What Keeps Me Awake
The European financial crisis is likely to cause some countries to default on their debt.
Everyone knows that I am a long-term bull on the stock markets and that I believe stocks will deliver excellent returns for investors. Yet I'm often asked what keeps me up at night and could change my bullish outlook.
There are a number of scary scenarios, starting with another debt crisis, originating either in commercial real estate, sovereign countries (particularly in Europe) or the municipal-bond market. I am no longer worried about a real estate-induced crisis. The decline in the price of residential and commercial real estate has already been reflected in the price of bank stocks, even though some banks have not fully written down the price of nonperforming assets. We know this is true because bank stocks are extremely cheap relative to their book value (assets minus liabilities) on a historical basis.
The European financial crisis is likely to cause some countries to default on their debt, and it could even cause a breakup of the euro currency area. I have consistently doubted the sustainability of the European Economic and Monetary Union, which includes far too many countries with disparate fiscal policies to form a successful common currency. Defaults or an exchange breakdown would cause some severe short-term disruptions. Nevertheless, European stocks are selling at a price-earnings ratio that's 20% less than the P/E of comparable stocks in the U.S., so any market slide is apt to be short-lived.
Excessive state- and local-government debt is also a concern. Mutual funds hold more than $850 billion in municipal debt, with $350 billion concentrated in money-market funds. If municipal defaults started a run on these funds, it could give the stock market fits. But the Fed would likely offer guarantees to fund investors, and the federal government would likely rescue states in peril. Does anyone doubt that President Obama would pressure Congress to bail out California, the state that gave him the most electoral votes (see Golden Opportunities in the Golden State)?
Of course, many investors worry more about our enormous federal deficit than our state and local obligations. But most of our current federal deficit is due to the recession and will shrink significantly when the economy recovers. In the long run, Medicare is the huge budget buster. Fixing it will require a fundamental reworking of our entitlement programs, but that won't threaten stocks in the near future.
If there's one thing that keeps me up at night, it's the threat of a terrorist attack -- particularly one that involves nuclear material in a city such as New York or a major European or Asian capital. A nuclear strike would be catastrophic not only because of the loss of lives and property but also because of the extraordinary security measures that would be taken to avoid a future attack. Those measures would restrict freedom and increase government regulation, neither of which would be good for stocks or private enterprise.
No backlash. But let me leave investors on a cheerier note. In the aftermath of the recent financial crisis, there was the real possibility of a strong reaction against capitalism. Fortunately, such a backlash didn't materialize. In fact, elections in the U.S. and around the world indicated a swing to the right as the public rejected the thesis that government could replace private enterprise in running the economy.
That doesn't mean the American public is happy with the state of affairs in the U.S. But despite anger directed at the investment banks that sold subprime mortgage-backed securities, most Americans aren't blaming our free-enterprise system for our current woes. The U.S. has faced many crises that have disturbed the sleep of numerous investors. Yet we've always surmounted them and rewarded those who stuck with stocks. I see no reason the future should be any different.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.