My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

Dr Jeremy Siegel discusses the economy, the equity market and CV19

Updated: Nov 25, 2020

Introduction

This article is a synopsis and synthesis of two recent presentations by the esteemed Russell E. Palmer Professor of Finance at The Wharton School, University of Pennsylvania, Dr Jeremy Siegel. The first such presentation by Dr Siegel was at the virtual Wharton MBA “Reunion@home” event on May 15th, entitled “The Economy in the COVID19 Crisis”. Dr Siegel did this presentation remotely and had slides which he walked through for those watching the presentation at home.

Subsequently, I listened to a podcast on Bloomberg Opinion’s Masters in Business, hosted by Barry Ritholtz. Mr Ritholtz interviewed Dr Siegel, and you can find the podcast from June 19th entitled “Jeremy Siegel on the Stock Market and COVID-19” here.

I highly recommend listening to this podcast if you have an hour to spare and have the time and interest after reading my summary below.

For the bulls out there, Dr Siegel presents an extremely compelling case as to why the stock market initially dipped so dramatically but has recovered so quickly from its late March lows. He remains bullish on equities, with daily sentiment driven mainly by the news and evolution of CV19 rather than the economy. Hs is also a bond bear. I have tried to combine and present below the major points he discussed during both presentations.

The COVID-19 crisis versus The Great Recession of 2007-09

In both presentations, Mr Siegel provides context by comparing the CV19 self-imposed recession to the previous U.S. recession of 2007-09, often referred to as the Great Recession (“GR”). Specifically, he discusses the effectiveness of the unprecedented stimulus provided to address both downturns. During the GR, banks were under severe stress due to a lack of excess capital caused by a mortgage / housing crisis in the U.S. As a result, the focus of the government and Federal Reserve was to first and foremost restore confidence in the financial system, meaning that banks’ balance sheets needed to be repaired. Much of the stimulus unveiled to rescue the financial sector in 2008-09 never found its way into the real economy because banks hoarded liquidity, using it to restore their capital bases and to enhance their reserves. In other words, the unconventional monetary stimulus unleashed during this period, specifically in the form of quantitative easing, did not ultimately increase M1 or M2 (remember those terms, which you rarely hear anymore?), meaning that the stimulus never made it into the real economy. This is one of the major reasons that the U.S. economy remained very sluggish following the end of the Great Recession in spite of record amounts of stimulus. The pretext for the government-mandated, pandemic-related recession in which we currently find ourselves is very different. Banks are well-capitalised, so this is not a banking crisis. As a result, the huge amounts of fiscal and monetary stimulus unleashed to address a shuttered economy have gone directly to the real economy, meaning consumers and businesses.  Even so, the liquidity at banks initially increased as people saved more because they were unable to spend (because of the lockdown). However, once things began to gradually reopen in May, the boost to the economy was apparent from the data. The better-than-consensus increase in May retail sales illustrated the existence of pent-up demand, the first of many economic indicators that pointed towards stimulus landing in the real economy this time. [N.B. - as an aside, better-than- consensus growth in retail sales in May also occurred in other countries, notably the U.K.] Interestingly, during the Wharton presentation, Dr Siegel mentioned that the money supply (M1) had increased more in the last seven weeks (so from late March to mid-May) than it did in the entire year following the Lehman bankruptcy in September 2008.

The U.S. Economy

Dr Siegel provided some statistics during the Wharton alumni presentation which are worth repeating. He said that the post-WWII economy had experienced quarterly growth of GDP of negative 10% annualised only three times. In comparison, the expectation is that for 2Q2020, U.S. GDP will decline by 44% on an annualised basis, more than four times worse than any quarterly decline in GDP since WWII. For the full year, GDP is expected to decline 6% to 7%. However, Dr Siegel went on to say that as bad as this quarter (2Q2020) and the full year 2020 will be, the negative growth is nowhere near the level at which the U.S. economy declined during the Great Depression. The U.S. economy shrank 27% over the five year period from 1929 to 1934, exacerbated by a series of policy mistakes during the period. This downturn in GDP will be only around one-quarter to one-third of the downturn experienced during the Great Depression, and the U.S. economy is expected to return to growth in 2021.

Stock market sell-off and recovery

As far as the sharp equity market decline in late February into March, Dr Siegel said that this can be attributed to the fact that most investors initially dismissed CV19 as a problem isolated within China. However, this became a real issue almost overnight with sudden and widespread fear that CV19 could be like the Spanish flu pandemic of 1918-20. In other words, investors went from complacency to panic almost instantly.  The fact is that the U.S. - and nearly all countries - were unprepared for a pandemic, which contributed to the panic. The CDC provided poor advice, and the U.S. ran short of some suddenly-essential items and most importantly PPE. The closing of the economy to combat CV19 was also “extremely destructive” in the way it was done.  There were heightened fears of insolvencies and potential impairment of bank balance sheets, accompanied by a massive increase in the market risk premium.

Seeing this sharp sell-off, Dr Siegel said that he turned “very bullish” in late March - and was on the record accordingly - for the simple reason that the sell-off was too harsh given even the worst case scenario and the stimulus was flowing. He expected the stimulus, landing in the hands of consumers and businesses, would translate into asset prices reflating quickly.  In both the podcast and the Wharton alumni presentation, Dr Siegel provided an excellent analysis of why stocks should not have sold off so deeply because of the earnings outlook alone, which he described as “lesson one of Finance 101”. Dr Siegel said that even if 100% of S&P 500 company earnings were wiped out for one full year (versus current expectations of a 30% decline in earnings for the year), and that earnings only manage to return to 2019 levels in 2021, the market should have only declined by 10% at most using almost any valuation method you wish. [I didn’t check this but it sounds reasonable, even more so in a low interest rate environment.] In other words, 90% of a stock’s value is related to earnings from the second year onwards.

He also said that the economy might have a U-shaped recovery (or a W-shaped if there is a second wave of CV19), but the stock market will – and has had – a V shape recovery because it looks forward.

The one caveat he is careful to mention is that a second wave of CV19 and a second closure of the economy could derail the stock market recovery, although he expects neither. Inflation

When asked about inflation, Dr Siegel returned to the comparison of this pandemic-related recession to the Great Recession. As you might recall, housing was a big problem in the U.S. during the run up to the Great Recession because of overly aggressive lending leading to severe loan losses at banks. Coming out of the recession, U.S. consumers then had to work through an overhang of excess supply of houses. Housing starts fell to a 70 year low, and many people had their home equity completely wiped out.  Millions of Americans struggled with mortgages / housing. This is another reason that inflation never materialised even with huge injections of liquidity into the market by the Federal Reserve during this period.

This time, things are different. Dr Siegel does expect moderate inflation in the coming 2-3 years, meaning 3% to 4% per annum. He said that over a 3 year period, CPI might be up 10%-15%. But this is the worst he expects – he does not foresee hyperinflation or even persistently stubborn moderate inflation.  He believes that any pricing pressures will gradually subside as the stimulus works through the system.   He does not expect the Federal Reserve to raise short-term rates in response, and he does not expect that the government will raise taxes to combat moderate inflation, either. Moderate inflation is not a bad thing for borrowers, Dr Siegel reminded his listeners, especially for large borrowers like the U.S. government. And it is certainly much better than deflation, a particularly troublesome issue that the Federal Reserve will want to avoid.

The bond market

In a nutshell, Dr Siegel believes that the U.S. Treasury market has seen its best days. He said that US Treasury bonds have seen their lowest yields ever in March (“generationally low yields”), and that the 40-year bull market for bonds is over as we are now entering a bond bear market. This prediction fits his expectations regarding moderate inflation perfectly. Even with yields increasing and bond prices falling, Dr Siegel expects there to continue to be strong on-going demand for USTs because they are a “hedge demand-driven” asset class (negative beta) when used in conjunction with long equity positions. As far as the unconventional purchases of corporate bonds by the Fed, he does not expect any dire effects on the market when the positions are unwound (or are not replaced at maturity), just like there were no overly-dire effects on stock prices of banks when the Fed ultimately liquidated its equity stakes post-GR.

The role of day traders in this recovery, comparison to 2000 tech bubble

Dr Siegel was asked a very interesting question regarding the role of day traders in this recovery given the availability of new apps like Robinhood which permit commission-free trading in small lot sizes, and related, whether the current market is overzealous so as to draw comparisons to the tech bubble (and subsequent bust) in early 2000. The higher amount of day trading that is currently occurring is related to people being bored, sitting at home looking to fill a void caused by lack of sports (and sports betting) and / or casinos being closed. Most of these day traders will lose money, and eventually sports will resume and casinos will reopen. He doesn’t see this sort of day trading activity as overly influential in this bounce-back, and furthermore, does not expect it to be an issue going forward. He added that philosophically, investors should invest for the long term (90% of portfolio) and not day trade, but that there is nothing wrong with investing say 10% of your portfolio in more speculative stocks or other asset classes “to have some fun”.

Dr Siegel also dismissed any comparison to the tech bubble (and subsequent bust) in late 1999 / early 2000. The comparison to the tech bubble raises the issue of P/E ratios, a timely discussion at the moment. He compared P/E ratios now with those at around the time of the 1Q2000 peak of the tech bubble, when the NASDAQ reached 5,000 [a level not reached again for 15 years until 2015]. The tech sector of the S&P 500 in early 2000 was trading at 90x earnings (and no internet companies as we know them now existed except AOL; the index was more comprised of well-rounded and established tech names like IBM, Intel and Microsoft).  Just before the March 2000 crash, Dr Siegel was on the record describing the rally as “a suckers bet”, and shortly thereafter, he was proved to be correct.  Pundits comparing the rapid recovery in equity markets this time to the lofty tech valuations of early 2000 simply do not understand the ridiculously high P/E multiples back then. Dr Siegel thinks an appropriate P/E ratio today is probably 18-20 for the S&P 500.  This doesn’t mean it couldn’t go down to 12 or up to 25, and he noted that in any event, it will be unusually high this year as earnings decline.

[It was unclear to me whether Dr Siegel meant standard “look back” ratios, especially given that his philosophy is to look forward at earnings. This is pertinent now because we will be emerging in 3Q from a deep reduction in 2Q2020 earnings. As a reference point with the S&P 500 at 3,131.29, the P/E ratio using earnings for the next four quarters (2Q20 to 1Q21) is 23.3x, and the P/E ratio using expected earnings for 2021 is 18.7x.]

Dr Siegel also discussed the CAPE ratio as an alternative to the standard P/E ratio. He does not believe that CAPE works well as a timing tool.  He became concerned after FSAB changed the way that earnings were calculated around 2010. CAPE ratios have been signalling a bear market since the GR, which has been incorrect, so Dr Siegel does not believe the CAPE ratio is effective as a forecasting tool. Level of U.S. debt

This area of discussion concerned the level of U.S. debt, at 106% of GDP for 2019 and expected to be 136% in 2021, the highest level ever. [U.S. debt-to-GDP was over 100% following WWII, from 1945-1947, and did not cross 100% again until 2016.] Federal debt is increasing significantly due to fiscal stimulus to combat the recession – the annual deficit this year will increase from $1 trillion in the original budget to $4 trillion (or possibly more, if there is another round of stimulus). Fortunately, the increase in national debt in the U.S. has coincided with tremendous increase in the use of USTs as a hedge asset against a long position of stocks (since USTs increase in price “when bad things happen”).  Moreover, the entire CV19 stimulus package, meaning around $3 trillion from the Fed (monetary stimulus) and $3 trillion from the U.S. Treasury (fiscal stimulus), is de facto being financed by the Federal Reserve. Dr Siegel made an extremely important comment in my opinion in this respect, saying that the increase in M1 (i.e. the money supply) is much more important than the increase in the balance sheet of the Federal Reserve.

He noted of course that Japan has had a debt-to-GDP ratio of over 200% for many years, a period throughout which Japan has suffered bouts of deflation and an impotent ability to stoke inflation. Therefore, he does not expect the increase in debt in the U.S. to have severe effects on the economy aside from moderate inflation.

U.S. unemployment

The discussion opened with a question: was the better-than-expected May employment report correct, since there was some controversy around some of the way that unemployed people and the labour force overall was calculated?   Dr Siegel said that it is hard to classify some workers / non-workers in this highly volatile environment. And in any event, most of the economic data is looking in a “rear view mirror”. What is much more important than historical economic data is to look forward at the factor which will most influence the trajectory of the economic recovery – CV19.

CV19

As mentioned above, Dr Siegel believes by far the most important data available is that concerning CV19, including its progression and the evolution of a vaccine and / or a treatment.  He noted that mortality is falling. He believes that as we approach a seasonal flu rate as far as mortality, things should become more normal. Assuming that vulnerable segments of the population can continue to be shielded and that people adhere to social distancing rules, most of the world should be able to return to what they were doing.  Still yet, this shock will have lasting effects and CV19 will remain in the background for some time to come.  He believes that there will be no more shutdowns like in March, because it makes no sense under any circumstances. 

The future of education

Dr Siegel was asked about the future of university education post-pandemic.  He believes that the pandemic will have no effect on top tier universities.  Second and third tier schools will feel some effects, because lower tier schools benefitted from aggressive student lending, enabling them to raise tuition prices to levels near to those of top tier schools even though the lesser tier schools had significantly lower post-graduation employment rates and wages. Now, people are catching on to this, and the pandemic will accelerate this thought process and trend.  

He also believes that students will continue to prefer to be on campus, even though more instruction/informative lectures (i.e. the basics) might move online, and the classroom will be used mainly for interactive discussions.

Equity/bond portfolio mix

Over the last two centuries (since 1802), Dr Siegel has calculated that the real total return of stocks has been 6.8%, compared to real rates of returns over the same period for other asset classes of: bonds, 3.5%; T-bills, 2.6%; gold, 0.6% and the US Dollar, -1.4%. Going forward, he expects real return on stocks to decrease to around 5.5% p.a., which is still much better though than bonds which will enter a bear market.  His expectation on real returns going forward means that he favours a higher mix of equities in portfolios. Rather than the standard 60/40 (equities/bonds) mix, he thinks the more appropriate mix is probably 75/25.  As an aside, Barry’s firm is closer to a 70/30 equity/bond split, but the point Dr Siegel is making is that the 60/40 mix no longer makes sense given the expected future returns of assets classes and longer life expectancies.  

Gold and real estate

Dr Siegel advises that investors have some protection against moderate inflation via gold, noting however that of course stocks are also good protection against moderate inflation.  Also, gold doesn’t look bad from a current return perspective now because yields on U.S. Treasuries are so low. Whilst Dr Siegel does believe gold has a role in a portfolio, he is not a fan of bitcoin.  

As far as real estate, Dr Siegel expects commercial real estate to be under pressure for some time. However, he expects residential real estate to boom.

Conclusion

After 44 years at The Wharton School, Dr Siegel is retiring, a loss for future students that plan to attend Wharton. I hope this article has given you some insights into this well-respected academic’s way of thinking about CV19 and the related economic crisis (and stock market performance) we are currently experiencing.

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