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Jeremy Siegel, Ph.D. The Future for Investors

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

Profit From Higher Long-Term Rates

by Jeremy Siegel, Ph.D.

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Posted on Friday, June 29, 2007, 12:00AM
Since the middle of March, the world’s bond markets have witnessed a sharp increase in long-term interest rates.

The ten-year U.S. treasury bond has risen from 4.50% to 5.15% and reached as high as 5.30% on June 12. Rates in Europe have increased even more than the U.S., as the ten-year German bond has risen from 3.90% to 4.70% and the U.K. bond from 4.75% to 5.55%.

Even in Japan, home of the world’s lowest interest rates, the Japanese government bond rose from 1.50% to almost 2%. These long-term rates directly impact not only the cost of corporate capital, but also the mortgage market, where rates have risen to nearly 7% for some 30-year mortgages in the U.S.

The primary source of these rising rates is not the tightening by central banks, but the brightening economic outlook for world growth. Higher growth raises rates since businesses and governments need capital to expand plant, equipment, and infrastructure.

The Pricing of Financial Assets

What does this mean for investment strategy? To understand what this means we should turn to some basic asset pricing theory. Finance posits that the price of any asset is the present discounted value of the cash flows that come from that asset. For stocks, the cash flows are dividends. For bonds, they are interest income. And for real estate, they are rental income.

Future cash flows are not just added together, but are “discounted,” since a dollar received in the future is not worth as much to investors as a dollar received today. The discount rate reduces the value of these future cash flows.

The discount rate is dependent on two factors: the rate of interest on safe bonds (such as U.S. government bonds) plus a “risk premium” to compensate for the possibility that the future cash flows will not be paid as expected. The interest rate in turn is composed of two parts: one part to compensate bondholders for inflation, and the other, called the real rate, which is linked to productivity and growth.

What we have seen over the past three months is an increase in the real rate of interest, not an increase in the inflation premium. We know this because the U.S. government issues special treasury inflation-protected securities (called TIPS bonds) that automatically compensate the owner for inflation so that the rate carried on these bonds is the real rate.

Since mid March the interest rate on the TIPS bond have risen from 2.10% to 2.70%, meaning that almost all the increase in the U.S. bond rate is due to this real rate increase.

Impact on Stocks, Bonds and Real Estate

With this understanding we can judge how an increase in economic growth influences the bond, stock, and real estate markets. The bond market, of course, suffers the most from the increase in rates since the cash flows of bonds, namely the coupon payments, are fixed in contractual terms and do not respond to the stronger economic outlook. Indeed, since mid-March, government bonds have fallen 4% or more in price.

However, the impact of increased economic growth on stock prices is ambiguous. Certainly higher growth means higher profits and therefore higher cash flows. But the rise in interest rates also increases the rate at which these higher cash flows are discounted, which has a negative impact on the price. Stocks have in fact been volatile with no clear direction since rates have risen.

Real estate falls between stocks and bonds. The rise in interest rates increases the cap rate, which is the name given to the rate at which future rental income is discounted and this lowers real estate prices. But a stronger economy allows for higher rents, particularly for commercial and industrial real estate, which partially offsets the rise in the cap rate.

For most real estate it is unlikely that the rise in future rents will completely offset the increase in the interest, so I expect the price of most real estate to continue to fall. This is particularly true of residential real estate in which the feedback from a stronger economy to higher rental rates is quite weak.

Finally we should talk about the risk premium, a component of the discount rate for real estate and especially stocks.

Stronger growth usually lowers risk premiums since higher profits mean better interest coverage on borrowed funds. But higher interest rates can be very burdensome for firms that are highly leveraged, such as real estate. That is why we are seeing the prospects for this sector continue to dim. If a real estate slowdown spills over into the rest of the economy, risk premiums could go up everywhere, driving down stock and risky bond prices.

Where’s the Market Headed Now?

I believe the real estate slowdown will not significantly damage the rest of our economy. The upward revision in growth has already brought about adjustments in the capital markets. These adjustments will actually help the Fed control the inflationary pressures and make it less likely, in my judgment, that it will raise rates in the future.

In this environment I think equities will hold up the best, with real estate lagging, and bonds, especially those issued by highly leveraged firms, faring worst. Higher rates only make one class of investor very happy – those that are in cash. But these investors should realize that cash has a very poor long-term return. If you have been lucky enough to have stayed liquid recently, think of deploying some cash to a world-wide portfolio of stocks now. In the long run you will not be sorry.

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73 Comments

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  • RobX - Monday, July 9, 2007, 12:23AM ET  Report Abuse

    • Overall: 2/5

    I think the potential for the housing recession to spillover into the rest of the economy is very high because: 1.) there are trillions of dollars worth of adj rate loans that will be resetting starting in august 2.) there are already a glut of homes on the market 3.) there are many, many foreclosures in the pipline already, let alone after the resets push more borrowers over the edge 4.) there are already many vacant properties 5.) we are already seeing how the housing recession has spilled into lending and autos 6.) as long rates rise, mortgage rates rise making homes less affordable 7.) lending standards are being tightened 8.) the things like rates and lending standards being changed now will take about 6 to 9 months for their effect to be felt by the economy. 9.) the global stock markets are all full of companies dependent on selling to U.S consumers for growth to be realized Anyway, as a result, i think his scenario of the housing recession spilling into the rest of the economy occurs by the election, and stock and bond prices get hurt globally, not just in the U.S. as a result as more risk is priced in and liquidity is reduced as a result.

  • Yahoo! Finance User - Monday, July 9, 2007, 12:10AM ET  Report Abuse

    • Overall: 5/5

    Some posters seem to have missed the point. Interest rates help some markets and hurt others. Debt and real estate get hurt, no doubt, which leaves equities and cash. The only question is how to allocate between those two components. I favor more cash because I think equities are also overvalued, but the impact of growth in China, India and much of the third world could cause a profit explosion over the next 10 years that makes current valuations cheap indeed. I think that's Siegel's position and he very well may be right. Until I see it though, I'm going to err on the side of having a little more cash and a little less stock.

  • BSGrinder - Sunday, July 8, 2007, 10:38PM ET  Report Abuse

    • Overall: 1/5

    Nothing you couldn't find in an Econ 101 text - Siegel just makes it even more boring and useless.

  • svg - Sunday, July 8, 2007, 9:11PM ET  Report Abuse

    • Overall: 1/5

    Same old boring song from Siegel. Buy international stocks? Wow - pure genius! The title of the article is "Profit from Long-term rates". And yet, save for a few simplistic and time-worn ideas, he offers precious little concrete advice. A lot of simplistic analysis of the current situation. Ah well, he has to fill up teh page with something I guess. As an investment professional, I am very aware of Siegel and his writings/opinions. I agree with some of the things he says, and disagree with other things. But to think that he isnt' an attention-hungry media wh0re just because he's educated. heheh. Get serious. A few additional comments to the commenters of this article: 1) Just because someone has a PhD does not in any way make their advice any more (or less) wise. I could line up many PhD's to refute Dr. Siegel's opinions. So what? It proves nothing. 2) Many of you mention Buffet. Are you aware that Buffet and Munger think Siegel is a fool? Google it. 3) Givent the choice between listening to eggheads versus real-life successful market players and managers (read: hundreds of millions / billions made in the markets) such as Bill Gross and Kenneth Fisher), my money will always be with those who have achieved REAL great success (not theoretical). Dr. Siegel has made a lot of money for himself off of the intellectual EXPERT image. As you can see in teh many comments, that expert image works well with the general public. In truth, he says absolutely nothing that isn't common knowledge. It has value to novices who weren't aware of the basics. But when he leaves the domain of presenting FACTS, and instead indulges in that most UN-scientific (surely a PhD shoudl know better?) practice of conjuring the future... trust me - his crystal ball works about as well as yours or anybody else's.

  • MahavirJ - Sunday, July 8, 2007, 11:43AM ET  Report Abuse

    • Overall: 5/5

    This is a thorogh and excellent coverage of the present financial scene for the interest rates, equity, and real estate markets from an extremely knowledgabe, experienced, and credible professor.

  • william - Sunday, July 8, 2007, 7:14AM ET  Report Abuse

    • Overall: 5/5

    the most cogent and clear explanation of finances that I have ever read..congrats, Jeremy

  • alanrichrd - Sunday, July 8, 2007, 4:30AM ET  Report Abuse

    • Overall: 4/5

    Good info on the bond market situation.

  • JOSEPH - Sunday, July 8, 2007, 3:27AM ET  Report Abuse

    • Overall: 5/5

    please do more of these. It was very helpful.

  • John - Saturday, July 7, 2007, 7:57PM ET  Report Abuse

    • Overall: 1/5

    just banal; nothing new or informative. how insightful just to say, take a global position in stocks. not very helpful!

  • Vitus - Saturday, July 7, 2007, 7:39PM ET  Report Abuse

    • Overall: 5/5

    World wide porfolio of stocks have been suggested for several years. I am glad the higher long term rate have added its life. Hopefully, the strong foreign market will not be as volatile as the coming market in US.

  • paul - Saturday, July 7, 2007, 4:58PM ET  Report Abuse

    • Overall: 1/5

    For some advisors, stocks are always the place to be. Always. But I think that there is a time and place for every type of investment, which is what I believe history tells us. Investing right before the (last) Great Depression would have been disastrous. Cash was king then. Each person should bet his own money, and make his best informed choice. Platitudes like "stock always" are parrot talk. ToadX

  • Julian - Saturday, July 7, 2007, 8:13AM ET  Report Abuse

    • Overall: 5/5

    It is fantastic to have this sort of information made available to everyone. Markets would be healthier indeed if people make their own independent decisions in valuing equities rather than looking at price charts all the time. Incredible that people are giving him one start just because he was endorsing equities as a better investment - even if you disagree with this surely you can give him more than one start for the rest of the article.

  • Yahoo! Finance User - Saturday, July 7, 2007, 7:06AM ET  Report Abuse

    • Overall: 5/5

    Just a few links for your own research: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/real_yield.html CPI-U is just fine as an inflation index, IMHO. Rents over the past five years have been much more stable than home prices ... increases in homeowner "wealth" are not part of CPI-U, just the increases in rent. With a 5.2% 10-year regular yield, and a 2.7% real TIPS yield, the market is expecting a mid-term inflation rate of 2.5%. If your income 12 months from now is greater than 2.5%, your employer is rewarding you for higher productivity. If it's greater by less than 5.2%, some of your productivity is returning to the owners. Obviously, these are very, very broad assumptions across the whole economy - I was just highlighting some of the basics.

  • b v - Saturday, July 7, 2007, 6:29AM ET  Report Abuse

    • Overall: 1/5

    "Since mid March the interest rate on the TIPS bond have risen from 2.10% to 2.70%, meaning that almost all the increase in the U.S. bond rate is due to this real rate increase. " Next time i go shopping i will demand price adjustments based on TIPS rather than the absurd 10% Y-O-Y price increase i'm seeing. How dare they charge me more than TIPS rate??

  • Yahoo! Finance User - Tuesday, July 3, 2007, 10:08PM ET  Report Abuse

    • Overall: 3/5

    Jeremy: Might you be missing something? Could it be a growing risk premium, rather than economic growth, that's pushing rates higher? e.g. U.S. currency risk for foreign bond investors? Could it be that the rest of the world worries that U.S. consumer debt problems make U.S. govt debt less attractive, too? And couldn't this also be a reflection of America's weakening stature in the world due to the misguided adventure in Iraq?

  • Yahoo! Finance User - Tuesday, July 3, 2007, 10:47AM ET  Report Abuse

    • Overall: 4/5

    There are two powerful non-market (that is, price insensitive) forces that reinforce the appearance that the future inflation will be low. The central banks of account-surplus countries and the Social Security fund “buy” bonds but not because bonds are good investments or inflation is low. Thus, the current price of bonds does not reflect their real market value. With the dollar dropping against all major currencies and oil, the future for bonds does not look very promising. Remember that headline inflation is running at 4-5%. Inflation per se is good for stocks. But when the Fed is forced to do something about inflation, stocks will suffer.

  • Yahoo! Finance User - Tuesday, July 3, 2007, 10:38AM ET  Report Abuse

    • Overall: 5/5

    To the guy/girl that said "This guy was probably telling you to buy tech stocks in 1999," you have just proven your ignorance. In the March 14, 2000 edition of the Wall Street Journal--the peak of the tech bubble--Dr. Siegel wrote an article entitled "Why Big Cap Tech Stocks Are a Sucker's Bet." Again, I can spot you amateurs from a mile away because you are always talking about market timing. The title of Siegel's book--and a good slogan for his overall approach--is STOCKS FOR THE LONG RUN. Also, Dr. Siegel is an strong advocate for allocating a very large percentage of your equities to international stocks. Buy stocks--especially those with reasonable valuations and good dividends--and you'll build wealth, pure and simple. This is exactly what Warren Buffett preaches.

  • Yahoo! Finance User - Tuesday, July 3, 2007, 1:31AM ET  Report Abuse

    • Overall: 5/5

    I am a Chem Engineer who thinks FloridaChemEngineer has it all wrong. Maybe FL real estate and some of CA real estate is crashing but it appears to me rest of US housing market prices are leveling off and near bottom. Sure it may take a couple more years before housing prices again start going up. So what ? Jeremy did an excellant analysis of current economic situation. There is economic growth world wide, developing countries growth is staying strong and on track. I agree commodity prices will continue to rise, and oil, natural gas will continue to act as a tax or brake on growth and as source of inflation, thus helping FED to control any possible overheating of economy to point we have the crash Mr. FloridaChemEngineer is worried about. I believe we are and have witnessed a great balancing act to acheive stable slow but rising economic growth by all the major world banks since the tech crash of 2000. Just my two cents. Of course, bad politics and wars can upset the current world wide economic apple cart very easily. Slow steady change is needed to bring on replacements for depleting fossil fuels and fossil fuels are currently the energy foundation for all the worlds major economies. Lets get behind long term gradual but carefully planned and needed changes to move away from fossil fuels. Lets keep our eyes on how the US Congress works on the energy problem. Would live to hear Jeremys views on the place of government sponsered incentives for increased rate of change to non fossil fuels in our world wide economies.

  • Yahoo! Finance User - Tuesday, July 3, 2007, 12:39AM ET  Report Abuse

    • Overall: 4/5

    All, Kiyosaki and Siegel are not at odds with each other. They both offer possible diamonds in the rough in terms of info. I find I have learned from both. I've read both "Stocks for the Long Run" by Siegel and "Rich Dad Poor Dad" by Kiyosaki. I would say they both offer some good advice. Kiyosaki in my opinion summed up simpler than most before that I've read why "the rich get richer, the poor get poorer, and the middle class stay middle class". He also makes in my opinion a very reasonable argument that primary homes (not rentals) act more like a liability from a cash flow perspective than as an asset. Money in for the mortgage, money in for taxes, money in for maintenance, money in for insurance, etc. If you lose your job, your house acts as a liability and and not an income producing asset that he tells folks to focus on acquiring. That is basic, sound advice. He also makes a good point about folks being willing to ask questions when he talks about him and his friend learning in a summer what it takes most people a lifetime to learn. That is, simply to seek out folks who seem to have figured out how to escape from the "rat race". Most people won't ask others "how did you do it?". They just seem content to be discontent and caught spinning the wheel. Siegel on the other hand in many articles and his book "Stocks for the Long Run" have made excellent cases for the fact that bonds over long periods of time actually end up having negative real returns. This does not mean that savvy folks can't make a lot or even a killing in bonds but that inflation kills their value over time where with stocks generally inflation means companies have pricing power. Cash to me is a neutral position. It's value is in the patience of waiting for great opportunities that present themselves _much_ more than the rate of return one happens to be earning in cash. As for my outlook, I am a cautious GARP/GULP investor (value vs. growth is a pointless argument because value is always in the eye of the beholder) and believe it or not my guess is that simply the world is currently and will likely continue to experience the largest simultaneous combined expansion the world has seen in all of history. Not hype. Not throwing caution to the wind. I follow a lot of different mkts and think stuff like China is very dangerous right now. Overpriced and too rich for my blood. But all in all there are more regions expanding and growing today than I can recount at any other time in my life or investing career over the last 15 years (not as long as some). I'm pretty darn optimistic and actually don't believe the housing will be as bad as folks believe mainly because the Fed knows it walks the line there if rates go too high to kill housing too much. Also, I think foreigners start becoming interested in housing here with their stronger currencies and the great environment and opportunity the U.S. still presents to others in the world. I have worked with fellow engineers in India who want to come here still even with all the opportunity increasingly available in India. What does that say?!? Also, I don't think the U.S. will see anything other than maybe, just maybe a mild recession because Feds around the world have too much ammunition with rates that are decently high since rates have been rising and they could lower to restimulate growth if worldwide growth stalls. Also, I see combined growth in other regions preventing weaker regions like the U.S. right now from getting to severe. Folks, the sky is blue if you look for it. 3 billion new people just came on board wanting a taste of even the decent life if not the good life and they're not going back. Seriously, objectively, look around you when you're out shopping, driving, working, do you see some massive slowdown? I do not and think there is enough fear out there such that I do not see rampant complacency. My best guess is that folks are going to see surprise to the upside. Peace!

  • John - Monday, July 2, 2007, 11:52PM ET  Report Abuse

    • Overall: 5/5

    Although I rated Professor Siegel's article as excellent, I think he is wrong about the impact of the housing "bust"; one trillion dollars of re-set mortgages coming due will have an impact on the economy and sentence the stock market to a slow correction of 10 percent or more. Perhaps the stock market's sentence will be commuted by President Bush.

  • Hugo - Monday, July 2, 2007, 9:37PM ET  Report Abuse

    • Overall: 1/5

    Just one way of explaining the current situation. Another view is that runaway money and credit creation is fueling inflation and inflation fears. This makes investors look for bigger discounts on bond prices . The argument that TIPS automatically compensate for inflation depends on whether the CPI reflects real inflation or not. What do you think ... do your annual expenses grow at the ultra low rate that the CPI reflects ???

  • Jimbo2 - Monday, July 2, 2007, 9:25PM ET  Report Abuse

    • Overall: 4/5

    A lot of good food for thought. The key appears to be a "world wide portfolio". However, course that's been smart for the past several years.

  • ag - Monday, July 2, 2007, 7:29PM ET  Report Abuse

    • Overall: 5/5

    Wow. This well written, logically organized article is welcome respite from some of the scrawlings that Yahoo publishes on this page.

  • Yahoo! Finance User - Monday, July 2, 2007, 6:08PM ET  Report Abuse

    • Overall: 3/5

    If the 10-year US treasury bond rate has risen from 4.5% to 5.15% (0.65 percentage point increase in the rate) and the TIPS rate has increased from 2.1% to 2.7% (0.6 percentage point increase in the rate), why isn't almost all the bond rate increase due to inflation? Why does Siegel say the opposite: all the increase in the US bond rate is due to the real rate increase?

  • Napolean - Monday, July 2, 2007, 5:36PM ET  Report Abuse

    • Overall: 4/5

    Good article. Thank you for the insight

  • John H - Monday, July 2, 2007, 5:26PM ET  Report Abuse

    • Overall: 5/5

    Nice informative article. The discounted cash flow valuation model mentioned here is a useful tool (among other considerations) whenever you can apply it. Bonds and RE are logical arenas. Hoopa4life, I also get a good chuckle out of the unsubstantiated or one dimentional comments from people more accustomed to tabloid financial advice. You see similar comments in Chandran's articles...pearls before swine.

  • Crazy Fuk - Monday, July 2, 2007, 4:50PM ET  Report Abuse

    • Overall: 4/5

    It's highly comical seeing a bunch of yahoos completely rejecting analysis from a world renown economist, especially those that spout the ramblings of R.K. who's only real credentials are that he wrote a book that he's trying to sell. You don't have to agree with everything that he says, but Dr. Siegel is generally recognized as one of the foremost authorities on the economy; arguing that he is an idiot who doesn't know what he's talking about simply shows your own ignorance.

  • Yahoo! Finance User - Monday, July 2, 2007, 4:11PM ET  Report Abuse

    • Overall: 2/5

    credit where credit is due, Dr Siegel writes very well and makes a lot of sense. But I would argue for greater caution at the present time. The housing sector problems have not affected private consumption growth so far. But this does not mean this will continue to be the case in the future too......

  • Gershon - Monday, July 2, 2007, 4:09PM ET  Report Abuse

    • Overall: 1/5

    Demented

  • ad - Monday, July 2, 2007, 3:47PM ET  Report Abuse

    • Overall: 3/5

    Poor rating is not allowed for this article, Otherwise this author doesn't have any clue about the market. finance yahoo section should never print article like this. It misguide new investor and hurts them lot.

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