Bristlemouth: A Value Investing Blog
August 8, 2012

Bill Grossly Wrong On Stockmarket Returns

Bill Grossly Wrong On Stockmarket Returns

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.


August 8, 2012

Death of retail equity is good news for long term intelligent investors searching for good business to buy at lower prices. This will give ample opportunity for us to gradually build a solid portfolio at lower price. As long as a good business offers stable high return on our investment on a stagnated economy we can do well even the capital does not appreciate.

August 8, 2012

Thanks, Steve.
Although Gross's conclusions seemed wrong to me, I couldn't easily see the flaw in his logic. Your article is very sensible and well explained.

August 9, 2012

I agree with Bill Gross - stock market returns as a whole over the very long term, decades not years, are constrained by nominal GDP. The recent excess returns (1970's-2000's) are mainly due to a decrease in the interest rates, and thus discount rates, from the mid teens to low single digits.

In your static economy example how do you maintain a 10% profit margin if all the economies wealth is eventually transferred from everyone else to you? Think about it, if you can indefinitely get a higher return than nominal GDP you will eventually own the whole economy. That is not to say that you can't get above nominal GDP returns in the short term or on small amounts relative to the economy, just that someone else in the economy will be making below average returns to compensate.

August 9, 2012

Hi Freddy. Imagine an economy that had GDP of $100m and there was a large business (say a Woolworths equivalent) that had revenue of $30m and a profit margin of 10%, giving an annual profit of $3m.
If you bought this business for $30m (10 times earnings) and it didn’t grow in the stagnant economy, you would go about earning a 10% return on your investment – presumably all paid out in dividends (which you consume each year as you are unable to invest further capital into your business in the stagnant conditions). The mathematical problem comes into it if you assume that you could re-invest your annual payout back into the business and compound it. But you’re able to earn a 10% annual return (non-compounded) without getting into mathematical hot water.

August 9, 2012

I'm not sure I find this example relevant either Greg as it shows NO stock market growth which is what Gross is talking about. In your example the stock market growth (assuming the stock was bought on market at 10X earn) matches the GDP growth, zero.

Also I don't like Gross's use of the SP500 in being definitive as well. Sure incremental returns on capital peaked last century and stock market growth ahead of economic growth forever in a confined environment doesn't add up. But with more than half of the SP500 revenue comes from outside the United States to compare US GDP to SP500 growth, which it is not solely dependant upon, is misleading. As long as opportunities are there to apply capital at 12% (long term return on capital), either within the US or abroad why can't the SP500 continue to grow when capital is applied.

Steve Johnson
August 9, 2012

Gross is talking about growth but using stock market returns - and that's why his whole analysis is wrong.

August 9, 2012

Own the index long enough, don't payout much in the way of dividends and your market return is predominately your growth rate. He is questioning the next 100 years incremental return on capital - which will determine the return investors make.

August 9, 2012

Sure, but does that mean he believes returns on capital in the future will be 3.5% ?

August 9, 2012

Probably a higher return on capital than that Mars but a low real return on investment, something like you mention. I guess he is saying capitalism is due for a correction as company profitability is too high.

August 9, 2012

Hi Justin, long time no speak. Yeah, just to be clear though, as already stated by Steve, the growth is a function of the incremental return-on-capital of the underlying business (less the payout), the overall return is a function of what you pay. As you know!

If in a particular investment the dividend is minimal, because most earnings are retained, your return will be essentially derived from the growth, which will be equal to the return-on-capital of the underlying business (at best, as a mediocre business is prone to share dilution and other shenanigans).

If on the other hand your dividend is low because you've over paid, then that's another story.

I'm not 100% convinced that a market PE of 13 will give a high confidence of a 9-10% grossed up return, going forward, as stated by Steve. I guess it depends on how much corporate earnings contract (as you say). But hey, who knows? To be fair to Steve, he is referring to a selectively constructed portfolio, rather than the market overall.

I'm no economist, but I don't think there's any doubt that Goss is confusing GDP growth with overall economic output, which are definitely two distinct things.

August 10, 2012

It has been a while Mars and I hope all is well with you.

Investment returns, given enough investment time, become less dependant on the original purchase price paid than the underlying return generating ability of the asset(s). Using Gross's example the returns only drop to 5.7% from 6.4% when the original price paid is doubled. So whether someone pays 13X or 26X earnings today given enough investment time (100 years in his example) 90% of the eventual return will be explained by asset performance and not purchase price.

Shorten the horizon time and sure price becomes crucial but I think Gross is saying ultimately there is this anchor on returns out there and while it isn't visible at any one time it still exists and pension estimates (long term estimates) are ignoring this.

Mind you I don't think he is necessarily right - but for a different reason. US companies are not dependant on US dynamics alone for profitable allocation of capital, hence growth. There is a whole world out there where US companies can convince people to pay much more than it costs to make or do some thing.

August 12, 2012

I’m well Justin. By the way I enjoy your thoughts in your bi-annual letters.

I don’t want to bore everyone, but I find these sorts of discussions irresistible. You are absolutely right, given enough time your return will approach the return-on-capital of the underlying asset, for an asset that retains all it’s earnings. But here’s the thing, an asset that retains all it’s earnings will eventually receive a mediocre return on its capital. That is, the asset will ultimately grow no faster than the overall economy, for otherwise it would eventually BE the economy.

So yes, if a business retains all its earnings, for ever, it will come up against Goss’ limits, and that’s the return you will eventually get, regardless of what you pay (at best, though likely far worse).

But a business that returns some of its earnings, such that it can maintain a healthy underlying return-on-capital, need not come against such limitations. Your returns here will be more dependant on the price you pay (relative to capital).

August 9, 2012

I find it hard to understand who Gross is really writing to - is it the entirety of human civilisation? To his investors? To his rivals? Because the investment scope is an intrinsic factor in this discussion, and the debate is all over the shop at the moment from simplified economies to international vs domestic growth rates. It's like the parable of the 6-feet tall man drowning in a lake that was 1 foot deep on average.

August 10, 2012

Who says I have to consume the profits, perhaps I get utility out of having a big pile of money. In the case of no GDP growth and no inflation me or my descendants will eventually have all of the money. Where will the 10% profits come from then?

Assuming that indefinite greater than nominal GDP returns are possible leads to all sorts of paradoxes and contradictions no matter how you try and twist the logic.

August 10, 2012

I'm not an economist, so I could be wrong but I think the 'steady state' (ie no growth) assumption would mean either you spend it or perhaps it gets lent out to somebody else who does (through your bank, most likely). If you stuck the cash under the proverbial mattress and everything else stayed the same, then our theoretical economy would shrink. But we were discussing a 'steady state' situation, not a shrinking one.

August 9, 2012

Wow, how can the head of PIMCO make such a stupid statement? That's breathtaking.

Does the head of NASA believe in a flat earth?

But can someone please tell me, if the cult of equities is dead, where are the outrageous bargains?!

August 9, 2012

Wow where to begin, there are many flaws in Gross' thinking. For example stockmarkets often have many companies with large overseas divisions (ie the SP500 has a multitude of companies operating in international markets), this means there will definitely be variations between a countries GDP and a stock market.

Think, CSL, just because Australia’s GDP may slow in the near future, doesn’t mean the return from CSL will be poor. CSL’s large overseas exposure will provide protection and will most likely increase the shareholders return due to a potentially lower $A (due to a poor economic performance). Therefore, if an index like the SP500 is mainly composed of companies like CSL’s it should perform differently to the domestically focused GDP.

There is also the fact that markets are truly global, and the gap from the GDP rate to Siegel’s constant can be explained from transfer of wealth from less educated/developed countries to more educated/developed countries. For example CSL makes larger profits in India then Australia and then sends the money back to me the shareholder in Australia. The person in India is less wealthy and I am more wealthy. Ps I’m not saying people in India are less educated/developed than Australians, this is just an example.

Alastair Hart
August 9, 2012

Good on you for questioning Mr Gross. Why would anyone try and forecast returns over 100 years. It is close to impossible over five years so why bother with 100 years time. I can guarantee we will all be dead by then. This sort of nonsense is just what we need at a time when people are happy to lock in 2% returns on 10 year bonds when they can get 10% earnings yield on shares. It's easy to be an expert on investment returns when you are a multi millionaire and 2% p.a. on your portfolio is still more than you can spend.... The rest of us can't afford to take academic shortcuts. I agree with you Steve, all depends on the price you pay

August 9, 2012

I remember when 1 and 2 cent pieces were phased out and therefore became 'worthless' and a kind person advertised in the paper to take all this worthless money.
I agree with Gajen that experts predicting the death of equities is great news for value investors.
Businesses met some sort of demand or need and run with capital and human backing and the inherent risks demand a higher rate of return than lazier bonds and cash and in the longer run people that make useful stuff do well, and the companies that employ them do well, ditto owners and shareholders. It has to be so.
I think the average shareholder return in USA from low point of the stockcrash until early fifties was negative but this stat hides many socially destructive forces at this time. Sure if we are going back to the stone-age there won't be great company returns. However, on balance its in most peoples interests for things to improve and they likely will.
It's great news that equities are dying.

August 10, 2012

Bill's comments stirred up some reaction, as you can imagine.

Forbes reports that Prof Siegel subsequently pointed out that Gross "neglected to include any discussion of the dividend component and the effects of dividends reinvest­ed in his analysis, which to­gether have contributed more than 40% of long-term total return performance for large-company stocks, according to data from Morningstar. In fact, only 5.5% out of the 9.8% actual (nominal) average return enjoyed by Large Caps from 1926 to 2011 is attribut­able to capital appreciation" (quoted from Forbes)

Still - does any one believe that capital appreciation (as opposed to your dividend yield on initial capital invested) can, over the long term, exceed GDP growth??

And I wonder if Morningstar accounted for survivorship bias ....

August 10, 2012

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.

Les Goldmamm
August 10, 2012

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.

Steve Johnson
August 11, 2012

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

Les Goldmamm
August 12, 2012

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?


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