Bond market guru Bill Gross thinks that investors are going to be disappointed by stocks in the years ahead. In fact, Bill Gross thinks that investors have fallen under the spell of a "cult of equity" and the returns from stocks over the past century are akin to a Ponzi scheme.
In his most recent investing outlook, Gross writes (emphasis original):
Yet the 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy's GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)? The commonsensical "illogic" of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world!
Now before you jump to conclusions, I should note that Gross isn't using this view as a way to hype bonds as an alternative. He has a similarly dour outlook on the returns from bonds. The only thing that Gross seems truly bullish on is the potential for central banks to attempt to revive the economy through inflation-creating loose monetary policy. And Gross is definitely bearish on that.
Gross is a brilliant investor and when he speaks, the market listens. But when it comes to his view on stocks, Gross has it dead wrong.
Starting from the top
One of Gross' primary concerns is his view that the rate of return investors are expecting is vastly out of whack with what the U.S. is capable of producing in terms of GDP growth. And Gross emphasizes that, over the long term, the total return of stocks should be consistent with U.S. GDP growth (that's wrong too, but we'll get to that later).
A quick look at the companies in the Dow Jones
|Company||Market Cap||Percentage of Non-U.S. Revenue|
Source: S&P Capital IQ.
*Non-U.S. revenue excludes non-U.S. Americas.
As you can see, these companies do a significant amount of business outside of the U.S. And while that may allow them to take advantage of higher GDP growth rates in other countries, to the extent that they're expanding their presence in other countries, their growth can easily outpace the overall economic growth of the countries they're entering.
When lower margins attack
Like many others before him, Gross points out that recent years have been kind to corporate profits as taxes have fallen and a proportionately lower amount has gone to U.S. workers. He even provides a nice chart from Haver Analytics showing that the ratio of wages to GDP has been falling since 1960(!).
There are two issues with this. First, and I'm hardly the first to point this out, while more money going to labor and taxes would have an obvious detrimental impact on corporate bottom lines, what happens to that money? Well, it ends up in the hands of workers and the government -- both of which are likely to turn around and spend it. So while profitability may get hit, that could be counteracted by more flowing to the topline.
More importantly, though, Gross implies that the lower payments to labor and resulting increased corporate profitability was a key contributor to the great stock returns in recent decades. What he overlooks is that for the first couple of decades that wages were falling -- 1960 to 1980 -- were actually pretty lackluster for stocks. The S&P 500 appreciated a mere 3.1% per year -- in nominal terms -- over that stretch.
Further, if we believe Gross' assertion that a falling ratio of wages to GDP is good for stocks, then we could reasonably assume that a rising ratio would be bad for stocks. But if we look at the decade prior to when the slide began -- 1950 to 1960 -- that was a fantastic decade for stocks, with the S&P 500 notching an average annual gain of close to 14%.
Those tricky dividends
Perhaps the key mistake that Gross makes, however, is focusing his attack on stocks on the contention that they've appreciated far more than GDP growth over the past 100 years. The problem with that stance is that stocks haven't actually done that -- they've returned appreciably more than GDP growth. The total return that he shows in his investment outlook represents both stocks' appreciation and the dividends they've paid out.
Stock market cheerleader Jeremy Siegel, who Gross called out by name in his note, pointed out the same, as did Business Insider's Henry Blodget -- in the cheekily titled post "DEAR PIMCO: Would Bill Gross Maybe Like to Update That Analysis of Stocks He Published Yesterday." Economist Brad DeLong wrote a blog post, "Bill Gross Makes a Distressingly Common Error."
Rather than managing to make a savvy point about stocks, Gross really only managed to make himself look silly and underscore for investors exactly why they need dividend-paying stocks.
The punchy postscript
After Gross' analysis hit the wires, he and Siegel exchanged some barbs in separate TV appearances. Then, in a Wednesday appearance on CNBC, Gross backpedaled a bit, noting that stocks will most likely outperform bonds over the long term and that his personal portfolio contains more stocks than bonds. What he stuck to, however, was his view that his "Siegel constant" of 6.6% annual real return for stocks (which equates to a nominal return of more than 9%), is unlikely for years to come. I haven't seen him address the issue of total returns versus stock appreciation.
Gross' bottom line may indeed be correct -- I'm certainly not budgeting on a 9%-10% return. But as Blodget points out, if he does end up being proven right, he'll be right for the wrong reasons. And in a profession where your process means everything to your long-term performance, that's a very big deal.
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