Disagreeing with Jeremy Siegel

Jeremy Siegel wrote an article in the Wall Street Journal ($) yesterday about Alan Greenspan’s now famous “irrational exuberance” phrase. Siegel asks the questions

Should Mr. Greenspan have acted against the rising stock market when he made his famous "irrational exuberance" speech?

Then answers it.

Now that we have 10 years of economic and financial data, we can now accurately determine whether the market was indeed "irrationally exuberant" in December 1996. The answer is decidedly no. Had the market been overvalued, it would have shown poor return in the following decade. But it did not.

This is an interesting conclusion, and it begs a few points.

First, why is 10 years the demarcation for which the market is judged? Why not look at 6 years? Why not 16?

Second, the statement assumes that we have worked through the excesses of the bubble. Perhaps we have, I don’t know. However, when commercial real estate deals are being done in Manhattan at 1% cap rates, when commodities are or were at all time highs, when real yields on bonds stay low, when the 10 year hits 50-year lows, when housing prices double in six or seven years, etc., etc., one might come to the conclusion that the symptoms which caused the bubble have not yet worked through the global financial system. In other words, we may not be out of the woods yet.

Third, stocks may or may not be expensive currently. Stocks are trading at ~15x forward earnings, which isn’t expensive. However, corporate profit margins are at highs not seen since the 1960s while income accruing to labour is hitting lows. This condition may not be sustainable. The results of the recent Congressional elections were at least a partial response towards the widening disparities between the gains accruing to capital and labour. If this continues – and due the rise of China, I believe it will to some extent – then stocks are not expensive. However, if incremental gains begin to accrue back to labour – either through the forces of economics or through the political arena – then earnings growth is going to slow, and we may not be so sanguine about returns to stocks another 10 years from now.

Fourth, Siegel assumes that if Greenspan had raised rates to deflate the Bubble the outcome would have been worse. We don’t know. Perhaps the collapse of Asia would have been softer. Perhaps the collapse of Long Term Capital Management would not have occurred. Perhaps the Bubble would not have grown so big and the after-effects would not have been so painful to so many people, and so on Admittedly, we can only deal with what has occurred. But to conclude definitively at this point is, in my opinion, hasty given that history may not be finished.

Finally, I don’t recall professor Siegel or anyone other economist saying that China was about to storm onto the world stage and have such a large effect on the global economy. It may be that Greenspan’s inaction was one of wise prescience. Or maybe he was just lucky.

Professor Siegel continues

The compound rate of return from Mr. Greenspan's speech through the end of November 2006 on the broadest index of U.S.stocks, the Dow Jones Wilshire 5000 Index, was 8.2% per year, while the return on the Dow industrials was even higher. International stock returns have been almost as good, with the Morgan Stanley EAFE index of international stocks returning 7.6% per year. All these returns include the bear market of 2001-2002 and were far greater than what was available on government bonds or cash over the last 10 years. Even taking inflation into account, these rates of return were very close to that achieved in long-term equity studies. There is no evidence that the market was overvalued at the time of Mr. Greenspan's speech.

That very well may be, but there was no doubt certain parts of the market were egregiously overvalued, foreshadowing what was to come as nascent companies such as Netscape were soaring into the stratosphere.

Professor Siegel’s next statement really caught my attention.

So what happened to the stock bubble? In fact, the data show it did not start until late 1998, two years after Mr. Greenspan's warning of "irrational exuberance." And the exuberance was entirely concentrated in the technology sector, represented by the Nasdaq Composite Index. Tech stocks soared in 1999 and early 2000 in wake of the Internet mania and the surge in IT spending associated with the Y2K computer scare. This was the stock bubble that I and many others warned investors about.

The evidence also shows that non-tech stocks were never in a bubble, neither in 1996 nor when the S&P 500 Index reached its peak in March 2000. If one takes tech and the tech-related telecom stocks out of the S&P 500, the remaining stocks were actually depressed when the tech stocks hit their peak. From March 10, 2000, when the S&P 500 hit its all-time high, through the end of November this year, an index of all non-tech stocks experienced a very healthy annual return of 8.2%, indicating no overvaluation whatsoever when the popular averages, bloated by the tech bubble, reached their peak. [Emphasis added.]

I beg to differ with the good professor. Much of the rest of the market was dramatically undervalued – small cap value stocks have outpaced big cap tech stocks by triple digits since the Bubble collapsed. However, it wasn’t just tech and telecom (and media) related stocks that were in a bubble – big cap growth stocks were also way overvalued. The bubble wasn’t just in tech, the bubble was also in large cap growth.

At the end of the decade, Paul Volcker said that the global economy depended on the fate of 50 stocks, half of which had no earnings. So I went back and looked at the 50 biggest (more or less) stocks at the time.

Of the 50 largest by market cap on March 31, 2000, 20 were tech and new-age telecom stocks. The 30 remaining were as follows;

AIG
American Home Products (now Wyeth)
American Express
Amgen
AT&T (purchased by SBC)
Bank of America
Bell Atlantic (now Verizon)
Bellsouth
Berkshire Hathaway
Bristol Myers Squibb
Chase Manhattan Bank (now JP Morgan)
Chevron
Coca Cola
Disney
Du Pont
Eli Lilly
Enron
Exxon Mobil
General Electric
GTE (merged with Bell Atlantic to create Verizon)
Home Depot
Johnson & Johnson
Merck
Morgan Stanley Dean Witter
Pfizer
Procter & Gamble
SBC Communications (now AT&T)
Wal-Mart
Warner Lambert (purchased by Pfizer)
Wells Fargo

From March 31, 2000 to December 7, 2006, excluding dividends and dispositions from spin-offs, these 30 stocks on average returned -0.2% annualized, or -1.2% in total.

However, the returns for the more expensive stocks were even worse. Eight stocks – Bank of America, Chevron, Du Pont, Chase Manhattan Bank, Morgan Stanley, Proctor & Gamble, SBC Communications, and Wells Fargo – had trailing price/earnings ratios of less than 20x at the end of 2000. (We’ll call this the “Value” group.) Berkshire Hathaway was trading around 1.5x book value and is generally not valued on earnings so I included Berkshire in the Value group. I also excluded the pre-merger AT&T, Enron, GTE and Warner Lambert because I didn’t have sufficient data (the “Missing Data And I’m Too Lazy To Find It” or “MDAITLTFI” group.) Of the remaining 17 stocks (the “Growth” group) which all had PEs greater than 20x, the average return was -1.3% annualized, or -8.3% in total.

Eight stocks (the “Can’t Miss Growth” group) had PEs greater than 30x – AIG (33x), Amgen (61x), GE (46x), Home Depot (31x), Coke (36x), Pfizer (41x), Wal-Mart (42x) and American Home Products (30x). Note that those weren’t fly-by-night, talking-sock-puppet-type companies. Near as I can tell, pretty much all of them are still around.

Anyways, the returns for Can’t Miss Growth – with an average PE of 40x – was -2.6% annualized, or -14.4% in total. Poor stock performance certainly wasn’t due to poor earnings performance. On average, earnings growth from 2000 through 2005 for those eight was 14% per annum for five years, compared to 7% for the entire group of 30.

But we’d be intellectually dishonest if our only yardstick was the return from the top of the market to today. We should also look from the top to the bottom since investments are not only about returns, but also about volatility, and we’d be remiss if we didn’t fondly remember the pain investors experienced as the “non-bubble” unwound.

The bottom of the S&P 500 occurred on October 10, 2002. From March 31, 2000 to October 10, 2002, the entire group fell on average 31%. The Growth group fell 27% and Can’t Miss Growth fell 28%. Only five stocks were up while 25 were down, ranging from +19.2% for Berkshire Hathaway to -100% for Enron.

So, Professor Siegel, I have read your book and many of your articles, but I respectfully disagree when you say only tech and tech-related telecom were in a bubble.

- Edited to include Enron.  T.

Comments

[Henry P]

I don't disagree but I would like to do this study again removing the excesses in earnings caused by accounting fraud, stock options, restatements, backdating, etc. etc. Investors have been lied to and part of the increase in stock prices is without a doubt inflated by these excesses.