by Dan Burrows | August 1, 2012 12:29 pm
Bill Gross, the big kahuna at bond giant PIMCO, generated quite the stir with his latest take on the investment world’s outlook.
The fund manager has proclaimed the death of equities — always a sexy if not particularly useful thing to say. But his argument is not only flawed, it ignores all the great technological leaps of the past hundred-plus years that helped drive stocks’ outperformance in the first place.
Ordinarily, any time a bond-fund manager says stocks are dead, you would just dismiss the guy as talking his book. If equities are dead, then buy bonds! (And do so by putting your money into my bond fund, for which I get paid a percentage of assets under management.)
But Gross gets a pass there, if only because he doesn’t see much upside in bonds, either. Rather, his argument is that the equity risk premium — whereby stocks outperform bonds over long periods of time — is over.
In theory, stocks historically have returned more than bonds because they are riskier — the risk premium. Remember that there is no such thing as a free lunch: To get any investor to accept more risk, you have to offer more return.
Over very long periods of time, stocks have returned 6.6% a year after inflation. That’s the figure Gross says is dead, calling it a freak accident of history. Stocks will never do that again, if only because gross domestic product grows at only about 3% a year.
On that alone — that stocks can’t outpace GDP — Gross sounds persuasive at first blush. It seems so simple and elegant: Stock prices can’t rise faster than the underlying economy forever.
But as Henry Blodget astutely pointed out, Gross made an elementary mistake. Stocks did not appreciate nearly 7% a year over the last hundred or so years, as Gross maintains. Rather, they returned 7% — the difference being that “appreciate” refers only to price, while return includes dividends. Indeed, looking only at price, stocks appreciate only about 2% a year over long periods.
However, companies pay cash to shareholders in the form of dividends — cash that is then used to buy more stock or recycled back into the economy. That’s a (ahem) gross oversight on Gross’ part.
But perhaps a bigger blunder Gross makes is when he dismisses the last hundred-plus years as an anomaly and says the economy has downshifted to a permanent pace of slower growth.
Maybe it has, but would you really take that century-long bet?
Gross offers up the answer for an economic resurgence himself (emphasis mine):
“If GDP growth itself is slowing significantly due to deleveraging in a New Normal economy, then how can stocks appreciate at 6.6% (after inflation)? They cannot, absent a productivity miracle that resembles Apple’s wizardry.“
In the short term, sure, the economy looks like a slow-growth mess. But stocks returned that 6.6% annualized over decades and decades during the 20th century thanks in great part to — yes — Apple-like wizardry.
Here’s just a handful of new productivity miracles that helped stocks along the way during that remarkable 7%-a-year run: cars, planes, radio, TV, antibiotics, the integrated circuit, plastics, computers, the Internet.
And on and on.
Stocks don’t look poised for 7% real annualized gains anytime soon — not in the New Normal of a deleveraging economy.
But to extend that call out over decades because you can’t conceive of productivity miracles is to forget the slew of once-inconceivable inventions that helped drive stocks’ outperformance in the first place.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
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