The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of "stocks for the long run” or any run have mellowed as well.

I 'tweeted' last month that the souring attitude might be a generational thing: "Boomers can’t take risk. Gen X and Y believe in Facebook but not its stock. Gen Z has no money.” True enough, but my tweetering 95-character message still didn’t answer the question as to where the love or the aspen-like green went, and why it seemed to disappear so quickly. Several generations were weaned and in fact grew wealthier believing that pieces of paper representing "shares” of future profits were something more than a conditional IOU that came with risk. Hadn’t history confirmed it? Jeremy Siegel’s rather ill-timed book affirming the equity cult, published in the late 1990s, allowed for brief cyclical bear markets, but showered scorn on any heretic willing to question the inevitability of a decade-long period of upside stock market performance compared to the alternatives.

Now in 2012, however, an investor can periodically compare the return of stocks for the past 10, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously 'safer' investment than a diversified portfolio of equities. In turn it would show that higher risk is usually, but not always, rewarded with excess return.

Got stocks?

Chart one displays a rather different storyline, one which overwhelmingly favours stocks over a century’s time – truly the long run. This long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6 per cent real return (known as the Siegel constant) since 1912 that Generations X and Y perhaps should study more closely.

Had they been alive in 1912 and lived to the ripe old age of 100, they would have turned what on the graph appears to be a $1 investment into more than $500 (inflation adjusted) over the interim. No wonder today’s Boomers became Siegel disciples. Letting money do the hard work instead of working hard for the money was an historical inevitability, it seemed.

image

Yet the 6.6 per cent real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5 per cent over the same period of time, then somehow stockholders must be skimming 3 per cent off the top each and every year. If an economy’s GDP could only provide 3.5 per cent more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, labourers and government)?

The commonsensical 'illogic' of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3 per cent 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.

Cult followers, despite this logic, still have the argument of history on their side and it deserves an explanation. Has the past 100-year experience shown in chart one really been comparable to a chain letter which eventually exhausts its momentum due to a lack of willing players? In part, but not entirely. Common sense would argue that appropriately priced stocks should return more than bonds. Their dividends are variable, their cash flows less certain and therefore an equity risk premium should exist which compensates stockholders for their junior position in the capital structure.

Companies typically borrow money at less than their return on equity and therefore compound their return at the expense of lenders. If GDP and wealth grew at 3.5 per cent per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that. Long-term historical returns for Treasury bill and government/corporate bondholders validate that logic, and it seems sensible to assume that same relationship for the next 100 years. "Stocks for the really long run” would have been a better Siegel book title.

image


Yet despite the past 30-year history of stock and bond returns that belie the really long term, it is not the future win/place perfecta order of finish that I quarrel with, but its 6.6 per cent 'constant' real return assumption and the huge historical advantage that stocks presumably command. Chart two points out one of the additional reasons why equities have done so well compared to GNP/wealth creation. Economists will confirm that not only the return differentials within capital itself (bonds versus stocks to keep it simple) but the division of GDP between capital, labour and government can significantly advantage one sector versus the other.

Chart 2 confirms that real wage gains for labour have been declining as a percentage of GDP since the early 1970s, a 40-year stretch which has yielded the majority of the past century’s real return advantage to stocks. Labour gaveth, capital tooketh away in part due to the significant shift to globalisation and the utilisation of cheaper emerging market labour. In addition, government has conceded a piece of their GDP share via lower taxes over the same time period. Corporate tax rates are now at 30-year lows as a percentage of GDP and it is therefore not too surprising that those 6.6 per cent historical real returns were 3 per cent higher than actual wealth creation for such a long period.
 
The legitimate question that market analysts, government forecasters and pension consultants should answer is how that 6.6 per cent real return can possibly be duplicated in the future given today’s initial conditions which historically have never been more favourable for corporate profits. If labour and indeed government must demand some recompense for the four decade’s long downward tilting teeter-totter of wealth creation, and if GDP growth itself is slowing significantly due to deleveraging in a New Normal economy, then how can stocks appreciate at 6.6 per cent real? They cannot, absent a productivity miracle that resembles Apple’s wizardry.
 
Got Bonds?

My ultimate destination in this article lies a few paragraphs ahead so let me lay its foundation by dissing and dismissing the past 30 years’ experience of the bond market as well. With long Treasuries currently yielding 2.55 per cent, it is even more of a stretch to assume that long-term bonds – and the bond market – will replicate the performance of decades past. The Barclay’s US Aggregate Bond Index – a composite of investment grade bonds and mortgages – today yields only 1.8 per cent with an average maturity of 6-7 years. Capital gains legitimately emanate from singular starting points of 14½ per cent, as in 1981, not the current level in 2012. What you see is what you get more often than not in the bond market, so momentum-following investors are bound to be disappointed if they look to the bond market’s past 30-year history for future salvation, instead of mere survival at the current level of interest rates.
 
Together then, a presumed 2 per cent return for bonds and an historically low percentage nominal return for stocks – call it 4 per cent, when combined in a diversified portfolio produce a nominal return of 3 per cent and an expected inflation adjusted return near zero. The Siegel constant of 6.6 per cent real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.

The simple point though whether approached in real or nominal space is that US and global economies will undergo substantial change if they mistakenly expect asset price appreciation to do the heavy lifting over the next few decades. Private pension funds, government budgets and household savings balances have in many cases been predicated and justified on the basis of 7-8 per cent minimum asset appreciation annually. One of America's largest state pension funds for instance recently assumed that its diversified portfolio would appreciate at a real rate of 4.75 per cent. Assuming a goodly portion of that is in bonds yielding at 1-2 per cent real, then stocks must do some very heavy lifting at 7-8 per cent after adjusting for inflation. That is unlikely. If/when that does not happen, then the economy’s wheels start spinning like a two-wheel-drive sedan on a sandy beach. Instead of thrusting forward, spending patterns flatline or reverse; instead of thriving, a growing number of households and corporations experience a haircut of wealth and/or default; instead of returning to old norms, economies begin to resemble the lost decades of Japan.
 
Some of the adjustments are already occurring. Recent elections in San Jose and San Diego, California, have mandated haircuts to pensions for government employees. Wisconsin’s failed gubernational recall validated the same sentiment. Voided private pensions of auto and auto parts suppliers following Lehman 2008 may be a forerunner as well for private corporations. The commonsensical conclusion is clear: If financial assets no longer work for you at a rate far and 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. There are still tricks to be played and gimmicks to be employed. For example – the accounting legislation just passed into law by the US Congress and signed by the president allows corporations to discount liabilities at an average yield for the past 25 years! But accounting acts of magic aside, this and other developed countries have for too long made promises they can’t keep, especially if asset markets fail to respond as they have historically.
 
Reflating to Prosperity

The primary magic potion that policymakers have always applied in such a predicament is to inflate their way out of the corner. The easiest way to produce 7-8 per cent yields for bonds over the next 30 years is to inflate them as quickly as possible to 7-8 per cent! Woe to the holder of long-term bonds in the process! Similarly for stocks because they fare poorly as well in inflationary periods. Yet if profits can be reflated to 5-10 per cent annual growth rates, if the US economy can grow nominally at 6-7 per cent as it did in the 70s and 80s, then America’s and indeed the global economy’s liabilities can be 'reflated' away.

The problem with all of that of course is that inflation doesn’t create real wealth and it doesn’t fairly distribute its pain and benefits to labour/government/or corporate interests. Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades. Financial repression, QEs of all sorts and sizes, and even negative nominal interest rates now experienced in Switzerland and five other Euroland countries may dominate the timescape. The cult of equity may be dying, but the cult of inflation may only have just begun.

Bill Gross is managing director of Pimco. © Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.

More from Business Spectator

Comments

Please login or register to post comments

Comments Policy »
Bill, the formula is simple. GDP (gross domestic product) is a furphy. It is a lie. It does not exist (The great super time bomb, August 3).
Divide the world's economic activity by the world's population growth. It has to be a big negative.
So until world leaders address the one, the other is a figment of the imagination.
People have a choice they can live a basic lifestyle and give away all the material things they think are important but are not (The great super time bomb, August 3). The simpler your life the less money you need to maintain it.
Business may not like it but then who cares about they like.
Come on it's time to put this guy in a proper perspective and report he is fully owned by one of the biggest super fund managers in the world (The great super time bomb, August 3).
Alliance.
Gross needs to placate his bosses, he is not a lone character, charting his own trip, indeed he is not the boss of PIMCO.
Mohamed el Ali train has far more nous that Gross, but for some reason Alliance won't let him run the show.
Gross seems full of spin and his fellow CEO El AL. spout substance. One should be read for fun the other for knowledge.
I don't need to read this article. If the experts are saying "get out of stocks", that's a strong buying signal! Remember the "Death of Equities" Business Week article in 1979...be patient (The great super time bomb, August 3).
Unassailable logic from Bill Gross (The great super time bomb, August 3). The challenge for all investors is, like him, to keep thinking broadly and beware the assumptions and cliche aphorisms that abound in the money business. In the market, as in all of life, if it doesn't make sense it's probably wrong.
So, since Gross is obviously right – what's a bloke to do? Clearly, living off your money will be a lot harder than it was, and impossible for many. Thirty years of pleasurable idleness at the end of 30 years work always looked nuts. No bad thing in this country for the over-generous public sector pension schemes to take a belting. It always was immoral that one could retire at 55 then bludge on the public purse for decades. So – keep working if you want to keep eating. Second – ignore the ads about fun and games in retirement – endless round of golf, cruises, drinkies, and running along the sand with your beautiful wife and the golden retriever. Reduce your expectation. Be happy with less. A big cultural shift, but we always find a way to put up with reality and after all the grizzling, we'll accept what has to be. Asset allocation will be the big challenge and it's interesting that although Gross points out the problem, he doesn't advise on that. It think that's because he doesn't know. We'll all have to think for ourselves.
And we baby boomers also have a moral obligation to plan less for ourselves, and more for the welfare of those younger. We have been a shamelessly selfish generation.
I am staggered that so few people can see this (The great super time bomb, August 3).
What is worse – a long period of deflation, low growth, cuts in pensions, retrenchments and high unemployment as the real value of global debts are slowly repaid.
Or ... printing money to repay government debts and using inflation to reduce the real value of private debts. This will stimulate the economy and produce nominal growth to employ people and maintain pensions.
The only problem is to deal with requests to print money to feed starving people in third world countries, solve environmental problems, send men to Mars, etc.
Disappointing to see a personal attack by Mr Holland, but the tenor of most comments is anger (The great super time bomb, August 3). Yes, the world has changed. We have had a 1929 event and the world this time can bring better solutions to it. But when all is said and all is done, only inflation can distribute the pain – and some of us will suffer more than others.
Well said Bill! (The great super time bomb, August 3.)
Sadly, we in the developed world have been living a lie for the last few decades-using others money to fuel a lot of our 'growth'.That includes growth in the stock market.
Now we have the duel problems of huge debt and competition from much lower wage countries.The future WILL be more difficult for us, of that there is absolutely no doubt.
Our only option is how we choose to deal with it.
Peter Ross and David Mortimer: why not be honest and just confiscate people's savings at gunpoint to pay government debts instead of using inflation? (The great super time bomb, August 3.)
Curious using a 100 year graph to prove that "This time it is different"! (The great super time bomb, August 3.)
The 3.1% premium of equities over the growth rate is a reasonable return for enterprise and initiative and is offset by all sorts of governments and others who give away or otherwise lose the 3.1%.
Reflation is a proven method to get dead economies moving. Providing the long tern average of inflation over good times and bad does not change much there is no danger in stimulating flat economies and reigning in racing economies.
Back to the golf course for me.
So what are you going to do Bill? Go back to playing Blackjack? (The great super time bomb, August 3.)
As David Mortimer says, inlation is one way to get rid of debt, and it's the one that all the authorities bar Germany, Finland etc are pushing for (The great super time bomb, August 3).
It's a pseudo-sophisticated form of default that robs savers, as opposed to punishing borrowers that shouldn't have borrowed and lenders that shouldn't have lent. Reluctantly, one might accept that immoral 'solution' if if it had immense advantages over the cruder alternative. But I'm not sure that it truly does. It creates another kind of mess which you then have to clean up with an engineered recession ( like the one we 'had to have' .. he wasn't wrong .. in 1991). The big attraction for the suthorites is that that cleanup comes later! And they always willingly sacrifice tomorrow for today.
That said - it can be hard to 'make' inflation. Giving money to rich people and banks isn't working. They put it where they feel it most advantages them. An alternative is the Rudd/plasma screen path, which creates a momentary glow like that enjoyed brielfy by the the Little Match Girl when she is feezing and sets fire to her stock. Then what? A third option is state capitalism where they cut out the middle man and spend the money they just printed. Hmmm. Maybe the simple truth is that "there must be pain" and planning that should be the game, not avoiding it.
As govts keep inflating their economies with more and more money, the lazy amongst us rely on asset inflation instead of building things. Instead of super funds relying on dividends its all about gambling on prices (The great super time bomb, August 3).
I am surprised nobody pointed out survivor bias (The great super time bomb, August 3). The S&P500 index from 1912 does not have the same composite companies as 2012.
I will continue to hope a balanced portfolio of both equity and fixed interest funds.
It is not only a time bomb, but the Australian super is just a big fraud, and the managers of the super funds are doing very well, at the expense of its members (The great super time bomb, August 3).