From the October 2012 issue of Research Magazine • Subscribe!

September 25, 2012

Bill Gross vs. the Equity Cult

Does the bond maven have a point about stock returns?

Asking PIMCO founder Bill Gross his opinion of stocks is like asking the late Steve Jobs his opinion of Windows. The response may be as predictable as it is smart and incisive. Not only did Gross take on stocks as an investment, he directly called out long-time stock advocate Jeremy Siegel of the University of Pennsylvania Wharton School for promoting unrealistic expectations of future equity yields. The analyses of stock investing by both Gross and Siegel should be taken seriously by anyone who cares about estimating future equity returns.

In characteristically subtle fashion, Gross noted in his August PIMCO Investment Outlook column that stock investment is a fading cult resembling a Ponzi scheme buoyed by past returns that were a “historical freak, a mutation likely never to be seen again.” The most compelling point made by Gross is that the assumption of a 6.6% real rate of return on equities in an economy that is only growing by 2-3% is logically unsustainable.

Such a rate of return would imply that the majority of economic growth in society would be swallowed by equity investors. Any productivity gains would have to be allocated to equity owners at the expense of bond holders and workers who would merely tread water or lose ground as the economy expands. 

Gross is right. A 6.6% real rate of equity return in perpetuity implies that bond investors and/or workers are saps whose risk aversion and ignorance lead to a wealth transfer to equity investors. But this is more or less what occurred in the 20th century in the United States. Siegel’s book Stocks for the Long Run notes that an investment of $1 in T-bills grew to $18 between 1926 and 2001, while a $1 investment in stocks grew to $1,606. Presumably this is because T-bills are less risky than stocks. If so, then there should be at least a few examples of long-term stock underperformance. Siegel noted one in his book—between 1831 and 1861. We’ve already experienced a second.

I asked Wade Pfau, associate professor at the National Graduate Institute for Policy Studies, to calculate the long-run opportunity cost of bond investment versus equity investment. We assumed that in each period a 30-year bond is issued at prevailing interest rates (long-term government bond plus 1%) and that amount is invested for the next 30 years in a portfolio of large-cap stocks while paying off the bond as an amortized loan (as if it were a mortgage). All final wealth values are inflation-adjusted. Think of it as taking out a mortgage on a paid-off home and investing the proceeds in stocks for the duration of the mortgage.

Our results represent the wealth transfer from bond investors to equity investors within each 30-year period in the United States. If markets are efficient and long-run risk is real, then bond investors should have outperformed equity investors some of the time. The results reveal a bad century for American bond investors, but also a surprising trend toward market efficiency.

The Depression ruined a stock investor’s scheme of selling bonds to buy stocks if they started between 1928 and 1931. Those who borrowed $100 in 1932 earned $901 by 1962 after investing in stocks and paying off the loan. Those who borrowed $100 in 1993 saw their equity investment grow to $1,064. Investors who borrowed $100 in bonds and invested in stocks earned a remarkable $1,156 after 30 years if they began in 1942 and $1,192 if they began in 1943.

This high-water mark for the bond/stock arbitrage strategy hasn’t been matched since, and one might argue that high global economic and political risk made stock markets less attractive during the mid-20th century. Since then, the arbitrage strategy has declined in a nearly linear fashion to the point where there were no years where the strategy yielded more than $200 between 1959 and 1974 and in 11 of these 16 years an investor either lost money or gained less than $100. High equity returns in the 1990s again lifted gains to $532 for investors who borrowed $100 in 1975, but declined to just $16 by 1981. A quick glance at the graph suggests that the wealth transfer from bond to stock investors has declined over the last 50 years and may now represent a much more modest premium for long-term stock investors.

One of Gross’s most interesting points is that a coming generation may have lost its appetite for stock investment after having been burned by the stock market (Generation X) and by the labor market (Generation Y). While I speak with many advisors who have experienced a pretty decent return on equities during their lifetime, many Americans entering their peak earning years can’t relate. I accepted my first tenure-track academic job in August of 1999. Thirteen years later, my dividend-reinvested S&P 500 return is 1.99% per year. My total inflation-adjusted return is a negative 5%. Those who graduated a year later saw a total after-inflation return of negative 13%.

A reduced appetite for risk, however, may be what ultimately saves stocks as an investment. Stock returns have been higher than bond returns only because investors need to be compensated for the added perceived or actual risk of holding stocks. If everyone loves stocks, the risk premium falls and stock returns are as low as, or lower than, bonds. In December of 1999, investors were willing to pay $44.20 for one dollar of average corporate trailing 10-year earnings. Investors loved stocks, and they were subsequently burned for their irrational exuberance. Current stock valuations according the Shiller PE Ratio are about half what they were in 1999, but still about 35% above the historical average. 

A good way to think of PE is as a rough proxy of the risk premium. Yale economics professor Robert Shiller has shown a surprisingly consistent relation between PE and subsequent stock return. As PE increases, stock return over the next 10 years declines. Mapping out past PE ratios and returns shows that a PE of 15 has resulted in 10-year nominal returns of about 10%, a PE of 25 leads to predicted returns of about 5% and the nominal return goes negative after about a PE of 35. The Shiller PE has been in the low 20s in recent months. When the PE creeps past 20, there has never been a 10-year period where stock returns later exceeded 10% annually and 20 periods where they didn’t. History suggests that the best we might hope for is a nominal rate in the 5-7% range. And that is a nominal rate; if, for example, a government were to take on excessive debt and inflate itself to regain solvency, real rates of return could easily be negative for equity holders.

Revisiting stock valuation fundamentals is always valuable to gain a better perspective on expected returns. Gross criticized the Siegel constant (a 6.6% annual real return on equities) as an artifact of a high U.S. 20th-century growth rate that is unsustainable in the “new normal” economy. So what is the value of a share of stock? Dusty discount models base it on current discount rates and expected dividend streams. What about the majority of companies that don’t pay a dividend? We can base it on earnings that will eventually be returned to us through future dividends or through mergers and acquisitions. Either way, the value of the firm is directly tied to the growth in its ability to earn profit.

The only way to indefinitely receive a rate of return on equity much higher than the rate of return on bonds is if firms are able to borrow at a rate lower than their growth in profits while returning the excess to shareholders. This spread between money borrowed and money returned to shareholders may be caused by the previously mentioned excessive risk aversion or investor ignorance. Or it may simply go away as markets become more sophisticated. At a current PE of just over 22, I’d assume the latter.

The cult of equity promises a prosperous future that can prevent us from making the difficult choices required when asset returns fall below the Siegel constant. According to Gross, “if financial assets no longer work for you at a rate far above the rate of true wealth creation, then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both.” This helps explain why so many governments, asset managers and retirees want to drink the Kool-Aid. 

Michael Finke is a professor and coordinator of the doctoral program in personal financial planning at Texas Tech University.

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