Death of Equities
Bill Gross is an interesting fellow who has been on the news a lot lately, which reminds me of a very influential article that Mr. Gross wrote about one and half years ago called “We’re Witnessing the Death of Equities” (http://www.pimco.com/EN/Insights/Pages/Cult-Figures.aspx). It’s a very interesting article, because in there Mr. Gross provides some very discomforting statistics and arguments. Here’s a basic summary of it:
1) The stock market has generated a 6.6% annual return in the past 100 years, while real GDP growth during the same period has only averaged 3.5%.
2) Therefore, the value of stocks has grown at a rate disproportional to overall wealth creation in the economy, and equity holders have enjoyed a long period of abnormally high returns at the expense of other stakeholders of the economy (ex. bond holders, government, laborers)
3) Based on this argument, Gross believes that the historical out-performance of stocks has been “is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.”
4) Anyone who utilizes the “buy and hold” approach to investing and expects similar returns going forward is basically delusional, lazy and unsustainably benefiting at the expense of other members of society.
5) Many savings institutions build this historical return figure into their future projections; if the expected returns do not materialize, however, a serious mismatch between assets and liabilities will arise.
6) And we are basically screwed, unless the government produces a lot of inflation to get us out of this problem. Expect lots of inflation in the future.
One Bad Assumption
When the article was published, it attracted a ton of attention and was re-posted by many mainstream media outlets. Many high profile market “strategists” also went on national TV to voice support. This shouldn’t be very surprising – Bill Gross is a very authoritative figure on macroeconomic issues and a very articulate man. His arguments were quite convincing, and if the outcome proved to be anywhere close to what he predicted, it spelled huge trouble for anybody who was heavily involved in the ownership of U.S. equities. The S&P has risen 36.5% since the article was written (or 40% if you add back dividends), so “the death of equities” clearly hasn’t been the case so far. But who knows? It’s only been a year and half, and if Bill Gross was really right, we are only 40% more screwed now than we were a year and half ago, right?
I always thought this was a quite instructive case on the role of faulty assumptions and how they can sustainably lead to even faultier conclusions. But some faulty assumptions, for one reason or another, tend to “stick”, and even the foremost experts can fall prey to them if they’ve never been challenged. The reason I say this is that Mr. Gross’s argument, while appearing convincing, is actually very easy to discredit. All you need is Chapter 1 of Intro to Statistics.
The pitfall of Gross’s article lies in this paragraph: “…6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. 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)?”
What’s wrong with this argument is that it assumes stock market returns and GDP growth are comparable figures. They actually aren’t at all. This is because in formulating his argument, Mr. Gross failed to take into account a critical distinction: the value of the stock market is a stock variable (something that accumulates over time, like a balance sheet), while GDP is a flow variable (something that is generated within a specific period of time, like an income statement).
Comparing growth in a stock variable and growth in a flow variable is meaningless, because the two variables are not meant to be proportional to each other in the first place. The correct statistic to compare GDP growth with would be earnings growth. Earnings are a component of GDP; both are flow variables and represent what is produced by a specific economic agent within a specific period of time. Most sources I have read so far suggest that nominal earnings growth in the last 100 years has been roughly 5% – 6% a year; taking out 3% inflation, real earnings growth has been 2% – 3%, which is a lot more consistent with the 3.5% real GDP growth that Mr. Gross cited. This is important because if earnings have grown at a similar rate to GDP, then equity holders have basically received a “fair share” in the continued prosperity of the American economy, and all of Mr. Gross’s subsequent arguments in the article would be invalid.
Another way to think of this is that rationally, stock market returns shouldn’t really have much to do with GDP growth at all. If stocks are fairly valued (suggesting that their prices already reflect the expectation of lower GDP growth in the future), the logically expected return one can generate is simply the discount rate applied against the future expected cash flows of companies in calculating the value of stocks. If that discount rate is 10%, then long-run stock market returns will average 10%, regardless of whether GDP is growing at 8% or 0%.
Why didn’t Mr. Gross take this simple idea into consideration? I think it has to do with how the metric GDP has been consistently abused in the field of economics in general. This is because economists frequently use the term GDP to describe the total size of an economy. That is a very misleading practice because GDP is a flow variable that only represents the value of all of the “new stuff” that’s produced within a given year. To say that GDP measures all of the activities of an economy would be to suggest that anything that wasn’t produced that year that participated in economic activities simply did not constitute part of the economy. It’s analogous to using revenue to measure the total size of a corporation, but as we know the more relevant measurement would be the corporation’s enterprise value. You often hear people say that billionaire X is richer than country Y because X has a greater net worth than Y’s GDP. That statement suffers from a similar problem.
The sentence “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.” also suggests that Mr. Gross confused GDP (a flow variable) with wealth (a stock variable). GDP is not the size of an economy, but the total gross growth in the economy in XXXX year (before depreciation). GDP growth, therefore, is “the growth in the gross growth relative to the previous year”, not “growth in total wealth”.
Mr. Gross does not say that GDP growth is the growth in the gross growth of an economy, because that sentence is very confusing to say. It’s easier to say that GDP growth is the growth in wealth, but it’s also wrong. Whew, news of the death of equities has been greatly exaggerated.