Photo: Bloomberg TV
Last week, a very prominent bond investor, Bill Gross of PIMCO, published a startling article about the future of stock returns.Bill Gross argued that future returns on stocks will be lower than the historical average return on stocks–a conclusion that most intelligent stock-market observers agree with.
Bill Gross also pointed out that the crappy returns on stocks in the past decade are dampening enthusiasm for stocks, which is absolutely true.
(What Bill Gross didn’t say is that this happens every time there is a long bear market like the one we’ve had for the past decade. This bear market, like all the long bear markets before it, is gradually correcting the severe over-pricing of stocks that culminated in the 2000 stock-market peak. These bear markets usually take 10-30 years to work through, and at the end of them, almost everyone hates stocks. We have almost certainly not reached the end of this bear market.)
In the context of making his argument that future stock returns will be below average, however, Bill Gross also made a major methodological error–one that, given his prominence and following, he should have corrected by now.
Specifically, Bill Gross argued that stocks cannot sustainably return more than the rate at which GDP grows, lest stock-market investors soon end up with all the money in the world.
This argument is flat-out wrong.
As many observers explained last week, including Wharton professor Jeremy Siegel and I (first politely, and then with increasing annoyance as Bill Gross doubled down on his mistake and started insulting Professor Siegel instead of just admitting that he had goofed), Bill Gross is confusing “profit growth” and “stock appreciation” with stock returns.
You can read the whole explanation here if you like, but the gist of it is this:
If you buy a stock for $100 that has a 5% dividend, you will earn a 5% return on your investment forever even if GDP never grows again and the stock never appreciates again (as long as the dividend isn’t cut). This is true whether you spend the dividend or whether you reinvest it. (If you reinvest it, you own slightly more shares and get slightly bigger dividends). The same is true for a real-estate investment. Or, for that matter, a bond.
In any event, some of our readers felt that, because Bill Gross makes boatloads of money a year running PIMCO and Jeremy Siegel works in academia and I just run a little web site, Bill Gross is obviously right. I explained to these readers that I wasn’t arguing that I was smarter or more successful than Bill Gross–just that I had been startled to see Bill Gross make a boneheaded mistake and that I thought it would be appropriate for him to correct it. I also pointed out that I was hardly the only one pointing out that Bill Gross was wrong.
(And I should say upfront that I like Bill Gross. I’m generally a big fan of his writing, and I’m tremendously impressed with his success. I was startled as anyone when I read his latest note.)
Anyway, for the sake of those readers who still believe Bill Gross because he’s rich and successful I am happy to say that another very well-respected investment firm has come out and pointed out that Bill Gross is wrong.
The firm is GMO, which is run by the legendary Jeremy Grantham.
(I’m not certain that Grantham is richer and more successful than Bill Gross, but if he isn’t, he’s close. GMO manages well over $100 billion.)
Anyway, here’s what GMO has to say on this topic:
1) GDP growth and stock market returns do not have any particularly obvious relationship, either empirically or in theory.
2) Stock market returns can be significantly higher than GDP growth in perpetuity without leading to any economic absurdities…
There you have it.
The research report, which is available here, and which was obviously issued as a direct rebuttal to Bill Gross even though it does not mention him by name, goes on to explain in great detail why Bill Gross is wrong.
The paper concludes, as Bill Gross does, that future stock returns (adjusted for inflation) will be lower than the historical average–3.5% instead of the 6.6% average. But, importantly, the paper does not argue (as Gross does) that this is because stocks can’t return more than GDP growth.
The real reasons stocks will likely return less than the historical average are:
- Stocks prices are still higher than average
- Stock dividends are lower than average
- Profit margins are higher than average
Profits and prices tend to be “mean-reverting,” and as they mean-revert, this will weigh on stock returns.
So, yes, Bill Gross is likely right that future stock returns will be lower than average. But he also made a boneheaded mistake in his reasoning, and it would be appropriate for him to acknowledge and correct it!