Systematic Relative Strength

Jeremy Siegel - March 14, 2000

On March 14, 2000 Professor Jeremy J. Siegel of the Wharton School penned an article in the WSJ titled “Big-Cap Tech Stocks Are a Sucker Bet“ in which he argued that tech stocks were overvalued and should be avoided:

Until yesterday’s sell-off the Nasdaq Stock Market had enjoyed quite a run, surpassing 5000 for the first time even as the Dow Jones Industrial Average went through a correction. But are the high valuations of the tech stocks that drive the Nasdaq index justified? History Suggests not.

Included in that article was the following chart. Look at those P/E ratios!

Siegel continued:

Many of today’s investors are unfazed by history-and by the failure of any large-cap stock ever to justify, by its subsequent record, a P/E ratio anywhere near 100.

What does all this mean? Our bifurcated market has been driven to an extreme not justified by any history. The excitement generated by the technology and communications revolution is fully justified , and there is no question that the firms leading the way are superior enterprises. But this doesn’t automatically translate into increased shareholder values.

Professor Siegel’s call turned out to be prescient. As of this writing the Nasdaq index remains 56% below its value of 5,048.62 achieved just days before Siegel’s article appeared in the WSJ over 10 years ago.

Jeremy Siegel - August 18, 2010

Well, Professor Siegel is at it again with his article, “The Great American Bond Bubble“ in the August 18, 2010 WSJ. My emphasis added.

Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago.

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.

We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.

Those who are now crowding into bonds and bond funds are courting disaster. The last time interest rates on Treasury bonds were as low as they are today was in 1955. The subsequent 10-year annual return to bonds was 1.9%, or just slightly above inflation, and the 30-year annual return was 4.6% per year, less than the rate of inflation.

Furthermore, the possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?

With future government finances so precarious, private asset accumulation and dividend income must become the major sources of retirement funding. At current interest rates, government bonds will not be the answer. One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.

How long will the bond bubble go? I don’t know. Last time Siegel made such a call he was within days of the top. Given the strength in bonds, many of our tactical asset allocation models currently own some bonds. However, I take great comfort in knowing that relative strength models have the flexibility to reduce or even eliminate (depending on the model constraints) any asset class that deteriorates and loses sufficient relative strength. As Siegel points out, all the investors who are giving up on other asset classes and piling into bonds for their perceived safety may well be sorely disappointed in the coming years and decade.

HT: Joel Chitiea