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Economic Outlook: What Has Changed and What Has Not By Jeremy J. Siegel We hear that September 11, 2001, changed everything. Certainly, the terrorist attacks have shattered our belief that we Americans are safe in our own country and that suicide bombers and other nasty events only happen in foreign countries. But this is not the first time anxiety has hung over America. The acquisition of nuclear bombs first by the Soviet Union and then by Red China, the proliferation of intercontinental ballistic missiles to deliver them to America soil, the Russian launch of Sputnik and the Cuban missile crisis all caused Americans anxiety. Yet none of these stopped our economy or caused permanent damage to our economy or stock prices. That said, there is no question that in the short run our economy will be negatively affected by the terrorist attacks. Production is centered on the ability to anticipate consumer demands. When a shock like September 11 occurs, demand patterns change radically - the demand for travel and related services fall while the demand for security rises. It takes time for both the government and the private sector to adapt to these changes although at this writing an impressive arsenal of government monetary and fiscal ammunition has been brought into play. There is no reason why, in the long run, the level of corporate profits should be influenced by the terrorist attacks.
Stock Outlook In the coming months pessimists will say that stocks are not a good buy because although prices are falling, earnings are falling faster. This means that the price-to-earnings ratio, that fundamental yardstick of valuation, is rising rather than falling. But high P-E ratios do not necessarily signal danger ahead. I have looked at all the peaks in the P-E ratio over the past 100 years. These peaks are caused by one of two factors: either stock prices are surging or earnings are falling. If the peaks in the ratio were caused by surging prices, that did portend bad stock returns in the future. Over the next five years, returns after inflation in those cases were a measly 1.1% per year. But if collapsing earnings caused the peaks of the P-E ratio, the opposite was true; real returns averaged nearly 10% per year over the next five years. The reason is that stocks have been historically good buys in recessions. The peak of the P-E ratio in early 2000 was caused by surging prices and that peak correctly forecast a weak stock market. But falling earnings will cause P-E ratios to rise over the next year, and that has historically foretold higher returns. A second favorable prognosticator for stocks is lower interest rates. The aggressive action by the Federal Reserve to lower rates is very positive for stocks. There is little doubt that the terrorist attacks have increased the risk premium or extra return that stockholders demand above the return on safe government bonds. An increase in the risk premium can be accomplished either by increasing expected future stock returns, which entails falling stock prices, or by lower yields on government bonds, or some combination of the two. By lowering short-term rates the Fed has provided for a higher risk premium without forcing all the adjustment onto stock prices. All of this does not mean that there are not substantial short-term risks in the equity market. In fact, as of this writing, stock prices have run up to their pre-September 11 levels, despite an unmistakable worsening in the economic outlook. Stocks are nowhere near the dirt-cheap levels they were at the bear market bottoms in 1974 or 1982. Furthermore the early post-attack readings on investor sentiment have remained remarkably stable. Usually stock market bottoms are marked by much more bearish sentiment.
Real Estate Outlook Residential real estate will hold up much better. I believe high-end residential real estate will be impacted by what happens to the stock market. Low-end residential real estate will be impacted by what happens to the unemployment rate, which is most certainly headed upward. It is apt to be the mid-level real estate where values will hold up the best, since jobs are relatively secure and stock market wealth is not as critical to these borrowers.
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