In the 1980s, I worked for a relatively small pharmaceutical company that obtained the rights to sell a blockbuster Japanese drug in the U.S. The company had an obsessive desire to keep the unions out of its factory, so upon us employees it lavishly bestowed stock options that were not-so-subtly laced with the understanding that this flow of riches would be dammed should any labor organizer be granted so much as a peek in the window.
A stock price that appreciated by 2,000% in just five years certainly kept the unions out, as even janitors became millionaires. It was a "drug-induced" love fest, as we'd gather around the water cooler and joke that "It sure beats five and a quarter in a savings account!"
Today we'd kill for five and a quarter in a savings account. But don't get your hopes up, say the folks at Pacific Investment Management (Pimco). They ominously characterize today's low-return environment as the beginning of a "new normal" that's going to last a long time.
Pimco founder Bill Gross this month declared that the "cult of equity is dying" and that the 6.6% inflation-adjusted return on stocks since 1912 has been "an historical freak," as GDP has long lagged real returns on stocks by 3%. If this 100-year pattern were to continue for another century, he says, people who invest in stocks would ultimately end up with 16 times more money than those who don't. In other words, the 1912-2012 performance is unsustainable, and resistant economic forces have already begun an inevitable corrective process.
To be sure, Gross and Pimco CEO Mohamed El-Erian, are not merely in the minority, but are roundly derided as heretics for their unpopular view. Critics note that Gross is still recovering from the wound caused by his shunning of Treasurys last year. Still, Bill Gross, notwithstanding recent coup attempts by the likes of Jeffery Gundlach, remains The Bond King. Investors ignore him at their peril.
Gross observes that long-term Treasurys have had higher returns than equities over the past 10, 20 or 30 years, so it's not as if the pedestrian performance of stocks, itself, constitutes a new normal. What is new, contend Gross and El-Erian, will be a dismaying 4%-6% real return for stocks for, it would seem, the rest of our lives. And with their not unreasonable forecast of 3% average annual inflation, a 1%-3% real return on stocks is the sad product of the arithmetic.
Maybe they're wrong. Most everyone else certainly thinks so. But these guys have earned their stripes, and anyone who's interested primarily in capital preservation at this point in their lives ought to grant them considerable deference. I do.
Are we thus doomed to nanoscale returns and collective retirement-plan ruin because we previously counted on 7%-8% minimum annual asset appreciation? Indeed, say the Pimco guys.
"If financial assets no longer work for you at a rate far and above the rate of true wealth creation," Gross writes, "then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both."
Not at all what we want to hear. But is there a way to avoid continuing to set our alarms every day and/or suffer haircuts? If we accept Pimco's new normal, then it stands to reason that any refashioned investing approach would also have to be new and, well, abnormal. Is there a prudent way to do this?
Let's take a top-level and admittedly unrefined initial look at where we might find above-average returns with reasonable risk in today's marketplace. We know that we want to do better than Pimco's expected 4%-6% return for stocks, and we obviously will dismiss bank CDs, Treasurys and other low-return instruments. The field is thus largely reduced to corporate bonds.
I therefore embarked on developing a hypothetical portfolio* consisting of 25 BBB (or better)-rated corporate bonds that would be held to maturity. The portfolio's yield to worst (accounting for one callable bond), results in a 6.4% yield to worst. The allocation is: 70% with 16- to 25-year maturities, 35% with 6- to 15-year maturities and 15% with up to 6-year maturities.
Under the Pimco assumptions, the portfolio's real return of 3.4% wouldn't be much better than Pimco's optimal 3% outlook for stocks. Of course, this assumes no defaults, but these are still obligations to repay the bondholders with a guaranteed return. Besides, stocks come with their own particular risk, as prices can decline, and stock issuers have no comparable obligation to make the investor whole or better than whole.
Bear in mind that, at this point in the study, this is in no fashion a recommended solution. The "top-level and admittedly unrefined" caveat is there for a reason. But it gets us thinking, and in my next article, we'll dig into the ingredients and see if we can, in fact, refine the portfolio to make it substantially better.
*The 70% allocation consists bonds of the following companies: Telecom Italia, Telefonica Europe BV, Assured Guaranty Holdings, AXA SA, Fairfax Financial Holdings Ltd., Abbey National PLC, Safeway, Inc., Mountain States Telephone & Telegraph Co., American General Corp. and Energy East Corp. The 35% allocation consists of bonds of: Sovereign Bank FSB Wilmington, Del., SunAmerica Inc., Harcourt Gen Inc., Jefferies Group, Hartford Life, Inc., Swiss Bank Corp., Arrow Electronics Inc., Macys Retail Holdings Inc., Compass Bank Birmingham Ala. and Alcoa. The 15% allocation consists of bonds of Genworth Financial, Telefonica Emisiones SAU, Astoria Financial Corp., Delhaize Group SA and Morgan Stanley.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long certain bonds of SunAmerica, Jefferies Group, Hartford Life, Alcoa, Genworth Financial and Morgan Stanley and may initiate additional or new positions in the bonds of any companies mentioned within the next 72 hours.