And Now The Bull's Turn: Jeremy Siegel Explains "No Way There Is A Bubble, No Signs Of Recession"

Having detailed the less status-quo-sustaining side of things, thanks to some frankness from Nobel Prize winner Robert Shiller, who warned "unlike 1929, this time everything - Stocks, Bonds and Housing - is overvalued," we thought it only fair-and-balanced to illustrate the alternative perspective and who better than Jeremy Siegel to deliver it. In his anti-thesis of Shiller's facts, Siegel unleashes textbook dogma to pronounce, "in no way do current levels quality as a bubble", that stock returns should remain supported by fundamentals, there is no sign of a recession in the next 18 months, The Dow's fair-value currently is 20,000, and "not much" could dissuade him from holding stocks.

Below is an interview he gave to Goldman Sachs' Allison Nathan

Allison Nathan: You have long argued the benefits of a buy-and¬hold strategy for stocks. But do stocks look overvalued today?

Jeremy Siegel: Looking at current P/E ratios and interest rates, I find that stocks are only slightly above their historical valuations today. The average long-run P/E ratio of the S&P 500, going back to the 19th century, is about 15.0x earnings. Over the last 60 years, in the post-war period, the S&P 500 has averaged around 16.5x earnings. Today it is between 17.5 and 18x. So it is just a bit above its historical level. That level is completely justified; in fact, even perhaps a higher level is justified, given the low level of interest rates.

Allison Nathan: What is your response to those who say the US equity market is in a bubble or on its way?

Jeremy Siegel:  I completely disagree. A bubble implies a very significant overvaluation. The stock market was most certainly in a bubble in March of 2000, when the S&P 500 was selling at 30x earnings, and the technology sector of the S&P 500 was selling at nearly 100x earnings. In no way do current levels that are nowhere near those highs qualify as a bubble.
 
Allison Nathan: The CAPE ratio created by your longtime friend and colleague—Robert Shiller—and often viewed as a useful valuation tool is showing material overvaluation. What are your thoughts?

Jeremy Siegel: I have great respect for Bob Shiller and his CAPE ratio, which uses a 10-year average of earnings against price to assess the valuation of a company. The problem is that starting in the late 1990s, Standard & Poor's changed the way that it computed earnings; it went to a mark-to-market orientation, which sharply depressed earnings in recessions. Since the last ten years of earnings encompass the Great Recession, when earnings plunged close to zero, earnings appear far below what I think they should be, which inflates the CAPE ratio way above what I think is the true value. To adjust for this problem, I have done some work instead using a 10-year average of the National Income Product Accounts (NIPA) income estimates rather than the S&P's earnings estimates. Once you make that substitution you get far less overvaluation of the market now than you do under Shiller's valuation.

{ZH: It's Different This Time... "the old metrics don't work..."]


Allison Nathan: Is the real bubble in the bond market?

Jeremy Siegel: With interest rates generally at all-time low levels and likely set to rise, I think it is fair to say that bonds are now overvalued and much more so than stocks. However, I do not see short or long-term interest rates returning to anywhere near their post-World War II average. In fact, it's my feeling that we will see rates remain around 2.0% on the short end, maybe even a little less; and 3.0 to 3.5% on the long end. Given that there are some very persuasive reasons why interest rates are low and will stay relatively low in the future, I wouldn't necessarily call the bond market a bubble.

Allison Nathan: To what extent does valuation impact future equity returns?

Jeremy Siegel: I find that the future real returns on stocks are linked to the earnings yield on the market. And the earnings yield on the market is nothing more than the reciprocal of the price/earnings ratio, E over P. So a P/E of 18 suggests a 5.5% earnings yield or real return; a P/E of 20 suggests a 5.0% real return. So as stocks sell for higher prices, it does mean their forward-looking returns will fall short of the long-term average, which I have found to be about 6.5% per year after inflation.

Allison Nathan: How much more will multiples expand?

Jeremy Siegel: That depends on what happens to interest rates. Although interest rates are going to rise, I think that rise will be moderate. And therefore I expect equities to continue to sell above their long-term average valuation ratios. I definitely think that a 20 P/E ratio is justified by the current level of interest rates. That does not mean these levels will be reached anytime soon; it may take a year or two to reach that level. But I do still see upside to the stock market from expanding P/E ratios over the next 12 months.

Allison Nathan: Does the fact that US profit margins are at all-time highs concern you?

Jeremy Siegel: It doesn't really worry me. There are several reasons for very high profit margins, which actually did decline a bit last quarter. One is the increased percent of foreign sales of US corporations. Because tax rates are lower outside of the United States, higher foreign sales raise profit margins. Also, the technology sector, which has a high profit margin because of the intellectual capital involved, is becoming a bigger part of the S&P 500. Very low interest rates and relatively low leverage at firms has also helped profitability. In most cases, these factors completely explain the record-high profit margins and are unlikely to reverse anytime soon. I think that we will see secularly higher margins because of the interest rate structure and the percent of foreign sales for many years to come.

Allison Nathan: How much upside to stock index levels do you expect?

Jeremy Siegel: I think that the fair market value of the Dow, given current circumstances, is about 20,000. We are at roughly 18,000 today, which implies more than a 10% increase in prices. Again, we may not get that in the next six or even 12 months. But I do think that given the likely persistence of relatively low interest rates over the next several years, a 20,000 level on the Dow can certainly be justified.

Allison Nathan: If interest rates stayed where they are today, and the Dow reached 20,000 within a couple of months—crazier things have happened—would you advise investors to sell their stocks?

Jeremy Siegel: I think that you would need an improvement in what have been some very disappointing earnings numbers over the last six months in order to see that kind of move. But even if we did, I would not recommend that people sell. At that point, you would have only reached fair market value, depending on your expectations for interest rates and earnings into the future. So I don't think we would be in a dangerous or bubbly situation. Of course, stocks can be tremendously volatile in the short run. So even though the fair value might be 20,000, the index may fall to 17,000, or may rise to 23,000 in the short run. There can be a lot of variation around the justified market value.

Allison Nathan: How concerned are you about the prospect of a meaningful correction in the near term, perhaps triggered by the approach of US rate hikes?

Jeremy Siegel: The market has pushed off its expectations for Fed liftoff to September. Any news that the Fed will hike earlier will be disturbing to the market. And we have not had a correction in the market—meaning 10% or more—for many, many years. I would not have been altogether surprised if one had happened in the first half of this year, but so far we have held in very well. Investors are looking forward to an earnings improvement, getting out of the relative slump that we saw in the first quarter. And so as long as the Fed's timetable does not seem to accelerate to a June increase, I would not expect a 10% correction in the near term. But if we did see a correction, I would view it as a buying opportunity.

Allison Nathan: What else might trigger a correction beyond interest rate risk?

Jeremy Siegel: Another significant leg of appreciation in the US dollar would be bearish for US equities, which are already contending with a 20% increase over the last year. OH prices have also started to rise again. If Brent crude oil stays in the $60 to $70 range, I think that would be healthy for the market in the long run. But there has been so much volatility in the oil price that that could also foster volatility in the equity market.

Allison Nathan: What about a scenario of continued weak economic growth and rate hikes pushed off into 2016? How vulnerable would that leave the equity market?

Jeremy Siegel: In that scenario, the risk would be on the profit side rather than on the interest rate side. The impact on the US equity market would depend on the source of the disappointment and whether it was just a US slowdown or a global slowdown. But if the Fed recognizes the slowdown and pushes off tightening, that would obviously moderate any correction in the equity market. Certainly a recession would drive down equity prices. But there are just no signs at all that I see of a recession in the next 12 to 18 months.

*  *  *

[ZH: nope none at all...]

Retail Sales are weak - extremely weak. Retail Sales have not dropped this much YoY outside of a recession...

 

And if Retail Sales are weak, then Wholesalers are seeing sales plunge at a pace not seen outside of recession...

 

Which means Factory Orders are collapsing at a pace only seen in recession...

 

And Durable Goods New Orders are negative YoY once again - strongly indicative of a recessionary environment...

 

Which is not going to improve anytime soon since inventories have not been this high relative to sales outside of a recession

 

In fact, the last time durable goods orders fell this much, The Fed launched QE3 - indicating clearly why they desperately want to raise rates imminently... in order to have some non-ZIRP/NIRP ammo when the next recession hits.

And just in case you figured that if domestic prosperity won't goose the economy, Chinese and Japanese stimulus means the rest of the world will save us... nope!! Export growth is now negative... as seen in the last 2 recessions.

 

And deflationary pressures (Import Prices ex-fuel) are washing upon America's shores at a pace not seen outside of a recession...

*  *  *
Allison Nathan: What do you make of the boost to equity prices from large share buyback programs? Does that concern you at all?

Jeremy Siegel: I am very favorable towards buybacks. I think they tell you that firms are making good profits, which they want to return to shareholders. It also means that firms don't see a lot of very profitable opportunities to invest in right now, given slow global GDP growth. But that's not necessarily bad. Giving cash back to shareholders is a very effective way to generate value in the equity market. And with the substantial amount of slack in the global economy today, I would worry that expansion in plant equipment would be overinvesting, which would not be a good use of shareholder money. The reality is that there is not a lot of persuasive technology for firms to invest in today. But I view that as a temporary pause and not necessarily detrimental; if world demand expands or new technologies emerge that would be profitable for companies, I am confident that they would deploy cash effectively for shareholders.

Allison Nathan: Do you find foreign equity markets even more compelling than the US market?

Jeremy Siegel: I think that European equities are persuasive right now. I do believe that Euro depreciation is largely over; I expect the EUR/$ to trade in the 1-1.10 range in the future. And European equity valuations have increased dramatically. They were selling 10-12x earnings, and are now selling around 15¬17x. But that is still about 10% below US levels. Japan also looks relatively attractive. Although Japanese stock prices have increased tremendously, so have earnings. So Japanese P/E ratios remain around 15-17x earnings, which is a compelling range given current interest rates. And emerging markets in particular could be the best performing markets in the next three to five years given that their valuations have declined significantly in recent corrections and that their currencies are now selling at a very reasonable price relative to the dollar.

Allison Nathan: So would you recommend investors overweight emerging markets and/or foreign equity markets in their portfolios today?

Jeremy Siegel: It depends on risk preferences. But I would still generally recommend an allocation of roughly 50% US, 25% non-US developed market and 25% emerging markets.

Allison Nathan: What—if anything—would dissuade you from holding equities over the medium term?

Jeremy Siegel: Not much. There is always the potential for unexpected shocks such as terrorist attacks or natural disasters that could hit stocks dramatically. That is one of the reasons why many people shy away from them. But it is also the reason why investors who are brave enough to hold them through tough times end up with superior returns. And today I believe that prices are low enough that investors will likely be paid quite handsomely over time to hold risk in equities.

[ZH: yep, everything looks good here...]