April 23, 2001

Shiller and Siegel: Two Takes on the Market

By Harris Arch

The audience's enthusiastic, passionate applause, usually reserved for movie stars and famous politicians, indicated that this event was not your typical business lecture. Before the full capacity audience at the Zelterbach Theater stood two of the finance world's heaviest hitters, Wharton professor Dr. Jeremy J. Siegel, and Yale University professor Dr. Robert J. Shiller.

These two distinguished professors discussed their differing views on asset markets in the first ever Ashish and Sapna Shah Speaker Series event, sponsored by the Joseph Wharton Scholars Program. Ashish Shah, who graduated from Wharton in 1992, was a former Joseph Wharton Scholar and assisted Dr. Siegel in research during his under-graduate years. The event was entitled, "Two Views of Asset Markets: Are Stocks Still Right for the Long Run?"

Before the professors discussed their ideas, Dr. Thomas Dunfee, Vice Dean and Director of the Wharton Undergraduate Division, quipped, "We purposely scheduled [this event] after the market close. We didn't want to have an impact on the market." Dr. Martin Asher, a Wharton professor of Finance and Director of the Joseph Wharton Scholars program, introduced the two speakers. He reminded the audience that "this is not a debate. It is a discussion."

Dr. Shiller, the Stanley B. Resor Professor of Economics at Yale, was the first to speak. Shiller said that the current stock market is seriously over-valued as a result of several structural, psychological, and cultural factors. He compared the scenario to events in history, which often have numerous, diverse causes.

Shiller described these factors in his recently published book, Irrational Exuberance. The title refers to a now famous December 1996 comment by Federal Reserve Chairman Alan Greenspan regarding the speculative frenzy of the bull market. Much of Shiller's explanations rely on behavioral finance, which analyzes investors' mindset.

The purpose of Shiller's lecture was to hypothesize as to the direction of the stock market. He asked, "Where is it going from here?"

The bulk of Shiller's argument was that certain economic trends were illogical. For ex-ample, one chart displayed the Standard and Poor 500 price relative to earnings. While earnings steadily increased in previous years, the price sky-rocketed, especially in the last bull market. Since the earnings did not explain the steep rise in price, Shiller attributed it to an instance of irrational investor behavior.

Another interesting piece of evidence was that average price to earnings ratios have been higher today than ever before. Shiller constructed a scatter plot of P-E ratios against market returns. The result yielded an inverse relationship, with high P-E ratios correlating to low or even negative market re-turns. Since many of today's stocks, particularly technology, have high P-E ratios, Shiller believes that the market will not generate the unusually high re-turns of previous years.

He explained, "It's not a new era. It's a speculative bubble that has driven the market."

The causes for the bubble were a confluence of factors. In an investor survey, Shiller detected that nearly 95 percent believed that the stock market was good for the long run, a tremendously optimistic response. Also, investors were prone to view down turns in the market as opportunities to buying at lower prices. The rise of financial media outlets was another factor.

"Every speculative bubble [has been] fueled by the media," he noted, including the infamous tulip frenzy in Holland during the 1600s.

Another cause of the bubble was the psychological theory of anchors. People tend to use precedents when making a judgment, particularly during uncertainty. Consequently, investors have been using unreason-able market levels such as the 10,000 points for the Dow as normal barometers for in-vesting, fueling the bubble even more.

Shiller concluded about the current market swoon, "My inclination is that the market is still reeling from a bubble."

Dr. Siegel, the Russell E. Palmer Professor of Finance of the Wharton School, followed with his own perspective on the market, which was more optimistic.

"I'm still bullish long run," he announced in a reference to his famous 1994 book, Stocks for the Long Run. The book is widely considered an essential for investors and was updated in 1998. A third edition is planned for release in the near future.

Siegel graphed the annual return of stocks, which averaged 7 percent, compared with a 3.5 percent return for bonds over the past 200 years. Bonds earned only half the return of stocks, and if the trend continues, bonds will earn even less in the future.

One of Siegel's primary justifications for stocks is the tendency for the standard deviation of risk to decrease overtime. In fact, in twenty years, stock risk levels were even less than bonds.

Like Shiller, Siegel analyzed the high P-E ratio of the present market. He said that the P-E ratio was a critical forecast of the market. The high P-E ratio of the technology stocks was especially alarming.

"I am still very uncertain about the valuation of technology stocks," he commented.

His explanations for the bull market were the decline in transaction costs, lower taxes, and significant real earnings per share growth. Brokerage commissions and bid-ask spreads have declined over time, to almost 0.2 percent. The cheaper costs have encouraged more in-vestments. For example, Vanguard's Index Trust, which represents all the sectors, charges only .18 percent expense ratio. The fact that capital gains taxes are at an all-time low is another incentive for investors to buy into the market. He attributed the earnings growth to reinvesting retained earnings.

He said that in order for companies to reach faster growth, they must focus on expansion and ways to lower capital requirements by replacing labor with better production and in-creasing intellectual capital. He referred to Microsoft, which has in-vested $30 billion, but has a market value nearly ten times that figure. The difference was the intellectual abilities of its employees.

Siegel's ultimate conclusion was that investors should want a combination of his bullish ideas with Shiller's bearishness. If stocks fall now, as Shiller predicts, then Siegel recommends investing to build future wealth.

Following their presentations, each professor commented on his colleague's viewpoint.

Shiller expressed reservations in Siegel's analysis of transaction costs. He said, "I'm a little uncomfortable with focusing on transactional costs and taxes, not behavioral finance."

Siegel responded that he certainly does believe in behavioral finance as "dominant in the short-run."

From the thunderous applause and strong interest of the audience, the first Ashish and Sapna Shah Speaker Series event kicked off with an impressive start. The two professors, among the best in their profession, provided substantial proof for their ideas.

While they certainly differed on some points, Shiller captured the tone of the event best when he said, "Jeremy and I see eye-to-eye."