Bill Gross, head of PIMCO, the world’s largest bond fund says the cult of equities deserves to die and future stock returns will have to be much lower than what we’ve seen historically. It’s an argument that’s worth running through because it’s wrong in an interesting way. He starts with the observation that stocks have historically enjoyed an inflation-adjusted return of 6.6 percent, a level he says is unsustainable:
Yet the 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)? The commonsensical “illogic” of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world!
The problem here is that Gross is assuming that returns to equity holders just pile up in a vault somewhere. Wealth is being skimmed off the top, transferred, and then it halts. In fact just like labor income, capital income is partially saved and partially used to finance purchases of goods and services. It’s true that a person who earned a return of GDP+3 and saved all his money would, over the course of an infinite time horizon, eventually end up owning all the wealth in the world. But that’s neither here nor there as to sustainable stock market returns.
Stocks should earn something like the inverse of the long-term sustainable price-equity ratio plus a risk premium. Economists have long debated why the historical risk premium has been so high (the “equity premium puzzle” it’s called in the literature) and I think one very plausible theory is that it’s just been too high and futures returns will be lower. But the real GDP growth rate is not a ceiling on stock market returns.
