Jeremy Siegel, Ph.D. The Future for Investors

Ouch!! That's how I felt when I read my stock market prediction for 2008. Not only did I think that the market would do well last year, but I thought financial stocks would lead the way. Instead, 2008 turned into the worst year for the markets since the Great Depression, and financial stocks led the way down, not up.

I did hit one nail right on the head. I warned that a major risk to my forecast was the price of oil, stating, "If oil surges past $100 a barrel, we will be in trouble. Three dollar gasoline did not prove to be the tipping point for the consumer in 2007. But with a weak housing market, I believe $4 gasoline would do considerable damage to consumers' pocketbooks in 2008. And $4 gas would happen if oil rose to $120 a barrel or higher."

Indeed, oil soared past $147 a barrel and gas topped $4 a gallon in July, greatly accelerating the economic downturn. But I certainly didn't predict the depth of the subprime crisis. It is important to explain why I, like so many others, didn't believe the downturn in real estate would tank our major financial institutions -- and why this has relevance for the 2009 forecast.

The Path to the Crisis

I certainly recognized that there was a bubble in real estate prices. And, yes, a good part of the increase in consumer spending over the past few years was fueled by easy borrowing against rising real estate prices.

But if that was all there was, the popping of the real estate bubble would have caused, at most, a mild recession. What has made this slowdown particularly severe was the fact that these mortgages and mortgage-related securities were concentrated in investment and commercial banks. Banking firms leveraged these securities so highly that, when prices fell, their capital bases were decimated.

I had wrongly assumed, as did Alan Greenspan and most regulators, that mortgage-related securities were widely distributed and diversified in portfolios throughout the world. The total value of subprime and Alt-A (slightly better) mortgages was about $3 trillion. This is a hefty sum, but even if all these securities went to zero, the capital markets could have absorbed such losses without undue economic stress. The popping of the Internet bubble in 2000 dropped the value of US equity markets by over $7 trillion, but even this decline caused only an extremely mild recession.

It Could Have Been Avoided

Ironically, Wall Street firms could have easily taken measures to insulate themselves from this crisis. Think of the Internet craze of the late 1990s. Wall Street made a nifty bundle by selling new stock in Internet companies. But, by and large, they did not hold these stocks. "Take the Profit and Run" was the strategy, as Wall Street sold them before their prices tanked, letting investors absorb the losses.

But Wall Street wasn't nearly as smart this time. After making a bundle by writing and securitizing these subprime loans, it held on to most of them, believing that it was getting a generous return for little, if any, risk. Greenspan said in Congressional testimony that he assumed Wall Street shed these risks by entering into credit default swaps and other risk-reducing arrangements. But he was wrong: He never examined the banks' balance sheets. If he had, he could have sounded the alarm.

When the housing market turned, Wall Street firms were still holding on to these securities, believing that their prices had fallen too much to justify selling. By the time they realized how bad the situation was, it was too late. As prices fell, their losses overwhelmed their capital and the firms descended into bankruptcy.

Economists will long debate whether the Fed should have bailed out Lehman Brothers. But after the firm failed in September, the credit markets panicked. Lending by the banks froze, and millions of borrowers either had their loans called or were under threat of such an action. Risk premiums soared to levels not seen since the Great Depression, and the economy went into a freefall.

Credit Crisis Aftermath

There is no denying the severity of the current global economic downturn. Lax lending, inflated real estate prices, and, most important, expectations that the rapid economic growth of the past few years would continue far into the future led to over-lending and over-investment, and weakened banks' balance sheets.

Although current economic indicators are bleak, there has been some improvement. Stocks are about 20 percent off their lows, and risk spreads have declined. The spread between the Libor rate, an all-important borrowing benchmark, and the Fed funds rate is down 122 basis points. Although this is considerably higher than before the Lehman demise, it is down significantly from the 364-point spread at the peak of the crisis last October.

The financial crisis has been met by a massive governmental response. The Fed has de facto insured all deposits and money market funds and much interbank lending. Interest rates are at or near their lowest in history. Freddie Mac's 30-year conforming mortgage rate has recently dropped to near 5 percent, the lowest in the nearly 40-year history of these rates. On the fiscal side, the Obama Administration is preparing a massive stimulus that will likely produce not only new spending programs but also another tax rebate.

The steep decline in energy prices is another important positive for the economy. As I wrote last summer, the doubling in oil prices from $65 a barrel to $130 shaved two percentage points off GDP growth. That means the fall to $40-$50 has not only reversed that drag but will probably boost real income and output.

Forecast

All of this means that, although the first quarter of 2009 will see negative growth, GDP should stabilize in the second quarter, earlier than most economists now anticipate. In real terms, housing prices have already retraced most of their gains from 2000, and by midyear prices should stabilize in this low-interest-rate environment. Year-over-year inflation should sink to zero, especially in the first half of 2009.

This year, as the economic slide abates and investors realize a catastrophe has been avoided, stock prices should enjoy a 20 percent or higher return. All equity sectors should recover.

The financial stocks will still be burdened by bad loans and government obligations. Nevertheless, new lending will prove extremely profitable to the banks whose cost of funds is now essentially zero. The Fed might find that it will be forced to raise rates during the summer, earlier than planned. And I believe long-term Treasuries are in a giant bubble and their prices will fall to earth once the economy improves.

Final Word

All of this doesn't mean there are no risks to stocks. The Fed must do more to encourage banks to lend to credit-worthy, non-delinquent customers. And the Obama administration must carefully structure its recovery plan so as not to bail out those that have been profligate and penalize those who have been thrifty.

Still, just as 2008 disappointed us on the downside, 2009 might surprise with better numbers than most are expecting.