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Jeremy
Siegel and Robert Shiller first met standing in
registration line at the Massachusetts Institute of
Technology. The “si” in Siegel’s name and
“sh” in Shiller’s made them alphabetical
neighbors.
As
fate would have it, both men became Ivy League
professors nationally renowned for books about the
stock market. Siegel, who teaches finance at the
University
of Pennsylvania’s
Wharton
School,
penned Stocks for the Long Run, which documented how stocks have
consistently out-performed other classes of
investments such as bonds, T-bills, gold and the
dollar over the past 200 years. Shiller, who teaches
economics at Yale, coined the term “irrational
exuberance” in his book of the same name
predicting the demise of the technology stock bubble
of the late 1990s.
Saturday
night at the Richmond Forum, the
Richmond
region’s leading speaker series, the two old
friends reunited to share perspectives on their
investment outlooks as the U.S.
business cycle enters a new round of expansion. True
to form, Siegel praised stocks as a great long-term
investment, although he conceded that technology
stocks are looking pricey right now. And Shiller,
ever the bear, emphasized the vulnerabilities in the
economic recovery in explaining why he currently
prefers U.S.
savings bonds over stocks.
After
hearing the articulate and erudite presentations of
both men, moderator Geoffrey Colvin, an editor and
columnist for Fortune magazine, expressed the sentiments of many in the audience
by declaring, “You’re both right!”
How
can they both be right? The key, of course, is that
Siegel and Shiller have different time horizons.
Looking 20 to 30 years out, Siegel make a persuasive
case. Focusing on the next two or three years,
there’s a high likelihood that Shiller is correct.
Midway
through the Forum presentations, it struck me that
the Siegel-Shiller debate over investment strategy
is paralleled here in
Virginia
in the wrangling over Gov. Mark R. Warner’s budget
and tax plan. The anti-tax forces led by House
Speaker William Howell emphasize a long-term
perspective. Keeping
Virginia
taxes low will improve the state’s economic
performance, which over the long-term will expand
the tax base and bring in more revenue than we would
if we raised taxes. The evidence for their view, to
my mind, is strong and persuasive.
Gov.
Warner, by contrast, is focused upon the here and
now: most immediately upon the necessity of
preserving
Virginia’s
fiscal integrity and AAA bond rating. Although the
economy at the moment is expanding faster than the
assumptions underpinning his budget forecasts, many
risks – the very same risks that Shiller talks
about – could throw that growth off track.
Building a budget around overly optimistic economic
forecasts could bring another round of spending cuts
and perhaps even lead to a downgrade of the
state’s
credit rating.
(I
am probably the only person in the audience seized
by such thoughts. Anyone with any
sense was trying to figure out how to maximize
performance of their investment portfolios.
But, obsessed as I am with
Virginia’s
fiscal and economic health, I seeking guidance for
decision making in the Commonwealth anywhere I can
get it.)
Of
the two gentlemen, Siegel was the most fun to listen
to: Everyone likes the thought of getting rich. An
ebullient speaker, he lays out an optimistic case
for stocks. One dollar invested in stocks back in
1801 would be worth an inflation-adjusted $597,000
today, assuming dividends were reinvested and no
taxes were paid. A dollar invested in bonds would be
worth $1,072 and T-bills $301. Gold bugs take heed:
A dollar invested in gold, adjusted for inflation,
would be worth a mere $1.37 today. And a dollar
invested in dollars -- U.S.
currency -- would be worth a nickel and two pennies.
Over
the 200-year period, despite the vicissitudes of
war, financial panics and depressions, stocks have
averaged an after-inflation return of 6.8 percent
annually. That considerably outperforms bonds,
Siegel said, which yielded a 3.5 percent annual
return.
Admittedly,
few investors have a 200-year time horizon. And
Siegel concedes that returns can be much more
volatile over shorter periods of time. But over any
10-year period, stocks have out-performed bonds 82
percent of the time. Over any 30-year period, stocks
have always
out-performed bonds.
Siegel
contends that stocks are “fairly” priced at
current levels, neither unreasonably high nor low,
despite the fact that the S&P 500 market
multiple is 24.6 times earnings, considerably higher
than the historical average of 15 times earnings.
Siegel insists that the financial economy has
undergone profound changes that make the higher
multiples justified. The stock market is far more liquid
in the 21st century than it was in the 19th century:
Thanks to information technology, which
lowers transaction costs of getting in and out of an
investment, and to the introduction of
mutual funds, which provide inexpensive portfolio
diversification, much of the risk has been taken out
of stock ownership. Therefore, investors don’t
demand the same risk premium they did a century ago,
which means they’re willing to pay more for a
dollar’s worth of earnings.
Siegel
suggests that a price-earnings ratio of 20/1 to 22/1
is perfectly reasonable. Based on a composite
earnings estimate of $55 for the S&P, that
implies a fair market value for the S&P 500 of
1,000 to 1,250. The S&P now stands around 1,140.
Siegel’s
analysis assumes that investors are, by and large,
rational. When it comes to pricing individual
stocks, suggests Shiller, they may be. But there are
a lot of “wiggles” in the stock market averages
that cannot be explained by earnings and interest
rates. Pyschology is a major driver of stock prices,
and investors are subject to irrational exuberance.
Apparently,
the dot.com crash quelled investor exuberance only
temporarily. The latest figures, says Shiller, show
that investor confidence has hit another all-time
high – equalling the levels of the 2000 Internet
mania. If that confidence collapses, so do stock
prices.
What
could go wrong? Many, many things, according to
Shiller.
-
Savings. The U.S.
savings rate has reached an all-time low. As
recently as the 1960s, Americans saved eight
percent of their incomes. Today, they’re
saving about one percent. Household debt burden
is growing rapidly. An increasing number of
people, in over their heads, are declaring
bankruptcy. How long, Shiller asks, can that
continue?
-
Interest rates. The decline in interest rates over the past 20 years
has made the debt burden relatively manageable.
Even though the debt is higher, lower interest
rates mean that interest payments have not
increased significantly. What happens when
interest rates head back up? Suddenly, the debt
burden could become unbearable.
-
Jobs. The U.S.
economy
has shed three million jobs over the
past three years, some to dramatic gains in
productivity, some to the out-sourcing of jobs
overseas. Even with the economy expanding
rapidly, U.S.
job creation remains essentially flat. Could
continued job losses impact investor psychology?
Shiller’s
discussion on the housing bubble are particularly
apropos to readers of Bacon’s Rebellion, which
highlighted this very concern in a recent column,
“The
Housing Bubble” (November
17, 2003).
Lower
mortgage rates may have helped make sky-high prices
a tad more affordable, but local markets for housing
vary so widely across the country – some markets
booming, others stagnant – that
something else must be going on. Shiller thinks
we’re experiencing another bubble psychology.
As
investors bailed out of stocks when the dot.com
bubble burst, many of them piled into real estate.
Prices increased as a result, spurring speculative
fervor in the housing market. People bid prices even
higher in the expectation that they would continue
rising. California,
which has seen the largest price increases in the
country, is particularly vulnerable to a setback,
Shiller says. One million dollars for a two-bedroom
house in Los
Angeles is simply unsustainable. “The whole mentality can
change, and the market can drop very suddenly.”
If
it’s any consolation, housing price increases in
Virginia
have been moderate, Shiller says. Prices have
largely tracked the inflation since 1975, though
they have seen an up-tick since 2000. Judging by his
overall figures, the Commonwealth has seen little of
the speculative excess of states like California,
Colorado
or New
York,
he said. “I wouldn’t worry too much here in Virginia.”
(What
Shiller’s figures don’t adumbrate is the
two-tier housing market in Virginia.
Housing prices in
Northern
Virginia,
part of the larger Washington
metropolitan region, have shown signs of speculative
excess. Although average housing prices statewide
may not be out of line, there could be localized
distress in Northern
Virginia,
the state’s economic engine.)
Shiller
doesn’t like stocks right now. Fearing an up-turn
in interest rates, he’s not happy with bonds
either. And he’s downright bearish on real estate.
“There are good times to be an investor, and some
times when it’s not so good to be an investor,”
he says. “This is one of those times when it’s
not so good to be an investor.”
Where
to put your money? Consider investing in overseas
markets. But his favorite is inflation-indexed
savings bonds. They’re not sexy -- the
inflation-adjusted yield is only two percent -- but
they’re really safe! And they’re redeemable with
only a small penalty when you decide it’s time to
get back into the stock market.
That’s
all fine and good for investors, but what does it
mean for readers of Bacon’s Rebellion fixated,
like myself, on the implications for
Virginia
governance? Neither Siegel nor Shiller had anything
to say on the subject.
Here
are my thoughts, for what they’re worth. Just as
individuals should invest for the long term,
Virginia
needs to govern for the long term. That means
creating a business climate conducive to long-term
growth and expansion of the tax base. To my mind,
that means keeping taxes as low as possible,
consistent with providing the core services of the
state. The connection between lower taxes and higher
economic growth is indisputable. By contrast, the
connection between “investing” more on public
schools/roads and economic growth is theoretical.
But short term
risks cannot be ignored. Virginia
must maintain its AAA bond status. A downgrade would
raise borrowing costs, making less money available
for supporting state programs, and would tarnish
Virginia’s image as a superbly well run state, a
tremendous advantage in recruiting new business and
investment.
I
have no quarrel with where
Gov. Warner wants to increase spending – education
primarily. But I’d suggest that the best way to
mitigate the risk of a slowdown in the national
economy, with its negative implications for state
revenues, is not to raise taxes and accelerate
spending. It’s to increase spending to the rate of
revenue growth. Virginia’s
economy has consistently out-performed the national
average. As the tax base expands, we’ll be able to
afford to spend more in the long run.
--
January
19, 2004
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