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Jeremy Siegel, Ph.D. The Future for Investors

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

How to Play the Market Sell-Off

by Jeremy Siegel, Ph.D.

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

It doesn't take much when you're near the tipping point.  Last week Countrywide Financial said it had increased defaults on some of its home equity loans and several banks took unexpected charges against potential credit defaults.  Suddenly investors reacted as if the whole world had changed. Their fears sent the popular stock averages to their biggest loss in almost five years and the bears proclaimed that the days of easy credit that has fed the bull market over the past 4 ½ years were finally over.

Valuations are Sound

But the purveyors of doom and gloom are wrong.  It's true that over the past few years the interest rate spreads between the high and low-rated debt became extremely low by historical standards. Then tremors developed last February when the sub-prime mortgage crisis surfaced. These tremors turned into an earthquake last week when the private equity firms and banks wanting to acquire Chrysler and Alliance Boots failed to attract the lenders needed to finance their $20 billion buyout. All of a sudden, the stock market bears emerged from hibernation to yelp "I told you so!"

But the bull market in equities did not depend on these low spreads or on the rising tide of leveraged buyouts. Despite the fizz in a few stocks, the overall level of the stock market never became overpriced relative to the most fundamental metric of firm value - corporate earnings.

Based on the S&P 500 Index, which constitutes 80% of the total market value of U.S. stocks, these stocks are now selling at 16.5 times a conservative estimate of 2007 earnings.  In a world where government rates are below 5% and inflation is below 3%, stocks are not only reasonably priced, but cheap on a historical basis.

Positives for the Equity Market

But valuation is not the only reason to stay invested in stocks.  The following facts are also very positive for equities:

(1)  Although there was a sharp increase in the interest rate on low-grade debt securities, there was little if any increase in interest rates on investment grade securities, which constitute the vast majority stocks in S&P 500.  This is because the increase in the spread between investment-grade bonds and the Treasury yields was more than offset by the drop in U.S. treasury yields, so credit costs for quality stocks have not increased.

(2)  Although the housing market remains in the tank - and will stay there for quite a while - there is still no convincing evidence that the rest of the economy is headed for a significant slowdown and certainly there are no signs of a recession.  Second quarter GDP grew at 3.4% rate despite a lousy housing market.  Early estimates for this quarter are for 2.5% to 3% growth.  This would be greater than the slow growth of the first half of the year during which time corporate earnings still rose briskly.

(3)  In a worst-case scenario where the tightening of credit standards does lead to a substantial economic slowdown, the Fed has ample room to ease interest rates from the current 5.25% level.  With the sharp drop in treasury yields across the board, the term structure of interest rates has once again become inverted, with the ten-year bond falling to 4.75%.  This puts the central bank on alert that the market thinks that short term rates may be too high.  In fact, the Federal funds futures market now expects two 25 basis point reductions in the Federal funds rate by next summer.  Although I think the economy will stay strong enough so that the Fed will not have to lower rates, if the Fed does act, this will be very positive for stocks.

(4)  A large part of the stock decline last week was due to portfolio managers establishing defensive positions by buying index puts to protect themselves against market declines.  The VIX index, which measures the premium that investors pay for such puts reached 24, the highest level since the start of the Iraq war 4 ½ years ago.  Spikes in this index have historically been great times for investors to buy stocks.

(5)  It will be several months before we find out how hedge funds faired during this turmoil.  If their returns suffered, this could ultimately be very good for stocks.  Hundreds of billions of dollars have migrated from the equity markets to "alternative investments" in recent years.  If these alternatives fail, it is very likely that much of this money will return to the equity market.

What Should Investors Do?

The strategy for investors is clear.  The cost of credit has not gone up to the top credit companies - such as those rated A and B by Standard and Poor's. It is the lower-rated firms, as well as many smaller stocks that have do not have a ready access to the credit markets that will be hurt the most if spreads remain wider.  Those lower rated stocks have had a wonderful ride for the last several years, but that ride is over.  Quality stocks are set to outperform the market and withstand the credit storms.

Is there anything to worry about?  Sure. Oil prices continue to rise in spite of the declarations of Kuwaiti officials who said they would like to see crude oil back in the $60 range.  If oil and its derivatives - gasoline and heating oil - keep marching upward, this will crimp consumer spending and slow the economy.

But, history tells us that the worst time to buy is when there are no clouds on the horizon and everyone is optimistic.  On the other hand, the best times for stocks are when there are mountains of worries.  Despite the scary headlines, the underpinnings of our economy and stock market remain strong.  Rotate to quality stocks and you will weather the storm well.

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145 Comments

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  • Ben - Sunday, August 26, 2007, 6:06PM ET  Report Abuse

    • Overall: 2/5

    Well, I am embarrassed for Jerry. Just like the Beardstown ladies, he's confused "earnings" with "dividends." A PE of 16.5 is not the same as a 6.25% interest rate on a bond as his incredibly inept example suggests. (And they gave this guy tenure at Wharton?) You can't spend earnings, and you certainly can't reinvest them. You can only do that with dividends, which most of these highflying companies neglect to pay nowadays. And why not? The system allows corporate executives take their companies' 6.25% earnings, skim most of it off to pay themselves fat salaries and options (with nice payoff to Mr. Siegel and his buddies by means of offering them lavish speaking engagements etc.), and then claim to invest whatever's left for inflated, empire building corporate expansion and stock buybacks, which increase the value of the execs' stock options but do nothing for the basic health of the company or for your investment. So by Siegel's own reckoning, a 6.25% earnings rate, which is seriously puffed up to begin with before it is ransacked by the corporate bigwigs, is hardly the equivalent of a boring T-bill at 5%. Why? Because you never see the money. But of course Jerry couldn't sell all those awful books if he just told you to buy T-bills, could he?

  • John B - Tuesday, August 21, 2007, 6:56AM ET  Report Abuse

    • Overall: 4/5

    Succinct, clear, and to the point. Accuracy will be determined by time; but the thought process is well-done. Negative responses seem to be coming from those already in panic mode; not those who are open to logic and controlled behavior. Thanks for sanity in the midst of turmoil.

  • Sloan - Monday, August 20, 2007, 9:56PM ET  Report Abuse

    • Overall: 1/5

    Jerry proves again his advice is worse than his prose.

  • Yahoo! Finance User - Monday, August 20, 2007, 1:49PM ET  Report Abuse

    • Overall: 5/5

    Short term investing is a crap shoot. It forces you to turn paper losses into real losses. Long term investors know from experience that the old maxims are still true.....buy when everyone else is selling and sell when everyone else is buying.... If you buy quality, you can control when you sell and avoid panic selling losses!

  • Gumby - Monday, August 20, 2007, 12:30PM ET  Report Abuse

    • Overall: 4/5

    Over the years those buying after a large downturn in the market have been rewarded handsomely.

  • Yahoo! Finance User - Sunday, August 19, 2007, 8:11PM ET  Report Abuse

    • Overall: 5/5

    Even if the future turns out to make a fool of Siegel - his writing is useful and backed up with information. Good article. When people get fearful, be aggressive.

  • Nick - Wednesday, August 15, 2007, 4:54AM ET  Report Abuse

    • Overall: 5/5

    I just got done reading many of the comments posted here by the multitude of proverbial Chicken Littles that are predicting that the sky is falling. In reading the columns here on Yahoo, I find that most of the columnists are indeed long term INVESTORS and not short term market speculators. Here's the deal. I watched my own portfolio of stocks take a real beating long before the dot.com bust; my blue chips were already in decline in early 2000. They went down more the into 2001 and the events of 9/11 saw them drop even further. During that entire period of time, I watched as houses in my area when from $150K to $450K. (Frankly, they were overpriced at $150K!) So, the housing market had its boom and the people that had short term memories and could not remember the housing bust of 1990 are now own their primary residence and 2 more that they were speculating on. Now 1 in 8 houses on my street have For Sale signs on the front lawns, with people hoping it is either not too late to cash-out and make a little money, and others are forced to sell because their ARM just increased to the point where they can no longer to afford to pay the mortgage and buy food. It's called leverage people and it's dangerous; dangerous to buy stocks on margin and dangerous to take your uncle Elmer's advice and Buy More House Than You Really Need. (And you always wondered why he ate breakfast at the Kmart coffee shop? Sound advice your relatives give.) There will always be people with money to invest and right now, the housing market is not going to rebound anytime soon. But, if you look at the FUNDAMENTALS of stocks, you will find that (A) most companies are earning more quarter to quarter (B) most companies are awash in cash and simply have more money than they know what to do with, which means (C) they will increase dividends, or (D) they will buy back their own stock, or (E) they will buy another company and merge. Furthermore, let's not forget (F) that most of the American blue chip companies have already expanded overseas and they are no longer a pure USA stock play - they will benefit from the continuing boom in Asia and elsewhere. But hey, better yet, do like my cousin did back in 1979 when he bought gold at $800 an ounce...and held it every since. He's still waiting for it to come appreciate in price...whilst my own investments have gone up more than 1,000 percent in the past 20 years.

  • Yahoo! Finance User - Monday, August 13, 2007, 3:44PM ET  Report Abuse

    • Overall: 2/5

    True inflation has not taken it's toll yet. Oil, comodities along with lower wages will continue to way on the market. The housing market will only make inflation look better to the bulls. The working man needs to be very careful here.

  • Anon - Friday, August 10, 2007, 5:43PM ET  Report Abuse

    • Overall: 2/5

    Keep waving those pom-poms. See you at Dow 8000.

  • Nick S - Friday, August 10, 2007, 5:08PM ET  Report Abuse

    • Overall: 5/5

    First, let me point-out that Jeremy Siegel is one of the few Yahoo finance columnists whos content is worth appearing here. Of course, we love it when someone validates our own viewpoints, and I am no exception. What I enjoy about Jeremy Siegel's article is that he has a much better knowledge of the markets that I do and he knows how to drill-down to get the answers from Wall Street. Here's my own (rather lame) take on things... The vast majority of American businesses that are traded on the NYSE are showing increased earnings quarter over quarter. They are awash in cash and many of these companies are buying back their own stocks. (Hint hint. If the company has money and feels that the best investment that they can make is in their own stock, then I think investors should take note!) I really pay little attention to my portofolio, as I am a cheapskate and buy all of my stocks though Direct Stock Purchase plans and then reinvest the dividends through the Dividend Reinvestment Plans (DRIPs). But, I was looking at General Electric today on the Yahoo stock area and looked at the historical quotes for the past year. What I found is that Yahoo also shows the dividends paid throughout the year. What I suddenly realized was that GE increased their quarterly dividend from 25 cents a share to 28 cents a share. Now, 3 cents may not sound like much, but that is a 12 percent increase in dividends. When was the last time I got a 12 percent pay raise? Hmmm. The total annual dividend yield on GE stock right now is about 2.8 percent. Guess what? My bank money market account is only paying me 1.8 percent right now. And, right now, the current P/E ratio on GE is at 18. (The P/E was at 30 during the dot.com boom-bust.) I'll go out on a limb here. The DJIA will close at at least 14,000 by 12/31/07. (More likely 14,500.) We will see it close at 16,000 by end of year 2008. There is just too much money chasing after too few stocks these days. As privave equity companies goble-up the likes of Chrysler and Dollar General, we all have fewer places to invest (unless you want to buy one of the dozen properties with FOR SALE signes on their font lawns that sit within a half-mile of where I live).

  • Daniel - Friday, August 10, 2007, 11:10AM ET  Report Abuse

    • Overall: 5/5

    Haha when i read the comments people leave about being in cash and gold i picture people who store their wealth under their mattress. Let's meet-up in 15 years and see who's doing better.

  • Yahoo! Finance User - Monday, August 6, 2007, 6:06PM ET  Report Abuse

    • Overall: 4/5

    Very concise view of the market at this point from an individual who is very clear on market conditions from a historical point of view. No reference to Geopolitical events, however.

  • William - Sunday, August 5, 2007, 11:41PM ET  Report Abuse

    • Overall: 2/5

    Overly simplistic cheerleading with a few good points. For example, the US$ is tanking, and all this guy can talk about is the equity market. The U.S. may have to attract buyers of its currency with HIGHER interest rates. It's not that simple. The world does not revolve around the U.S. equity market any more.

  • Peter - Sunday, August 5, 2007, 11:29PM ET  Report Abuse

    • Overall: 4/5

    Overall this is good advice. I'd like to add this, sell stocks that have done well (20% ), buy stocks that have dropped significantly and are in Healthcare, tech, and oil & gas services, hold, yes sit on your hands and hold on your other stocks since the market is now over sold EXCEPT do not keep anything that is related to sub-prime, banks, brokers, non-commerical real estate, hopefully you've already sold those.

  • ShaniqaP - Sunday, August 5, 2007, 10:08PM ET  Report Abuse

    • Overall: 3/5

    I do time the market, in sectors, and my timing (not buying financials and shorting GOLDMAN SACHS (GS)) is paying off better than the rube's "long term" buy and hold strategy. When it's this obvious, sit on the sidelines and let everyone else lose money. Then, when 90% of the analysts admit there's a bear market, start looking for bargains. Sitting it out when you should sit it out takes discipline.

  • David - Sunday, August 5, 2007, 10:02PM ET  Report Abuse

    • Overall: 2/5

    Mr Siegel is still stuck in the 80's-90's investing. What he doesn't talk about is the mountain of derivatives (several trillions of dollars) and debt which noone can manage or understand. How much of that funny money is actually propping up economies worldwide is the million dollar question. When this money evaporates, will it impact the economy so much that real earnings will be completely out-of-sync with expected earnings? Also do you think the Fed can fight it when they lose credibility? There has been too much complacency, too much money supply and the debt market has witnessed the same irrational exuberance as many other markets before (read carefully what the Bear Stearns guys said, they know what they're talking about). There's more pain ahead and it is reckless to recommend stock investing at this stage. Take your money and put it in the safest thing you can find, and that's not even bonds. Finally let us not forget that the Long Term Capital Investing hedge fund was headed by some of the most respected and well-known academics in the world before it's collapse (MIT if I'm not mistaken). They make very costly mistakes too.

  • sss - Sunday, August 5, 2007, 9:59PM ET  Report Abuse

    • Overall: 2/5

    What Siegel does not take into consideration is the value of the US Dollar, which is on a precipitous decline. Add a couple of rate cuts, and soon dollar would be as cheaper than NZD. The real value of the purchasing power of the dollars earned through the US stock markets though, will be unattractive - all the more reasons to move investments overseas

  • tien - Sunday, August 5, 2007, 9:58PM ET  Report Abuse

    • Overall: 1/5

    Please let me know if anyone play stock, and don't know this!!!!

  • bruce - Sunday, August 5, 2007, 9:39PM ET  Report Abuse

    • Overall: 2/5

    Nothing new said here. Listen to these guys and you will eat your losses !

  • phil - Sunday, August 5, 2007, 7:51PM ET  Report Abuse

    • Overall: 1/5

    There is no mention of the fact that the DOW was at 11,920 just 6 months ago and 10,600 just 14 months ago. Those are whooping increases that caused the DOW to be extremely over-bought.

  • Rosa - Sunday, August 5, 2007, 7:38PM ET  Report Abuse

    • Overall: 1/5

    How to "Play" the Sell-off. Interesting word to use for someone who pretends to be a long-term investor giving advice to the masses. He is the symptom of a disease of viewing investing as a pastime of lesiure or play, without giving any reasonable thought to what it is you are buying, a part ownership of a business. Shameful. The University of Wharton regents should consider firing this guy.

  • MatthewS - Sunday, August 5, 2007, 7:33PM ET  Report Abuse

    • Overall: 5/5

    Siegel is a genius...its so nice to read an ACTUAL expert in the yahoo finance expert advice column instead of someone trying to sell tapes and books. He is spot on IMO on his analysis. Historically stocks follow earnings and earnings are still strong. On P/E basis the stock market is a bargin in historical terms.

  • John - Sunday, August 5, 2007, 6:46PM ET  Report Abuse

    • Overall: 5/5

    Jeremy Siegel adds a lot of sound fact based advice. You wonder who these people are that crashing the market. Do they have any sense? They need to read this article!!!

  • phil - Sunday, August 5, 2007, 5:25PM ET  Report Abuse

    • Overall: 2/5

    Wouldn't it be great if logic and reason were used to buy and sell stocks !

  • Bifen - Sunday, August 5, 2007, 2:47PM ET  Report Abuse

    • Overall: 1/5

    I'd like to rate it -5 if I could. People hold NSDQ from 2000 still down 50%. Not to mention so many Co.s went out of business, like ENRON, or thrown out of SP500, in last 100 years. If you count those "dead bodies," all major indexes can't beat inflation. Yea hold 1 million years, if you can, you would blabla.

  • Yahoo! Finance User - Sunday, August 5, 2007, 2:28PM ET  Report Abuse

    • Overall: 1/5

    how in the world does a wall st mouthpiece even get classified as an "expert." maybe we should all go out and buy his Wisdom Tree Funds before the financial stocks that pay their high dividends get hammered in the upcoming sell-off. rah rah sis boom bah, gooooo jeremy. he should be pumping stocks all day on cnbc. as to his silly cheerleaing points: 1. credit costs have increased significantly as wall st banks and other lenders are holding hundreds of billions of subrpime infected paper that has no buyers. 2. housing is getting significantly worse, and the collapse of the residential building industry has negatively impacted the economies of the housing bubble states. florida is in a recession, arizona, cal, and nevada have seen recent unemployment spikes and with 20% of jobs dependent on housing, their ecomies are on the brink or in a recession as well. combined, the populations of these states represent over 20% of U.S. population. So much for real estate bubbles being regional. 3. the fed does not have ample room to cut unless they want to cut our throats along with the value of our dollar. inflation will be a worse problem at that point. the greespan solution is no longer viable at this point in the credit cycle. 4. no one can tell you with a straight face what the cause of the decline in stocks was due to. for him to say "the main cause" was put buying reveals how vapid this clown and his arguements are. 5. yes, "ultimately" it could be very good for stocks. it's a shame that for those who listened to as "expert" wharton professor and bought last week could be experiencing painful declines for the next year until the markets better understand the fallout of this problem and its effects on our ecomies. remember in Jeremy's world IT'S ALWAYS A GREAT TIME TO BUY STOCKS when you pick and choose your data and only present half the picture!

  • Yahoo! Finance User - Sunday, August 5, 2007, 1:20PM ET  Report Abuse

    • Overall: 2/5

    I think the good professor may have missed something - the possible effect of the housing bust on the consumer's perception that the "wealth effect" that had for many years enabled him/her to save less and spend more may now be history. If so, we may expect consumer spending to slow down and saving to increase and the knock-on effect will be to lower GDP growth, corporate profits and stock prices. Furthermore, his perception of value is based on P/Es derived from the highest profit margins in four decaded, not a more sustainable average of, say, the last five years. The latter would show much higher P/Es than he sets forth.

  • Michael - Sunday, August 5, 2007, 10:50AM ET  Report Abuse

    • Overall: 1/5

    Your 16 PE for the S & P going forward won't look so good after we start to see dramatic downward earnings revisions. Siegel is just like Kudlow in that they are not taking into account future unraveling developments: declining housing, weak dollar, credit contraction, slowing consumer spending, rising unemployment. Who cares about today's earnings. The smart people are only interested in the events that will shape earnings going forward. You would expect better advice from a top weanie from UPenn (Wharton) if he wasn't tied into a fund group with inherent interests in a ever-increasing stock market. Very disappointing....

  • espresso - Sunday, August 5, 2007, 10:37AM ET  Report Abuse

    • Overall: 4/5

    Most of the negative posts about this article seem to be written by newbie investors, with a poor grasp of the market's direction in the past 20 years. Those who believe weakness in housing and the credit crunch will kill the market obviously aren't old enough to remember the housing collapse and the S&L scandal of the late 80's. That housing bubble was worse than the current one, and the crisis that hit the Savings and Loans pretty much took out that entire sector of the lending industry. Despite the substantial negative impact on the economy, the market continued its climb and didn't hit a brief rough patch until '94. In comparison, our current economic problems are much smaller and more contained than the situation that disrtupted the economy (but not the stock market) from the late 80's- 90's, Furthermore, those who are harping about the weakness of the dollar have no grasp on what that really means for the economy. The last time the dollar was really strong (the 70's) our industries weren't competitive with foreign operators, particularly Japan. The Midwest became the "Rust Belt" it is today. The auto and consumer electronics industries collapsed. Our dollar is much weaker now, but the country is economically stronger, in particular due to innovations in technology and finance. Those who think the dollar's recent wane is catastrophic haven't been watching currencies very long. Hey, the dollar and most other currencies have been fluctuating greatly for the past 30 years. What goes down usually goes up and vice-versa. If you can't remember the Euro dipping 82 cents in 2002, then you have a poor perspective on recent currency valuations. Finally, those who think our recent market volatility is a "wall street crash" or beginnings of a bear market are particularly amusing. A market decline of 5% in one week isn't squat, Volatility of this nature is actually quite normal for stock markets. We've gone through a sustained period of low volatilty in the US markets, but that is likely to change. Hey, nobody said it was going to be a smooth ride uphill. Want some perspective? Back on Oct 19, 1987 the US stock market began a catastrophic crash and the S&P 500 lost nealy a third of its value in 6 days! But it was back on top a year and a half later, and it offered an amazing buying opportunity in the ensuing months . Personally, I'd like the market to decline 5% a week for the rest of the summer. That would only make stocks cheaper. If you can't see market dips as opportunities, then you aren't cut out to invest in stocks.

  • Yahoo! Finance User - Sunday, August 5, 2007, 9:43AM ET  Report Abuse

    • Overall: 1/5

    Just two things. Jeremy uses averages skewed by PE's in oil and energy. Secondly, the bulk of the sub prime mortgage resets will occur in January, February, and March of 2008. The amounts of resets this year in total through July 2007 do not even equal what will be reset in any of the above three months. Hold on to your cash.

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