Why Bill Gross Should Stick To Bonds

Includes: BOND, SPY
by: Sameer Advani

It's all over the financial web, Bill Gross is stabbing a heart through the "Cult of Equities," as he calls it. Never mind that Mr. Gross is the Bond King and until recently did not have much to say about equities. Facing 2.5% yields on long term bonds, I'm guessing Mr. Gross is looking for higher yield, and the idea of equities being so foreign, he feels compelled to find fault with the investment class before he plunges in to buy while holding his nose.

You can read the Pimco commentary here.

First, analyzing equities over the last one hundred years doesn't make much sense. Most equity investors have an investment life of 50 years at most (ages 22 to 72). Moreover, the shift in the latter half of this century towards democracy, capitalism, and fiat currency have dramatically changed the structure of the global economy. If there ever was a "New Normal," the post-war era defines it.

Let's review Mr. Gross' assessment about the death of the cult of equities. I'll keep this mostly qualitative as he does in his discussion.

"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)?"

1. Productivity. Productivity has increased over 300% since 1947. This benefit typically goes to capital versus labor, however, the increases in productivity generate higher quality goods and more efficient services for consumers at an increasingly lower cost. This allows standards of living to maintain relatively high in the face of stagnant real wages.

2. Globalization. S&P 500 companies now generate 45% of their revenues globally. A decade ago this was around 30%. To compare profits of US corporations strictly to US GDP is myopic and discounts the reality that globalization has allowed companies to diversify their supply chains and labor pool, and to expand to far flung markets.

3. Innovation. Every technological innovation in the last 100 years that is ubiquitous today has been invented in America. Everything. Our system of free enterprise and risk taking, and the ability to pool capital (i.e, stockholders) to commercialize new innovations cannot be replicated anywhere in the world. Stockholders can and should generate profits well in excess of real GDP growth, as it is stockholders that provide the capital for the commercialization of the greatest innovations in the history of mankind.

"Common sense would argue that appropriately priced stocks should return more than bonds. Their dividends are variable, their cash flows less certain and therefore an equity risk premium should exist which compensates stockholders for their junior position in the capital structure."

Common sense would be right. Leave it at that. $10,000 invested in the S&P 500 in 1960 is worth over $1 million today with reinvested dividends. The same amount in ten-year treasury bonds is worth $121,000. This will likely be true over the next 50 years, just as it was over the last 50 years.

Stock dividends are not really that variable, they have been increased 47 out of the last 53 years, and have grown 12-fold since 1960 at an average rate of 5.4%. Cash flows are less certain. However, earnings per share on the S&P 500 have increased from $3 to over $100 since 1960, with declines in 12 of those years.

Bonds have fallen in value in 19 of the last 53 years (i.e., yields rose in excess of cash returns), versus the stock market, which has fallen in 12 of the last 57 years. Which one is riskier? Maybe bonds should have a risk premium over equities? In fact, for 27 of the last 53 years, they have had a risk premium over equities.

S&P 500 and 10-Year Treasury Annual Total Return Since 1960

"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 which historically have never been more favorable for corporate profits."

In a zero sum game, U.S. corporate profits would have to decline, taxes increase, and wages rise to return to Mr. Gross' "Normal" economy. However, we don't live in such a world. There is sufficient global demand for corporations to continue delivering returns in the face of rising domestic taxes and wages. Global GDP has increased at an average rate of 3% since 1970, and trade as a percent of global GDP has gone from 27% in 1970 to 60% today. More than ever, investors must think globally and remove their U.S. blinders.

"With long Treasuries currently yielding 2.55%, it is even more of a stretch to assume that long-term bonds - and the bond market - will replicate the performance of decades past."

This is the great takeaway from Mr. Gross' letter. His commentary should really be titled "The Death of the Cult of Bonds." Hold your nose and buy stocks, Mr. Gross, it's the only game left in town.

"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."

More the reason to own equities instead of bonds, you actually have a chance of getting a real return, even under Mr. Gross' dire scenario for nominal returns. However, Mr. Gross is making a grand assumption, not based on reality, that stock returns will be sub-par for the next 100 years relative to the last 100 years. The only thing certain over such a long time is that we will all be dead, and in the process, great strides in productivity and innovation will continue to occur.

Nobody can say what long term returns will be on any asset class. One must analyze each asset class for its near term risk/reward scenario, and at this point, equities earn 7.5%, pay 2% in dividends at a ratio of 26.5% of earnings, and offer some protection against inflation. Long bonds pay 2.5% and guarantee your principal back with no inflation protection. Rational investors don't have a choice. It's not a "Cult," it's just reality.

"The primary magic potion that policymakers have always applied in such a predicament is to inflate their way out of the corner. The easiest way to produce 7-8% yields for bonds over the next 30 years is to inflate them as quickly as possible to 7-8%! Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades."

Probably true. However, at least stocks provide some protection from inflation, whereas bonds are a clear loser. What if he's wrong, and inflation doesn't take off, nor does deflation occur, and interest rates normalize over the next several years as the economy slowly improves?

"The cult of equity may be dying, but the cult of inflation may only have just begun."

Maybe, maybe not. The point of monetary policy is to maintain a steadily increasing level of aggregate demand within the structural capacity of the economy. If we start to exceed that capacity, inflation will become a problem. So far, we are nowhere near that point.


Investing in equities is not a ponzi scheme. Investing in companies that produce goods and deliver services is necessary and real. Contrary to Mr. Gross' claim that stocks are just IOU's on future profits, real companies do have assets (tangible or not), and a claim on their assets and profits is much more appealing than just a claim, and that is why the "Cult of Equities," as he calls it, will never die. Human ingenuity, curiosity, risk appetite and overwhelming optimism is what drives investors towards stock. That will not change.

Disclosure: I am long SPY, QQQ.

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