Photo: Bloomberg TV
Even brilliant people occasionally make boneheaded mistakes, and one of the world’s most prominent investors appears to have made a big one.Yesterday, Bill Gross, the bond king at bond giant PIMCO, published an analysis of of the stock market that instantly grabbed everyone’s attention.
Arguing that the “cult of equities” is dying or dead (true–and, ironically, a bullish observation), Gross went on to ridicule the idea that stocks will have the same long-term returns in the future as they have had in the past–for one simple reason:
If stocks appreciate at ~7% a year forever, while GDP only grows at ~3%, the stock market will soon be worth more than the entire world.
At first blush, this seems like an obvious but profound observation, one that would make every equity strategist, scholar, and financial advisor who has ever cited the ~7% long-term stock return (after adjusting for inflation) look and feel like a moron.
Alas, it’s wrong.
And after chewing through the analysis, in fact, most observers came away thinking that Bill Gross should probably stick to bonds.
Why is Gross wrong?
Because stocks actually have not “appreciated” at ~7% a year.
Stocks have returned ~7% a year.
Why is this distinction important? Because there is a big difference between “appreciate” and “return.” And Bill Gross, importantly, used the word “appreciate”:
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.
Again, stocks have not, in fact, “appreciated” at ~7% per year for the past couple hundred years. Stocks have only “appreciated” about 2% per year.
That is to say, the prices of stocks, after adjusting for inflation, have only risen about 2% per year for the past couple of centuries.
So where has the rest of the return come from?
Over the past century, about 4 points of the ~7% annual return of stocks has come from dividends.
Companies have paid out cash to their shareholders, and these shareholders have either used the cash to buy more shares (from someone else–not usually from the company) or used the cash to buy other stuff. Either way, the dividend part of the stock “return” is then recycled back into the economy.
This is a very fundamental mistake. And for an investor with Gross’s stature, responsibilities, and following, it’s highly embarrassing. Here’s hoping he acknowledges and corrects it.
Addendum: By the way, Bill Gross is probably absolutely right that stocks will return less in the future than they have in the past, but not for the reason he suggests. The reason stocks will likely return less in the future is that 1) stocks are still overvalued relative to historical averages, 2) dividends are much lower than historical averages, and 3) profit margins are much higher than average, suggesting that they will soon drop. All of these factors suggest that equities will return about ~2%-3% real over the next decade instead of the ~7% average. But this has nothing to do with the flawed idea that stocks can’t return more than GDP.
Bill Gross also makes another very important point about how corporations and shareholders have become greedy in recent years and now pay an all-time-low per cent of GDP as wages. This is a big problem, one that will have to change if the economy is to heal itself. I’ve discussed this issue frequently: You can check out the charts here. As companies pay employees more, margins will drop, which will hurt stock performance (see point 3 above). But, again, this has nothing to do with the claim that stocks can’t return more than GDP.