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Finance Professor Says Stock Market Is Cheap. Here’s Why He’s Wrong

Last Updated September 23, 2020 12:50 PM
Lawrence Meyers
Last Updated September 23, 2020 12:50 PM

Jeremy Siegel, a normally astute finance professor from the University of Pennsylvania, told CNBC  that he thinks the stock market has another 5 percent to 6 percent upside to reach fair value.

He’s out of his mind.

How to Determine Fair Value

Fair value in the stock market can be determined in many different ways. One of the more accurate ways to judge stock market valuation is to use the Shiller P/E ratio. This is a price-to-earnings ratio based on the average inflation-adjusted earnings from the previous 10 years.

It’s a more accurate view of the stock market because it translates earnings from 10 years ago into present-day dollar value and also smooths out the data by using a 10-year average.

As we can see from the Schiller P/E ratio chart below, the stock market is now at its second most expensive in history. A P/E ratio of 30.73 is almost twice what the long-term average has been.

A 50 Percent Stock Market Crash Is Coming

Everything reverts to the mean at some point. The only question is when that is going to happen. Consequently, according to this valuation method, the market needs to crash by 50 percent to return to the long-term average.

Jeremy Siegel believes the market may go up another 10 percent or 15 percent before selling off by about 10 percent.

The finance professor also believes that a P/E ratio of 18 is more likely to be the “new normal” as opposed to 15.

He also pointed out that there is a huge appetite for Treasury bonds around the world. As a result, because of the strong U.S. dollar, Treasuries will continue to be purchased.

That will keep interest rates low. With lower interest rates, that means the government can continue to engage in deficit spending without running up as much debt service as it had in the past.

Mind you, the national debt is now at $20 trillion. So while it may seem like the market will continue to be supported by government spending on top of consumer borrowing and spending, at some point that that is going to have to be paid down.

In order to accomplish that, the government will have to carefully modulate economic policy, fiscal policy, and monetary policy so that the robust growth we’ve been seeing does not become stifled.

The other issue is that lower interest rates force investors further out onto the risk curve in order to capture higher dividends. That means continued flow into the stock market, making a crash ever more likely.

The Biggest Concern There Is

The one concern Jeremy Siegel has is the inversion of the yield curve, which historically has forecast bad times for the economy. When shorter-term yields are higher than longer-term yields, it means investors have less confidence in older bonds. That generates fear of a recession and a possible crash.

The last seven U.S. recessions were preceded by an inverted yield curve.

What this means for investors is that valuations are extremely stretched at the same time that we are running up enormous debt and there are signs of recession.

The only way to defend against what’s coming it to have a long-term diversified portfolio across multiple asset classes. Only over the long term have we seen the stock market consistently provide positive returns.