Bill Gross penned a recent commentary in which he made a case that the cult of equity is dying. Above is the front page of BusinessWeek, which made the same proclamation in 1979. Then as now, commentators have made arguments as to why stock market returns have been poor and are forecasting further poor performance on the basis of past results. The central premise Gross' argument is that the stock market's one hundred year average real annual return of 6.6% hides a commonsense flaw. If real wealth is only increasing at the rate of GDP growth (3.5% since 1912), how can investors in stocks skim an extra three percentage points a year? How can one segment (stockholders) so consistently profit at the expense of others? And more importantly for investors how sustainable is this outperformance? Below is a chart of stock market returns over the past one hundred years, this is were we have been, but where are we going?
How the Stock Market Works: Discounted Cash Flow Analysis
Try analyzing this problem from the bottom up. There could be some doubt as to the exact number, but normalized S&P 500 earnings are approximately $80/share. Now let us assume GDP growth approximates earnings growth for the next 100 years and the economy grows at 3.5% per annum. To receive 6.6% real returns what would the proper price of the S&P 500 be? Under these assumptions the sum of future cash flows from the S&P 500 would be worth 2320, yet the S&P 500 trades at 1380. Why don't we make more conservative assumptions about the future earnings of the S&P 500? Assume the economy grows at 1.5% per year over the next one hundred years and that the normalized earnings of the S&P 500 are 10% lower - that would give you discounted future cash flows for the S&P 500 indicating that the market is fairly valued at the present time. Let me repeat: 1.5% real earnings growth, normalized earnings almost 30% below last year's earnings and you can still expect 6.6% real price appreciation for the next one hundred years. Clearly cash flows can be used for many purposes, they can grow a business and productive growth will net capital gains. They can finance buybacks or dividends, which return money to shareholders. But when productively utilized they must provide a real return on capital.
How is it possible for the stock market to give a return so far in excess of the risk-free rate? Well if you have lived under a rock for the past ten years let me be the first to tell you that equities are scary. You can lose 45% or more during the course of a bear market, two of which have occurred during the past ten years. If I told you the future cash flows of stocks were fully valued at the same expected return that you could get from a bond you would be a fool to buy stocks. If you had two choices (stocks or bonds) with the same expected return, but one asset could lose half your money, while the other had little volatility why on earth would you pay the same for the more volatile asset?
Incidentally, this is exactly what happened at the top of the 2000 bull market. In 2000 the normalized earnings of the S&P 500 were roughly half what they are today, extrapolating robust 4.5% growth the cost of capital for the S&P 500 was 6.5% or about what you could get from a ten year treasury note in 2000 (it was trading at 6.66%). Yet investors could not get enough of stocks leading into the 2000 bear market. Today we have the exact opposite occurrence: bonds are so overpriced that the holder of a portfolio overweight in bonds must have a very negative outlook on the future, provided the cash is not needed in the near term. Not surprisingly, mutual fund inflows convincingly demonstrate that bonds are the new favorite asset of the retail investor for whom past performance is the only determining factor for asset allocation.
This time it's different: Wealth Distribution
Gross makes several points during his analysis for why this time is different. In 1979 Businessweek published its famous piece on the death of equities because at the time inflation was supposedly destroying the stock market and the economy. Take the time to read it, does it sound familiar? Today, Gross speculates that several factors mean that the past returns of stocks will not be replicated over the next hundred years. He likens stocks to a "Ponzi scheme" which redistribute wealth to the upper classes at the expense of the poor. While it is beyond doubt that America is highly polarized in terms of wealth distribution, this analysis implies we are at a new high of wealth distribution which will kill stock returns. Below is a graph included by Gross of Capital vs. Labor and a second graph, showing wealth distribution in America.
While capital trumping labor is touted by Gross as a reason to avoid stocks, it is interesting to note that the times labor's share of GDP has declined have not been very good times to hold stocks. Labor's share of GDP remained near 52% from 1960 until 1974, a very good time to own stocks. Then the share declined precipitously from 1974 until 1981, a very bad time to own stocks. It was then roughly flat through the entire 1982-2000 secular bull market and has trended down since. There is nothing in this graph that would indicate that labor's share of GDP increasing would destroy the stock market. In fact, the opposite conclusion could be drawn. If capital employed more labor, jobs reports were good and consumer spending increased it would be exceptionally bullish.
The second graph shows concentration of wealth in America. For all the talk of wealth being concentrated among the top 1% through the stock market, there is little evidence that wealth distribution has changed all that much over the past one hundred years. Few are rich, many are poor, but what has changed? If the stock market is a Ponzi scheme redistributing wealth to the upper classes it certainly is not a very effective one. It is important to note that income inequality has increased significantly, while wealth inequality has not. In general this leads to the conclusion that while the rich earn more, they also spend more. Furthermore, huge beneficiaries of the stock market, such as Bill Gates, Andrew Carnegie or Warren Buffett often choose to redistribute their wealth to charity. If not, they leave it to heirs, who overall spend much of it. As a result wealth distribution has remained relatively constant over the past one hundred years. There is nothing different here that should change the expected return of the market moving forward. The bottom line is that spending now is easy, investing for later takes patience. The rich prefer to spend now just like the poor, and overall the stock market does little to change the distribution of wealth. While outliers like Warren Buffett exist, they ultimately choose to leave much of their wealth to charity after compounding it over a lifetime. If they don't their heirs will spend it.
This time it's different: GDP growth
Another argument is that the housing bust has permanently changed the expected GDP growth trajectory of the US economy. Slower GDP growth means that stock market returns will be muted for some time. Unfortunately, academic analysis of GDP growth compared to returns shows little convincing evidence that GDP growth causes better returns on stocks. The scatterplot below of GDP growth against returns in several foreign markets and the United States shows just the opposite (pdf) In fact, many cases of good returns came from economies that were not growing at nearly as robust of a rate. For example, returns on the British market approximated returns on the US market from 1958-2008, even though the US grew at more than a percentage point greater rate. While slower growth is certainly not bullish, it is questionable whether it is as bearish as Gross believes. Furthermore, growth five years out from the present date is hardly a certainty. Thus Gross is speculating about a factor that may not influence equity returns as much as he believes.
This time it's different: the deleveraging consumer
Gross asserts that consumers in the United States are drowning in debt and will be deleveraging for the foreseeable future. If they have to pay back all that debt plus interest, there will be no money to keep the economy moving. First, remember that debt once repaid is someone else's income. But maybe all consumer debt is held outside the United States and it escapes our economy. While consumers have certainly been motivated to reduce debt and firm up their balance sheets, debt service as a percentage of disposable income is reaching a relatively low level. While this is in large part due to exceptionally low interest rates the effect has dramatically lowered the cost of debt service. The question moving forward is: will 11% debt service to disposable income strangle our economy going forward? As this percentage is approximately what it was in 1980, or in 1992 thus it seems likely that it will not.
Equities are not dead, they are in hibernation. Unfortunately, the current valuation of the market remains a good deal above where past generational bull markets have begun. So it is likely that Gross may be correct for a while longer and 6.6% real returns may elude us for several years. Stock market returns are notoriously unpredictable, they could be zero for the next ten years or you could see all the returns of the next ten years in the next two or three years. With bonds yielding less than inflation a perceived turn in the US economy could push the market up. Then a market timer will face a difficult choice: chase a climbing market or wait. With bonds trading up to such elevated valuations the market is brimming with fear, but while the fear trade guarantees return of capital it will not provide return of purchasing power (at least for risk free bonds - corporate bonds may yet be an attractive alternative). The next generational bull will be confirmed when investors in the bond market realize that return of capital is not the same as return of purchasing power.
While I respect Mr. Gross, the four most dangerous words in the English language are: this time it's different. 2012 is not special, equities did not return 6.6% for one hundred years only to stop at this very moment. This time is not different.