Value Added


Why Bill Gross Should Stick to Bonds

Steven Goldberg

The bond guru predicts that over the long haul stocks will earn just 1% annualized after inflation. I think he’s flat-out wrong.



In an infamous 1979 cover story, BusinessWeek magazine predicted "The Death of Equities." The story was published about six months before the beginning of a bull market and just three years before the start of the greatest run-up in stock market history.

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Duly chastened, even the most bearish mainstream analysts -- and journalists -- have since refrained from making similar boneheaded predictions. Until now. Bill Gross -- manager of Pimco Total Return (symbol PTTDX), the nation's largest bond fund, with $270 billion in assets -- begins his new monthly outlook by proclaiming: "The cult of equity is dying."

Gross reminds readers that stocks have returned an annualized 6.6% after inflation for the past 100 years. Over the same period, U.S. gross domestic product has grown at an annualized 3.5%. Gross's conclusion: These kinds of returns represent "a Ponzi scheme" that obviously can't continue.

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"If an economy's GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?" he writes. No, this is a "historical freak, a mutation likely never to be seen again as far as we mortals are concerned." He predicts that stocks will return a piddling 4% annualized before inflation. Given that inflation has run about 3% a year over the long haul, he effectively suggests that stocks will deliver a real return of only 1% a year for as far as the eye can see.

What's wrong with Gross's prognostication? Pretty much everything. To start with, Gross totally ignores stock dividends. A company can still earn profits and pay dividends to shareholders even if its earnings stagnate. Historically, dividends have accounted for more than 40% of total stock market returns.

If good stock market returns were a Ponzi scheme, they'd be the longest-running one in history. Stocks have returned an average of 6.8% a year after inflation since 1802, according to Jeremy Siegel's seminal book, Stocks for the Long Run.

Nor have such rich results been confined to the U.S. Elroy Dimson, of the London Business School, and two colleagues studied stock market returns in 16 countries since 1900. They found that stocks, on average, returned nearly as much in those countries as they did in the U.S. over the same years.

The relationship between GDP growth and stock market returns? Numerous studies have found it to be almost nonexistent. In the book Triumph of the Optimists, Dimson and his co-authors asserted that per-capita GDP growth and stock market returns were negatively correlated.

Stock market returns make up just one component of GDP. GDP, which totaled more than $15 trillion last year, includes income of all kinds: salaries, rents, private and public corporate profits, and so on. "To call stock market returns a Ponzi scheme is a joke," says Michael Andreassi, an economics professor at Hillsborough Community College, in Tampa, Fla.

Gross says that shareholders have profited at the expense of other segments of society. But he overlooks the fact that corporate profits can grow without taking money from employees or others. How? By increasing productivity. And productivity can rise with technological advances and a more highly educated work force. Everyone can benefit when the economic pie grows larger.

Publicly traded U.S. companies earn a huge share of their profits overseas. They operate factories in low-wage emerging markets, and sell many of their goods and services abroad. Little of this shows up in U.S. GDP figures. Similarly, U.S. investors can profit by investing in the stocks of rapidly growing developing nations.

No question, the U.S. stock market has had an awful run since the dawn of the new millennium. From the start of 2000 through July 31, Standard & Poor's 500-stock index returned only 1.4% annualized. It's natural for people to lose faith in stocks after such long, dismal stretches. But to extrapolate the recent past into the indefinite future is almost always a costly folly.

Long bear markets are nothing new. We experienced similarly terrible stock returns during the Great Depression, as well as during the 1970s "stagflation," an awful period of high inflation and slow growth. Bear markets are the price you pay for the healthy, long-term returns stocks generate.

I do buy one part of Gross's analysis. He predicts lousy, long-term future returns for bonds. I think he's right (see VALUE ADDED: The Dangers Lurking in Bonds), at least as far as high-quality U.S. bonds are concerned (particularly Treasury bonds). Since 1982 -- coincidentally, the year that Gross founded Pimco -- Treasury bonds with average maturities of 20 years have returned 11.1% annualized. Much of that stellar performance stems from the steady decline in bond yields. But yields, which move in the opposite direction of prices, can't fall much lower. What is more likely to die is the cult of bonds.

As for stocks, I don't know when the next major bull market will start -- one that continues for many years and pushes the averages far above their all-time highs, hit in 2007. It may have begun more than three years ago when stocks hit bottom on March 9, 2009, after the financial meltdown. But long term, I see no reason not to expect close to the same robust returns we've had historically.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.


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