The latest monthly note from PIMCO’s Bill Gross is pretty great.This time, instead of talking about overindebted governments, and about how all sovereign bond investors are victims of financial repression, he takes dead aim at the stock market, and argues that future returns can’t possibly be as good as they used to be.
Well he notes that historical rates of return on stocks of about 6.6% per year were always outpacing GDP growth of just over 3%. This seems like a contradiction, until you realise that over the last few decades, capital has been extracting more and more from the economy, compared to labour.
Thus, stock investors have consistently ‘beat’ the economy thanks to capital beating labour.
But that trend, it would seem, can’t go much further, and thus it’s time for things to swing the other way, to the detriment of equity investors.
Chart 1 displays a rather different storyline, one which overwhelmingly favours stocks over a century’s time – truly the long run. This long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return (known as the Siegel constant) since 1912 that Generations X and Y perhaps should study more closely. Had they been alive in 1912 and lived to the ripe old age of 100, they would have turned what on the graph appears to be a $1 investment into more than $500 (inflation adjusted) over the interim. No wonder today’s Boomers became Siegel disciples. Letting money do the hard work instead of working hard for the money was an historical inevitability it seemed.
Yet the 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. 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)? The commonsensical “illogic” of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world! Owners of “shares” using the rather simple “rule of 72” would double their advantage every 24 years and in another century’s time would have 16 times as much as the sceptics who decided to skip class and play hooky from the stock market.
Cult followers, despite this logic, still have the argument of history on their side and it deserves an explanation. Has the past 100-year experience shown in Chart 1 really been comparable to a chain letter which eventually exhausts its momentum due to a lack of willing players? In part, but not entirely. Common sense would argue that appropriately priced stocks should return more than bonds. Their dividends are variable, their cash flows less certain and therefore an equity risk premium should exist which compensates stockholders for their junior position in the capital structure. Companies typically borrow money at less than their return on equity and therefore compound their return at the expense of lenders. 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. Long-term historical returns for Treasury bill and government/corporate bondholders validate that logic, and it seems sensible to assume that same relationship for the next 100 years. “Stocks for the really long run” would have been a better Siegel book title.
Yet despite the past 30-year history of stock and bond returns that belie the really long term, it is not the future win/place perfecta order of finish that I quarrel with, but its 6.6% “constant” real return assumption and the huge historical advantage that stocks presumably command. Chart 2 points out one of the additional reasons why equities have done so well compared to GNP/wealth creation. Economists will confirm that not only the return differentials within capital itself (bonds versus stocks to keep it simple) but the division of GDP between capital, labour and government can significantly advantage one sector versus the other. Chart 2 confirms that real wage gains for labour have been declining as a percentage of GDP since the early 1970s, a 40-year stretch which has yielded the majority of the past century’s real return advantage to stocks. labour gaveth, capital tooketh away in part due to the significant shift to globalization and the utilization of cheaper emerging market labour. In addition, government has conceded a piece of their GDP share via lower taxes over the same time period. Corporate tax rates are now at 30-year lows as a percentage of GDP and it is therefore not too surprising that those 6.6% historical real returns were 3% higher than actual wealth creation for such a long period.
The legitimate question that market analysts, government forecasters and pension consultants should answer is how that 6.6% real return can possibly be duplicated in the future given today’s initial conditions which historically have never been more favourable for corporate profits. If labour and indeed government must demand some recompense for the four decade’s long downward tilting teeter-totter of wealth creation, and if GDP growth itself is slowing significantly due to deleveraging in a New Normal economy, then how can stocks appreciate at 6.6% real? They cannot, absent a productivity miracle that resembles Apple’s wizardry.