Recently, PIMCO’s Bill Gross generated controversy by implying that stocks could not sustainably deliver greater returns than GDP growth, as they have for the past several decades.
He hinted that the strong performance of equities was something akin to a “ponzi” and that it was mostly the result of capital squeezing more and more out of labour, and that now equities were likely to do badly.
The note was widely panned — not for predicting that stocks would do badly — but for the assumption that stock market returns necessarily had something to do with the GDP.
The best rebuttal we’ve seen to date comes from Ben Inker at investment firm GMO in a note titled. Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns.
Inker doesn’t actually mention Bill Gross at all, but the subject of his writing is obvious since he devotes it all to this quesiton of equity returns vs. GDP, and the question of whether equities are in fact dead.
Based on the title of the note, you already know Inker’s answer: No equities aren’t dead.
To start, he devotes a significant amount of time pointing out how theoretically and empirically, the connection between equity returns and GDP is non-existent.
These charts actually show a negative relationship between equity returns and GDP growth across many countries and various timeframes.
In addition to the raw numbers, Inker presents a theoretical explanation for why equity returns and GDP needn’t correlate.
Read this paragraph about a factory, and you’ll get it. The gist is that equity returns and output (a proxy for GDP) are two totally separate moving parts in the equation.:
In thinking about the two, let’s use a simple example of a factory in which 1 worker with 1 machine can output 1 widget per day. You are the factory owner, currently outputting 10 widgets per day with 10 workers and 10 machines. To achieve a 10% growth, you either need to hire another worker and buy another machine, or you need to improve or replace your machines such that they can output 1.1 widgets per day when manned by one worker. The ﬁrst method increases output but not output per head, the second increases output as well as output per head. From your perspective as the owner, your choice between the two is going to be driven by the cost of improving or replacing the machines relative to the cost of paying another worker and buying another machine identical to your current ones. Both scenarios involve an investment on your part, though, so while the output of your factory has risen by 10%, we do not have enough information to determine your return on investment. It would only be 10% by the oddest of coincidences. You might have a unique widget creation technology such that your machines were twice as productive as any other, giving you a huge return on the investment. Widget production might be an utterly cutthroat competitive business, such that your return on investment is barely greater than your cost of capital (or, if you’ve screwed up your analysis, less than your cost of capital). Output is up 10%, and assuming no change to the price of widgets, your aggregate output and gross proﬁ ts should be up 10% as well, if we don’t take into account the cost of capital. But you as the owner had to invest to achieve that higher proﬁ t, and to do that, you either forwent a dividend you could have otherwise paid yourself out of proﬁ ts, or had to raise the capital from someone else. The faster you want to grow, the more you will need to invest, but this investment must either come from retained earnings (forgone dividends) or dilution of shareholders.2 In practice, companies in fast-growing countries generally exhibit both low dividend
payout ratios and high rates of dilution of shareholders, both of which hurt shareholder returns enough to more than counteract the higher aggregate proﬁt growth associated with fast growth.
There’s a lot more in the note about why equity investors should generally expect outperformance over time.