Jeremy Siegel – Why Long-term Investors

Should Own Stocks: Bonds are “Dangerous”

November 28, 2016
by Robert Huebscher

Jeremy Siegel is the Russell E. Palmer 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, now in its fifth edition,
is widely recognized as one of the best books on investing. It is available via the
link below. He is a regular columnist for Kiplinger’s, a “Market Master” on CNBC
and regularly appears on Bloomberg, NPR, CNN and other national and
international networks

I spoke with Jeremy on Monday, November 21st.

In our interview on November 30th of last year, you said that 2,300 was a possibility for the
S&P 500 by the end of this year, but that it was contingent on an earnings recovery to
approximately $120/share. On Friday the S&P 500 closed at 2,182 which is about 5% below
your forecast, but S&P operating earnings are approximately $102.80/share, considerably
below the target you set. Given the lack of an earnings rebound, your forecast was accurate.
What is the fair value for the S&P 500 now and what is your forecast for the coming year?

Obviously with the election – which we’ll talk about – there is more uncertainty than usual. Actually the
$102.80/share is for the 12 quarters ending in September. I just pulled S&P’s current estimate for the
full year, and it looks like it will be $109/share, still below my year-ago estimate.

S&P’s forecast for next year is, as it was last year, overly -optimistic. When S&P looks out more than
two or three quarters they put on their super-rose-colored glasses. S&P is looking for $130 to
$131/share for 2017 operating earnings. At these levels we are only 16- or 17-times earnings. Wow! I
wish the market P-E would be that low, even considering that we are in a low-interest-rate
environment.

I would hope that we could go to $120/share next year, given the market is priced at a very reasonable
18-19 times earnings. There are a lot of wildcards. Right now the market is selling at 20-times this
year’s estimate of operating earnings. That is a high figure from a historical standpoint, but in a low-
interest-rate world it should not be considered at all unreasonable.

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Let’s talk about your forecast for the economy given the new administration. Obviously we
don’t know what policies President-elect Trump will pursue, but let’s start with the following
scenario: a significant infrastructure package, a reduction in corporate regulations, a
decrease in the corporate tax rate, and at least for the first couple of years no imposition of
significant trade barriers. How does that align with your policy expectations? Given that
scenario, what would be the impact on the economy and the markets?

That would be a very positive scenario. Before the election, I used to get the big question, “How would
a Trump upset affect the stock market?” I said in the short run, it’s bad because the market hates
uncertainty and there is certainly more uncertainty with Trump. In the long run, a Trump victory is good
because all the Republicans policies, including Trump’s, are capital-positive.

Little did I know the short run would be only six hours long! The very next day we had a huge rally in
equities.

Are investors putting the rose-colored glasses on with Trump? To some degree, yes. Your scenario
included no imposition of significant trade barriers. That certainly is a big wildcard.

Trump’s initial statements after his election, particularly working with House GOP leader Paul Ryan,
made the markets really feel comfortable. Clearly lowering the corporate income tax is something that
is very likely and very, very positive for stocks. Of course we should add that a good stock market
assumes there will be no unusual foreign problems or geopolitical threats from China, Russia, or
anywhere else that put the Trump administration under pressure and under threat right away. Such
threats certainly will make the markets very, very nervous.

Is there any specific policy decision that will have a significant impact either positively or
adversely on the market?

The most positive policy for stocks is a tax cut. If we could get our statutory rate down from 35% to
25%, expert estimates say that it will boost S&P earnings by 10%, and that is assuming no faster
economic growth. If we get a boost in economic growth from Trump’s policies, clearly, we could be
looking for a greater increase in earnings. But in terms of what is likely, I would say corporate tax
reduction is most likely followed by some cuts on the individual side. Individual tax cuts are something
the Democrats are going to fight, but we did have a big increase in capital gains tax and the dividend
tax rate under the Obama administration, and some rollback of those increases under a Trump
administration would be another positive factor for stocks.

Obviously on the negative side would be tariffs, quotas or restrictions on trade. I believe the market
would react quite negatively to those policies. Right now the market is saying, “Trump is going to make
some cosmetic moves on trade, he’s not going to change the thrust of our policies.” But nothing is
certain yet. It is still very early in the Trump transition.

Last year you expected “some increase” in the 10-year Treasury yield. On November 30 of last
year it was at 2.21% and on Friday it closed at 2.34%, so your forecast was accurate. What is
your forecast now for interest rates? Have we finally seen the end of the 35-year secular

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downtrend in rates?

Rates took a huge jump after the Trump election. They are going to work their way higher. Again, there
is a lot of uncertainty about what policies will be enacted, but I would not be surprised to see the ten
year between 2.5% and 3% by the end of next year. That is a rate that should not be threatening for
equities. If rates move well above 3% without a corresponding big increase in economic growth, it’s a
problem. If there’s a big increase in economic growth, a move above 3% could still be all right. But if
there is an inflation problem, the Fed will fight by increasing rates even more. That certainly would be a
challenge to the equity market.

President-elect Trump has criticized the Fed for being too dovish. Would he be wise to
appoint a new chairperson or governors who are more hawkish?

Janet Yellen’s term doesn’t end until January 2018. Vice Chair Stan Fischer’s term ends about six
months after that. Trump has given no indication that he’ll ask either to step down now, although he
has definitely said that he wants to replace Yellen when he becomes president.

Yes, Trump has criticized the Fed for keeping interest rates down too much. After accusing the Fed of
trying to help Clinton and Obama by keeping rates low, Trump might have to welcome low rates if he
wants to implement the infrastructure program that he desires. In fact, I believe the Fed is going to
move with the 10-year rate next year. If the 10-year Treasury continues to rise to 2.5%, 2.75% or 3%
or more, you are going to see two or three Fed rate hikes. We are certainly going to see one in
December. That’s a slam dunk. But there could be anywhere from two to three hikes next year
depending on how high that 10-year rate goes.

It’s one thing to finance infrastructure at a near-zero rate, which is where short-term rates are. But if
short rates rise to 1.5% and the long rates approach 3%, it is going to be more of a challenge. Trump
may not appoint someone who is very hawkish, such as John Taylor, and maybe we’ll find that Yellen’s
dovishness will be welcome at a later date.

I should mention that for quite a while there have been two openings on the Board of Governors of the
Federal Reserve and the Board wants them filled. They want to be at full strength. There are only five
governors now and there should be seven. Trump will have the opportunity to appoint two new
governors very early in his term.

According to Paul Krugman this morning, Trump intends to finance his infrastructure
spending through tax breaks to the private sector.

Let’s talk about that. To the extent that you build a new highway, you could charge tolls for it, you could
raise tolls on current highways or you could raise the gasoline tax. If you want to build airports or ports,
there can be fees that are charged to pay for much of that. But I believe that it cannot be 100%
financed by the private sector, because if it could have been, it would’ve likely been done already.

Yet I approve of a private-sector plan. Clearly there should be user fees to the extent that people use
the roads. If you do drive, you should pay for highways. But realistically, on the scope that Trump is

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talking about, there is still going to be a lot of government debt that will have to be floated to finance
these projects. Additionally, Trump pledged to cut taxes and that too will raise the debt.

It’s likely that headline CPI inflation will surpass 2.5% given the increase in the price of gas.
What is your forecast now for inflation?

Oil is fluctuating between $40 and $50/barrel. Gasoline prices go with it. Where is oil going to be next
year? With a strong economy I could see it at $50 to $55/barrel. I don’t think that’s very inflationary.
One also has to take into account the strength of the dollar because of higher interest rates. This
lowers the price of everything we import.

I’m not convinced that we are going to see a lot more inflation. It might go to 2.5% on the CPI or CPI
core. The Fed has said it is willing to tolerate that level to get the economy going again. Anything above
that and they’ll be much more aggressive about raising the rates. But I don’t think we are facing any
runaway inflation or even a big acceleration of inflation, especially if the dollar stays strong.

Last year you talked about the potential for emerging-market stocks, particularly if the price
of oil rebounded, which it has. Given the potential for higher rates and a stronger dollar, have
the risks gone up for emerging-market investing?

Emerging-market investing is still a very favorable area for investors. The P/E ratios are still under that
of developed markets -the low teens for most emerging markets.

What has hurt the emerging markets over the last two years has been the collapse of commodity
prices. A few countries, like India, have been doing well because they do not supply those raw
materials. I think commodity prices have hit their bottom and stabilized early this year. From this point
on, I still think emerging markets offer good opportunities.

Rob Arnott has written that the nature of the markets has fundamentally changed because of
debt deflation and demographics and that past experience is no longer a reliable guide to the
future. Do you agree with his thesis?

I was with Rob last February when the oil prices collapsed. He and I agreed that emerging markets
were very, very attractive at that time. We all acknowledged the pain that all of us who have advocated
those markets had suffered up to that point. Of course, that February was the bottom from which they
rallied some 30% and 40%. As I stated earlier, I still think their valuation is attractive.

I’ve written on the demographics issue. Most emerging economies have a much younger demographic,
except for China. If their economies grow rapidly, they could be the buyers of many of the assets the
baby boomers will be selling over the next 10 or 20 years. I also know that the developed economies
have a debt burden. And there are large, unfunded liabilities for Social Security and, in particular,
Medicare. One should note that those debt burdens don’t really begin to bite for another 10 to 15 years.
At this particular juncture debt is not a problem for the U.S. or most of the world’s developed
economies. It’s a problem down the road and something will have to be done in the future. But I don’t
see a need for any emergency fix now.

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Have prospective equity returns been permanently lowered in the U.S. due to tighter
regulations, greater transparency, the rapid dissemination of information and the
preponderance of indexing? How does this affect the equity-risk premium?

Stocks are slightly above their historical normal valuation, which is 15-to 16-times earnings. Now P/E
ratios are 19 or 20. Bonds are enormously above their historical valuation, which means that the
forward-looking returns on bonds are very much lower than historical returns, while the forward-looking
returns on equity are slightly below their long-run average. The difference between the forward looking
returns on stocks and bonds is still very large, in fact larger than average. So the equity premium is
very much alive.

In my book, Stocks for the Long Run, I’ve documented that equities have delivered a remarkably
constant return of 6.7% per year after inflation, including dividends plus capital gains. Stock returns are
likely to be somewhat lower in the future. I now look for about 5% to 5.5% as the long-run equity return
after inflation. On bonds, after inflation returns are very likely zero or perhaps even negative.

You are an advisor to Wisdom Tree Funds, which offers a number of dividend-oriented
strategies. Why do dividends matter? Can’t investors always create a synthetic dividend by
harvesting capital gains? If there is an advantage to dividend-based investing, why hasn’t it
been arbitraged away?

Dividend-based investing is quite similar to value-based investing. Warren Buffett has been a fan of
value-based investing. He has often been asked the same question, “Why hasn’t value-based investing
been arbitraged away?” He has said it is because investors’ brains are hardwired to go for growth and
they overpay for growth. Ultimately that’s what gives the value stocks their superior long-run risk return
characteristics. Dividend-based investing has done quite well this year, even with recent pressure of
higher interest rates.

What I like about dividend-paying stocks is the commitment of management to pay cash and to
maintain or even raise this through time. This commitment is superior to hoarding or overpaying for
acquisitions or other assets. I realize that under our current tax system there is a built-in benefit for
capital gains, and that feeds stock buybacks. So I like stock buybacks and feel they are a very close
second best, after cash dividends.

Maybe under the Trump administration we will get more favorable dividend taxation. One change I
would like to see is that if you reinvest your dividends, you are not taxed until you actually sell the
stock. That would put dividend payments on par with capital gains, which as you know are not taxed
until the stock is sold. This policy would not be hard to implement and would encourage corporations to
pay more dividends.

Lastly, what overall guidance, in terms of asset allocation or otherwise, would you offer to
long-term investors such as those who are saving for retirement or for a child’s education?

I see no reason, despite the fact we’ve had two sizable bear markets in the past 15 years and a nice
run from the March 2009 lows, to stay away from equities. U.S. stocks are only slightly above their

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longer-term average price-earnings ratio. Europe and emerging markets are below their long-run
valuation averages, so they are very attractive. Do not ignore foreign markets, even though you might
think the U.S. is going to grow faster, because faster growth is already impounded into the prices of US
stocks.

I find bonds and fixed income to be very dangerous at the current time and much more so since the
Trump victory. Although many of us had reservations about Trump for any number of reasons, on the
economic front, if he does not veer off into tariffs, quotas, trade wars, or foreign adventures that are
not in our interest, the policy which the Republicans advocate is tremendously more capital-friendly
than the Democratic positions that many of us were resigned to endure for four or more years.

The Republicans control all three houses, but they don’t control it by such enormous margins that all
their policies are a slam dunk to be passed. In fact, GOP margins have been reduced in both the
House and the Senate from the last Congress. Nonetheless, the opportunity to enact more-capital
friendly regulations and tax policies, particularly for corporations, is very positive for equities going
forward.

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