Siegel adds he is "fairly optimistic" about the stock market, predicting a 10% to 12% return for broad market gauges like the Russell 3000 and Standard & Poor's 500.
According to Wharton finance professor Franklin Allen, home prices and the cost of oil will be key factors in the U.S. economy and financial markets. "The key thing ... is what happens in the property market -- the housing market -- and how far prices will go down," he says. The severity of the situation may depend on which geographical regions are hit hardest. "That will determine what happens in the credit markets and if there is any spillover into the rest of the economy. That will drive what happens in the stock markets."
As for his prediction on housing prices, "I think they will fall for quite a while," he says, adding that "It's been a speculative market for quite a while. No one was sure how much speculation was there, but I think what we are finding out is that there was a fair amount.... There were people who were buying because they just thought prices would keep going up."
Speculators are putting homes that cannot be sold onto the rental market, depressing rental rates so far that they do not cover the speculators' carrying costs, he notes. When it becomes much cheaper to rent a home than to buy one, there are fewer buyers and home prices drop even further, he adds, warning that property prices could fall until the cost of owning is closer to the cost of renting.
Allen also suggests that with oil having recently climbed above $100 a barrel, energy costs could play a big role in the economy and financial markets this year. "That's an interesting issue -- just how high the price of oil will go," he says. "I don't think it will go down significantly in the mid-term. I will think it would stay where it is and possibly go somewhat higher."
Allen predicts that stock-market performance will be heavily influenced by the prospect of recession, which will largely depend on the severity of the housing crisis. "The longer these house prices keep falling, the more likely it is that there is going to be a recession." At current prices, stocks will be "significantly overvalued" if there is a recession, causing share prices to fall substantially.
Meanwhile, the Federal Reserve is in a poor position to deal with the threat of recession because the standard remedy, cutting interest rates, could spark inflation, which is a looming risk because of high oil and food prices, Allen says. "With inflation picking up, the Fed has limited tools for dealing with the problem."
The behavior of long-term interest rates, which are set by the marketplace rather than the Fed, is something of a mystery, he adds. Normally, long-term rates drift upward as the Fed raises short-term ones, but this did not happen in the Fed's most recent tightening. "It's a fascinating question. I don't think we understand properly why [long-term rates] are so low." One possibility is a "flight to quality" as nervous investors move money from risky stocks to safer bonds, such as U.S. Treasuries, he suggests. The high demand pushes bond prices up, causing yields to fall.
This could change, he adds, if inflation picks up, causing long-term rates to rise. That could undermine economic growth by increasing the cost of borrowing, and it could exacerbate the housing crisis by making it harder for homeowners to get fixed-rate loans to pay off high-cost adjustable-rate mortgages. Rising interest rates, Allen says, "would be very negative for the housing market and everything else."
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