Will Stock Returns in the Future be Gross?
Earlier this week, Bill Gross, the founder and Chief Investment Officer of PIMCO, one of the leading bond management companies, provided his viewpoint on bond and equity markets in the future. He led off his commentary by saying “the cult of equity is dying,” described the buying of stocks as “a Ponzi scheme,” and went on to present his opinion that stocks will provide a return no higher than the projected growth in GDP. I have tremendous respect for Mr. Gross, and his company has done a great job in providing investors solid bond management over the past 30 years. However, in his analysis of equities, his opinion is misguided, because his theoretical basis is dead wrong. His analysis ignores two basic facts about stock market returns:
Companies in the aggregate can provide higher returns than the growth in GDP because of increases in efficiency. If a company becomes more efficient by lowering its labor and other operating costs, it will enjoy an increase in profitability that will in turn add to its equity investors’ returns. The increase in earnings might not show in GDP – indeed, because it will involve reducing labor costs, it might even negatively impact GDP. For example, according to the Bureau of Economic Analysis, GDP in the U.S. increased by 1.5% in 2011, while corporate profits grew by 7.9%. Obviously, growth in profits, and stock market values, can exceed growth in GDP.
Returns on equities are influenced by cash flows, but are also impacted by investors demand for stocks – specifically the return that investors require a company to provide in order to induce them to purchase the stock. If government bonds are yielding 2%, and I offered you the opportunity to purchase stocks at a price so that future expected dividends and the expected selling value provided you a return of 2%, would you buy them? No, because you would want to be compensated for the additional risk you are taking. What about if I lowered the price, so your return was 4%? Probably not – you would still likely demand a higher return to compensate you for your risk. The actual return is up to you – but your decision, along with the aggregate decisions of every investor, are what determine the price of equities, which in turn determines long-term equity returns. And those long-term expected returns have nothing to do with the growth of GDP.
I have no doubt that Mr. Gross believes what he is saying. But I do find it interesting that the CIO of a bond management company is commenting negatively on the future of stocks – if investors have less faith in stocks, they are likely to invest more in bonds, which would make PIMCO a more profitable entity. I have similar suspicions when equity portfolio managers provide a positive outlook on the stock market. When I want an unbiased opinion of the quality of a Ford Fusion, I go to Consumer Reports, and not the president of General Motors or Ford.
The timing of the comments by Mr. Gross is curious. His analysis is not dependent on the time period – he could have provided the same insight back in 2000 or 2007, when investors had enjoyed long-term run ups in stock values. I think his commentary has more to do with the sluggishness of past performance than with a future outlook. This brings to mind another analysis of the stock market, published by Business Week, titled “The Death of Equity.”
“Institutions that have so far remained in the financial markets are pouring money into short-term investments and "alternate equity" investments. At the same time, individuals who are not gobbling up hard assets are flocking into money market funds or into municipal bonds. … On Wall Street, the flight from stocks has forced firms to push alternative investments hard—thereby drawing still more money from the stock market. Further, this "death of equity" can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries, and booms.”
The article was published in August of 1979. The S&P 500 averaged an annual return of 18% over the next 20 years, increasing in value 25 times by 2000! To quote Monty Python, maybe equity was not quite dead yet.