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Jeremy Siegel, Ph.D. The Future for Investors

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

The Bullish Case for Stocks

by Jeremy Siegel, Ph.D.

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Posted on Monday, April 30, 2007, 12:00AM

Although the Standard & Poor’s 500 Index is still just below its all time high reached in March 2000, many high-profile market analysts, including Jeremy Grantham of GMO and Cliff Asness from AQR Capital, are pessimistic. They claim that profits are at a cyclical peak and that a low dividend yield will generate poor future returns for stocks.

Yet I believe the opposite is true and think that the current valuation of the stock market is very favorable for investors. Before explaining why, let me respond to these bears.

The Bear Case

It’s true that last year the level of after-tax corporate profits relative to gross domestic product (GDP) reached 11.4%, slightly exceeding the previous highs set in 1929 and the late 1940s.

One reason is that an ever-increasing share of the profits of U.S.-based firms is being earned in faster-growing overseas economies. As a result, it shouldn’t be surprising to see the ratio of U.S. corporate profits to U.S. GDP rise.

But more importantly, corporate profits are only one form of the return to capital. Of nearly equal dollar value is what is called “proprietors’ income,” which is the return to private and partnership capital.

The share of proprietors’ income has been trending downward over most of the last fifty years as more capital migrates into corporate entities. This transformation has particularly been strong in the financial sector, where many commercial banks, brokerage houses, investment banks, and government sponsored enterprises such as Fannie Mae and Freddie Mac have become public corporations. Once this shift is taken into account, the total profits to corporate and non-corporate capital, now at 20% of GDP, is only slightly above its post World War II average and is not at all at record levels.

Another bear claim is that the long-term real earnings growth rate of 2% is insufficient to generate good returns at current 2% dividend yields. But 2% real earnings growth is no longer relevant to today’s market. Earnings per share have been growing more rapidly not just because of the cyclical expansion but also because of the low dividend payout ratio. This has allowed firms to buyback record number of shares, thereby boosting per share earnings growth. In essence, firms are trading dividend yield for capital gains, a trade motivated by the tax advantages of capital gains and the proliferation of management options.

Earnings Growth

Future returns are linked to current valuations. One the most widely used measures of stock market value is the price-earnings (P-E) ratio, the price that investors are willing to pay for a dollar’s worth of earnings. But the reciprocal of the price earnings ratio -- the earnings yield -- is the key to projecting real stock returns.

The earnings yield for stocks is analogous to the “coupon yield” of the bond, which is the ratio of the coupon to the market price and measures the “current yield.” But there’s a big difference between the earnings yield and the coupon yield. The coupon yield is a yield insofar as the bond’s coupon is fixed in money terms. But the earnings of a firm is based on real assets whose value will, over time, increase with the rate of inflation. Therefore the earnings yield is a real yield.

The historical data confirm this contention. In the United States, data of corporate profits go back to 1870 and the average P-E ratio during that period has been 14.4, leading to an average earnings yield of 6.9%. This is one-tenth percentage point above the average real return on equities, which is 6.8% over the period.

What then are the current prospects for earnings growth? Estimates for 2007 earnings on the S&P 500 Index range from $89 for the very conservative “core earnings” developed by Standard and Poor’s to a more optimistic $94 per share for operating earnings. With the index at roughly 1490, this leads to a current P-E ratio of between 15.8 and 16.7 and a bit lower if we extend the next twelve months through the first quarter of 2008.

This P-E ratio corresponds to an earnings yield of between 6% to 6.5% on S&P 500 stocks and an identical estimate of real return. This real return can be broken into a real per share earnings growth of 4% to 4.5% per year plus a 2% dividend yield.

Valuations Could Go Higher

Even though current returns on stocks look good, I believe that stock returns may even be higher. Two characteristics in today’s financial markets argue for higher long-term P-E ratios: the steep drop in transactions costs, which permits low cost global diversification, and the reduction in economic volatility, which lowers the equity risk premium.

Two factors have led to the reduction in transactions costs: the sharp drop in brokerage fees, starting 30 years ago with the deregulation of commissions and the collapse of bid-ask spreads that has accompanied the increase in global liquidity. These factors have enabled investors to acquire and maintain a fully diversified portfolio at a small fraction of one percent per year, far less than the one to two percentage points that existed when brokerage costs and bid-asked spreads were much higher. And low-cost diversification has now extended to global indexes.

The second factor arguing for higher stocks prices is the decline in the variability of real economic variables. Economists call the reduced volatility of the economy “The Great Moderation” and have attributed it to better central bank policy, more precise inventory controls, and a growing service sector, which is inherently more stable than manufacturing. A reduction in economic variability reduces the risk premium that investors demand on stocks above the return on safe assets.

These factors could boost the average future P-E ratio for equities to 20, with a resulting earnings yield of 5%. Once these higher price levels are reached, stocks will not likely offer the 6 ½ % to 7% real returns that have marked their historical average. But a 5% real return on stocks still yields a 3% premium over inflation-indexed bonds, a margin that many money managers consider very reasonable.

If these new higher valuations come to pass, then stocks will on average be priced about 25% above their current levels. Even if stocks do not reach this higher valuation, equities at today’s valuation are priced to yield a real return of 6% to 6.5%. This return is much higher than bonds and I would argue considerably higher than available on real estate at today’s high prices.

No one can predict stock market returns from year to year. But longer run returns must be based on current valuations and the case for equities is very persuasive at today’s prices.

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15 Comments

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  • Alice - Saturday, July 21, 2007, 12:22AM ET  Report Abuse

    • Overall: 5/5

    Priceless!

  • Yahoo! Finance User - Friday, May 25, 2007, 12:37PM ET  Report Abuse

    • Overall: 5/5

    Good column with some"meat" to it. Siegel is the anti-Kiyosaki

  • John - Wednesday, May 23, 2007, 11:20PM ET  Report Abuse

    • Overall: 1/5

    This is total crap. The equity market today is the most risky it's been in years. While I agree that transaction costs have dropped for stock trades, that hardly translates to peaceful economic times for the economy at large. "The Great Moderation"? Oh, and I laughed and laughed.

  • Sir Stanks a-lot - Friday, May 18, 2007, 4:32PM ET  Report Abuse

    • Overall: 4/5

    Ahh. Hardcore Quant. I like it

  • Yahoo! Finance User - Thursday, May 17, 2007, 3:30PM ET  Report Abuse

    • Overall: 1/5

    Lots of numbers and economic yada yada. As the years go by, I am very much convinced that anyone that tries to put macro economics and stock market into a 'koolaid' is probably very naive or very motivated. I can't put Mr. Siegel in either one and I am stupified. All it might take is the next terrorist attack to bring out the sob stories. Where do the numbers guys go? The only thing that I am certain about is 'uncertainty' . 126 Mil for a pitcher and investing in the stock market - They all reflect the times. SO Go figure!

  • Charles - Sunday, May 13, 2007, 12:42PM ET  Report Abuse

    • Overall: 1/5

    r. Siegel has become very famous for his advocacy of stock investing. He wrote Stocks for the Long Run, he is a Ph.D. professor from Wharton and he is well respected for (among many other things) the database that he developed that helped quantify the relationship between earnings yield and long-term real stock returns. I have respected and admired him for a long time. However, I find a number of flaws with Dr. Siegel’s argument. Worse than this, I think he recognizes many of these flaws and presents them anyway. In fact, most of the data that I am using come from either his database or that of his good friend, Dr. Robert Shiller. Taken on an individual basis, these flaws may appear small, but when we are talking about an expected equity risk premium of only 3%, these flaws start to add up. I will address them in the order they appear in the referenced article. 1. Profit margins ARE at cyclical highs and it has nothing to do with private companies going public. You just need to compare earnings to revenues. John Hussman (Hussman Funds) has done extensive analyses on this: http://www.hussmanfunds.com/rsi/profitmargins.htm 2. Profit margins have always, historically, been mean reverting. This makes economic sense. High profit margins attract new competitors that drive margins back down. Conversely, low profit margins drive firms out of business, allowing the survivors to increase profit margins. 3. Inexpensive foreign labor has, indeed, improved the profit margins of multinational companies that have off-shored their labor costs. However, by assuming that this profit margin expansion is sustainable, Dr. Siegel has assumed that new competitors will not also be attracted to this labor arbitrage and seek to exploit it. He is further, implicitly, assuming that foreign labor will never want to take the same share of the corporate revenue pie that U.S. labor traditionally demanded. Maybe this is true. Maybe U.S. labor was overpaid. I just want to point out that this is an inherent assumption in Dr. Siegel’s analysis. 4. Over all thirty-year periods since 1870, real earnings have grown at an average rate of 1.5% per year, not the 2% to which he rounds up. 5. The current dividend yield on both the S&P 500 and the Wilshire 5000 is 1.7%, not the 2% to which he rounds up. 6. Buybacks have been more than outweighed by stock issuance (primarily for executive stock options). Over the last decade, S&P 500 earnings have grown at 9.6% per year whereas earnings per share have only grown at 7.7% per year. This is because stock issuance significantly outpaced buybacks resulting in an increase in shares outstanding. Even over the last five years of buyback hoopla, growth in earnings has still equaled growth in EPS. 7. The 14.4 P/E he uses for his historical earnings yield is based on trailing S&P 500 earnings. Yet, he uses FUTURE earnings to calculate the current P/E. If you compare apples-to-apples, the earnings number he should be using is $83/share (per S&P’s own data). Using his 1490 number for the S&P 500, the earnings yield is 5.6% (not 6%-6.5%). 8. Even if real earnings per share growth were to continue to maintain pace with real earnings growth, Dr. Siegel’s estimate of “real per share earnings growth of 4% to 4.5% per year” is wildly optimistic. a. First of all, earnings cannot indefinitely grow faster than the GDP. If this happened, earnings would eventually be bigger than the GDP. The U.S. emerged from the devastation World War II as the only major industrialized economy still standing. As a result, we had the obligation and opportunity to essentially rebuild the rest of the world. It was an incredibly successful time for our economy. Yet, over the last sixty years, our GDP grew at a real rate of only 3.06% per year. You would be hard pressed to find an economist whose long-term forecast exceeds this past performance. b. Second, the earnings for public companies have typically only grown at about half the rate of the

  • Yahoo! Finance User - Tuesday, May 8, 2007, 5:40PM ET  Report Abuse

    • Overall: 1/5

    I am a fun of “stocks for the long run”, the book and even more the concept. But I hate it when people just promote stocks based on some (slightly misleading) averages and disregard COSTS and RISK. (Anybody interested in a sub-prime mortgage?) If you are considering investing in the stock market, first do your homework. There are some good books. I recommend highly John Bogle’s The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. And remember: Folks have lost their money in the market and even the average investor has done far worse than the market averages given in this article. And yet, you can get a decent return if you are common-sensical about it. “Fortune favors the prepared mind” Louis Pasteur.

  • Yahoo! Finance User - Tuesday, May 8, 2007, 3:04PM ET  Report Abuse

    • Overall: 3/5

    Not a bad article, but his analysis claiming that equities should continue to have good returns may coincide with his affiliation with Wisdomtree. Since, in essence, he is a spokesperson for them, it would not make good marketing sense to say that equity ETF's (like mutual funds) could be poor investments, if only over shorter periods of time. He does have a vested interest in that company. As with all forecasters, his article data mines in order to prove his case, perhaps he will be right, but perhaps he will be wrong. Shiller, for example, is in the bearish camp. Still far better than the real estate shill and variable annuity spokesperson that Yahoo! continues to let thrive on this board. It makes me wonder who pays who - that is Yahoo! or the authors.

  • ScottS - Tuesday, May 8, 2007, 1:07PM ET  Report Abuse

    • Overall: 4/5

    In this case, I do not agree with his conclusions (that higher P/E in the future is good for stocks, especially now that P/Es are not as high), but at least he is bringing data to the table and not talking down to his readers. Dr Seigel is a bright spot among the so-called "experts" (Kiyosaki, Stein, Whalen, Orman, et al) that Yahoo publishes in its Finance section.

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