Irene:

Hi everyone. Thank you for joining today's special edition of WisdomTree's Office Hour series titled Is the Fed Embarking on an Irreversible Policy Mistake? Where you'll hear from Professor Jeremy Siegel, Senior Investment Strategy Advisor at WisdomTree and Emeritus Professor of Finance at the Wharton School of the University of Pennsylvania. Kevin Flanagan, WisdomTree's, Head of Fixed Income Strategy. And Jeremy Schwartz, Global Chief Investment Officer at WisdomTree. So with that, let me turn it over to Kevin Flanagan for some opening remarks.

Kevin Flanagan:

Thanks, Irene. Good afternoon everybody. Professor, Jeremy, great to have you guys back on, of course. I think I have a funny feeling…how the professor's going to answer the question, which is, is the Fed making an irreversible policy mistake? But we'll wait. We'll let some of the suspense build up for a couple of minutes on that one.

So obviously a lot to talk about. Send us in your questions. We'll hopefully get to them. I'm sure the Professor will probably be answering them as we go along but to get started, we thought it would be good to take care of the three polling questions. So we're going to throw them up there right now and see what your answers are to what you think about what occurred today, what you think could occur next year, and where we could be going in the stock and bond markets as well. So with that Professor, let me turn it over to you while we wait for the polling questions and we'll get started.

Professor Siegel:

Yeah. And you might answer these questions differently after hearing Powell than before. The first one is about how much more they'll go if they go any further. The second one is, do you think they might cut? He certainly said no, but maybe reality will set in at the Fed. And then the last one is, what do you think about bonds and stocks next year? Both rise, stocks up more, or bonds do better, or neither rise or they both fall?

So Irene, do you want to show us the answers on these? No, when things are going to stop here. Okay, half of them think another 25 or 50 and there was more than 50 is about the same percentage. Certainly listening to him, that's exactly what you'd think. Of course, I think they should stop here and I'll talk about that, but that's another thing.

Do you think there'll be cuts? Now, this is interesting because almost half of you think that there will be cuts. Modest but cuts. The way he talked, we're not even thinking about cuts. Of course, a year and a half ago he said, "We're not even thinking about raising rates." So we'll have to see how credible that is.

Let me move down on here to see the answers on that. I do like that. I actually think stocks will go up more. Although clearly after hearing him, you think bonds might do better given that they may overdo it. Bonds will rise, the stocks will fall as 19% and both will fall. It's only 8%. So that is interesting.

So our discussion today, see if that nudges you one way or another in terms of how you think about the Fed.

So I have several points to make. One is somewhat of a technical point but it's an important point, Fed Fund's futures are not unbiased estimates of what the market thinks the Fed Fund's rate will be in that particular month. They are underestimates of what the market thinks…and you sort of say, "Why would they be underestimates?" That is because the Fed Fund's futures are hedges. If something really bad happens to the economy the Fed is going to lower rates, and risk assets are not going to do well. So they become negative beta assets and as a result they're going to sell for a lower rate than they would otherwise. So a lot of people say, "Oh, it isn't in the Fed Fund's futures market," realize that is a misunderstanding that these are not unbiased estimates. I think probably you got 25, 50 basis points in there that you have to add to the Fed Funds more as you go out in terms of getting an unbiased estimate of that. So I think the Fed Funds market is much more closely echoing what Powell is saying.

The second is I think we always make way too much of a big deal about these dot plots. I could be strong and say that the dot plots are not worth the paper they're written on. But let me just remind you the meeting a year ago this week, so it was the December meeting, facing rapidly accelerating inflation, which I was stomping my foot on for over a year, all but two members of the FOMC thought that the Fed Funds rate as of this month, so December of 2022, would be less than 1%. In other words, all but two. And those two thought it would be between one and one and a quarter percent.

So do they know what they're going to do next year? The evidence is overwhelming, no they don't. They have no idea. They float with the data. They have virtually no forecasting ability. Their forecasts have been very bad, in fact, and they're forced to move.

All right, thirdly, let's get to the heart of the discussion. I was listening to this idea, he said…, "The dot plot is higher now in December than September." That inflationary pressures have gotten worse over those three months. I don't see that anywhere. I don't know what he is referring to, that inflationary pressures are worse now in December than in September.

Secondly, he keeps on talking about year-over-year inflation, as if that has to come down, using 11 old months and one new month. What does that have to do with where the Fed has to go? But more disturbingly, he repeats the situation with the housing. We've talked about this many times, the Housing Index, which is 40% of the core, lags dramatically from what is actually happening in housing.

So he actually acknowledged it by saying, "We know how price is going down, and that will begin to show in the data in six months because we use lag data." So is the Fed supposed to continue to tighten during the time when they know that the inflation rate is going to go down, and quite dramatically? As we have calculated at WisdomTree, and by the way, I'm getting other economists that are sending me very similar data, if you put the true rental Housing Indexes in, what's going on today, into the data, you have three consecutive months of negative core inflation today with current data. Why you would ever use greatly lagged data and then wait until that greatly lagged data shows up is just absolutely beyond me. It just shows a total misunderstanding of how to interpret statistics.

Secondly, he mentions, "We know that monetary policy proceeds with a great lag." In fact, he was sort of asked, "Are the lags any shorter than they are now?" "No, they're long and variable lags." But then he talks about we have to see year-over-year data to go down. As inflation is going down, we are raising the rate, making it more and more restrictive throughout the year, knowing that it takes six to 12 months for that rate to affect the economy. That is absolutely crazy monetary policy.

What does this all mean? Well, why did the market not go down 500 or a thousand points? Because they said, "As thick as Powell is, he'll finally get it. The data will come in softer and we'll come in softer on the labor market." I'll talk about that in just a second. This will be brought up more and more. And on February 1st, the next meeting, they may in fact not do an increase. Of course, it depends on what the data shows.

On the labor market, again, terrible economic mistakes. Labor is catching up to inflation. It's not causing inflation. Real wages have fallen behind. Now he's talking about we have to see real wages moderate to 2% even though he doesn't think inflation is going to go to 2% for several years. What is he doing? Is he permanently relegating the American worker to sub-normal wages? It hasn't caught up and he's going to force them down so they don't catch up.

Now, that is also completely inconsistent with his statement that we're suffering a structural labor shortage. Well, if we are, what does economics say should happen to the equilibrium real wage? It should go up. In other words, if less people want to work, those that do want to work are going to have to be paid more to induce them into the labor force. That's to increase supply, that's economics 101, and nothing to do with inflation. It has to do with supply and demand. I mean, if people are not working, then you're going to have to pay them more. There's nothing the Fed can do to force the people to work if they're not.

So on two fronts, they haven't caught up to inflation, they can't be causing the inflation, and if there's structural shortages of labor then you just have to pay them more. That's a real economic fact that is completely independent of what the Fed has control over or can do to. In other words, in my opinion, as Powell and the Fed have done over the last year and a half there, they flunk economics 101 on many, many fronts.

Now I want to get to the bottom line. If they do stay near 5% for this year, you can make sure that we're going to have a recession. I think they're going to be forced to pivot. Also, my feeling is... I mean, it's interesting, again, he never explains why we had such a strong labor market and a half percent rise in and good hiring, as he said, a strong hiring, payroll growth, and we have a projection of a half a percent growth of GDP for 2022. Now they project a half a percent growth of G-

And '22. Now they project a half a percent growth of GDP for 2023. I think it's going to be much more. I have mentioned, I think the productivity collapse is going to turn into a good year of productivity growth. So the labor market will in fact soften. We may see labor losses and that will allow firms to get rid of unneeded or unproductive workers, which will improve margins, improve the bottom line. GDP, I think is going to grow faster than a half a percent, even though the increase in the non-farm payroll next year might be only a million workers, much subpar. So those are the favorable trends. Looser labor market firms getting rid of the workers, they don't need, productivity jumping that puts downward pressure on prices, upward movement on margins, and makes the profit outlook far better than what the market now expects. All right, so I've gone on for 15 minutes. I like Kevin's view, maybe Jeremy's view. We do have a store of questions that have been asked, and you can also send in questions. Kevin?

Kevin Flanagan:

Let me throw out one of the first questions for you and kind of dovetail it with this thought. So to me, the expression, I watched the treasury market's reactions early on, and the more Powell spoke, actually you started seeing the yields come off their highs. It was almost as if treasuries ain't buying what Powell's selling. So one of the questions was, where do you see the 10-year treasury yield in 2023?

Professor Siegel:

Yeah. Well, by the way, not only did yields come off their highs, but stocks came off their lows. I mean, that was actually a brief period toward the N word that Dow was. I guess we ended down a $1.42 on the Dow, which is a pretty narrow, I mean for that aggressive a policy stance, that's a pretty mild decline in the stock market. So I agree with you, they're not buying this.

Now, the decline in yields could be two things. You see, the thing is if they're overly tight, inflation will come down more, and it's more likely of a recession and you want to buy bonds. So the bonds have a double reason for going down in yield. The stocks like lower inflation, but they don't obviously a recession or lower economic activity. So they are much more wary of that sort of scenario. However, I agree with you, there's a feeling that it took a long time for the Fed to finally wise up to how expansionary their policy had been, way too long to cause this inflation. But they finally did get it and they will get it next year.

By the way, as I mentioned many times the money supply exploded from March, 2020 to March, 2022. It has declined for seven months. And by the way, I've been looking at weekly deposit, it looks like we get it on the fourth Tuesday of every month, and we'll get it for the month of November in a couple weeks. It looks like another monthly decline in the money supply. Again, a very contractionary situation for liquidity and for the economy.

Jeremy Schwartz:

Today's discussion, he made some comments about are they restrictive, are they overly restrictive and you didn't think they were sufficiently restrictive. Is the money supply to you, the best evidence that they're overly restrictive? What else would you say about how restrictive they really are versus his comments that they're not?

Professor Siegel:

Well, there's two things. One thing is definitely the money supply. Again, the greatest decline in the money supply since World War ii, seven month decline that we have seen…but more importantly, again, he talks about getting the real rate to a certain position and then he uses year-over-year data. Well forward looking data on inflation, forward looking data, I think forward looking data on inflation is probably 0.1, 0.2%. I mean it obviously not in the Bureau of Labor Statistics because of the lagged effect of housing, but it's very low. So now have the Fed funds rate of 4.33. If you have zero, 1% or you have a real short-term rate around 3%, I think the real short-term rate in equilibrium should be zero. Okay, make it one, it one and a half. It's extremely restrictive. If you actually look at current forward looking real inflation data, it's very restrictive and we see it in the housing market. We see it capital expenditures. We're going to see it in a lot of different places.

Again, we talked about the productivity collapse of this year, mostly consummated first two quarters of unprecedented size. I think it is the labor hoarding. I think firms are shaking their heads about some of these people that they hired and as soon as they see, "Hey, we can get rid of them," and in beginning in tech, which of course everyone thought had so many profits that would never have to worry about laying off anyone as soon as they say, "Do we really need these people?" Because if GDP really only grows a half a percent, the way the Fed predicts... Oh by the way, let me just mention, guess what the pro last December's projection for GDP growth was this year. 4%. Could they be more wrong than that?

I mean, we could go on and on. If you want to have a laugh, look at the December, 2021 projections. Look at their dot plots. Look at do they know what they're going to do? And I think what's happening is the market says, "Yeah, you're talking one way, but the data will hit you over the head at some particular point. And then at that particular point, you will have to make the shift." And what we'll take, we have negative payroll growth one month? Certainly we could have that. We'll see what actually happens the first week in January when we get that payroll. We'll see what kind of Christmas sales actually come up. We're getting retail sales tomorrow, but I see a lot of slowdown in the economy that could record to a very weak labor situation.

Kevin Flanagan:

Professor, I wanted to ask you a quick question here. Actually, this won't be a quick question, probably won't be a quick answer either, but there was an article in the Wall Street Journal the other day from our Fed whisperer friend Nick Tammaro. And he was suggesting in there, I guess one of the camps within the Fed is, they don't want to stop and/or cut and then have to restart raising rates later. Do you think that's a genuine concern within the Fed?

Professor Siegel:

Well, that's been the narrative for eight months of Powell. The policy mistakes of the past. Well, I looked at the past and let me say the following, yes, there were times of cuts and then they had to go further. But guess what? They cut the rates, but the money supply kept on going up, and up and up. They never restricted the liquidity the way they did now. So that is the big difference. And by the way, they started cutting rates and saw a little bit of weakness, but they never saw... I mean we really seen declines mean commodities are off 30% from their high oil is off 30, 40% from its high. All the sense of things are off, housing is going down. Housing was never going down during that period, by the way, ever. So he's referring to historical, and I'm talking about Powell, they've invented this boogeyman of, "We made that mistake in the past and we don't want to do it in the future." Failing to realize how different this period is from the period of the 1970s.

I mean, supply side restrictions have eased dramatically. As we can see everywhere and we'll see what happens in China, this rapid opening up really shocks me. I mean, we'll see what happens there, but that will assure a smoother supply side chain coming through. Now some people say it also increase the demand for commodities. To some extent, yes, but it is much more important to make sure that the supply chain through China comes through because we still import hundreds of billions of dollars through China. And if those are restricted, that will be much more inflationary. And the commodity markets, by the way, only reacted very mildly to when she made that 180 degree turn on COVID restrictions. I mean, it wasn't like all of a sudden you saw…shoot up because of that. So my feeling is that's a deflationary good force, a positive force on the China reopening that we're seeing in that country.

Jeremy Schwartz:

Well, some of the commentators, and I wonder if you think where Powell thinks it's going to go based on some of his comments is he thinks that they might want to, is inflation going to come back to their two percenters, are going to stay elevated? We've got a number of people saying it might come back to after this situation, and it might only settle out to three or 4% and that they should raise their target. Any comments on settling over the-

Professor Siegel:

Yeah, well it was, and that was a question from the audience and Powell put the kebash on that immediately and said, "No, there was absolutely no discussion of changing our target." And that's right. Now there is discussion among economists about, in a world of declining interest rates, as we have documented, and you know Jeremy, we have a whole chapter in our book about the decline of real interest rates over time, it gets harder and harder for the Fed to stimulate by moving towards zero by having a 3% inflation it gives you more headroom. So there is talk about it among academics and policymakers, but when you're fighting inflation is not the time to say, "Well, we've moved our target from two to three," so he'll never say that. Now again, my feeling is on real data, we're already down to 2% inflation or less. Year-over-year, of course takes time because you have 12 old months and not only that, but then you have a 12 month flag in the housing sector of that which compounds it for that to go, even if we had zero forward inflation for the year-over-year to go down to 2%, it was going to take a year at least, if not more.

So sometimes, I mean he made some statement like, "We want to get down to 2% inflation and year-over-year core is six." Yeah. Well that have to do with the forward looking rate of inflation? I mean first of all, the change in the policy stance of the Fed before COVID where they said, "We're not going to restrict the economy until we see the whites of the eye of inflation." That not being preemptive, which was a bad mistake to begin with. But then they compounded the mistake by that when they finally saw the inflation for six, nine months, they called it…I mean it's unbelievable. I've never seen a more backward looking Federal Reserve ever. It's like I'm looking at year-over-year that it's in and of itself is using lag statistics in terms of judging whether we've reached our goal or not.

It was astounding to me their ineptness on the inflationary front, as I was banging the door for them to raise rates much more and they waited, and now my feeling is they're on the verge of making the mistake on the other side. Someone's got to convince them. It might take a negative payroll, it might take the claims to start going up might take that unemployment rate to go up and people say there's a labor market out there, but to just look at wages when he says there's a structural shortage that's nothing the Fed can do about real wages will go up. Real wages are in catch up mode. I mean, he never acknowledged that the American worker has fallen three to 4% behind inflation and they're trying to catch up. He's saying, "We've got to get the inflation now below even current inflation." That's like, "I'm going to permanently assign the workers to an impoverished future through my policy as a way of crushing inflation."... through my policy as a way of crushing inflation. It makes absolutely no sense. I mean, no one asks these questions or points these out. I'm pretty shocked that a number of people in the Democratic Party is supposed to represent labor are saying, "Just a minute, are you trying to crush wages when they haven't caught up to inflation yet and you say there's a structural shortage?" What kind of policy is that? Or do they just not understand anything about the basics of these issues? Maybe it'll filter through, but those are my impressions.

Jeremy Schwartz:

We've got some requests for Powell to be on this call listening to you. They want the Fed to be taking your advice.

Kevin Flanagan:

Jer, I think this is better than the CNBC interview the professor did a little while back there. This is good stuff.

Jeremy Schwartz:

We agree with Paul. Paul's writing in that Powell needs to take some more advice. We agree with that comment there, Paul. So I guess Kevin, from a fixed income standpoint on what people should do with all this, I mean, the professor comments that if they keep at five, it's going to be a word... It's really got the Powell versus Siegel questions, how quickly will they listen to his advice to pivot and move things lower? We didn't get to your more bold call professor, but I guess Kevin, what do you think people should be thinking in the fixed income world? 'Cause there's a lot of questions about what this means for rates, how to position portfolios and what people are thinking here.

Kevin Flanagan:

Well, if you take the Fed and palette their word and say they go to 5.1% on the dot plot, and professor, I couldn't agree with you more, the Fed funds futures dot plots, horrific track records with respect to forecasting. I mean, it's fascinating. The Fed can't even forecast what they're going to do. It's kind of tongue in cheek on that point. But let's just take them for their word and they take us to 5%, then I still think you have a runway here with respect to treasury floating rate notes. So our USFR product, which has really been a huge beneficiary of what the Fed has done, still makes a lot of sense in that environment, especially if you also believe what seems to be PALS guidance today that they're going to be on hold even when they stop for an extended period of time.

But I think professor, to your point, when that happens, the claims go up, you get a negative payroll number, I think you are going to see that shift in the bond market. You are going to then want to move out further on the curve, on the duration side to take advantage of what we feel will be a bond market rally later in the year. I mean, it was a great question, which is going to do better, stocks or bonds? To begin the polling question. But for us, it would be getting back to the core like our Enhanced Yield Ag, AGGY, moving into positioning such as that because we are dealing with yield levels, a generation of investors have never seen before. You have to go back to 07, 08 before this recent rally to see treasury yields at these type of readings.

So I think it's kind of like a two-part answer to the question, Jer. I think early on you still have that treasury floating rate strategy working for you, but then there's going to be that shift where from a portfolio allocation, you're going to want to get closer and closer to that benchmark duration and not be underweighted anymore.

Professor Siegel:

Yeah. I just want to follow up on Kevin. Yeah, I do think that bond yields are going to work lower. I think we also should acknowledge that there's never been a more anticipated recession than this one, which makes me very suspicious about whether there's going to be a recession. Again, if we get a partial reversal of the crazy pattern of strong jobs in 2022 and terrible GDP, we'll have weak jobs in 2023 and better than expected GDP and better than expected profits, is there still a chance for a runway of that so-called soft landing?

I think there is, but sometimes what I worry about is the Fed is going to linger so hard and the economy's going to go down, and then finally again, they're going to be late and there'll be momentum built just like there was momentum built on the upside of momentum built on the downside.

They act as if monetary policy is like an automobile that you steer to the right and you steer to the left, you step on the accelerator and you step on the brake and there's instant response. That has never been the case of monetary policy. It's more like turning around a supertanker. Whoa, it has incredible momentum on its own and it's not going to react instantly to that.

And again, it's interesting because he does state, we know that it has legs in the policy and then says we have to make sure that inflation doesn't reappear. If we're going to get year to year down to two, that means that actual is going to be down to zero or negative and then we're going to take the foot off the brakes and then there's long legs and then you're going to continue and do a downward spiral. It's inconsistent to say we have to see that rate go year-to-year down to maybe 3%, I don't know, whatever, and then take the foot off the brakes and then say, "Oh yes." And there's long and variable legs between monetary policy and what we're going to do on the economy.

Basically, one thing that gives me confidence is again, I think there's going to be a rise in productivity once there's more of a labor market and people, firms can get rid of excess labor and I think that will surprise people. Also, even though the money supply has in fact fallen for the last seven months, its fall, although record breaking because that's very unusual, still puts the money supply way above where it was pre-COVID because of the incredible 40% increase in money between then.

So the whole structure when people are talking about getting to back the S&P profits of pre-pandemic, no, I mean, the whole structure of prices is higher. My feeling is again, get the money supply growing at 5% a year. That's consistent with the two. Accept the inflation that's in the pipeline, and that would be the most healthy thing for the economy going forward. Not trying to crush a few extra percentage points down on the inflation at the cost of totally disrupting the economy. And it is not equally applied. As we all know, housing is suffering by far the most, the intrasensitive areas are suffering by far the most. And the housing decline, I think has just gotten started.

Whether there's a structural housing shortage or not, people are talking about it. To have a 45% increase in house prices in two years and now they have interest rates go now from 3% to six to seven, that almost chops affordability by 50, 60, 70%. Average American does not have the income to support that sort of rise with these interest rates. I cannot see how the housing market is in any sort of imminent turnaround here, which means-

Kevin Flanagan:

So Jer-

Professor Siegel:

... falling prices. Yeah.

Kevin Flanagan:

I was just going to say Jer, in the background there, I see three books there, Stocks for the Long Run that you and the professor just came out with the next edition. And I mean, it's a perfect segue in into what we're talking about here, professor, you were just talking about the S&P, what we think the bond market may be doing, where we should be going. What about the equity arena? What should we be thinking about in this environment for 2023?

Professor Siegel:

Well, first of all, our studies that we did when we wrote the book is that when there's a big switch from growth to value, it's not usually, I mean, I can almost say never, but it depends on what magnitudes you use. A one-year affair. It's persistent for a number of years. You measure coming off of the 1975 Nifty Fifty mania, you could still talk about coming off of the dotcom mania 25 years after that. Or you talk about coming off of the stay at home pandemic mania of 2020, 2021 again and legs a 20, 25 years cycle. These things usually persist.

Jeremy Schwartz:

And it's a very interesting week to be having this conversation. Actually, most of our US index is basically all rebalanced yesterday. So an interesting day for the rebalance, they all occurred. So you have new portfolios. I think if you look at our website tomorrow morning, all the fund pages, the index pages will reflect all the latest holdings. And for the valuation snapshots, you'll see on the index pages will be all sort of updated and refreshed basically tomorrow morning.

I think the current stories, and to the professor's comments on things continuing in its vein, you had this double digit decline in the S&P, you've had almost a double digit rise in high dividend US stocks. So DHS is the high dividend. It reflects some of the work that I did with the professor over 15 years ago. Now really over 15 years ago, from the future, for investors on high dividend investing, sorting the market by div yield, the DHS takes the top third approximately of the market, which is the top one and a half quintiles from the professor study.

And when the S&P is now what, 17 to 18 times forward earnings. And you got to see, there's a lot of questions where the S&P earnings going to be next year when you talk about that. But this basket is 12 times earnings. So we're talking five to six multiple points lower. If there's still valuation concerns, a lot will happen this year was the valuation compression, maybe that's still in the tech stocks. 

It's not like Tesla is a cheap stock, it's coming down, but not a cheap stock. Amazon is not a cheap stock.

High dividend stocks at 12 times earnings, I do think are relatively low, you don't have to go to Europe to get 12 times. You can just say US high dividend stocks are 12 times earnings, and that's a 500 type stock basket. So it's not a few stocks, it's a very diversified across sectors. I mean, it's definitely overweight energy as the cheapest sector, but it's not more than 20% energy. It's going to be less than 20% energy. So it's a diversified basket.

I think Europe, if you look at the same strategy, DHS is the US, DTH is the international version of that. That's eight times earnings. So it gets even lower and more depressed when you go overseas. And surprisingly, you could say only down a few percent this year. So value has definitely worked around the world. High dividend is outperformed value. There's been this definitely extra defensive nature. And it goes back to our studies professor, when we first wrote the original white paper for WisdomTree through all the bear markets across time, high dividends had done very, very well until the financial crisis. And the financial crisis, you had a lot of high dividends coming from the banks and they were the center of the storm.

And so in the 08 period, they didn't have the same down market protection as they did the previous 50 years. But this bear market has been a classic one where high dividends have been very, very defensive and potentially, I think for that, if there's any more volatility again next year, a very well positioned place to be

Professor Siegel:

Very good point. In fact, in our book Future for Investors, which was written before the financial crisis, we taught...and by the way, in the sixth edition of Stocks for the Long Run, we talk about all the things that have changed since the financial crisis, and we have many chapters on factor investing and the fact that momentum quality, many of those have not performed in the last 15 years. A lot of things changed at that particular juncture. They've been in every one except the financial crisis. There's a lot of sense for that because you know they're generating cash and they're giving you a dividend yield when interest rates are going lower in that recession. And there's confidence in... are going lower in that recession and there's confidence in that. I'm not surprised it reasserted itself. And. As I said, it's usually almost always more than a one year phenomenon. Look, as yields go down, we have the 10 year TIPS of 127. My feeling is that TIPS are probably going to go down to about zero eventually. They're 127. But think about a dividend yield of three or four, think about a PE ratio of 12, which indicates an 8.5% earnings yield, which is a real return going forward, 8.5.

You mentioned that Europe's dividend value tilted is eight, that's a 12% earnings yield. Those are real yields going forward. It's not going to be year by year, but long-term valuations, if something stays at an eight PE ratio, you're going to get 12% real returns, which is, by the way, virtually double the historical return on the U.S. stock market, which is 6.7. And many people say, "I'll be happy with five in the future after inflation." So think about those earnings yields when you think about how to allocate your future equity portfolio.

Kevin Flanagan:

Go ahead, Jer.

Jeremy Schwartz:

I was going to say, Mark just asked a question on small caps for this cycle and our small captivity dividend. Great question, Mark. Our team has been writing a lot on small caps and saying it was just like much of the value under performance was large cap growth out performing. We had done a few pieces last year. If you look at Brian Manby wrote a few blogs on the relative returns from small caps at these distressed valuations. I think they were center of the storm of pricing in the recession concerns that the professor talked about that everybody thinks of recession. And so you got to single digit PEs on a lot of these small caps in the U.S. You didn't have to go to Europe to buy single digit PEs. You were there in Q3 at single digit PEs on basically all of our small cap products.

That also is rebalancing. We just rebalanced that. So you're going to get close to single digit PEs again. It's going to be close to 10 to 11 times earnings, I believe. Maybe a touch higher. I've got to see the final numbers tomorrow. But I think that also is where the people have priced in that recession. And so we like the high dividends and paired with small caps. You get a little bit of the cyclical side on small caps and the more defensive high dividends for large caps. It's a nice combination there, Mark.

Kevin Flanagan:

Also, I just wanted to throw this out there because we haven't really touched on it yet, a question coming in, if we're higher for longer, what does that mean for the dollar?

Professor Siegel:

Stronger. Because the dollar is expecting going to be a pivot, but if they stay higher for longer, that means a strong dollar, and that would not be positive for those international portfolios. But, again, I don't think it's going to happen. I think the data's going to come and just like they never went through with any of their predictions before, they won't go through with their predictions now. I also want to say, when Jeremy mentioned that you can get large portfolios small cap stocks at 10 or less, the last time the market, the U.S. market, was 10 and people always like to bring that up to scare you about how low stocks can go, but they don't tell you that that's when the 10 year bond was 16% guaranteed by the U.S. government. That's a pretty good alternative, isn't it, for stocks?

Today, you can't even get 3.5. So why would the PE ratio of the market go to 10, which is a 10% real earnings yield, under those circumstances? Even though the Fed jacked up those real yields this year, we are in a secular worldwide decline of real yields over the past two and a half decades, which has its roots in many factors that we discuss. Demographics, fertility, age distribution, risk aversion, negative correlations between stocks and bonds, and many of these factors that go way beyond what the Fed does. And I expect that those factors will reassert themselves and these real yields will go down. So people say, "Yeah, but okay, should I lock in those real yields today?" Once those real yields go down, you're going to get a bigger pop for your dollar in stocks when the real yields go down than you will in bonds.

Don't forget, as I like to say, you can explain the entire bear market this year just by the changes in the discount rates. You don't need recession, you don't need change in earnings, you don't need any of that. Just discount and some constant flow by these changing discount rates and you get to the bear market. In fact, you get more than the bear market in many cases than you've got. So those discount rates are critical when talking about what is going to happen to stocks. I can see profits go down. If the discount rate goes down, stocks can still go up absolutely under that circumstance. And furthermore, you're looking beyond the valley. Oh yeah, all right. The Fed's too tight, could cause a year recession, so I'm going to knock $10, $15 off my S&P for a year or two and then they'll loosen up and it goes back up and all that.

Well, we've talked about the fact that put that in any model and see how much stock prices should actually decline. It's a matter of just a few percent in the long run. So everything to me still points to the fact that stocks will be the bigger winner when the real rates go down. Both bonds and stocks will be winners. The stocks will be the bigger winners. Of course, one also has to recognize that as real rates go down around the world, long-term forward looking returns go down too, which for younger people is going to be a problem. For older people, who just look at the value of their portfolio, they're interested in the value. Not so much those longer run real returns, but for the younger people it goes on.

So this whole question about real yields, we are so fixated, overly fixated, on just the value of the portfolio and not on the fact that those fluctuations and the value of the portfolio are generated by real rate differences that powerfully affect your future real returns in the opposite direction. So you're never really experiencing the decline in long-term purchasing power that you think you are just because your stock portfolio is down 20%.

Jeremy Schwartz:

We had two questions come in on emerging markets. Maybe we'll try to tie them together. One was about the growing middle class, which is something you talked a lot about in the future for investors about the growth profile of these young populations that grow, catch up with the rest of the world, and what's the impact on the rest of the world markets? But another one, and I haven't heard this podcast, but somebody, Daniel, pointed out a podcast that Eugene Fama did recently.

Professor Siegel:

With my colleague at my first teaching position in Chicago, and Eugene Fama was a senior professor. He's a very well known professor, well decorated. He was a middle-aged man at that point and I knew him very well. And, of course, he got the Nobel Prize in economics and well-deserving. I have not heard his podcast.

Jeremy Schwartz:

Supposedly, Daniel says that he suggested excluding emerging markets from portfolios due to the higher geopolitical risk, among other things. And he goes on to talk about the valuations and CAPE ratios being very cheap. Do you think the geopolitical risk is underappreciated?

Professor Siegel:

Let's put it this way, we all remember, how many years ago was it, 15, 10, the BRICs? Brazil, Russia, India, China, even India has had some political problems but has still maintained basically a free economy and a pretty good growth profile. China under Xi, I mean, he's done a pivot stage one, but unpredictable. Russia, we already know under Putin. Brazil, I mean, has been a great disappointment. What's a PE in Brazil now? I mean at one point it was down to six or seven.

Jeremy Schwartz:

Yep. Close to that.

Professor Siegel:

Yeah. So it was a buy no matter what happened. And they did get through a democratic election where the strong man did concede in that election. Don't like a socialist there heading in Brazil, but I don't think they're abandoning their basic free market system there. But all of those have had geopolitical risk that have been much greater. And it's really interesting. Until Putin is out, and he will be out at some point. Did Xi get religion and turn around 180 degrees? There were three things against Xi. First there's the COVID policy, terrible, the anti-tech policy not good, the seemingly aggressive policies towards Taiwan, and that's a big question mark and a big potential negative.

So one is pivoted. We'll see how the other two play themselves out. China's still an unbelievable big market. What's its P/E now, 10, 12, Jeremy? I mean, I remember looking all the time. We were paying 40 and 50 times Chinese stocks because we thought the growth was unlimited. So a lot of that wind is out of the sails, but you're also getting a much better bargain.

Kevin Flanagan:

I was just going to say we have only about two minutes to go for the top of the hour and just thought to wrap this up with the Fed call. Professor, we just got this question in and this is perfect because I know I've had this discussion with you before. Do you have anybody's ear at the Fed?

Professor Siegel:

I wish I did. Someone said that some of my statements on CNBC, Bloomberg, and elsewhere have filtered down to some of the Fed members. Although, unfortunately, from hearing Powell's talk today, I did not hear them. But I hope those voices will get louder. Austin Goolsby, professor at Chicago, is a new Fed voting member next year from the Federal Reserve Bank of Chicago. I know that he's heard me, so maybe we'll get some fresh air.

Irene:

We'll keep trying and we do get some of the Fed people on Behind The Markets. We've had Jim Bullard a number of times. Jim was a leading indicator. Now, professor thinks he's a lagging indicator because he's now still very hawkish and overly hawkish. But professor, these are always fun conversations. Thank you for all your support and comments here. If you haven't checked out the Siegel Models, we have a lot of Siegel Income Models on various platforms. We look to be doing more with those in the new year, but there's a lot on the various firms here on this call that have access to the Siegel Income Models. So check those out as well. Kevin, any closing thoughts?

Kevin Flanagan:

No. I just think this was a wonderful summary of what is going on and a classic example of following some thoughts of what we think the Fed should be doing versus what they may do. So a lot to stay tuned for, for the new year.

Jeremy Schwartz:

It'll be fun in the new year. Thank you, professor.

Professor Siegel:

Happy holidays to everybody.