Bill Gross vs. the Equity Cult

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.