Quarterly Q&A with Professor Jeremy Siegel

Every quarter, we hold a quarterly review and outlook conference call with our Senior Investment Strategy Advisor, Wharton Professor Jeremy Siegel, where listeners can submit questions ahead of time and help drive the content of the call. In this blog, we review the most pressing economic and market issues that were discussed during this quarter’s call.   Question: Professor, there have been a lot of interesting stories in the market this year. But of late, the gold and commodities markets are among the most interesting. What’s your take on the moves we’ve seen and what that means for other asset classes? J. Siegel: Most definitely. I think the break in gold prices is extremely significant and, let me say, very positive for equities. We all know that, over the years, commodities have increasingly been introduced as an asset class for investors to hold. Back in the 1960s, investors primarily chose between stocks and bonds. As time went by, assets—real assets, such as gold—were introduced in greater levels as a hedge against stock market declines. The tremendous volatility of gold, the tremendous decline of gold this year,¹ I think is going to put significant nicks in people’s trust of gold as a safe asset class. One thing that came to my mind—many times when I talk to people about stocks—is that everyone is concerned about the volatility. I am surprised how many questions, even today, I get asked about the flash crash, which was three years ago and lasted for about 30 minutes, when the market dropped about 8% or 9% and then came right back.² Well, if they were scared about the flash crash, what about what we just saw with gold? We had much more than a 10% drop that only barely has come back. Gold was supposed to be safe in QE. Everyone thought, “As long as QE is on, commodities are the place to be. Gold is the place to be.” Well, QE is on around the world at a level that we could’ve only dreamed of a year ago, and yet gold broke downward. As a result, I’m not sure that people are going to be as comfortable with the commodities and gold and silver as they used to be, which I think is going to be to the benefit of the equity market.   Question: Another big story of the year has been what Japan has been doing with monetary policy. Do you have any thoughts on the efficacy of their approach and what’s happening in the Japanese market? J. Siegel: I find what Japan is doing, as a macroeconomist, to be one of the most fascinating macro policy moves of not only this decade but perhaps of the whole post-World War II period. Super-aggressive QE, and I support it. Now, I’m not one of those who think that deflation is the only cause of their problems. I think there are structural problems. I think there’s an aging population that finds it very hard to deal with disruptive technologies and the concept of how fast one has to move in changing the world. But nonetheless, what they are doing and what they have done, and the market believes them, is depreciate the yen, help the exporters.   Question: And the European central bankers have made comments about the interest rate policy and about potentially cutting rates. Do you think they will lower the interest rates, and what impact could that have on their economy and the euro? J. Siegel: I believe that they most certainly should lower the interest rates. I’m a supporter of Mario Draghi. He knows what protocols to follow. He knows how critical it is to prevent a financial crisis. I think deep down he would like to cause a little depreciation of the euro and lower those rates, but he has political considerations that he has to watch from Germany and elsewhere. I think ultimately, though, they will lower rates and they will lower the euro. The economic news out of Europe is terrible. Auto assemblies in Germany are near 20-year lows. Once the slow growth spreads to Germany, I think they will finally give in on a lower euro and lower interest rates.   Question: We have seen continued interest on that currency hedging theme, as well as on the European hedged equities. The exporters are starting to do better than just the broader European markets this year, since we started focusing on the exporters in Europe for that hedged equity fund in Europe, HEDJ. Any thoughts on this approach? J. Siegel: This is with the euro at $1.31. Think of what happens if the euro goes to $1.20, as it should, or lower. It’s great to see this interest with the euro at $1.31. At $1.20, the exporters will be jumping up and down as they are in Japan, wringing their hands about, “Wow, we’ve got opportunities abroad.” It’s really hard to predict the short runs on any market, but the next move of the euro, in my opinion, is definitely downward.   Question: Let’s go back to the U.S. market for a bit and talk about what you see for valuations. J. Siegel: The valuation ratios are still extremely favorable. As you know, earnings dropped off at the end of last year. Many firms took a hit on their pension funds because interest rates were at record lows. That caused, even in operating earnings, a lot of those late December/January write-downs. I’ve maintained that the rally to new highs that I see in the next nine months—this year and into 2014—is going to be based on multiple expansion. I believe we are going to get multiple expansion as people begin to move from bonds to stocks. And don’t forget, it has only been a trickle so far. I believe we’re just at the very beginning of this train. This train might gain momentum as people say, “Wow, if I can’t trust gold, where is there a place for me to go?” They’re going to be looking at equities and alternatives and emerging markets, both debt and equity—asset classes that are worthy of their consideration.   Question: Let’s talk about risks. Many worry about a potential Fed exit. Any views on what the timing of that would be and how they would actually exit their policies? J. Siegel: I’ve written a piece about an exit that appeared about two weeks ago in the Financial Times. I said that in addition to or in place of just selling bonds they should consider raising reserve requirements. Raising reserve requirements shouldn't be viewed with as much fear it once was, because they can pay interest on those reserve requirements. In fact, I worked out that if the Fed puts a 15% reserve requirement on deposits, I believe the Fed would not have to sell one dollar out of its portfolio to mop up all the excess reserves that are now in the banking system. That’s pretty amazing, because there are approximately $1.7 trillion worth of excess reserves now in the banking system³. Many people worry when they start finally having to tighten and remove it—is the market going to be strong enough to absorb a $1.7 trillion open-market sale from the Federal Reserve? What I’m claiming is they don’t have to get rid of all of those. They could do a mixture of raising the reserve requirements and selling them as they desire to mop up those excess reserves and to prevent any of that money from truly becoming inflationary.     ¹Refers to the price of gold in U.S. dollars over the period from 12/31/2012 to 4/18/2013. ²Refers to the performance of the S&P 500 Index on May 6, 2010, the date of the so-called “flash crash.” ³U.S. Federal Reserve, 3/31/2013.