Earlier this week, the legendary bond investor Bill Gross made some startling observations about the stock market.In doing so, he made several smart points.
He also made a fundamental mistake that suggests he doesn’t understand the source of long-term stock returns.
Many observers, including Wharton professor Jeremy Siegel and I, politely called Mr. Gross on his mistake, explaining why he was wrong. I also suggested that, given his visibility and influence, it would be appropriate for Mr. Gross to acknowledge and correct his mistake.
As yet, Mr. Gross has not done that.
Rather, he has gone on the attack, insulting Professor Jeremy Siegel on Bloomberg TV and saying that Siegel belongs “back in his ivory tower.”
As I said in my original article, even brilliant people make boneheaded mistakes from time to time, and there’s no shame in doing that. What is shameful, or at least annoying, is refusing to acknowledge those mistakes and attacking other people when they call you on them.
So, it’s time to explain in more detail why Bill Gross appears to fundamentally misunderstand the sources of long-term stock returns.
First, Here’s What Bill Gross Is Right About
To avoid confusion, I first want to note what he is right about. He made many smart observations in his column, and he deserves to be applauded for those.
First, Bill Gross argued that the “cult of equities” is dying. He’s right about that. The “cult of equities,” you will recall, is the buy-and-hold religion that developed over the 18-year bull market that ended in 2000. Long bear markets eventually sour an entire generation of investors on the stock market, and we’re in the middle of one of those bear markets. If enthusiasm for stocks isn’t dead yet, it will be in a few more years. And, ironically, that should actually be an excellent buying opportunity. Most of the great bull markets, like those from 1920-1929 and 1982-2000 are preceded by long bear markets in which almost everyone comes to loathe stocks. Why are the end of those periods great buying opportunities? Because prices are low and there’s no one left to sell.Next, Bill Gross observed that the corporate wages are at an all-time low as a per cent of GDP because companies and shareholders are being too greedy. This is also a very smart point. This corporate and shareholder greed is hurting the economy because it’s depriving average workers of good salaries and, instead, putting more and more of the country’s wealth in the hands of “the 1%.” Over time, this situation will correct itself, either because corporations will choose (or be forced) to pay workers more or because the middle class will rise up in a revolution. And as this situation corrects itself, salaries will likely rise and corporate profit margins will decline. And that will be bad for stock prices.
Those are good points. And they both support the idea that stock performance will continue to be below average for many years.
The final and most important reasons why Bill Gross is right that stock performance will likely be weaker than average for the next decade, which Gross doesn’t mention, are these:
1) stock prices are still higher than average (on a cyclically adjusted PE ratio) and will likely continue to regress to the mean, and
2) dividend payouts are half of what they have been historically.
Put all these factors together and stocks are priced to have below-average returns over the next decade.
How Bill Gross Is Wrong About Stocks
But now we come to Bill Gross’s fundamental mistake.
Here’s the main reason Bill Gross cited for why future stock returns will fall short of the ~7% average annual return observed over the past two centuries—a rate of return that is more than twice as high as the economic growth over that period:
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!
In other words, Bill Gross appears to think it is a mathematical impossibility for stocks to return more than GDP growth on a sustainable basis.
That’s flat-out wrong.
As I explained earlier this week, what Bill Gross appears to fail to understand is that there is an important difference between stock “appreciation” and stock “returns.”
Bill Gross is correct that stock prices cannot appreciate faster than GDP growth in perpetuity.
But he is wrong that stock returns can’t.
To understand this, it helps to walk through 1) the components of stock returns over the last couple of centuries, and 2) a simple example.
Most people have heard the number that Bill Gross cited in his column—the “7% average annual return.” This number is adjusted for inflation. In nominal prices, including inflation, U.S. stocks have returned about 10% per year for the past couple of centuries.
If memory serves, the 10% return in the 20th Century came from the following elements:
- ~3% of the return was from inflation
- ~4% of the return was from dividends
- ~2% of the return was from earnings growth
- ~1% of the return was from price appreciation relative to earnings (multiple expansion).
Bill Gross was referring to “real” returns, so we can ignore the inflation component. Mr. Gross is also right that stock can’t appreciate faster than earnings forever, so we can ignore the final two components of the return (earnings growth and multiple appreciation.)
Where Mr. Gross stumbles is on dividends, which actually account for the MAJORITY of the long-term inflation adjusted return.
Dividends are cash that companies pay out to shareholders.
The shareholders do not generally keep this money.
Rather, the shareholders use the money to buy more shares—in which case the cash goes to someone else—or they use it to buy stuff.
Either way, the cash gets recirculated back into the economy. It becomes revenue for other companies and salaries for other people. And a small bit of it then gets temporarily captured as “profit” by other companies and paid out to their shareholders. At which point the cash begins circulating again.
Photo: Wikimedia Commons
The point is that the biggest contributor to long-term stock returns—the 4% dividend payout—is not hoarded forever by equity shareholders. It is spent. So, far from allowing stockholders to collectively “skim off” 7% wealth appreciation per year in an economy only growing at 3%, the dividends are merely cash that gets passed around and circulated back into the economy.And, contrary to what Mr. Gross asserts, companies can absolutely return more in dividends than GDP growth in perpetuity.
How can we illustrate this?
We can look at a simple non-stock example.
For example, let’s look at a real-estate investment.
Let’s say we invest $1 million to buy a building and then rent out the building for $100,000 a year. Let’s say we spend $20,000 on maintenance every year, so that our net cash flow (dividend) from the investment is $80,000 per year. Let’s assume that all of those numbers increase each year forever at the rate of inflation–the value of the building, the annual rent we collect, and the annual maintenance we pay.
We have invested $1 million.
We are getting annual “dividends” of $80,000 (net).
That’s an 8% annual return.
That 8% annual return can continue in perpetuity, as long as we hold on to the building.
That 8% return is much bigger than GDP growth. We are not, however, gradually accumulating a greater and greater share of GDP. We could hold the building for a million years and never accumulate “all the wealth in the world” (as long as we reinvested or spent some of the money.)
It’s the same in the stock market.
Today’s dividend payout on the S&P 500 is about 2% (versus the 4% historical). If you bought the S&P 500 today, you could collect that 2% forever even if GDP never grew and the price of the stock never appreciated (assuming the dividends didn’t get cut). In that case, you would be earning a return that would be 2% greater than GDP forever.
The level of dividends is a function of the stock price relative to the dividend and the dividend as a percentage of overall corporate earnings (the “payout ratio”).
So, theoretically, the S&P 500 could double its dividend tonight, and you could buy the S&P 500 on Monday and collect 4% forever, even if GDP never grew again, corporate profits never grew again, and stock prices never appreciated again.
So, Bill Gross is just flat-out wrong about his contention that stocks can’t return more than GDP sustainably.
He’s right about many, many other things.
But he’s wrong about that.