Entering text into the input field will update the search result below

Bill Gross' Questionable Analysis: Cult Of Equity

Aug. 08, 2012 11:12 AM ETSPY
Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

So now we know what Bill Gross really thinks of Jeremy Siegel. Mr. Gross, a famous bond fund manager, took his August monthly newsletter to discuss the demise of what he refers to as the cult of equity and its poster child, Jeremy Siegel, author of Stocks for the Long Run.

The cult of equity references the shift in asset allocations towards equities (and away from bonds) in pension funds and other large institutionally managed assets. Behind the cult is the belief of an outsized equity risk premium (ERP) over bonds. While this subject might seem academic to individual investors - it underlies why asset allocations to equities often garners the highest percentage.

Unfortunately Mr. Gross' attempt at humor ends up badly representing the subject. I believe he could have summed up his note in rather short order as follows:

"Based on current equity valuations, equities are priced for lower-than-historical-average forward returns, which have been 6.6% on an inflation adjusted basis. We would expect forward returns closer to 4% on a nominal basis or 1% on a real return basis. Furthermore, based on the debt deleveraging cycle in most developed economies, expect persistent inflation created by central governments to combat the deflationary pressures of the deleveraging process."

Instead, Mr. Gross presents a note that is more confusing than helpful. The following are snippets from the note followed by our thoughts:

[A] 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes - a Ponzi scheme

Mr. Gross argues that an equity real return of 6.6% can't happen when GDP growth is only 3.5%. First, a breakdown of the equity return components.

Figure 1:

Total Equity Return (1926-2010)

Dividends

4.1%

Inflation

3.0%

Real Growth in Dividends

1.3%

Valuation Increase

1.1%

Compounding

0.4%

Total

9.9%

Source: Ibbotson from CFA Pub "Rethinking The Equity Risk Premium"

As you can see the dividend yield of 4.1% was the largest contribution of returns. Furthermore the real growth in dividends contributed 1.3%. Dividends and dividend growth contributed 5.4% of the total returns and with compounding it increases to 5.8%. That hardly looks like a Ponzi scheme to me.

Secondly, GDP growth is should be assumed by default to be greater than corporate earnings growth. Mr. Gross is misrepresenting reality. Entrepreneurial capital (new business and new stock) will dilute existing capital stock, which will slow corporate growth. This can easily be shown in the data (discussed next.)

Lastly, corporate growth rates are better compared with GDP on a per capita basis -- not real GDP. GDP on a per capita basis has been ~1.8% since 1871. Corporate earnings and dividends grew at a lesser rate at 1.4% and 1.1% over the same period, respectively. (Data from Arnott, "Rethinking The Equity Risk Premium".)

Economists will confirm that not only the return differentials within capital itself (bonds versus stocks to keep it simple) but the division of GDP between capital, labor and government can significantly advantage one sector versus the other.

This is a valid point and a known channel for corporate profits to grow faster than the economy as a whole. However, with corporate real earnings having only grown at 1.4% compared to 1.9% real GDP per capita-- the data doesn't support the claim. Furthermore, any short-term dislocations between labor and capital should experience a reversion to the mean. (A better argument from Mr. Gross would have been on the impact of international profit share.)

The legitimate question that market analysts … should answer is how that 6.6% real return can possibly be duplicated in the future given today's initial conditions …

While I am befuddled by most of Mr. Gross' argument, here we are in agreement. Based on current valuations, I don't believe the historic return is possible. And I don't think many others do either. Mr. Gross rather expects (off handedly) 4% nominal equity returns or net of 3.0% inflation, a real return of 1.0%.

With the S&P 500 (SPY) dividend yield currently at 2.0% and dividend growth of 1.2%, a more representative real return would be 3.6% (including compounding and no valuation increases).

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

Obviously Mr. Gross didn't recall the last market downturn which bottomed in March 2009. While brief, there was a period in the spring of 2009 where forward returns on the S&P 500 were priced in for that 6.6% real appreciation!

Conclusion

The cult of equity is driven by the equity risk premium. Investing in equities requires compensation via the equity risk premium. Unfortunately, Mr. Gross confuses the discussion and argues incorrectly (in my opinion) that future equity returns can't replicate historical returns because of unsustainable "Ponzi-like" growth.

The data clearly shows that previous returns are from dividends and dividend growth which are sustainable and proven to be durable. Furthermore, real return from growth is significantly less than real GDP growth and more importantly on a real GDP per capita basis. Rather the problem is that the current dividend yield of 2.0% is much lower than the historic level of 4.1%.

Disclosure: I am long SPY.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Recommended For You