Thursday, December 24, 2009, 9:48AM ET - U.S. Markets close early today in 3 hours and 12 minutes for Christmas Eve.

Jeremy Siegel, Ph.D. The Future for Investors

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

What the New Volatility Means

by Jeremy Siegel, Ph.D.

Email this Page IM this StoryBookmark this StoryAdd to your Del.icio.us accountDigg this StoryPrint this Story
Excellent (550 Ratings)
4.103636/5
Posted on Sunday, March 4, 2007, 12:00AM

When the market moves sharply upward, brokers call it a "bull surge" and attribute it to "waves of optimism." But when markets fall decisively, they call it "volatility," a euphemism for a bear market or downward correction.

There's no question that markets were volatile last week and are likely to remain so in the near future. But I believe that good earnings and low interest rates will still make 2007 a rewarding year in stocks. And despite the fact that virtually all world markets sunk together, international diversification is still as important as ever to the success of investors' portfolios.

Trading Strategies

Whatever you want to call what happened to the market last week, it wasn't pretty. After marching upward for many months with nary a pause, the market suddenly plunged without warning. Why did the market fall and what does it mean?

The truth is that many market movements are not due to economic forces but to traders watching what other traders are doing, or what we call "technical trading." This is largely what happened on Feb. 27, when the Dow Industrials plunged 546 points in the late afternoon before closing down 416 points.

The backdrop is important. The stock market had been steadily rising for seven months. That was the longest period when markets hadn't even corrected by 2 percent in more than a half-century.

When stocks were in this uptrend, the market attracted many "trend followers" or "momentum players." These are speculators who make no judgment about whether stocks are cheap or expensive but only want to jump on the bandwagon. There's an old expression on Wall Street -- "Make the trend your friend" -- and that's just what these speculators did.

But these trend-followers knew that the bull market wouldn't last forever. They protect their profits by placing stop-loss orders below the current price. A stop-loss order tells the market maker to sell whenever the stock penetrates a predetermined level. Because the market never moved down 2 percent for so long, many stop-loss orders were placed 2 percent below the market. Once the 2 percent limit was breached, a wave of selling broke out.

The Straw that Broke the Camel's Back

Any event, however insignificant, could trigger a 2 percent decline. For several weeks, markets had been nervous over defaults in the subprime (below investment grade) mortgage market. On the night before the big decline, China's Shanghai index, reacting to rumors that the Chinese government was going to clamp down on speculation, fell 9 percent, the most in a decade.

Furthermore, there were reports that former Fed chairman Greenspan had said that a recession was a "possibility." Finally, the durable goods report that came out on Tuesday morning showed a much larger decline than the market had anticipated.

Even taken together, these events didn't justify a 400-point drop. The fall in the Shanghai index had followed a record-breaking 130 percent gain in the prior year, and even after the decline, the Chinese market was higher than it was just two weeks earlier. Greenspan said that a recession was only a "possibility" (anything is possible!), and his remarks were actually posted on Monday and the market barely budged. Finally, the durable goods report, though dismal, is a notoriously volatile and, unlike the inflation or employment reports, almost never has a big impact on the market.

Nevertheless, when all these small factors were added together they pushed the market through the 2 percent barrier that speculators had set as a selling point. These trend followers then bailed out of the market, sending the market down another 3 percent in a matter of hours.

Stock Returns in 2007

There's little question that economic growth has slowed over the past several quarters. GDP growth, which had been between 3.1 percent and 3.7 percent over the past four years, has fallen to about 2 percent. The record 19 consecutive quarters of double-digit earnings growth will certainly end this quarter. In fact, current estimates of earning growth in 2007 are only 7 percent to 7.5 percent.

But the market doesn't need double-digit earnings growth -- or a roaring economy -- in order to do well. If the price-to-earnings ratio remains unchanged, the return on stocks will be the earnings growth plus the 2 percent dividend yield. In this case, the market will return a very healthy 9 percent to 9.5 percent in nominal returns and 6.5 percent to 7 percent after inflation. This return is right in line with historical averages and well above bonds.

And there's a good possibility that the price-to-earning ratio will rise, especially if the Federal Reserve lowers interest rates later this year. If the economy is particularly soft, then such a move is a virtual certainty. So if earnings come in under expectations because of a sagging economy, lower interest rates will cushion the impact on the stock market.

Nowhere to Run, No Place to Hide

One of the fascinating aspects of last week's decline was that it was replicated throughout markets worldwide. Every major developed and emerging stock market declined, and all did so by nearly the same magnitude. Some claim that the high correlation between markets means that the purported advantage of international investing, namely diversification, doesn't work. Diversification is supposed to reduce risks by investing in different stocks, sectors, or countries whose returns are not synchronized. If all the markets move together, diversification is lost.

But the very high correlation between world markets only occurs in the short run. This correlation has increased because investors now operate in world markets and easily transmit their hopes and fears to traders in other markets.

Although emotion may rule the stock market in the short run, economics rules in the long run. Long-term returns will vary across countries because of differences in economic policies, currency movements, and sector growth. Don't despair that international diversification didn't cushion last week's decline. It will certainly do so over longer periods.

Final Words

Sell-offs understandably scare investors and garner much media attention. But history has shown that they're excellent buying opportunities.

Given the reasonable levels of today's stock markets, I advise investors to remain internationally diversified and stay with stocks.

Email this Page IM this StoryBookmark this StoryAdd to your Del.icio.us accountDigg this StoryPrint this Story

Rate This story

Excellent (550 Ratings)
4/5
Sign-in to rate!

58 Comments

Showing comments 6-35 of 58<< PreviousNext >>
Sort: first to last

  • Rainmon - Monday, March 19, 2007, 10:11PM ET  Report Abuse

    • Overall: 3/5

    I don’t know why everyone is getting so excited, before passing judgment on this guy, consider his income source. I am guessing he is a college professor and makes his living from a tenured cushy teaching job. This article is basically for the simple minded retail investor. The guys that make real money on Wall Street don’t waste their time giving out free advice or writing articles for a few hundred bucks. I suggest the average retail investor is too lazy to learn stock analysis or how to use derivatives. Moreover, doesn’t have the stomach to handle volatile markets and should stick to keeping their head in the sand and check their IRA on a annual basis, instead pretending they know something about stock market investing. If you’re investing as a way to pay the mortgage etc, you better know what you’re doing, or get a job…

  • Yahoo! Finance User - Monday, March 19, 2007, 9:22PM ET  Report Abuse

    • Overall: 2/5

    Yeah, yeah yeah... I get a little sick of these articles suggesting that the stock market always has to go up. "Just stick with it. It'll go back up and you'll get your teensy little 9%." The fact is, the people who are really making money in the market are able to do so whether stocks rise or fall. They don't want you to know how to do this -- and how to reduce your risk at the same time. So how do you do it? Simple: Put 80-90% of your money into a safe place and use the remaining 10-20% to trade call and put options on the stocks you would have otherwise traded. Here's the deal: "In-the-money", 1-6 month calls (or puts) trade in the same (or opposite, in the case of puts) direction as the underlying stocks. So you can make money when the market is up (from calls), when the market is down (from puts) and you have minimized your risk to 10-20%. Of course, if you're wrong about the direction of the market, you'll still lose money. But YOU control the maximum amount you can lose. And your potential upside is as big, or bigger, than that of the ordinary shareholder. So who's smarter, the guy who risked 20% in options or the guy who risked 100% in stocks? Of course, all of the happy brokerage houses don't want you to know this. They LOVE making the money you're willing to give away. How do you think they have such grand offices and healthy bonuses? Do you think that THEY make only 9% returns? Think again! Read a good book on options and read a good book on market trends. Then practice with two fake portfolios. Use one to trade stocks and use another to trade 20% of that same amount of money in options. Don't buy options that are too far out of the money and don't risk more than 20% of your portfolio. Yes, you've got to have a brain and some passion for the stuff. And yes, there's risk involved. But if you're invested in the stock market or mutual funds, you have no control of your risk. With options, and a good head on your shoulders, you can control that risk. I made over 20% in the stock market over the last two months -- mostly while it was falling. I don't buy mutual funds and I don't care if people say the market is always going to go up. I'll make money even if it doesn't. Good luck to all!

  • joelk - Monday, March 19, 2007, 2:31PM ET  Report Abuse

    • Overall: 5/5

    analysis of situation is very thoughtful

  • Greg - Sunday, March 11, 2007, 5:33PM ET  Report Abuse

    • Overall: 1/5

    This article is just identifying the events of the past week and implying that they are causally related to one another. This is not technical traders selling, it was that no one was buying. All of the major indexes were down 5% or more in a span of 8 days. All of the world markets are driven by the psychology of the masses not the fundamentals. When everything is going well everyone is jumping on the band wagon. When there is a little scare, the smart money jumps off to protect their gains. Unfortunately, the buy and hold crowd will be burned one of these days soon. The up markets last for a while, but the down markets are quick and vicious. They come and are gone before most people know it. And to imply that today's 'professional' investors are not trend followers is ludicrious. Ask any investment 'professional' and you'll here the same mantra, there is one direction for the market and that direction is UP. The Shanghai market is a rocket getting ready to reenter the earth's orbit. It will come crashing back to earth. The recent history of the US stock markets should remind investors how irrational markets can become before they come back to earth. We'll see the Shanghai index 1/2 the price it is today in the next year. If history has proven anything, its the shape of a bubble is the same all over the world. And as for the Yen carrry trade coming to an end, we've seen the same type of sell off about a year ago. What was the relationship then. When the Yen recovered this week what was the relationship? The only good point on the article was about the lack of diversificataion. There is none. All the world markets declined together. Same with precious metals. This is the shape of the collapse to come.

  • Yahoo! Finance User - Sunday, March 11, 2007, 1:43PM ET  Report Abuse

    • Overall: 1/5

    always an eternal optimist, if economic growth slows, earnings growth will follow. To be ignorant of this fact is leading the sheep to slaughter.

  • retiredinPrescott - Saturday, March 10, 2007, 8:25PM ET  Report Abuse

    • Overall: 4/5

    This article makes good sense. You don't make money by falling prey to panic. Slow and steady wins the race to retirement.

  • Eddie Larry - Saturday, March 10, 2007, 12:51PM ET  Report Abuse

    • Overall: 2/5

    I did my rating wrong, actually I thought the article was pretty good. I do agree with those who argue that the yen carry trade is coming to a slow end. The Japanese will go very slow on this but it will end. I guess we can sell each time the Japanese raise their interest rates and buy back after the resultant crash. But what comes next? Will the yen carry trade be replaced by a dollar carry trade? I do think it will be replaced eventually.

  • JamesR - Saturday, March 10, 2007, 12:33PM ET  Report Abuse

    • Overall: 1/5

    What a lightweight this Siegel is. Take his recommendation to "internationally diversify" investments: This is extraordinarily dangerous advice without some additional caveats. The unwinding of the yen carry will be utterly devastating to some emerging markets -- particularly South America. Take Siegel's advice that sell-offs make "excellent buying opportunities". Sure, if you can "time the market" and call the bottom. But every great crash has been preceded by a series of smaller "stumbles". Did each of those smaller "sell-offs" make "excellent buying opportunities" also? Yet again Siegel flaunts his silly degree and follows through with meaningless oversimplified drivel. Heed the words of this 'luftmensch' at your own peril.

  • bob - Saturday, March 10, 2007, 11:14AM ET  Report Abuse

    • Overall: 5/5

    Capital formation is shifting from the entrepreneur who invests in the future to the trustee who invests in the past.---Peter Drucker

  • Yahoo! Finance User - Thursday, March 8, 2007, 2:41AM ET  Report Abuse

    • Overall: 2/5

    What all the "experts" don't want you to know is, that the stock market is oversold since the dow passed 8000. The dow is going sideways since 6 years and will continue so. Adjusting for inflation, most stocks look very tired.

  • Yahoo! Finance User - Thursday, March 8, 2007, 2:29AM ET  Report Abuse

    • Overall: 5/5

    whether you are a current bull or bear, those of you who dont understand the logic and theories behind Siegel's long-run advice shouldn't be investing in the market anyhow, you can only loose, quite frankly you are better off at a crabs table. you know nothing of finance if you are concerned with pulling out your money in order to pay for bills/mortgage.... investing isnt for anyone.

  • Tony - Thursday, March 8, 2007, 1:56AM ET  Report Abuse

    • Overall: 1/5

    "Stay for long-term?" Are you kidding? While many short-term traders gain no matter if the markets go up or down? And, I only hold a bunch of "paper" in the hope of "gaining" in the "long-term"? Boy, wish I can pay mortgage, car loan with the "paper". Who cares about 30 years down the road if you cannot surrvive by selling stock now? And there are other instruments which gives better than 9% annual returns, one just has to dig deep. Stay away from stocks for now, and they are headed lower. Last week was just the beginning. For those who still don't believe that a suprise party of Bears is coming, well hold on to your stocks and see...

  • __A_YAHOO_USER__ - Wednesday, March 7, 2007, 1:47PM ET  Report Abuse

    • Overall: 1/5

    What good is it when you don't know how much the CEO is going to rip the Co.off

  • MW - Wednesday, March 7, 2007, 1:27PM ET  Report Abuse

    • Overall: 5/5

    Siegal is not a bull or a bear. Those terms really refer to short-term investors who buy and sell constantly with either a bearish or bullish bias. A person who invests regularly in a simple and diversified stock portfolio and plans to do so for 30-40 years (like my dad did and I plan to) are realists, not bulls. Show me a 40 year period where stocks did poorly and, further, show me the exact indicators that reliably tell me when a 40 year downturn in stocks is coming, and maybe I'll change my mind. Don't try though. There is no such period and no such indicators. For those of you who are true bears or bulls and trade actively, I hope you do as well financially as your brokers.

  • Flarben - Wednesday, March 7, 2007, 12:54PM ET  Report Abuse

    • Overall: 1/5

    It's so easy to say "stay in it for the long run", until you realize that you needed that paper wealth to help pay your mortgage or cover a major health-care expense. High risk doesn't mean high reward, it also means high potential loss. Investors have been acting as if risk doesn't matter but of course, it doesn't matter till it matters, and then it's too late.

  • Yahoo! Finance User - Wednesday, March 7, 2007, 12:46PM ET  Report Abuse

    • Overall: 1/5

    One comment writer said that the "doomsayers"..have always been wrong about stocks. What utter nonsense. Smart investors recognize that trees can't grow to the sky and that different investment classes make sense at different times. The "doomsayers" who criticized the Nifty Fifty era were SPOT ON. Stocks tanked in the 70s and the opportunity costs of not being in hard money, commodities or even high-yielding CDs were immense. Stock promoters always have some reason why "it's different this time." Well, in this case they're right, but it's not an argument to keep throwing money at stocks. It's very different this time in that we have had in place a "carry trade" -- borrowing vast sums of money in ultra-low-interest rate yen to buy everything in sight regardless of risk, including junk bonds, subprime mortgage tranches and penny stocks in Shanghai. For years, "doomsayers" like Alan Greenspan have said that there are tremendous risks to long-term economic stability from global imbalances such as the outrageous US trade deficit, uncontrolled lending from Fannie and Freddie (and more recently, the subprimes). Such "doomsayers" as Warren Buffett have remarked that no one knows what the hell will happen when the mountains of derivatives are tested in a severe downturn. Furthermore, note that we haven't really had a severe downturn in world markets since 2000-2001, and when that happened, long-term rates were much higher than they are now and the Fed cut short-term rates from 6.5% in 11/2000 to less than less than 1%, where they remained for AN ENTIRE YEAR. This helped launch the insane housing debt bubble which made everyone feel good but is going to result in a hellacious hangover once all the condos still under construction finally get thrown onto the market later this year. The risk premium of high-yield debt relative to treasuries has never been so low. All these yield spreads would have to do is revert to their long-run means and we would have a meltdown. So please, stop lecturing us about the "long run" and how "doomsayers are always wrong." It's today's risk-ignorant investors who have ignored the long run. There are always "permabulls" and "permabears", but the old saying is that bulls and bears make money, but pigs get slaughtered. There's been a lot of pigs making money lately and it can't go on much longer.

  • Yahoo! Finance User - Wednesday, March 7, 2007, 12:12PM ET  Report Abuse

    • Overall: 4/5

    Excellent advise for investors. From posted comments, one can well see how speculators are feeling. I am in for long run and avid follower of Prof's advise.

  • Yahoo! Finance User - Wednesday, March 7, 2007, 11:54AM ET  Report Abuse

    • Overall: 2/5

    For every bull like this there is another "expert" with the bearish opinion. No one knows what the year will hold, even Dr. Siegel. But with the current bull market already historically old, slumping corporate profit growth, falling productivity, and rising employment costs it seems the prudent investor may want to be reducing his stock equity exposure at least somewhat. The stock gains are likely to be more muted from here, risks are mounting, and one can get over 5% in short term fixed income with near zero risk. The most important rule to keep in mind in investing is "don't lose money".

  • Yahoo! Finance User - Wednesday, March 7, 2007, 10:43AM ET  Report Abuse

    • Overall: 1/5

    demagoguery and propaganda

  • Yahoo! Finance User - Wednesday, March 7, 2007, 10:16AM ET  Report Abuse

    • Overall: 4/5

    The doomsdayers have claimed that the sky was falling in the 60s, 70s, 80s, 90s and now 00s. Well, they're on the verge of missing out on yet another historical opportunity.

  • Yahoo! Finance User - Wednesday, March 7, 2007, 9:27AM ET  Report Abuse

    • Overall: 1/5

    WRONG!!! Invest in equities now at your own risk. True, day to day (and even month-to-month) fluctuations are driven as much by emotions as anything else, but the long-term fundamentals dictate trends. I believe that dumb money has piled into markets recently and smart money has climbed the "wall of worry" to aid in the market's incredible run, and its current over-valued state. The long-run outlook is growing dimmer. The current spate of economic growth has been spurred by two factors that cannot be sustained in the long run - an enormous budget deficit (and a negative national savings rate - which hampers long-term growth) and ridiculously low interest rates (which discourage savings). In short, the economy's been kept afloat by easy credit, and most of the gains possible under such a scenario have been used up in recent years. I don't believe easy credit will have the same effect if rates plummet again (Long-term rates haven't risen much anyway). Anyway, given less friendly long-term growth prospects, PEs will decrease (stocks are valued on what they will do, not what they have done). Lower PEs along with lower earnings growth mean lower returns (and can be negative for cyclical businesses). I recommend defensive stocks (such as utilities) if you're bent on stocks. The guru

  • Yahoo! Finance User - Wednesday, March 7, 2007, 9:23AM ET  Report Abuse

    • Overall: 1/5

    This guy should be criminally prosecuted for pumping stocks 24-7. Junk statistics, data not adjusted for inflation, multi-year periods of negative returns, stocks for the long haul is a fraud. Like the market needs another mutual fund, with the professor lining his pockets, he say's don't worry about the PE ratios. Suddenly fundamental analysis is no longer relevant. The signs are all there for a new bear market, CNBC in full defensive mode, the "experts" telling us to average down, that it's a buying opportunity, a plethora of get-rich stock picking services, maybe Gorilla Trades will make me rich. Take a look at the INSIDER SALES of any stock on Yahoo finance, and tell me why you the retail investor should pay full bloated retail price so that insiders can exercise options at your expense?

  • stedyhand2001 - Wednesday, March 7, 2007, 8:40AM ET  Report Abuse

    • Overall: 5/5

    Puts the short term reactions in proper perspective. Good examples of how short term traders or trend followers can influence the market in short term. These necessary events help create a nice buying point opportunity for longer term investors.

  • Yahoo! Finance User - Wednesday, March 7, 2007, 5:28AM ET  Report Abuse

    • Overall: 1/5

    This clown was telling everyone to load up on stocks in 1999 and 2000. Wharton needs to revoke his tenure !! Small Cap P/E are in the 20's, Financials are operating at peak earnings, REITS yield below 4% !! The bursting of real estate bubble has only begun. Beware of the fall out to the economy (i.e. unemployment, consumer bankruptcy, ect.)

  • TomW - Tuesday, March 6, 2007, 5:55PM ET  Report Abuse

    • Overall: 5/5

    Keep them comming.......

  • Vigga - Tuesday, March 6, 2007, 4:50PM ET  Report Abuse

    • Overall: 5/5

    Um, did that guy down there just say the market runs in 16 year cycles. Put the crack pipe down. Do it now. Put it down. The market is still sitting undervalued by at least 10% to 15% as far as a broad-based index like the S&P 500 goes. Projections of 7% to 8% growth for earning seem right on...

  • LisaM - Tuesday, March 6, 2007, 3:01PM ET  Report Abuse

    • Overall: 3/5

    Investor behavior IS irrational. While individual investors may be well-informed with disciplined investment strategies, the collective behavior of those investors is just plain nuts. In order to not succumb to irrational market behavior it takes a cool head and the ability to override perfectly natural, even instinctive impulses to do otherwise. Humans aren't wired to prevail in the markets, just as they aren't wired to ignore the blandishments of the latest lottery jackpot. Take a deep breath, consider your investment strategy (or formulate one if you don't have one), make a plan and follow through on that plan. Don't let your lizard brain dictate your investment decisions. It sounds simple. It's not. Good luck.

  • sandy - Tuesday, March 6, 2007, 2:24PM ET  Report Abuse

    • Overall: 3/5

    the stock market runs in cycles of about 16 years. the current down cycle started in spring 2000, so we have another decade of downside ahead of us.

  • James - Tuesday, March 6, 2007, 1:02PM ET  Report Abuse

    • Overall: 2/5

    I question the long term volatility limiting of portfolios containing foreign stocks.

  • Mack - Tuesday, March 6, 2007, 12:38PM ET  Report Abuse

    • Overall: 4/5

    Professor Siegel provides an insightful analysis of recent events in the stock market. However, he contradicts himself by saying that international diversification will work in the long run even when international markets are becoming more correlated due to investors' transmitting their hopes and fears across markets. It seems to me that the transmission of emotional sentiments across international markets will certainly weaken the ability of international diversification to buffer investor losses in the long term. As time goes on, the emotional cross-linking will become an even greater factor.

Showing comments 6-35 of 58<< PreviousNext >>
The columns, articles, message board posts and any other features provided on Yahoo! Finance are provided for personal finance and investment information and are not to be construed as investment advice. Under no circumstances does the information in this content represent a recommendation to buy, sell or hold any security. The views and opinions expressed in an article or column are the author's own and not necessarily those of Yahoo! and there is no implied endorsement by Yahoo! of any advice or trading strategy.

More From Jeremy Siegel

What's happening in the economy? And how will that impact your portfolio?

Find out what Wharton Professor Jeremy Siegel says.

Have his timely newsletter sent by email each week and be the first to learn what's moving the markets and why.

Subscribe now at www.JeremySiegel.com

More from Yahoo! Sources

  • CNN Money
  • Consumer Reports
  • Kiplinger
  • The Motley Fool
  • Business Week
  • Wall Street Journal

Historical chart data and daily updates provided by Commodity Systems, Inc. (CSI). International historical chart data and daily updates provided by Morningstar, Inc. Fundamental company data provided by Capital IQ. Quotes and other information supplied by independent providers identified on the Yahoo! Finance partner page. Quotes are updated automatically, but will be turned off after 25 minutes of inactivity. Quotes are delayed at least 15 minutes. Real-Time continuous streaming quotes are available through our premium service. You may turn streaming quotes on or off. All information provided "as is" for informational purposes only, not intended for trading purposes or advice. Neither Yahoo! nor any of independent providers is liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. By accessing the Yahoo! site, you agree not to redistribute the information found therein.

Yahoo! Answers is provided for informational purposes only, and no Q&A is intended for trading or investing purposes. Yahoo! shall not be responsible or liable for the accuracy, usefulness or availability of any Q&A information, and shall not be responsible or liable for any trading or investment decisions based on such information. View Complete Answers Disclaimer.