“The Cult of Equity is Dying”
William H. Gross wrote a very interesting Investment Outlook piece that he begins with “The cult of equity is dying.” He argues that the century long 6.6% real return of stocks will not persist into the future. However, I don’t understand the logic in one of his arguments.
Over the past 100 years, real GDP growth has been 3.5% per year, but stocks have returned 6.6% per year. Gross likens the 3% excess for stocks each year to a Ponzi scheme. “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)?” Gross goes on to explain that if this persists into the future, the rule of 72 tells us that stock owners would double their advantage every 24 years and would eventually own everything.
The flaw in this logic is that stocks pay a slice of their returns in the form of dividends. These dividends get spent in the economy. Some dividends get reinvested into stocks, but that means that some other stock owner sells shares and receives cash that is then spent in the economy. The net effect is that all dividends are spent. As long as the capital gains of stocks don’t grow faster than GDP growth, there is nothing unsustainable about total stock returns (including dividends) exceeding GDP growth.
Gross isn’t telling us to sell our stocks. “Common sense would argue that appropriately priced stocks should return more than bonds.” He goes on to say “If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that.”
Gross’s main argument is that we should expect stocks to outperform GDP by much less than 3%. He may be right about this; I have no opinion. However, I disagree that 3% outperformance is necessarily unsustainable.
Over the past 100 years, real GDP growth has been 3.5% per year, but stocks have returned 6.6% per year. Gross likens the 3% excess for stocks each year to a Ponzi scheme. “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)?” Gross goes on to explain that if this persists into the future, the rule of 72 tells us that stock owners would double their advantage every 24 years and would eventually own everything.
The flaw in this logic is that stocks pay a slice of their returns in the form of dividends. These dividends get spent in the economy. Some dividends get reinvested into stocks, but that means that some other stock owner sells shares and receives cash that is then spent in the economy. The net effect is that all dividends are spent. As long as the capital gains of stocks don’t grow faster than GDP growth, there is nothing unsustainable about total stock returns (including dividends) exceeding GDP growth.
Gross isn’t telling us to sell our stocks. “Common sense would argue that appropriately priced stocks should return more than bonds.” He goes on to say “If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that.”
Gross’s main argument is that we should expect stocks to outperform GDP by much less than 3%. He may be right about this; I have no opinion. However, I disagree that 3% outperformance is necessarily unsustainable.
I am afraid I have to disagree with your statement that Mr Gross's argument contains a flaw.
ReplyDeleteHe is well educated, well informed and experienced investment manager leading a company for 40 years and overseeing $1.7 trln. He received numerous awards while doing all this. He could not possibly have made such a mistake. Nevertheless, I tend to agree with your common sense argument.
There is only one nuance in Gross's credentials: he works in fixed income securities, everything related to equities is his lifelong competition. Therefore, his "insight" argument contains not a flaw, but a carefully crafted commercial for his business.
@AnatoliN: It's up to you whether you base your decision on the arguments presented or on credentials. I would certainly like to hear what Gross has to say about my argument.
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ReplyDeleteHere is Patrick's comment after removing a broken link:
Delete...and Michael is not the only one who thinks Gross forgot the dividends. Jeremy Siegel has said the same thing.
@Patrick: Thanks for the pointer. The point about dividends seemed so obvious that I couldn't see how it could be wrong.
ReplyDeleteAnother part of his argument seems to be that "stocks have gone down, so they will do poorly in the future". Unconvincing words from someone who sells bonds! I was a bit surprised when he pointed out the obvious that bonds can hardly do much better starting from record low yields.
ReplyDelete@Patrick and @Anonymous: I watched the video of Siegel's critique of Gross's argument and then watched Gross's response. Gross simply ignored the substance of Siegal's criticism. Either Gross isn't taking any of this seriously, or he knows that he wasn't making sense.
ReplyDeleteThe sad part is that Gross's excellent point that pension funds should not be counting on huge returns is lost among his nonsense Ponzi scheme related remarks.
True. Siegel's explanation is obvious in hindsight... if stocks get more than GDP growth and bonds get less than GDP growth in a compounding way, we'll end up with one guy owning all of corporate america and one guy holding a $1 bond. Obviously this is not where we're headed.
ReplyDeleteAs for the pensions, they've probably ignored far more frequent and dire warnings. At this point it's not the boy who cried "wolf". More like saying "you know, there's this picture online of a dog growling but you probably don't care". If us amateurs understand the conclusion (and we're not just playing games), the people who are paid well for it should know that much and more.
For all the times that marketing inflates a meaningless message, maybe this time a good message is hidden behind marketing.
Correction - a lot of pension managers probably do understand this, but their pension plan wouldn't work if they admitted to it.
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