Jonathan Portes Makes Me Blush...
Stocks for the Medium Run

Equity Returns and the Size of the Economy: Bill Gross Makes a Distressingly Common Error...

Bill Gross:

PIMCO | Investment Outlook - Cult Figures: ​The cult of equity is dying…. [I]nvestors’ impressions of “stocks for the long run” or any run have mellowed as well…. 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… 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….

PIMCO | Investment Outlook  Cult Figures

[The] long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return (known as the Siegel constant) since 1912…. 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.

Yet the 6.6% 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% 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 the others (lenders, laborers 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% 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!…

Has the past 100-year experience shown in Chart 1 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…. If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that….

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% “constant” real return assumption and the huge historical advantage that stocks presumably command…. [R]eal wage gains for labor have been declining as a percentage of GDP since the early 1970s…. [G]overnment has conceded a piece of their GDP share via lower taxes…. [I]t is therefore not too surprising that those 6.6% historical real returns were 3% 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% real return can possibly be duplicated in the future given today’s initial conditions…. [H]ow can stocks appreciate at 6.6% real? They cannot, absent a productivity miracle that resembles Apple’s wizardry….

Together then, a presumed 2% return for bonds and an historically low percentage nominal return for stocks – call it 4%, when combined in a diversified portfolio produce a nominal return of 3% and an expected inflation adjusted return near zero. The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned…

Bill Gross implicitly makes three assumptions: (i) that the total stock and bond valuations in the economy add up to the economy's private corporate capital stock, (ii) that the capital stock of the economy cannot grow much faster than real GDP (currently projected to grow at between 2.5%/year and 3.0%/year), and (iii) that all transfers from corporations to savers--dividends and share backs and bond interest and principal payments--are reinvested in the market. If those three assumptions are true, then indeed the weighted average of stock and bond returns must be in the 2.5-3.0%/year range.

But assumption (iii) is wrong. When a company pays me money by buying back a share, I do not have to reinvest that money in the market. When a company pays me money by issuing a dividend, it does not have to raise that money from the market by selling a new stock or bond--it can (and does) raise that money from its customers by selling them goods and services at more than their cost of production. And if (iii) fails, then there is no necessary direct arithmetic connection between the rate of return on stocks and bonds and the growth rate of the economy.

So what is the right forecast of long-run future stock returns? The S&P earnings yield is currently 7.7%. If the economy strengthens wages will rise and that would tend to push earnings yields down, but if the economy strengthens businesses will be able to take greater advantage of economies of scale and that would tend to push earnings yields up. I have seen no arguments that one factor is likely to be much stronger than the other.

That 7.7% earnings yield means that every year, after repairing worn-out capital, businesses have $7.70 for every $100 of stock market valuation adding to their physical capital stocks (which should boost fundamental value and so show up as a capital gain) or paying out via dividends and stock buy-backs. The right stock return to forecast is to mark that 7.7% earnings yield down to whatever you think the sustainable profits of American companies are, and to go with that.