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Jeremy Siegel, Ph.D. The Future for Investors

Jeremy Siegel, Ph.D., The Future for Investors

Why Stocks Are Dirt Cheap

by Jeremy Siegel, Ph.D.

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Posted on Friday, October 31, 2008, 12:00AM

No one can guarantee the future of the stock market. But I believe that stock prices are now so extraordinarily cheap that I would be very surprised that if an investor who bought a diversified portfolio today did not make at least 20% or more on his investment in the next twelve months.

Valuations Low Worldwide

The case for equities at these levels is compelling. The last time we have seen prices this low was more than 30 years ago, when the US economy was in far worse shape than today.

The table below lists the price-to-earnings ratios of the world's major stock markets as of October 29. It is taken directly from the Bloomberg World P-E Ratio (WPE) screen. These P-E ratios are calculated based on 2008 earnings, of which the first two quarters have already been reported and the 3rd and 4th quarters' earnings are estimated. Keep in mind that the average historical P-E ratio of the US stock market has been 15 and that when P-E ratios are ten or lower, investors have reaped generous rewards from investing in stocks.

COUNTRY/INDEX P-E RATIO
North America  
Dow Jones Industrials 10.7
S&P 500 Index 11.7
Nasdaq 16.6
   
Canada 9.3
Mexico 9.7
   
Europe  
Euro Stoxx 50 7.9
UK 7.3
France 7.8
Germany 9.5
Spain 7.7
Italy 7.2
Netherlands 5.7
Switzerland 17.3
   
ASIA  
Nikkei (Japan) 11.4
Hong Kong 8.8
Shanghai 12.3
Australia 8.9
Singapore 8.2

Except for the tech-laden Nasdaq, the US markets are selling at 10 to 11 times 2008 estimated earnings while European markets, save Switzerland, are selling between 7 and 9 times earnings. Asian stocks are also very cheap, as the Japanese Nikkei Index is selling at 11.4 times earnings, not much different than stocks in Hong Kong, Australia, and Singapore. The Chinese market, which had been selling at over 50 times earnings last year is now selling at a far more modest 15 times earnings.

Bears will claim that these P-E ratios are too low, since earnings will sharply deteriorate over the next twelve months. Indeed, the last 12 months of reported earnings on the S&P 500 Index have fallen to $51.37 from $84.92 a year earlier. On those numbers, the US market is selling at about an 18 multiple.

But this gives a very distorted picture of the market. Aggregate earnings over the past year are greatly depressed by huge write-offs not only in the financial sector but in other firms. For example, Ford, GM, and Sprint, whose aggregate market value is less than 0.2% of the S&P 500 Index, lowered the S&P's reported earnings by about $12.00, more than 20% of the current aggregate earnings.

Even if these firms all go bankrupt and their stock prices go to zero, it would have a negligible impact on the market value of a well-diversified stock portfolio. The same is true of the financial sector as S&P adds the huge losses in banks that now have almost no value today to the earnings of profitable firms. This means that the P-E ratio of firms that are still profitable is far lower than the ratio calculated for the whole index.

Furthermore, it is a major mistake to use earnings in a recession when calculating the right valuation of the market going forward. That is because stock values are dependent on earnings far in the future, not just those estimated over the next 12 month.

Since stocks have historically sold at 15 times annual earnings, the earnings of the next twelve months contribute only 1/15 of the value of the firm, or less than 7%. The other 93% of the value of stock is realized beyond the next twelve months. Right now the "normal" level of earnings, based on trend analysis of past 15 years of earnings on the S&P 500 Index is $92 a share.

If the average 15 price-earnings ratio applied to these $92 per share normalized earnings, the S&P 500 Index would be selling at 1380, which is almost 50% above its current level. Even if it takes two, or even three years for earnings to return to thetrend line, the normalized valuation of the market is far above what it is today.

Worse Economy in the 1970s

The last time the market was at ten times earnings or less was in the late 1970s and early 1980s. Although the financial stocks are more stressed today, the economy was in much worse shape then. Inflation hit 14.8% in the early 1980s and interest rates on perfectly safe, long-term government securities soared to 15.9%. It is little wonder that nobody wanted stocks when you could pocket nearly 16% per year by just investing in treasury bonds. Short term interest rates soared even higher and some money funds were offering yields near 20%.

To get inflation down from these wrenching levels required an extreme tightening by the Fed, which set the Fed funds target at 20% in both 1980 and 1981. These high rates caused a severe recession and the unemployment rate soared to 10.8%, more than 4 ½ percentage points higher than the current level. As soon as inflation abated and interest rates eased, the stock market soared. From 1982 onward began the biggest bull market in the history of stocks.

Final Word

Markets go to extremes in both directions. The prices of tech and internet stocks were unjustified in 1999 and 2000, as the Nasdaq soared beyond 5000. But the Nasdaq fell too low in 2002 when it sank to 1100. Similarly, the irrational exuberance in the housing market in 2005 has turned to unjustified despondency for all world stock markets in the fall of 2008. Chew on this fact: The total losses in the world stock markets have been over $30 trillion dollars over the past year. That is about ten times the entire size of subprime mortgages issued over the past five years, the purported cause of the current crisis. I believe a year from now we will be looking back on this October, kicking ourselves for not having the courage to buy stocks.

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  • Paolo - Thursday, November 20, 2008, 10:47AM ET  Report Abuse

    • Overall: 1/5

    I rated the article as Poor. This is just because it's not possible to rate it even lower. In the meantime DJIA has lost additional 15%.

  • D - Thursday, November 20, 2008, 1:17AM ET  Report Abuse

    • Overall: 1/5

    i guess the next article will have to be called "why stocks are dirt cheaper...than my last article". and then "no, now they are really cheap". and finally, "with your last dollars, please support my ivory tower view". have to love this guy - great as long as he is no where near my money!

  • Yahoo! Finance User - Tuesday, November 18, 2008, 11:29AM ET  Report Abuse

    • Overall: 1/5

    Apparently this "genius" is so old-school he doesn't even have the fortitude to admit there's trouble EVEN AS HE STANDS IN THE BURNING BUILDING! There's is no hope for someone who's so myopic as to suggest buying into a market that is in the middle of financial collapse and on the way down. Who are you shilling for? Goldman, Citi or Morgan Stanley? I noticed you didn't mention the 18% currency inflation rate annually. When do you think this is all going to come through the economy? Never? You think the average person wants to just hand your bankster buddies free money?! The worst is not yet upon us and this "cheerleader" for wall st. can't even see it coming. Maybe Jeremy needs a couple of lessons from Peter Schiff!!! Seigel's advice is nothing but an unabashed "damage path" of bad advice! Off with his head! (as the saying used to go.)

  • Yahoo! Finance User - Thursday, November 13, 2008, 10:08AM ET  Report Abuse

    • Overall: 4/5

    Well thought out article addressing the current state of panic in todays market. I am buying a few good dividend payers and waiting for that total capitulation period to jump in.

  • espresso - Wednesday, November 12, 2008, 10:44PM ET  Report Abuse

    • Overall: 4/5

    I applaud Siegal for pointing out the difficult economic time we faced in the late 70's. I came of age at this time, and I can attest to the damage that inflation did to the economy. A lot of people are screaming "the sky is falling", but that is only because they have little personal experience with recessions. Trust me, it could be worse.

  • KillerKat - Monday, November 10, 2008, 6:17PM ET  Report Abuse

    • Overall: 5/5

    Bravo!

  • Yahoo! Finance User - Monday, November 10, 2008, 5:02PM ET  Report Abuse

    • Overall: 5/5

    Well said. Panic doesn't pay. Reason does. Great article. Great examples.

  • Yahoo! Finance User - Sunday, November 9, 2008, 6:35PM ET  Report Abuse

    • Overall: 5/5

    Easy to agree but as always only the ones that have the guts , the means and the understanding will profit in this situation. The majority will let the opportunity pass and whine later for not acting. OK

  • Alfred W - Sunday, November 9, 2008, 4:19PM ET  Report Abuse

    • Overall: 2/5

    The trailing PE of the S&P500 is 22 to 1, not 18 (see latest Business Week). The future earnings PE is unknowable, but based on current economic projections by leading economists, it looks to be worse than the trailing PE. The stock market has been in a bubble since 1982 based on expanded PE ratios. This is similar to California home prices (based on price-to-rent ratio). Prior to about the 1960s, it was not uncommon for families to make an all-cash purchase of a home.

  • Lynn - Sunday, November 9, 2008, 2:23PM ET  Report Abuse

    • Overall: 3/5

    The world standard of living is going through a leveling process that is going to last for many a year. Our living standards have been head and shoulders above the rest of the world for a hundred years. Now that we have a world economy. The US is no longer a self suficent island. We must rely on other countries to provide us with goods and services because we can no longer afford our own products. Thanks mainly to the labor unions and their insistance on higher wages and better benifits. Each country is like a glass of water when it comes to their standard of living.It happens that our glass was very full and many of the emerging countries had very little water in them. When you connect all of them together with a hose in the bottom of their glasses, guess what. The water starts to seek its own level and the water in our glass has been going down for some time. Guess where our water has gone. China, India, Brazil, Russia, Canada, Mexico, and many other countries that provide us with our daily needs. Ford, GM and Chrysler, its checkmate, game over. The asians have beaten you at your own game. Why, well they can build better cars right here in the US without the labor unions. All of the analysts are telling us what is causing the ression

  • GG - Sunday, November 9, 2008, 8:49AM ET  Report Abuse

    • Overall: 3/5

    It's pathetic that we have people on here who talk about free market capitalism being dead, finished, and broke. I suppose if you're lazy, overweight, broke, and clinging to a $40K per year job like most people, you might wish for socialism to help level the playing field for you. The fact is that most people on here have no clue what they're talking about. None. They regurgitate the catch phrases of the month that they hear on TV, and use them to act like they're suddenly experts on the economy. I don't agree with everything Dr. Siegel says, but he makes some very valid arguments. We have an unprecedented, coordinated global effort to fix the credit markets. There is no quick fix, but eventually the markets will stabilize and pull out of this recessionary period. Now that there is a real "risk premium" factored back into the market, there will also be the potential for above average returns.

  • Kevin - Saturday, November 8, 2008, 10:39PM ET  Report Abuse

    • Overall: 5/5

    Conservatives always underestimate the role of enthusiasm. I went to Stanford Shopping Center today--it was packed. People spending money.

  • Gene - Saturday, November 8, 2008, 9:40PM ET  Report Abuse

    • Overall: 3/5

    Fair article. Ben Stein in his book, "Yes you can time the market" basically has the same thesis. Long term I think you will be right. However don't count on a 20% bounce in 2009. Flat to down 10% is my prediction. With higher unemployment, nervousness, and a stream of bad news it will be hard for the market to move higher. Markets react much quicker now with the internet and all the available info. Market won't move higher until there is at least one sign of a turn around. None at all so far. Economy in the 70's was much worse. All the comparisons to the depression were for political reasons. Plus there are better values in Europe so expect foreign investment to fall. The dollar is strong simply because people are moving into cash right now. I think the govt and Federal Reserve will inflate until the jammed up gears of the economy are loosened. Except they won't loosen slowly it will let loose suddently causing massive inflation. Again we'll see. The biggest problem about forecasting the future based on history is that no one seems to know the extent of the problems. Too much off balance sheet stuff.

  • ailikishi - Saturday, November 8, 2008, 5:14PM ET  Report Abuse

    • Overall: 1/5

    Yes, in the 1970's the national debt was not of 10 trillion! A New New-Deal towards the banks will not be as jump-starty as before since all this money will be going towards patching up existing financial black holes. So many analysts are wondering why the stimulus package is not working and where did all the money go? With banks lending 1.94 times of their deposit and with all the consumer credit card debt, a couple of more trillions of dollars will still be needed. Hence the current LIBOR rate. With unemployment rising which will result in lower 401K contributions, there will be less money for the funds to use to hit that 15x PE. More importantly, foreign investment will not be interested in the US or the dollar. So a 15x PE is ridiculous. The main reason why the dollar is currently still holding its ground is because of the low price of crude which is on a downward trend because China did not exercise its monthly futures contract. A PE of 7x is more likely and I'm being extremely generous. The recession will be more than two years because the US will have to adjust to the fact that its people will no longer be able to keep its economy going by buying on credit, using other people's money, i.e. consumerism. This shock will take a long time for its businesses and economy to adjust.

  • Yahoo! Finance User - Saturday, November 8, 2008, 4:51AM ET  Report Abuse

    • Overall: 1/5

    Using a distorted analysis of PE ratios alone will not provide an accurate answer to the true valuation of the market. Siegel claims that the economy is stronger than it was in the late 70's. I disagree strongly and so do most people who equate our situation not to the late 70's, but to the Great Depression. Seigel ignores some extremely important things about balance sheets: both the consumer and the goverment have record levels of debt. As the consumer stops spending, we will have a recession to rival the one in the early 80's. Earnings for most firms won't return to "normal" levels for quite some time. We'll see how long it takes for the S&P to get to Jeremy's "normal" level of $92 per share in earnings.

  • pkpg - Saturday, November 8, 2008, 12:53AM ET  Report Abuse

    • Overall: 1/5

    I believe this article is purposely misleading. That is to say, Dr. Siegel is trying to hoodwink you with this work of intellectual fraud. I wrote the exact reasoning here in my blog: http://www.prestonpoulter.com/wordpress/?p=353

  • Yahoo! Finance User - Friday, November 7, 2008, 10:07PM ET  Report Abuse

    • Overall: 1/5

    Stocks arent cheap at all. Most companies in the S&P 500 havent reflected in their stock prices the consumer falling off a cliff. Just take every sector piece by piece. Take energy, oil has gone from 147 to 60 a barrell. Yeah, their refining margins may get better but dont expect any more record profits. Earnings will tank. What about financials. Well all these firms are basically insolvent and laden with debt not too mention where is the future growth going to come from? The business model is broke. Consumer products? Most people are shopping at walmart and costco and staying away from name brand products. Industrials? I dont see any construction projects coming online in the future. Credit cant even be obtained for the simplest task. This is a short covering rally and the dow will probably hit the 5000 area. How can the worst crisis since the great depression only crater the S&P 30%? This country is printing money like crazy and they are trying to inflate their way out of this problem. That may work but in the end you pay for it because all your asset classes and investments decline in value and your purchasing power declines. I would go long agriculture and commodities and buy puts on the S&P 500.

  • Harry - Friday, November 7, 2008, 2:23PM ET  Report Abuse

    • Overall: 4/5

    yes they are cheap, and if one is looking for a quick turnaround, and they cant handle the volitility, then by a CD tht pays 3%. In the long run the stocks will make you money, even with obamanomix. Just rememeber stocks are cheap, and they can get cheaper, as the last two days proved.

  • Tim - Friday, November 7, 2008, 2:20PM ET  Report Abuse

    • Overall: 4/5

    Fear and anger is a very real part of the process. I enjoy the comments as well as the article. Like earthquakes, market behaviour is impossible to predict. The best we can do is examine the history and apply statistics and reason. The article is a good example of just that.

  • Neeraj - Friday, November 7, 2008, 1:29PM ET  Report Abuse

    • Overall: 1/5

    This kind of hypocrisy and conman talk is exactly what got us in trouble in the first place. The only people making money are the ones who dish out this bogus stories about stocks being great. no one knows what is going on and you may as well go to las vegas and spin the wheel

  • Yahoo! Finance User - Friday, November 7, 2008, 12:38PM ET  Report Abuse

    • Overall: 1/5

    Jeremy - I don't need another schmuck telling me how to lose my money. However what I would appreciated from you is some sort of explanation as to why the Wharton School of Business in the University of Pennsylvania is seemingly incapable of graduating anyone with any sense of scruples, business ethics or social responsibilty. From Michael Milken to Donald Trump to more than your fair share greedy hedge fund managers, this pathetic litany goes on and on. In Philadelphia, the joke is that the sharks from New York send their kids to Penn with their endowment checks in hand , to learn the fine art of exploitation and then head back to New York to ply their trade. Maybe one reason for the state of this instituion is that it has all but put up a "not welcome here " sign to white American Christian applicants wanting to attend. Or maybe Wharton just can't hire a Professor to teach a Business Ethics class. At any rate America, I believe , is slowly beginning to wake up to the fact that Ivy League institutions are fundamentally cess pools of hypocrisy and elitism.

  • Dustin F - Friday, November 7, 2008, 12:13PM ET  Report Abuse

    • Overall: 5/5

    Some of the fools writing in are precisely the reason money can be made in stocks.

  • Yahoo! Finance User - Friday, November 7, 2008, 12:11PM ET  Report Abuse

    • Overall: 3/5

    Good data but draw your own conclusions. In bad times, markets can undershoot 30 to 50%; current valuations are perhaps closer to 30% undershoot so very likely we have some more correction ahead of us. Buy when everyone stops talking about the bottom or better still when everyone stops talking about investing in the stock market, period. If anyone wants to venture in now do so very selectively with small amounts using dollar cost averaging; there is a lot of pain and volatility ahead of us, especially in NASDAQ, which is way overpriced, where most of the high tech discretionary spending type companies are listed. If and when recovery happens it will be a long slow one, don't forget what has happened to Japan-Nikkei in last 15 years.

  • Yahoo! Finance User - Friday, November 7, 2008, 1:19AM ET  Report Abuse

    • Overall: 1/5

    Sir, Your analysis sems long on relative value and short on absolute value. The massive leveraging cycle (total household debt) since the early 1990's is falling off a cliff, and when you combine negative operating leverage on income statements from the top down will shake many companies with even moderately leveraged balance sheets, add on refinancing risks and this type of effect will tke years to turn around. Look ahead two to three years earnings and it does not look like a value. The consumer is bloated and can easily cool off for several years. After that, money supply issues will be alrmingly inflationary, and only once that is under control will there be light at the end of the tunnel. If you want a mindset to compare relative value, when we hit the lows in 2003 the econonny was less leveraged with tough fundamentals only speculative. This go asround we are much more leveraged, fundamentals are horrible and we should be much lower than the lows back then.

  • Alex - Friday, November 7, 2008, 12:59AM ET  Report Abuse

    • Overall: 1/5

    Someone needs to ask this moron what was he touting during Siegel & Shiller series at Wharton just before the tech collapsed. Oh right, he was the moron with the "It will go higher!" message, but that's no surprise as it is the same Shiller that is known from Case-Shiller index, the same Shiller that predicted the tech bubble collapse... This clown on the other hand is the idiot writing pump pieces for Yahoo.

  • Rick M - Thursday, November 6, 2008, 8:18PM ET  Report Abuse

    • Overall: 1/5

    If you listened to this fool in the past, you are already heavily invested in the stock market, you have taken a severe beating, more pain is coming, and there is no way out. And you deserve it. The smart folks did their own research, found a massive credit bubble was going to implode, and got out in time or went short. So, thanks Jeremy and followers for keeping the stock prices up for me to short the market successfully! I could not have done it without you. By the way, the stock market is still WAY overpriced.

  • Yahoo! Finance User - Thursday, November 6, 2008, 6:46PM ET  Report Abuse

    • Overall: 5/5

    As always, clear, reasonable arguments supported by evidence. And you even discuss the (occasional) irrationality of the markets. I find the negative comments here to be encouraging! They seem to support your thesis that a lot of the pessimism today is driven either by emotions or by simple bias against markets in general. Few of them dispute your arguments.

  • Terry - Thursday, November 6, 2008, 4:53PM ET  Report Abuse

    • Overall: 2/5

    Buy now! Buy buy buy. I've got a lot of stuff I want to sell, and I need buyers. Buy!

  • Yahoo! Finance User - Thursday, November 6, 2008, 2:33PM ET  Report Abuse

    • Overall: 1/5

    We are yet to see the majority of expected job losses. When we hit the bottom of the recession (2009? 2010?), then perhaps start thinking of buying. A sobering thought - during the Great Depression, stocks lost 90% of their value. Care to call a bottom?

  • Yahoo! Finance User - Thursday, November 6, 2008, 2:02PM ET  Report Abuse

    • Overall: 1/5

    Were down 35% YTD, and we could go much lower since earnings are going to implode, e.g., less consumer consumption.

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