Tuesday, October 16, 2012

Stocks or Bonds?

Nick Murray is one of my favorite financial writers, as he has a great way of keeping things simple.  I last referenced him in this blog back in September of 2010. He wrote an excellent article in last month's edition of Financial Advisor Magazine, in which he responds to this essay by Bill Gross, one of the world's most famous bond investors.  I have decided to post Mr. Murray's complete article, although I would draw special attention to the last three paragraphs, which I have put in bold print, because I agree with them wholeheartedly.  To link to the original source, click here.
September 2012 issue 
By Nick Murray  
It will be recalled by anyone with an adult memory that Mr. William Gross, the billionaire manager of the largest bond fund in the universe, strongly suggested not once but twice—in the last months of both the 2000-2002 and 2007-2009 bear markets—that the Dow Jones Industrial Average might fall as far as to 5,000.
His musings are enshrined forever in the Contrarian Hall of Fame, as they were quite spectacular buy signals. And their timing was very close to perfect.
It will come as no surprise, then, that in his August 2012 “Investment Outlook” piece titled “Cult Figures,” Mr. Gross has, in his own highly idiosyncratic fashion, done it again. That is, I think he has, to the limited extent that I can make any sense of his reasoning. Because where he is not simply wrong—and that covers a lot of territory—Mr. Gross’s logic is well nigh impenetrable, and the only really important question it raises goes not simply unanswered but essentially unaddressed.
It is not necessary to try to parse this screed line by line—one would surely go mad—but his main points seem to be as follows.
(1) The hundred-year real (net of inflation) equity return of 6.6% during a period when GDP growth has only been 3.5% is “an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.” In and of itself, this is a quite remarkable statement, implying as it does two ideas that are manifestly untrue: (a) that the return of equities should not exceed the rate of GDP growth, and (b) that markets are so persistently irrational and inefficient that they have, lo these hundred years past, steadfastly refused to obey the iron law expressed as (a).
This is beyond voodoo economics. This is Monty Python economics.
Note that Mr. Gross does not say that corporate earnings, cash flows and dividends —which are the essential drivers of return, and which have always grown at a significant premium to the economy—ought not to have done so, because only a fool would suggest that. No, he says that the market’s response to that premium performance—i.e., a premium rate of return—was irrational, indeed “an historical freak.”
It is impossible to derive the foregoing theory rationally. But it is the quintessence of Aristotelian logic compared to what comes next.
(2) The premium return of equities—6.6% despite only 3.5% GDP growth—is not merely irrational, says Mr. Gross; it is malign—premised on “a commonsensical flaw much like that of a chain letter or yes—a Ponzi scheme.” For in the act of owning businesses which enjoy significantly better outcomes than does the economy on average, and deriving from this activity a concomitantly enhanced return, stockholders “consistently profit at the expense of (other economic actors such as) lenders, laborers and government.”
Can we even be sure we know what he is saying at this point? Is he asserting that the economy is (and the markets are, or ought to be) a zero-sum enterprise, in which an enhanced return to one class of economic actors is somehow theft from the others? Because that would be positively Marxian, would it not? (A point of clarification: I’m referring here not to Groucho but to Karl. Admittedly, reading Mr. Gross, this would be an easy mistake to make.)
Yet in the next breath Mr. Gross admits that the equity investor is fully entitled to a premium return compared to lenders (like Mr. Gross), for the simple reason that his returns are so much less certain, and subject to so much more volatility and risk. Thus, the stockholder’s enhanced return is neither irrational nor theft, but an efficient market’s way of rewarding him for taking on more risk. Otherwise, he wouldn’t do it.
And Mr. Gross must also be aware, as is any sentient being, that equity capital earns a higher return than does labor, because if it didn’t, no rational company would hire anybody. The first duty of any business is to earn a return for its owners—as even the great labor pioneer Samuel Gompers observed—and a rational business will attempt to derive as much productivity (i.e. the greatest return for the least expenditure) from its laborers as it possibly can. For if it does not, a competitor will, and it will be driven out of business. Indeed, there is a school of thought which holds that, excepting only innovation itself, productivity is the essential genius of the American economy. (Full disclosure: I myself am an alumnus of this school. I wear my raccoon coat and porkpie hat, and wave my pennant lustily, at all its football games.)
(3) It will be clear to you, as you slog your way through this philosophical bog, that Mr. Gross must be winding up to suggest that equity returns will henceforth not be (because by his reasoning they cannot be) those of the last century. This he surely does, but here we come to something of a grace note, and we begin closing in on what, to a rational investor, must be the real issue. To wit, never mind what the absolute return of equities will be going forward; what will it be in relation to the alternatives, most particularly bonds?
Here, to his credit, Mr. Gross has the decency to acknowledge what presumably everyone already knows: “With long Treasurys 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.” Forgive me: The italics are mine.
I think it no more or less than fair to sum up Mr. Gross’s position so far in two sentences. Equities should not have produced—and from here on out will not produce—the return they have for the last hundred years. It is a mathematical certainty that bonds will not produce the same return they have over the last 30 years.
Now, at last, we may be getting somewhere.
Set aside for the moment the fact that, if a rational market is about to slash the return it pays the equity investor, the rate of growth of corporate earnings and dividends—of which the return is simply the discounting mechanism—would have to slow significantly from its trend of the last hundred years. Set it aside, that is, because this isn’t Mr. Gross’s argument.
Then set aside for the moment the fact that—if the developed world is going to try to inflate its way out of its current fiscal hole, as Mr. Gross believes it is—bond returns aren’t merely going to be lower than they’ve been in the past three decades. They are in all probability going to go negative, as an efficient market prices in the inflation gambit and demands higher—and perhaps much higher—interest rates.
Set those dispositive facts aside, I say again, and let us proceed directly to the only issue that matters, by asking Mr. Gross, “Sir, as rational investors we believe we are capable of making rational decisions if we can just get you to quantify your qualms, as it were. Sir, can you give us your best guess as to what the real returns of equities and bonds are going to be, in the scenario you hold most probable?”
At this, the oracle goes silent. He either cannot (heck: join the club) or will not hazard a guess at these two numbers.
And so we must return to his essay, where with diligence we may unearth one sentence fragment that refers hypothetically to “ … a presumed 2% return for bonds and an historically low percentage nominal return for stocks—call it 4% ... ”
And that’s all the specificity we’re going to get out of Mr. William Gross.
But it is in fact quite a lot, when you come to think of it. It certainly demonstrates a significant capacity for magical thinking on his part with respect to the prognosis for bonds in an inflationary environment. But once again: put that aside.
The real news here is that Mr. Gross seems to see the nominal return of equities (historically upwards of 10%, which is how you get to his 6.6% real return obsession) falling by a factor of 60% or so to the neighborhood of 4%.
Speaking only for myself, I’d take it. I certainly wouldn’t be happy about it, but I’d take it. If I think for a minute that the nominal return of equities (Mr. Gross’s hypothetical 4%, say) is still going to be twice the nominal return of bonds (his 2%), then I was an equity investor going into this exercise, and I’m still an equity investor coming out of it. I might have to make some big adjustments in the percentage of my income that I’m saving (if I’m in the accumulation phase of life) or the percentage of my capital that I’m withdrawing (if I’m in the distribution phase), but so be it. You can’t get blood from a turnip.
But suppose we reason this out just a little further. Again, if nominal equity returns are going to go down 60%, they would have to be discounting a concomitant, secular decline in the rates of earnings and dividend growth. Now, as reasonable observers of the global economy, does such a savage slowing seem probable to us?
I confess that it doesn’t to me. Maybe I’ve got stars in my eyes, but I see billions of people in the developing world vaulting into the middle class between now and midcentury. I see my country—which had been a huge net importer of foreign oil for forty years and more—suddenly sitting on a hundred years’ supply of natural gas that it can produce (and even export) cheaply and cleanly. I see a new industrial revolution getting underway, spurred by technological miracles in robotics, 3D printing and even product engineering at the molecular level. Finally, I see corporate earnings, cash flows and cash positions stubbornly continuing to rise to new all-time highs even as we speak. (Presumably they have not yet gotten Mr. Gross’s memo.)
And in an inflationary environment such as the one Mr. Gross forecasts, would I rather own bonds that tick down in value every time interest rates tick up? Or might I prefer to own—just to pick a number off a bus—500 well-managed, well-financed global companies which may have some ability to raise their prices (and thus, nominally, their earnings and dividends) in response to that inflation? This seems to me a rather easy choice to make.
Mr. Gross is not the first high-profile person to herald the death of equities; he will not be the last. Such pronouncements are always wrong, and much more often than not they actually signal the imminence of an era of excellent returns. Coming as it does at a moment when—for only the second time since 1958—the world is already so down on equities that the dividend yield of the S&P 500 is higher than the yield of the 10-year U. S. Treasury note, Mr. Gross’s essay most probably indicates that he’s about to go three for three.

© 2012 Nick Murray. All rights reserved. An earlier version of this essay was previously sent to the subscribers of Nick’s newsletter, Nick Murray Interactive.