer to get there, but I would not be surprised to see that hit in late 2023 or 2024.
it's going to take some time to work it out. But the market is too bearish around the possibility of a recession. The Fed has a chance to pivot; that would be quite a surprise to the market. Earnings may come out closer to expectations than many are fearing today.
One of the reasons you gave last year for the strong performance of U.S. equity markets was the growth in the M2 money supply. But this year M2 growth has been essentially flat through the end of October, reflecting in part the selloff of securities by the Treasury. You have studied the relationship between money supply and economic growth, and it was the subject of your PhD thesis. What does the lack of M2 growth mean for the economy and stock prices?
It means an awful lot. Last year I was railing against the Fed for ignoring the burst of money supply that followed the pandemic, the highest growth of money in history. In the two months after COVID hit in March of 2020, I said we're going to have a lot of inflation.
The Fed continued to be overly stimulative until March of 2022, when not only did the money supply stop growing, but it started declining. We've had the largest seven-month decline in the money supply since World War II. I became very cautious in the summer, and said, "This is too much. The Fed cannot continue that decline. It will cause a recession. It's tightening too fast."
Normally we need is a 5% increase of the money supply to achieve a 2% inflation. But money growth was way too rapid from March 2020 to 2022 and now it's way too slow. A 5% growth will give us 2% to 2.5% inflation, which is the Fed’s goal. The Fed has been too tight. We're expecting a 50 basis-point increase tomorrow [Editor’s note: That was what the Fed did on December 14]. That should be, in my opinion, the last increase by the Fed.
The Fed should allow the money supply to grow again, which implies no further increase in interest rates. That would cause credit to grow, and the housing market decline would stop.
The Fed went 130 miles an hour in a 70-mile zone and then slammed on the brakes far too hard. It is hurting several industries that should not be hurt – housing number one – and is risking a recession that we should not get in 2023.
The primary concern among our audience of advisors is inflation. Last year, you predicted high inflation, and that we would see a cumulative rate of 20% over a three- to four-year period. We are on track to hit that, with a 7.1% increase in the CPI for the 12 months ending in November. You said last year the primary driver of inflation was the increased demand for goods among consumers, along with the growth in the money supply. What is your outlook for inflation for 2023 and beyond?
There's two points to mention. The official statistics that the Bureau of Labor Statistics publishes for the CPI are distorted. They're distorted because of the way it treats housing prices, which are very lagged. This is something that I've been pointing out for two years.
People were saying in late 2020 and 2021, "We don't see that much inflation," I said, "There's much more inflation that the statistics show." The BLS showed very little housing price inflation when the actual index of housing prices and rental prices were showing much more. The actual statistics understated the amount of inflation we've had in the past, but today we're on the other side. Inflation is overstated. For example, just this morning we had the CPI release, and it showed a six-tenths of 1% increase in housing prices.
Yet all the official indexes of housing are down – the Case-Shiller and the Federal Finance Housing Agency indexes. The rental indexes, computed by Zillow and others, are going down. But there is a lag, and it is going to take a year before those numbers show up in the CPI statistics. Remember housing is almost 40% of core inflation and a very important component. It is computed with a lag, an averaging process that the Fed does not fully appreciate
If you put zero inflation for the housing sector for the month of November, you get negative overall inflation, which is what I've been saying is happening. Inflation now is negative, not positive. We had about 10% to 12% inflation in 2021, but it was recorded as 8%. This year we're probably going to have inflation recorded as 4% to 6%, when we're really having 1% to 2%.
Last year, you forecast the possibility of a mild recession driven by Fed policy to arrest inflation. GDP contracted in the first two quarters this year, and then rose by 2.6% in Q3. The annual growth rate through the end of Q3 was 1.9%. What is your outlook for economic growth?
It's modest. I’m looking at 1.5% to 2% growth this quarter. It depends on how the holiday shopping plays out. GDP growth is going to be very modest this year.
There is something that has been inadequately emphasized by the Fed and others in the media. We added more than four million new workers to payrolls this year with very little increase in GDP. Year-over-year growth will probably be 1% if that.
Productivity fell by a record amount in the first two quarters of 2022. The reasons are not exactly clear. It could be related to absenteeism because of the Omicron COVID surge. It could be other factors. I think it has to do with over hiring by firms. Firms over-hired because of the fear of a shortage of labor. Those hires were not that productive.
Also, a lot of people didn't feel they had to be productive, especially those working at home. They said, "Well, can’t you fire me. You can't get anyone else." Productivity went down.
In 2023, we are going to see the reverse of that. We're going to see productivity go up. As a result, the labor market and payrolls will not be tight, and GDP could go up 3% to 4%. It'll be the flip side of what we saw this year, which was very good hiring and very bad for GDP.
This development will be good for the stock market. It’s good for productivity and for inflation because higher productivity reduces inflation. That's another reason I am optimistic about my macroeconomic forecast for next year.
Can we avoid a recession? The Fed will be forced to pivot much sooner than it thinks. A month ago, I said something, and people were aghast. Instead of a 5% Fed funds rate by the end of next year, I said it could be 2% to 3%. I'm going to maintain that possibility. On the other hand, if the Fed doesn’t ease, a recession is odds-on.
Inflation and payrolls are going to come down much faster than the Fed thinks. We're going to see softness and the Fed should reduce rates rapidly by the end of next year. Expect lower short-term rates, stronger growth and much weaker payroll growth.
There will be a recession only if the Fed is so thickheaded that it keeps its expectations that it's going to maintain a 4% to 5% funds rate through 2023.
Last year, you forecast that the long-bond rate would be 2.5% to 3%, and that the short-term rate would be 4%. As of yesterday, the 30-year rate was 3.55%, the 10-year rate was 3.60% and the three-month rate was 4.19%. Your predictions were a little bit low, but overall very accurate. Where are rates heading now? Do you still believe, as you did last year, that we will not have a repeat of rate increases like we saw in the 1970s?
We're in a totally different situation with inflation coming down rapidly. The Fed has stopped the growth of the money supply and started a mild decline. Its purpose is not to get the money supply back to where it was before the pandemic. It printed too much money after the pandemic. But it would be disastrous for it to reduce the money supply back to its previous level. That will cause a severe recession.
The good news is that the decline in the money supply is very modest compared to how much it increased. We've given back maybe 5% to 10% of the increase. With the actual price level today, we absorbed that increase in the money supply. I say “Get the money supply growth back to 5%, and we'll get the inflation back to 2%.”
(The difference between money-supply and inflation growth is real growth. We want real growth to be about 3%.)
Now, going back to interest rates, the fact that the long rate is much higher is because the Fed has talked about being aggressive through 2023. Believe We saw peak rates earlier this year. We were well above 4%. We've declined almost a full percentage point below the high.
I do not believe 4% will be reached again. I believe 3% will be punctured on the downside. The Fed funds rate will go up 50 basis points at the December meeting and should go no further. I know that the FOMC will pencil in a couple more 25 to 50 basis point moves. But on February 1, which is the next meeting, with realistic figures for housing rather than the bogus figures that it has been using, it should realize it doesn’t need to raise rates.
When softness in the labor market comes to fruition, they will say, "I don't have to do anymore hiking." Then the discussion will be when it starts lowering rates. I expect that Fed funds rate to go back betwen 2% and 3% by the end of the year, and I wouldn't be surprised to see the bond rate below 3% next year.
One notable movement in the capital markets has been the increase in real yields for Treasury Inflation Protected Securities (TIPS). Yields increased by almost 400 basis points across the TIPS yield curve. Are TIPS a compelling opportunity?
At the beginning of the year, 10-year TIPS yielded -1.5%. That went to above 1.5% and almost to 2%. At this moment, it's 1.2%, so it has come down. The equilibrium 10-year TIPS yield should be zero. We're going to migrate downward to that. We may not get there by 2023, but probably by 2024.
Stocks should be discounted using that real interest rate represented by TIPS. The rise of real interest rates from -1.5% to 1.5% was a huge shock. It's not the change in cash flows that caused the bear market; it was the increase in real, TIPS rates.
You can explain the entire bear market by the rise in the TIPS rate, by discounting a steady stream of earnings at a higher real rate.
As was the case when we spoke last year, we have an inverted yield curve. You said at that time that yield curve inversions will be more frequent and less predictive of recessions. There have been other ominous signs, such as surge of layoffs among tech companies and rising credit card debt, signaling that consumer savings are being depleted. Will the U.S. economy face a recession in the next year?
We're going to face flatter curves, but the current sharp inversion is concerning. If the Fed raises 50 basis points with the Fed funds rate now at 3.83%, that would be put it at 4.33%. With the 10-year at 3.60%, it is 73 basis points inverted.
That's a lot. It implies a lot of slowing. It doesn't guarantee the recession. But the Fed has got to get the funds rate below the 10-year. The inversion is saying to the Fed, "You're too tight."
We didn't have the inversion during the inflationary 1970s. The 10-year bond hit 16%. The funds rate hit 20% temporarily, but that was at the very end of the expansion, after 10 years of futile efforts to stop inflation. This tightening is much faster. We also don't have the inflationary expectations that we had back then. They're very much under control.
I believe curves will be flatter in general. In the 1960s and 1970s, term premiums were 100 to 200 basis points. Now they are zero to 50 basis points.
The equilibrium Fed funds rate, with 2% inflation, is, in my opinion about 1.5%. The TIPS equilibrium is zero. That gives you the nominal yield of 2% and a 50-basis-point term premium. Markets move way away from those equilibria, but it's an anchor. It's a way to think about what a normal rate is when you're asking what should happen to interest rates and inflation.
Last year, you forecast strong growth in housing prices, but not as strong as the roughly 20% growth that we had seen in the prior year. The latest Case-Shiller data, through the end of September, showed a 10.6% annual increase, so you were very accurate in your prediction. Prices have started to decline, at least in part due to rising mortgage rates. What is your forecast for housing prices?
It is not a coincidence, by the way, that the most respected of the housing indexes, the Case-Shiller index, peaked in March when the money supply stopped growing. People don't realize the magnitude of the surge of housing prices that followed the COVID credit explosion. From March 2020 to March of this year, average national housing prices were up by 45.5%.
That two-year surge exceeded by a large margin any two-year period in the post-war history, including the tremendous boom in housing that preceded the 2008 financial crisis.
For the last four months, the Case-Shiller housing index has been negative. I expect housing to retrace about one third of the 45% increase that it had. I expect very soft housing prices over this next year. By this time next year, I wouldn't be surprised to see the Case-Shiller to be 10% or so below what it is today.
There will be no crash like the financial crisis. I do not expect home prices to go down 30% to 50%, as they did in 2009. It will be quite some time before we get back to those March 2022 prices.
Last year, I asked which sectors of the market you thought were particularly attractive. You said you liked dividend stocks. The iShares high-dividend ETF (HDV) is up 10.23% over the last 12 months, and the Vanguard dividend appreciation ETF (VIG) is down 5.76% over that period. That compares to SPY, which is down 14.39% over those 12 months. Congratulations on another accurate prediction. What sectors of the market are attractive now?
I hit a home run on that one. But let's step back a little bit. From 2009 until late last year, growth stocks had their greatest surge in history, and value stocks their poorest relative performance in history. We have data going back to 1926, and the under-performance of value stocks was huge.
I had a feeling that it was going to end. The peak of the Nasdaq was in November, when we talked last. I saw that peak; the speculative parts of Nasdaq – DocuSign, Zoom, Peloton, et cetera – had peaked already, and that's always the case. Just like the dot-com era, the Nasdaq peaked before the S&P. I said, "This is the coming of that shift to value," and it was a powerful shift.
My research shows that, in general, these shifts are not a one-year phenomenon. The shift to value goes on for three to four years. It may not go on at the spectacular magnitude it has this year. Between dividend-paying stocks and the S&P, a 30% to 35% gap is incredible. But I still believe that dividend-paying stocks will outperform.
About every 25 years we have turning points in growth and value cycles. In the mid-1970s, it was the Nifty 50 growth stocks that grabbed the attention of pension funds and others and sent them to unsustainable heights; then they crashed. In 2000, 25 years after that, we all remember the dot-com boom and bust. In both of those periods, it was a five- to seven-year cycle where value outperformed following the growth bust. Then almost 25 years after the dot-com era, during the pandemic, there was another boom for growth, but that speculative period ended this year.
I'm banking on the experiences of the 1970s and the dot-com era that this value trend will continue and that value stocks, based either on earnings or dividends, will continue their outperformance.
It should be noted that several good quality growth stocks have come down to the point where they're almost value stocks. Stocks cannot be pegged to growth or value and retain that label for the rest of their life. They can move categories. A lot of the growth stocks have come down. Advisors know which ones are much more reasonable on the basis of dividends or on earnings.
I want to ask about some of the risks that investors face, starting with China. There are several risk factors that stand out with respect to China, and I want to know how serious a threat they pose. China’s economy has been crippled by its zero-COVID policy, although there are some signs that it may be easing that policy. That will mean a large population of Chinese without mRNA vaccinations or the antibodies that are acquired from COVID will be exposed to one another. Second, unlike the rest of the world, China’s CPI is flat and there is no inflation, which suggests that its central bank will ease monetary policy. Third, there is a risk that has gotten less attention, which is the potential for an invasion of Taiwan. In China’s recently concluded 20th congress, President Xi appointed or elevated several individuals with military roles, in a move that many saw as an increasingly aggressive focus on Taiwan. What is the likelihood of a Chinese military action against Taiwan, such as a blockade of its ports, which are all on the western coast of Taiwan, facing China? What would be the economic impact of such a blockade on the U.S. and the rest of the world? How do you view the risks of relaxing its zero-COVID policy or of more aggressive monetary policy?
We've seen a remarkable turnaround in President Xi's COVID policy. I thought the policy was the height of insanity over the last three to six months. He now made a statement that we in the west have known for a year: Omicron is no worse than the flu. There will be deaths among the elderly and the immunocompromised and those with other preexisting conditions, to be sure. But Omicron is much less deadly than the original strain. The healthy population will get over it like the flu, so it will not have a great effect on the working population.
But the insane actions of President Xi over COVID policy have left a permanent negative impact on the young people of China who now say, "Do I want to live in this type of country that is so unpredictable and making decisions that don't seem to be scientifically based?"
The United States could use a lot of Chinese who are talented and want to make their fortunes elsewhere. We need to revise our visa policy. That has bipartisan support. But it keeps on getting stuck because immigration is a hot-button topic.
It would be a disaster if China moved against Taiwan. I'm old enough to remember when red Chinese in the 1950s were bombing Quatzu, Quemoy, and Matzu. The U.S. came to the defense and was aggressive in supporting Taiwan, and I hope they do now. The west must defend against aggression as they have in Ukraine.
There are lots of business ties between the Taiwanese and Chinese that have grown in the last 20 years. There's a lot of the businessmen and women in China who don't want war because of those business ties.
But does Xi feel he needs a victory? I don't know. His behavior was so irrational under COVID and his reversal so shocking, who knows what is in his mind. Given that reversal, can he refurbish his image by taking Taiwan?
I'm not a China expert, so I'm not going to really judge that question, but the U.S. has to show extremely strong support for Taiwan. If it comes to a blockade and embargo on China exports, that would be much more serious than the blockade on Russia, especially for the US. We don't get oil and energy from Russia the way Europe does, but we get billions of dollars of goods from China. Let us hope this does not come to pass.
Watch the replay of the interview to see Professor Siegel’s comments on developed and international equities, small-cap stocks, the fiscal agenda following the mid-term elections, the outlook for the economy and markets given the 2024 presidential contenders, allocating to alternative investments, his own asset allocation, and cryptocurrencies.
Robert Huebscher is the founder of Advisor Perspectives.