[By Zhou Tao/Shanghai Daily]

Editor's note:

T he Dow has hit its highest level in years, loan rates are at record lows and the US economy appears to be gaining momentum. But is this a real recovery - or a false start like last year's?

Wharton finance professor Jeremy Siegel and Scott Richard, a Wharton practice professor of finance, think the economy is showing signs of a true rebound and predict that stocks should do well in the next 12 months.

Q: Should we believe there is an improvement, or should we not believe it?

Jeremy Siegel: (Last year) it was a head fake. I think things are far more real now. The employment numbers are much better; the private payroll expansion is much better.

Take a look at even home building, because that has been the most depressed area. Figures from the National Association of Home Builders are suddenly moving up. That was dead last year.

Scott Richard: I agree with that. We are in the beginning of a serious recovery, both in jobs and in output. And I expect stock prices and bond prices will react accordingly, with the bond market going up in yield and down in price.

Q: Professor Siegel, we've talked about the gears and levers inside the market that you look at to see what's going on - things like price-to-earnings (PE) ratios and so on. What are you looking at now?

Siegel: The two things that are important are cash flows and the discount rate - which for stocks are earnings, basically, and the interest rate environment in which you find those earnings. It was very favorable last year. Actually, it is more favorable, to me, this year because interest rates are a lot lower now - especially those long-term interest rates - than they were a year ago. So the PE ratio is about the same as a year ago: 12 to 13, as we had last year.

Q: That's forward looking?

Siegel: Yes, that's the forward looking in the next 12 to 13 months, which is lower than the long run average of 15, and in what is in some ways a record low interest rate environment.

So the question is, what about those alternatives out there that are not attractive at all. A lot of people tell me nowadays, "Well, Jeremy there's not just bonds out there. There's all these other assets that they talk about, and commodities and private equity and venture capital and all the rest."

But you shouldn't be fooled. I'm sure that Scott will agree that fixed income is still the biggest asset class that you have to compare these alternatives to. Fixed income is the big comparison there, and the comparison is extraordinarily favorable.

Q: So with PE ratios low, the risk level of stocks looks relatively low, and you can make nothing in bonds or anywhere else.

Siegel: Of course when I say risk level in stocks, I mean they could go lower. The bears like to point out, "Well, Jeremy, we had PE ratios of seven and eight back in the late 1970s and 1980s." And I say, "Yeah, and that's when interest rates were 15 percent and 20 percent and there was a lot of competition there." There isn't any competition. So to see a PE ratio of 13 in an extraordinarily low interest rate environment is really extraordinary.

Q: And that's a positive sign?

Siegel: Extraordinarily positive going forward. I think people are beginning to put their toes in the water and buy a little.

Q: Given what the market has done over the last few years, would it be a good period to look back at to compare how stocks are doing?

Siegel: Well, that this period is not unlike the 1950s.

In the mid-1950s, we had very low interest rates and low valuation of stocks. People were very frightened then. They still had memories of the Great Depression and the tremendous stock collapses that happened. They didn't believe the post-war recovery was real because so many economists were talking about a relapse into another depression. The fear was there.

And if you remember, that was one of the best times to start accumulating stocks and one of the worst times to start buying bonds.

Q: So it would be risky to be sitting on the sidelines now?

Siegel: I think you're missing out on great values in stocks, even in terms of the dividend yield. This is the first time since the 1950s that the dividend yield on the S&P 500 has been higher than the 10-year government bond. And stocks have growth and inflation hedge properties that the bonds don't have. If you want the inflation hedge properties in the bonds and you go to TIPS (Treasury Inflation-Protected Securities), their yields are negative - incredibly so, in my opinion.

Q: So a person who is in or near retirement, should really consider dividends as a source?

Siegel: Good blue chip dividend paying stocks, low PE dividend paying stocks - that's going to be your best answer.

Q: What worries you the most?

Siegel: I'm not happy about rising oil prices.... Any sort of war in the Gulf that could send oil up to US$250 a barrel is obviously a threat out there. A longer-term threat is - and I don't see this happening - if the emerging markets stop growing.

Richard: You have two billion people in the last 20 years who have come out of abject poverty into the cash economy and huge growth in the middle class in India and China. That's nothing but good news. I don't see anything that will cause that to derail, unless their governments adopt very bad policies.

Adapted from China Knowledge@Wharton, http://www.knowledgeatwharton.com.cn.