Jeremy Siegel: Stocks for the Short Term

We have featured the work of Wharton Finance Professor Jeremy Siegel on a number of occasions and are doing so again to get some badly needed perspective on what is, by all objective accounts, a very confusing current market picture.

Siegel’s work has both adherents and detractors, but it’s hard to argue with his data. His most famous work may be the following bit of pictorial pulchritude:

Plotted on log scale so that percentage gains are apparent (rather than nominal gains), Siegel has traced the value of a single dollar invested in a number of asset classes from 1800 until the present. His findings are shown on the chart above.

In short, a dollar invested in stocks has produced gains that dwarf all other asset classes. On average, equities have returned 7% per year for the last two centuries. Cash has become worthless, while gold, interestingly, has proven itself a near perfect store of value. One dollar of gold purchased in 1800 has returned nearly exactly that – one dollar nineteen cents. (This may be the most compelling argument for those who maintain that gold is the ultimate hedge against inflation.)

Whether or not any of these trends will continue into the future is a point of debate for another time. What is most interesting for us at this juncture is the absolutely straight regression line that marks the return in equities over the period in question. It is to this straight line that we now turn our attention.

A Truer Regression to the Mean?

Many of the arguments of the investment world’s perma-bears center around the phenomenon of “regression to the mean,” a perfectly legitimate line of reasoning that states:

1. that there is a verifiable, historical statistical norm, and
2. that deviations from that norm are eventually corrected such that
3. the long term historical trend remains in force.

The bears employ this argument with respect to dividend yields, P/E ratios and a host of other metrics to prove that the market is out of whack and has to fall before we can be sure that it’s safe to own equities again.

Nothing wrong with that.

Until Professor Siegel comes along with his charts and explains otherwise. According to him (via the chart above), the regression line that is most significant to equity ownership has, in fact, been adhered to remarkably well for hundreds of years, and we needn’t worry about doing anything but buying equities and holding them for the long term.

Here is another look at his equity return line for the last 40 years.

What can be seen here are the dips and jabs above and below the regression line that mark the overbought and oversold moments in market history since 1970. Deeply oversold markets in 1974 (40.7% below trend) and 1981 (40% below trend) were only worsted by the grand-daddy bear market of 1932, which brought equities 42% below trend (not shown).

Until now.

Siegel’s research shows that the 2008 bear market has brought stocks 43.1% below trend, pointing to a bear market relatively worse than anything we have seen for the last 200 years!

Does that mean stocks will not fall further? Absolutely not. Things can fall apart (as nearly everything eventually must). And we have certainly entered a new era where the results of unprecedented central bank meddling will reap consequences unknown, unintended and likely dire. But, at the same time, investors must also be aware that two hundred years of history has a momentum of its own – and must also be reckoned with.

Therefore, should we regress to the mean that Professor Siegel’s work points us toward, we could be witnessing the S&P 500 back between 1200 and 1400 in no time.

Conversely, Siegel’s work indicates that there’s no historical precedent for indexes to fall significantly from these levels. Figure out what history means to you, and take that for what it’s worth.

Option Strategies for the Siegel-Wise

If Siegel’s data and the conclusions drawn from them make sense to you, there are some fairly straightforward options strategies that could net you (limited) profits while at the same time minimizing your risks.

We would recommend bull put spreads on the SPY with a nice cushion on them – earliest expiration April. That should give the market time enough to find its feet. And be sure both strikes chosen are below the November lows of 75.

For those who’ve never traded them, there’s lots of liquidity in the SPYs. Pick the credit spread of your choice (and the amount you’re willing to risk) and set up shop.

If the Siegel pop comes as we expect it should, you’ll walk away with your chosen credit easily.

“Our ignorance of history causes us to slander our own times.” – Flaubert

Disclosure: no positions

Comments

[Hefaistos:]

Another premature bottom call, which I highly doubt is sanctioned by Prof. Siegel...
Why? well, if you look at the stock market in total isolation, in a pure TA perspective, as is done here, you COULD come to such conclusions.
However, as is well known, the reason that we have this long-term trend, and mean reversion to it, is that the stock market is strongly linked to the development of the real economy, i.e. GDP growth. From that follows the growth in profit generation that drives the stock market.
Now, I think it is entirely premature to talk about any reversal as long as we have the situation we have in the real economy: Recession for maybe another year. Monetary politicy in completely uncharted waters. A banking system in ruins. Etc.

Hold your horses, it's too early for the recommended "bull put spreads on the SPY".

Jan 23 05:16 AM

[bobbobwhite:]

Just how long can we expect the USA to be a high growth country? And, more important than that growth, what happens to investment yields when no growth is the on-going and standard econ. situation?

America has been a high growth country, especially in the past 63 years. But, that could be mostly over now as we have known it, as newly developing countries will now grow much faster than we, and America will be left behind to deal with the bitter consequences of its decayed civil infrastructure, overloaded-to-ineffect... social services, greedy and corrupt politicians and business people as a way of life, moronic entertainment/media worshipers putting it above God, and an apathetic and sheepish public which has grown nearly immune to any feeling, thinking or resultant outrage and action over what has been so obviously done to spoil the best country the world has ever known.

Jan 23 02:26 PM

[X-15:]

Bobwhite - USA has had periods of corruption before. This could be more serious- but hey, Canada,Australia,China... Korea,Japan, Brasil, Chile need investor input, while the USA twists in the wind for a while.

Reap what you sow.

Jan 23 11:42 PM

[Robert H. H...:]

Thanks for the article, but I advise caution.

Siegel's graph indeed shows that US equities -- held for a sufficiently long time -- have delivered higher real returns than bonds, bills, gold or cash. That's utterly consistent with modern financial theory that says that investors demand (and historically have received) a higher expected return for bearing the higher risk of owning equities.

Siegel's work also suggests that one can diversify much of the short-term volatility of equity risk by holding equities for a sufficiently long time, much as one can diversify idiosyncratic equity risk by holding a portfolio of stocks rather than one or two names.

But keep in mind that a plot of an ordinary least squares regression line through a data series that follows a random walk will always exhibit apparent cases of “regression to the mean” over some time frequency. That’s in the nature of the math, and not necessarily indicative of a mean-reverting tendency of the process being analyzed. True, Siegel claims that US stock returns exhibit a mean-reverting tendency because the decline in the standard deviation of average annual terms over lengthening holding periods is lower than one would expect in a true random walk. But note that this phenomenon manifests itself when you consider holding periods of five years or longer. (1) As Siegel puts it “…[US] stocks… have never offered investors a negative real holding period return yield over periods of 17 years or more.” (2)

This is not to say that the chart is uninteresting. A plot of major US market indices shows long periods (18-25 years) of below- and above-trendline performance, which might be suggestive of changing investor tastes or demographic trends playing out on generational time-frames. But again, caution is in order here. If you have 200 years of data to evaluate 20-year trends, you have only ten independent data points.

As regards a short-term market call, your excerpted chart shows that the “regression to the mean” that followed the “oversold” market in 1974 took 20 years to regain the trendline. These facts and indeed Siegel’s advice against market-timing hardly seem consistent with a recommendation for a short-term trade, even one with a “nice cushion” of 750 on the S&P and a holding period all the way out to April.

Finally, I doubt any of this provides comfort to an investor who loaded up on Japanese equities in 1989 with the Nikkei Dow at 38,000. Unless Japanese stocks increase four- to five-fold this year, Japanese investors from 1989 are facing a twenty-year holding period with a significantly negative return.

(1) See Siegel, Stocks for the Long Run, 2nd edition; page 32, figure 2.4

(2) Ibid., at 26

Jan 24 01:36 PM

[Jim Hawthorne:]

As Siegel puts it “…[US] stocks… have never offered investors a negative real holding period return yield over periods of 17 years or more.”

Nonsense! Stocks in the DOW bought in July 1929 (assuming they never went to $0.00 as many did) took until 1954 to regain their price... NOT adjusting for inflation!

Bobwhite raises several important issues, to which can be added the huge super debt bubble that has financed our imaginary super-growth since WW2.

Yes, the key question is, 'Will past performance provide indicative guarantees of future returns? If so, the mighty DOW better get a move on!

It should be standing at over 21,000 by now based on the trendline formed on your 1970-2009 chart! (above) The days of 'buy and old' may return one day, but today is not the day!

Jan 31 10:01 PM

[Robert H. H...:]

Jim Hawthorne -

You're right that the 1929 peak for the DJIA was not recovered until 1954.

Siegel's calculation includes reinvestment of dividends and is inflation-adjusted. As a consequence of the market decline in the the 1930's, dividends were meaningful. And of course, the first half of the 1930's were deflationary, so it is reasonable that on a inflation-adjusted basis, with dividends reinvested, an investor in 1929 would have been "back to even" by 1946.

Feb 01 10:52 PM

[Robert H. H...:]

The past five weeks since this article was written have almost perfectly illustrated why time horizons matter when it comes to stock investing. The day this article was posted the S&P 500 closed at 831.95. As I write (mid-day March 2) the S&P 500 is trading at 714.17, a decline of 14.2%.

While Siegel's work suggests some regression to the mean in stock returns of very long time horizons, it is dangerous to assume that holds true over short holding periods.

Mar 02 11:10 AM

[dzager@comc...:]

Mr. Heath: I agree with your analysis about the limits of this kind of regression analysis. I also have been haunted by the low rate of return for Japanese stocks over the last 5 of its last 20 year holding period. It would be interesting to see a Japanese stock trendline over the last 100 years. It would be interesting to see other country trendlines over the last 100 years and to see a regression analysis of how global securities have fared over the very long term and how typical or untypical U.S. long term holding periods are for superior stock returns. Is a superior U.S. return on average every 12 years different or within the data set for stocks of other countries. How do global stocks individually do over 25 year periods? Are there differences for Japan or any other European country or Canada? It would be also interesting to see how currency or individual country inflation affects the data set and what other variables such as GDP growth you identify and other exogenus factors might explain the data set for holding stocks. Is there a universal conclusion about stocks for the long term? Does studying global stats close in on the question of what is the long term? Are you familiar with any studies in this regard? Perhaps Professor Siegel is familiar with some definitive global studies?

On Jan 24 01:36 PM Robert H. Heath wrote:

> Thanks for the article, but I advise caution.
>
> Siegel's graph indeed shows that US equities -- held for a sufficiently
> long time -- have delivered higher real returns than bonds, bills,
> gold or cash. That's utterly consistent with modern financial theory
> that says that investors demand (and historically have received)
> a higher expected return for bearing the higher risk of owning equities.
>
>
> Siegel's work also suggests that one can diversify much of the short-term
> volatility of equity risk by holding equities for a sufficiently
> long time, much as one can diversify idiosyncratic equity risk by
> holding a portfolio of stocks rather than one or two names.
>
> But keep in mind that a plot of an ordinary least squares regression
> line through a data series that follows a random walk will always
> exhibit apparent cases of “regression to the mean” over some time
> frequency. That’s in the nature of the math, and not necessarily
> indicative of a mean-reverting tendency of the process being analyzed.
> True, Siegel claims that US stock returns exhibit a mean-reverting
> tendency because the decline in the standard deviation of average
> annual terms over lengthening holding periods is lower than one would
> expect in a true random walk. But note that this phenomenon manifests
> itself when you consider holding periods of five years or longer.
> (1) As Siegel puts it “…[US] stocks… have never offered investors
> a negative real holding period return yield over periods of 17 years
> or more.” (2)
>
> This is not to say that the chart is uninteresting. A plot of major
> US market indices shows long periods (18-25 years) of below- and
> above-trendline performance, which might be suggestive of changing
> investor tastes or demographic trends playing out on generational
> time-frames. But again, caution is in order here. If you have 200
> years of data to evaluate 20-year trends, you have only ten independent
> data points.
>
> As regards a short-term market call, your excerpted chart shows that
> the “regression to the mean” that followed the “oversold” market
> in 1974 took 20 years to regain the trendline. These facts and indeed
> Siegel’s advice against market-timing hardly seem consistent with
> a recommendation for a short-term trade, even one with a “nice cushion”
> of 750 on the S&P and a holding period all the way out to April.
>
>
> Finally, I doubt any of this provides comfort to an investor who
> loaded up on Japanese equities in 1989 with the Nikkei Dow at 38,000.
> Unless Japanese stocks increase four- to five-fold this year, Japanese
> investors from 1989 are facing a twenty-year holding period with
> a significantly negative return.
>
> (1) See Siegel, Stocks for the Long Run, 2nd edition; page 32, figure
> 2.4
>
> (2) Ibid., at 26
>

Mar 22 11:55 AM