Recently Bill Gross, the brilliant “bond king” who founded Pimco, published a market commentary which The Wall Street Journal summarized with the headline:
Bill Gross: Stocks Are Dead and Operate Like a ‘Ponzi Scheme’
It sounds ominous, but it could be bullish. Judging from published reports, the timing of Mr. Gross’s bearish stock market calls has been less than perfect. A CNNMoney article dated Sept. 6, 2002 carried this headline:
Gross predicts Dow 5,000. Influential Pimco bond manager sees stocks moving lower before recovery begins.
CNN reported that Gross expected stocks to fall another 40%. In fact stocks troughed in September 2002 and rose 22% over the next year, 37% over the next two years, and 87% over the next five years.
Deconstructing the “Cult of Equities”
Nevertheless, Gross’ recent commentary spotlights an issue that merits close attention. He argues that baby boomers became unduly infatuated with stocks. They
“. . . grew wealthier believing that pieces of paper representing ‘shares’ of future profits were something more than a conditional IOU that came with risk. Had not history confirmed it? Jeremy Siegel’s rather ill-timed book affirming the equity cult, published in the late 1990s, allowed for brief cyclical bear markets, but showered scorn on any heretic willing to question the inevitability of a decade-long period of upside stock market performance compared to the alternatives.”
Mr. Gross is being a bit unfair to Prof. Siegel of the Wharton School, who published Stocks for the Long Run not “in the late 1990s” near the top of the bull market, but rather in 1994. The latest data points in the book are for 1992, when stocks were languishing during an anemic “jobless recovery.”
Gross’ claim that the equity cult only “allowed for brief cyclical bear markets” is also questionable. It is well known that stock prices “went nowhere” in the 1930s and 1940s, and again in the 1970s. Indeed, Siegel wrote “Stocks have what economists call mean-reverting returns, meaning that over long periods of time, high returns seem to be followed by periods of low returns and vice versa.” This is particularly relevant today, because if Siegel is correct then stocks, following poor returns from 2000 to 2012, should be about to enter an extended period of strong performance.
Ponzi Scheme?
The clever title of Gross’ piece, “Cult Figure,” refers to 6.6%. This is what Jeremy Siegel determined, after exhaustive historical research going back to 1802, to be the “normal” and surprisingly consistent long-term real total return from equities. Let’s unpack this figure, because the details matter:
- “Long term” means not five or ten years, but something like fifty years—long enough to even out the lags and lurches in stock prices.
- These are pre-tax returns.
- These are real, i.e., after inflation, returns.
- All dividends are reinvested in the stock market.
The cult figure means if you put $100,000 in a tax-free account, invested it in the S&P 500, and reinvested all the dividends, then after fifty year the purchasing power of the fund should have climbed to $2,442,644. Not bad, but you do have to wait fifty years before spending a dime.
Gross claims this 6.6% real return is a “Ponzi scheme” because real GDP has only grown 3.5%. If equity investors get 6.6% “then somehow stockholders must have been skimming 3% off the top each and every year.” This will be even less sustainable in the future, he claims, for two other reasons:
- Wages and salaries’ share of U.S. GDP has been declining pretty steadily since 1960 while corporate profits’ share has increased, and that can’t go on forever.
- Effective corporate tax rates have been declining, and that can’t go on forever either.
Mr. Market Is Not Bernie Madoff
It seems implausible that equity investors somehow managed to get 310 basis points of spurious returns per year, and did so for over a century. In fact, they didn’t. The mistake in Gross’ reasoning, as Henry Blodgett points out, is that he is ignoring dividends. He is confusing “stock market appreciation” with “total return” which includes reinvestment of dividends.
Another big conceptual flaw in Gross’ reasoning is that the S&P 500 is not coterminous with the U.S. economy. Fully one third of the S&P 500 is outside the U.S., and even the domestic portion of the index is only a fairly small segment of the U.S. economy and a segment that is much more concentrated in high-tech, high-productivity growth parts of the U.S. economy. (To get a feel for what I mean, wander into your local town and look around. You will see hundreds of businesses, employing thousands of people, that are not in the S&P 500. Most of them are labor-intensive service businesses with low productivity growth.)
Future of the “Cult Figure”
With 10-year treasuries delivering a real yield of minus 0.5% (1.5% minus 2% inflation), the equity cult figure does not have to be as high as 6.6% to be attractive. It may well turn out to be lower, but this is not inevitable by any means. It is worth pointing out that Mr. Gross and his Pimco colleagues have been mostly wrong in expecting poor profit growth during the post-financial crisis “new normal” era. S&P 500 profits have doubled from their third quarter 2009 low, on a pro forma, rolling four quarter basis – despite egregious mismanagement of the U.S. and European economies. Some of the factors that will determine whether stocks manage to maintain their 6.6% cult figure are:
- Do U.S. firms intelligently use their free cash flow to boost shareholder return via dividends, buy-backs, and M&A? More on that in a future post.
- Does the U.S. remain a capitalist country or slip into European-style socialism with a stagnant private economy?
- Does U.S. population grow at a fairly healthy clip, partly via increased immigration geared toward economic growth?
- Do large U.S. firms continue to prosper in foreign markets? For example, judging from its disastrous power blackout hitting 600 million people, India could use a bit more help from the likes of GE, Eaton, and IBM.
- Does the European economy implode and stagnate, or rediscover capitalism and regain the economic vigor it had in the 1950s and 1960s?
