Bill Gross, famed bond investor and managing director of one of the world’s largest investment companies, PIMCO, has recently turned his hand to forecasting equity returns. ‘The cult of equity is dying’, Gross tells us in Business Spectator. The theme is reinforced in this Bloomberg interview.
From first hand experience owning a retail equities research business, ‘dead’ might be a better way of putting. I have never seen less interest in equities as a place for Australians’ savings. Fortunately, for those of us left, the rest of Gross’s argument for significantly lower equity returns is seriously flawed.
His starting point is that equities have indeed been an exceptional place to be invested for the past 100 years:
[The history shows 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.
So far, so good for equity investors. But Gross then goes on to dash hopes of a return to anything like these returns in future:
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.
He explains some of this excess return as a function of leverage – owners of debt are prepared to accept a lower return for their increased security, and that leaves more for equity holders. But he need not have bothered. It’s Gross’s logic that belies a commonsensical flaw, not the numbers.
I’ve said it before and I’ll say it again. There is no correlation between GDP growth and stock market returns. If anything, the correlation is negative. Don’t believe me? Read The Growth Illusion in The Economist, where two separate studies completely debunk the ‘growth equals returns’ argument:
Alas, this is not the case. Work done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School established this back in 2005. Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting. In a second test, they took the five-year growth rates of the economies and divided them into quintiles. The quintile of countries with the highest growth rate over the previous five years, produced average returns over the following year of 6%; those in the slowest-growing quintile produced returns of 12%. In a third test, they looked at the countries and found no statistical link between one year's GDP growth rate and the next year's investment returns.
Paul Marson, the chief investment officer of Lombard Odier, has extended this research to emerging markets. He found no correlation between GDP growth and stockmarket returns in developing countries over the period 1976-2005. A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stockmarket return over the same period has been minus 3.3%. In stodgy old Britain, nominal GDP growth has averaged just 4.9%, but investment returns have been 6.1% per annum, more than nine percentage points ahead of booming China.
Still don’t believe me? Think about what Gross’s argument implies at the other end of the spectrum. Imagine an economy that doesn’t grow at all and doesn’t have any inflation. You own all of the equity in this economy, you paid 10 times earnings for your investment and it returns all of its profit to you every year as dividends. The economy doesn’t grow and the profitability doesn’t change for the next 100 years. Does that mean your return will be zero? Of course not. Your return will be 10%, despite the economy not growing one iota.
Equity returns are all about return on capital. They will be dependent on the return on initial capital (a function of the price you pay) and the return on incremental capital (the return generated on capital retained by the companies you invest in and not returned to you as dividends). As incongruous as it may seem, economic growth has nothing to do with it.
Gross’s mistake is to confuse equity market returns with equity market growth. It is impossible for a stock market to grow faster than its economy indefinitely. But it is perfectly plausible for equities to provide a rate of return higher than economic growth indefinitely.
Growing economies typically have growing capital bases, through retained profits, high domestic savings and foreign inflows of capital. The increase in capital generates increased profits, but not necessarily increased returns, due to the larger capital base. It won’t be a surprise, then, to anyone with a contrarian bent to see that the economies with highest growth rates have the lowest rates of equity market returns. The flood of capital is a direct cause of lower returns.
What to expect for equity returns from here
Gross is right in one important respect. Twisting past returns into golden rules is a certain way to lose money. ‘Stocks are better than bonds’. ‘Property is better than stocks’. ‘Cash is king’. Whatever your golden rule, it’s a stupid one. The moment any investing strategy becomes accepted as superior, it becomes self-destructive. At the right price, any asset can provide a better return than any other. At the wrong price, you’ll lose money even if there is a thousand years of data behind you.
My belief is that, if you want real returns, you need to own real assets, purchased at an appropriate price. Property or equities, it needs to be something that is yours, to keep, irrespective of how much inflation, deflation or economic growth there is. Holding cash might seem prudent today but, long term, it is almost certain to erode your real wealth.
The good news is that, from today’s prices, your returns on a well-constructed equities portfolio will be perfectly acceptable. The average industrial stock trades on a price/earnings ratio of about 13 times.
If that can be maintained – after these past few years of semi-recession, that looks a reasonable assumption – you’ll earn something like 7% on your money through dividends and sensibly reinvested profits. Grossed up for franking credits, perhaps 9-10% pre-tax equivalent.
In real terms we’re talking roughly 6%. There’s nothing to suggest it’s going to be a nice smooth ride, but the Siegel constant isn’t done with yet.
24 thoughts on “Bill Grossly Wrong On Stockmarket Returns”
Just thinking aloud here but perhaps another explanation is the nature of an index itself, which has an inherent survivorship bias. So those large companies that are unsuccessful (especially large insolvencies etc) do not show up in the index return – or at least their negative contribution to the index return is limited to the size of the smallest company in the index. And the big insolvencies do not contribute at all: they are merely replaced in the index and become a blip in the total return. In this way the index return can be illusory – though whether this accounts for anywhere near 3 percentage points is another matter.
Steve is right Bill appears to have made a mistake, but Bill’s not completely wrong either and here’s why:
Investors returns are made up of share price growth plus dividend yield. But Bill forgot dividends in his analysis, lucky he’s a bond investor is all I can say.
But it is not true that GDP growth has no impact on equity returns either – the truth lies somewhere in the middle.
Share price growth – the other say 50% of investors returns is mainly driven by the markets estimation of future earnings growth (assuming all other factors are equal).
And there is a reasonable body of evidence that suggests GDP growth and listed corporate earnings growth are linked in developed economies over a long period of time.
It is not a simple relationship because the economy includes many economic entities that are not part of the listed market – and as Bill points out taxes and productivity are two other factors.
In emerging economies there are a number of reasons why the relationship between corporate earnings and GDP growth might break down. Emerging economies undergo large structural shifts. And the Chinese Bureau of Statistics (or “Ministry of Truth”) can probably teach the Greeks a thing or two about accounting.
But to some greater or lesser degree, it is fair to say GDP growth in developed economies will effect the returns equity investors can expect. And if we enter into a period of low GDP growth equity investors (as a class – not intelligent investor subscribers though!) can expect lower returns.
Hi Les, there is no doubt that earnings growth and GDP growth are linked. The problem is that earnings growth doesn’t equal stockmarket returns, it almost always comes about as a result of increased capital. So the earnings might rise, but the earnings per share don’t. Check out this paper from GMO – it explains it much better than I have
Yup I agree earnings can be diluted and shareholders would be much better off if they did earn 100% of return on capital! Thanks to wonderful underpaid over performing management teams (how does Albanese survive blowing up billions of dollars?)
Actually stock market valuations probably the bigger problem, because at any point in time what an investor is prepared to pay for a $1 of EPS changes. So the starting and end point matter a great deal.
My point is that Gross is not completely wrong either, there is a strong body of evidence over 40 years that suggests GDP growth rates (in most cases) put an upper limit on the returns shareholders can expect. But the precise relationship between GDP and shareholder returns is not well understood, and appears to breakdown in emerging markets.
It’s reasonable to suggest, given the broad sweep of recent history, a stifled global economic growth scenario is likely to hit short-medium term equity returns (as a class). Whether through valuations or GDP growth expectations which are the same barometer.
Having said all of which I won’t be investing in Fairfax for example because GDP growth rates are expected to remain robust. Who cares?