Is the Cult of Equity Dying?

Highlights

  • In his latest commentary PIMCO’s Bill Gross asserts that the cult of equity that baby boomers believed in is dying (Investment Outlook, August 2012).  He argues that the period of long-term inflation-adjusted returns for stocks of 6.6% over the past 100 years is over, and future returns will be noticeably lower.
  • My own assessment is less dire: Gross is too pessimistic about the prospect for U.S. economic growth, and the linkage between economic growth rates and equity returns is not as close as he suggests. While real returns of 6.6% per annum may be a stretch, a recent study by Goldman Sachs’ portfolio strategy research team concludes that an annualized real return of close to 6.0% is attainable.
  • Gross is correct that pension plans will have difficulty meeting actuarial targets of 7%-8% annualized returns in the current context.  However, record low interest rates pose a greater challenge for pension plans than prospective equity returns.  The bottom line: stocks should outperform bonds handily once the economy fully adjusts to the aftermath of the financial crisis.  However, equity managers will need to be nimble about taking profits along the way.

Gross’ Rationale

Gross begins his commentary with the provocative statement, “The cult of equity is dying.”  He asserts that investors’ impressions of “stocks for the long run” have mellowed and 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.”

Gross’ argument is directed at Jeremy Siegel’s book Stocks for the Long Run, which presents evidence that US equities have delivered inflation-adjusted returns of 6.6% annualized since 1912. Gross asserts that a 6.6% real return belies commonsense, because it is considerably higher than the long-term growth rate of the U.S. economy. “If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. 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 others (lenders, laborers and government)?”

Gross answers this question by first acknowledging that equity owners are entitled to a risk premium over bondholders for bearing greater risk.  He also notes that real wage gains for labor have been declining steadily for the past 40 years, which has been accompanied by a significant increase in the share of income going to profits.  Looking forward, however, he contends real GDP growth will be well below trend due to deleveraging, and he believes it is unlikely that the share of GDP going to wages and taxes will decline further.  Accordingly, he believes the return on equities in the future is likely to be considerably below the 6.6% trend rate.

A Rebuttal

My own assessment is that the prognosis for equities is less dire than Gross contends for the following reasons:

Equity returns are not simply a function of economic growth.

One of the key assumptions Gross makes is that equity returns are primarily a function of economic growth. If this assertion was correct, one would simply have to forecast economic growth to project stock market returns. Yet, this is rarely the case. Over time, the return on capital may be a more important driver of market returns, and the United States ranks as having one of the highest returns on capital in the world, reflecting the relative efficiency of U.S. companies and the financial system.

One reason why stock market returns may exceed economic growth over time is that the companies included in a stock market index tend to be the most dynamic companies. The guiding principle for inclusion in the S&P 500 index, for example, is “leading companies in leading U.S. industries.”  For the most part, they are also growing market share, both in the United States and abroad. Today, roughly 40% of profits earned by companies in the S&P 500 index are from abroad, compared with only 5% in the 1950s.  Furthermore, the list of stocks included in a market index changes over time. Thus, as companies are acquired or fail, they are replaced by newer, faster-growing companies. The manner in which the indices are constructed therefore may contain a survivorship bias.

Apart from these index considerations, the linkages between economic growth and stock market performance are not particularly close in the short-to-intermediate term. In the aftermath of the 2008 financial crisis, for example, Gross was correct that economic recovery would be sub-par. However, he was incorrect about the stock market’s performance, which doubled from its lows during the Great Recession. Part of the reason is that U.S. companies restored their profitability in a difficult environment, owing to extensive cost cutting and innovation.  Also, the Federal Reserve was pro-active in stabilizing the financial system, which caused investors to reassess the outlook.

Over longer periods of time, there can also be considerable disparity between stock market performance and economic growth.  The 1970s, for example, was a period of poor equity performance even though the U.S. economy sustained reasonable growth, mainly because inflation drove interest rates higher and equity valuations (or multiples) lower. By comparison, inflation today is below its trend rate, and equity valuations are close to their long term averages.

In sum, Gross’ argument that the excess annualized return of the stock market relative to real GDP growth is “a Ponzi scheme” may have intuitive appeal, but it fails to capture the complex relation between growth and stock market returns. Ponzi schemes, after all, rarely last more than a few years let alone a century!

The “New Normal” Is Still Up for Grabs 

Gross’s pessimism about the stock market is rooted in his belief that the “new normal” for U.S. growth is likely to be only 1%-2% per annum, or considerably below the 3.5% trend rate in the post-war era.  The basis for his view is that growth of consumption is likely to be much lower than the prior trend, because households need to de-lever, and government spending will be more constrained in the future.

My own take is that this assumption is too extreme and is mainly based on demand side considerations.  Over the long term, economic growth tends to be driven by supply side factors, including growth of the labor force and capital stock and the rate of growth of total factor productivity. There is no evidence to suggest that any of these factors has been permanently affected by the 2008-09 financial crisis. And while the 2008-09 financial crisis has contributed to only a tepid economic recovery, the economy has sustained real growth of about 2 ¼% over the last three years. Once the recovery in housing gains traction, I believe the economy is capable of growing at a rate of 2.5% to 3% per annum. If so, we’ll be hearing less talk about a “new normal” in the future.

Goldman’s Findings

Weighing these considerations, what is a reasonable expectation for U.S. equity returns over the next 10 years?

Goldman Sach’s portfolio research strategy team headed by David Kostin recently published a thorough study of this issue (“Forecasting Long-term Returns for U.S. Equities,” July 26, 2012).  Their methodology estimated the S&P 500 annualized nominal return over the next 10 years based on four different approaches, which yielded the following results:

  1. Historical returns: 9.2%
  2. Initial valuation: 9.9%
  3. Economic modeling: 8.4%
  4. Dividend yield and growth: 5.0%

Combining these four approaches, Goldman’s researchers forecast an annualized return of 8% through 2022.  With inflation over this period projected at 2.1% per annum, the forecasted real return is nearly 6%, or only half of a percentage point below the long-term trend estimated by Jeremy Siegal.

With respect to recurring media stories about the “Death of Equities”, the Goldman study offers the following observation:

“In our view, this ‘Death of Equities, Redux is happening at precisely the wrong time.  Investors with a long-term horizon should be raising allocations to U.S. stocks. Companies are in terrific shape from a balance sheet perspective, operate at record high margins, retain most of their profits and generate ROE that is close to an all-time high.”

Implications for Pension Plans

One concern that I share with Bill Gross is that it will be very difficult for pension plans to attain a target return of 7%-8% per annum in the current environment. However, the main reason is that prospective fixed income returns are likely to be abnormally low, with bond yields at all-time lows. According to Goldman’s researchers, their analysis indicates there is a 97% probability that stocks will outperform bonds during the coming decade. Given this predicament, it is inevitable that plan sponsors will be increasing their allocations to equities at the expense of bonds.  Indeed, this will be critical for them to come close to achieving their target return. Therefore, Gross’ lament about equities should really be directed about bonds.