Jeremy Siegel Q&A on S&P 500 Valuation

At the CFA Institute at Baltimore, we had the pleasure of having Jeremy Siegel come speak to us this past Thursday.  He was lively, engaging, and utterly convinced of his theses.  Thanks to WisdomTree Investments for helping fund the endeavor.

Jeremy Siegel Q&A on S&P 500 Valuation

He openly asked us to poke holes in his theories.  This article is an effort to do that.

1) Stock tends to get bought in when it is undervalued, and sold via IPOs when it is overvalued.  Thus the time-weighted rate of return exceeds the dollar-weighted rates of return by a few percent.  This dents the main premise of “Stocks for the Long Run.”  Buying and holding is not possible, because valuable stocks are lost at the troughs, giving us cash, and we are forced to buy more near peaks, of overvalued stocks.

Dollar-weighted returns are what we eat, and they don’t vary much versus time-weighted returns when considering bonds or cash.

Also, in the present day, private equity plays a larger role, and they exacerbate the degree to which stocks get IPOed dear, and acquired cheap.

2) He spent a lot of time defending the concept of the CAPE Ratio, but not its execution.  He began a long argument about how accounting rules for financials were behind the drop in earnings for the S&P 500 (.INX), and that American International Group Inc (NYSE:AIG), Bank of America Corp (NYSE:BAC), and Citigroup Inc (NYSE:C) were to blame for all of it.

Sadly, he seems not to know financial accounting so well.  What was liberal in the early and mid-2000s was corrected 2007-2009.  In aggregate the accounting was fair across the decade.  Remember that accounting exists to try to measure change in value of net worth across short periods, and net worth at points in time.

Really, if we were trying to be exact, when a writedown occurs, we would spread it over prior periods, because prior accounting was too liberal – the incidence of the loss occurred over many years prior to the writedown.

Thus I find his argument regarding specialness of financial company accounting to be bogus – he is just searching for a way to justify valuations off of current earnings, rather than off of longer term measures.

3) The longer–term measures agree with CAPE:

  • Q-Ratio
  • Market Cap/ GDP
  • Price-to-Resources
  • Financial Stress indexes
  • Eddy-Elfenbein’s Stock Market if valued like a bond measure

All of these point to an overvalued market.  But markets can be overvalued for a while.  Why might that be in this case?

4) Because profit margins may remain high for some time.  In an era where the prices for labor and resources are cheap, should it be surprising that profit margins are high?  Those conditions will eventually change, but not soon.

With that, I would simply say that:

  • Stocks do outperform bonds and cash over the long run, but not by as much as Dr. Siegel thinks.
  • Stocks are overvalued by long-term balance sheet-oriented measures at present.
  • But stocks may stay high because profit margins are likely to stay high – there will be regression to the mean, but not now.

Finally I would note that he was one of the most graceful and generous speakers to come speak to us in some time, took a long Q&A, staying longer than he needed to, and happily signing the books he had written.  I showed him my First Edition version of his book, signed by him after speaking to the Philadelphia AAII chapter in 1995, and said, “We were much younger then.”  He smiled and said, “Yes, we were.”

I may disagree with him on some points, but he is one very bright and personable guy.

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.