Keynote address by Jeremy Siegel, Russel E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania
Valuation Of U.S. And World Equity Markets
Looking at global valuation, the price-earnings ratio from 1954 of this S&P 500 is 16.9. That was the mean. We see single-digit PEs when there are double-digit interest rates. Very rarely will you ever go below 10 when you have low interest rates. In fact, when you have interest rates under 8 percent, the PE generally fluctuates from 15 to 19. We’re just about 18 or 19 today, which is just about the median PE when interest rates are low. So yes, stocks are above their historical average, but by the way the biggest peak of all was 30, in history, in 2000. We are nowhere near that at the present time.
If we go back all the way to 1871, the average PE ratio is either about 14.5 or about 15.8, if you take Professor Shiller’s ten-year CAPE ratio. So when people say that 15 is the average PE ratio of the average stock market over history, they are pretty close to being correct. A relationship that is very important understanding what returns are going to be in the long run is the reciprocal of the price-earnings ratio, which gives you the earnings yield (E/P). It is an excellent predictor of long-term real returns. It is not a coincidence that with a 15 average price-earnings ratio, 1/15 is 6.7 percent. Where have we seen this number before? Indeed, it is the long-run real return on stocks.
It is fairly straightforward: you can predict the long-run real returns on any market by looking at the inverse of its price-earnings ratio, corrected for any business cycle impact. But when you have a sector that has a loss, you cannot add up earnings of all the companies and divide it into the aggregate earnings and say that
is the PE ratio that is correct. This is called aggregation bias. For example, imagine we have two firms. Firm A is a healthy firm, with 10 billion dollars in earnings, a 15 PE ratio, and 150 billion dollar market value. Firm B is a sick firm – maybe an energy firm that took a big loss: write-downs that are mandated by US accounting standards, so it reported last year a 9 billion dollar loss and it has only a 10 billion dollar market value.
Let us assume that it is your universe. You form a cap- weighted straight index of those two firms. You are going to have 94 percent of your portfolio in A and 6 percent in B. Your client calls you up and says, “OK, you’ve got a cap- weighted portfolio, what’s the price-earnings ratio of my portfolio?” What is the answer? One hundred and sixty — add up the earnings and divide it, adding up the market value. That seems rather absurd to have 94 percent of your clients’ assets in a 15 PE ratio. “What do you mean, the price-earnings ratio of my portfolio is 160? “ your client asks.
The bears out there love to talk about the PE ratio of the stock market. But there is a systematic mistake they make when they talk about that .The S&P is 18.3 times last year’s terrible earnings. This year, the earnings are estimated to be 114.77.
These earnings materialized will have a PE of 2, including energy. Hopefully, energy turns positive this year, because they won’t have markdown. They may have mark- ups this year, but you’re not allowed to mark up on GAAP earnings. You’re only mandated to mark down and you can never mark up, so you have all sorts of biases in the official earnings.
But what does 18.2 mean? People are scared, because that’s above 15. But what’s the earnings yield? It represents a 5.5 earnings yield in stocks. If you add a 1.5 to 2 percent inflation, that is a 7.5 percent nominal return. So, currently, if the PE ratio stays at 18.2 forever, there will always be 7.5 return on US stocks, which is quite good — not as high as historical, but still very good, especially compared to TIPPS, which are less than 0.5 percent. The current equity risk premium is over 5, well above the historical average. Even if we talk about a 20 PE, 1/20, so a 5 percent real return on the stock market, which is 6 to 6.5 percent nominal, it is well above the historical margin of equities.
Economic Factors Push Rates To Zero
How can interest rates on government bonds be so low, given that government debt has doubled over the last seven years? While that is true, the demand for government debt has quadrupled.
How low is the low interest-rate environment going to last? What about the collapse of yields around the world? The biggest myth in the world today is it is the Central Banks that have driven interest rates to zero. This is false. It is fundamental factors in the world economy that have driven interest rates to zero, and all the Central Banks have done is follow them down. This is very important to understand.
There is little demand for funds by firms. There is nothing for them to invest in. They don’t need to expand and plan equipment, because they can already supply everything they do. There is no persuasive new technology that they need to invest in, so even though the interest rate is zero, what are they going to invest in? It’s much better they give it back to shareholders, which is what they are doing. Otherwise, they would buy over-valued assets. And that would mess up the shareholders even more.
How can interest rates on government bonds be so low, given that government debt has doubled over the last seven years? While that is true, the demand for government debt has quadrupled. No one can get enough of high-quality assets. There is no regard for yield – investors a drawn to high-quality assets because they need them for regulation, for liquidity, because of risk aversion. Why is the world is sitting on 40 trillion dollars of zero and negative interest rate assets? The answer is unequivocally “At least I’m not losing any money.” That’s why interest rates are zero.
Are rates are going up? Not really. Real bonds are going to max out at 1 or 1.5 percent. Real yields short-term are going to max out at zero, which, of course, implies at 2 percent federal funds rate, in the long run, at most. People are going to bite the bullet, saying, “I don’t like it, but maybe I’m going to have to invest in stocks to get any sort of income now.”
The Worldwide Productivity Collapse
The big disappointment is the shocking collapse of productivity growth. What is particularly shocking is the fact that normally, in an economic expansion, which we’ve had since 2009, you have higher-than-average productivity growth and when energy prices are going down, you have higher-than-average productivity growth. The only other time we had productivity growth as bad is when energy prices were soaring as a result of OPEC’s raising the price from 6 dollars per barrel to 30 dollars per barrel. At that time, we understood the source of the productivity collapse. What we do not understand is the source of the productivity collapse that we have experienced in the last five years. It is really a puzzle.
Maybe it has increased regulations and compliance. There has been data that in the financial sector highlighting that all the increase in employment since 2009 has been in the compliance area and nothing in anything else. It is not a question of whether this is good or bad, but it does not add to GDP. No regulation does.
Perhaps the problem is that we are not training our labour force for 21st century jobs. In the United States, we’ve had a terrible decline in educational standards at the secondary school level, so perhaps people are not being trained for what they need to know to be able to do to get jobs. Then, there is a lull in technology. We had PCs in the 1990s and 2000s, we had high-speed Internet, firms spent billions adapting to these new technologies, but they’re not doing it anymore. There’s nothing new anymore — we’re getting marginal improvements in our iPhones and that’s it. Maybe it will speed up later — hopefully, it will.
Perhaps GDP is being undercut. Think of the things we used to buy. How many people buy encyclopaedias now? They don’t – they just Google it. How many people have bought an atlas, a dictionary, a thesaurus? These used to be 100 billion dollar industries that are now zero. There are a lot of things that are free now that are not counted in GDP. We also don’t know really how to make quality improvements in the service sector, particularly the healthcare sector. We have a very hard time accounting for what is real output in healthcare and that is becoming more and more important. If these are indeed the reasons, then inflation is even less than we think and deflation is more of a threat than we think.
Everyone says slow growth is bad. We are in a low real-rate world. There is no question: real rates are going to be lower. This argues for a higher equilibrium price-earnings ratio. A 20 PE ratio corresponds to a 5 percent real rate of return, which is still very healthy under current or even perspective real returns.
Mr. Siegel continued his discussion with Adrian Dearnell, Founder and COO of EuroBusiness Media and took audience questions.
What will be the economic Impact of US upcoming elections?
Well, you know, this is the time that I thank goodness that the US does not have the European-style Parliamentary system because your leaders have to have a majority in Parliament. Thank goodness that Trump and many of his extreme policies have virtually no support in Congress. And one has to realize that under the US Constitution, all tax policies must begin in the House of Representatives. So, there is no way that he alone can dictate any of those policies. And very few of even his own party have endorsed his policies.
So, in a way, whatever that position is, there is going to be, I think, a stalemate. I also don’t think Trump is going to win. I know he’s coming closer in the polls, but I think once it’s one on one, I do think Hillary Clinton will be the Democrat nominee, I think that she will win and with a bigger margin than the razor-thin margin that many now fear. I think we are going to have a Republican House, still, but I think the Senate could easily turn Democrat. Then people say, “Well, isn’t that going to be terrible for the US?” And I say, “Yes!” But that was exactly the situation we had in the 1990s, when we had a Clinton as President, a Democrat Senate, a Republican House, and the greatest bull market in world history.
Is the productivity decline over the last 15 years based on the sharing of value? What are your thoughts?
The productivity collapse really has occurred mostly since the crisis. There has been a slow decline, but it ratcheted downward since the crisis and again, we don’t really know. Economists are only beginning to explore. I want to say, and I said this in the fifth edition of my book, Stocks for the Long- Term, that I’m a long-run productivity optimist.
I actually think the communications revolution, particularly the Internet, has brought the potential for new ideas to come together, to solve problems, but it takes time for that and I think we are in a technology lull that is enabling better performance on that.
The interesting thing is that most studies actually show that the highest-level productivity is really reached by people between 45 and 55 and actually, from 55 to 65, productivity generally goes down. Then, they retire. So actually, the ones that are retiring are not the highest productive people in general. But there is a younger workforce. We had that in the 1970s, with the baby boomers coming in. That was part of the reason that was often given for that decline, including those oil price increases, so there may be something to the age profile of the workforce, but I think it’s still an unsolved problem and I truly hope it’s only a temporary problem, even though it’s not only persisting, it’s actually getting worse in the data in vey recent times.
What if the deflationary threat is becoming real?
Deflation is terrible for equity if a firm has debt, and most firms do. We saw what happened in oil. When oil went down to 26 dollars a barrel, what were the firms that got hit the most? Those with debt, those that were mostly equity. OK, we could survive – it wasn’t good – but we could survive.
When you have deflation fears, that’s one reason, Central Banks around the world want to avoid deflation. We saw what happened in the 1930s, when the price of oil went down 35 percent and basically everyone went bankrupt and the wages went down 35 percent, prices went down 35 percent, and debt did not. So, debt stayed constant, in nominal terms and soared in real terms, and everyone said, “Hey, I can’t finance this.”
People often ask me, “Why don’t Central Banks target 2 percent, why don’t they target zero? Isn’t that kind of an ideal?” They want to make sure that, if they miss, they miss with an upside bias, because it is so bad to have deflation and have that real indebtedness go up. That’s why we want to avoid a deflation in the world economy, and that’s why the targets of most central banks in the developed world are of the 2 percent nature.