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Are Equities Dead?
08/31/2012 10:45 am EST
To paraphrase the great Mark Twain quote, the death of equities has been greatly exaggerated...but as with most rumors, there's some truth to investors' loss of interest. But good stocks will always have a place with smart investors, writes John Reese of Validea Hot List.
Since 2008, when the financial crisis, Great Recession, and a nasty bear market sent the investment world reeling, stocks haven't exactly been getting great press.
Debt crises in the US and in Europe, high unemployment rates, and several Wall Street scandals have all kept some pretty big clouds hanging over equities. There has been a lot of talk of paradigm shifts and "new normals," with many believing that the stock market's best days are behind it.
Recently, Bill Gross of bond giant PIMCO sounded the latest salvo against stocks, declaring that the "cult of equity is dying." Gross said that the US market will not be able to replicate the 6% to 7% real annual gains that it posted in the last century, largely thanks to debt woes and a slowing economy. In fact, he says that it would be impossible for stock returns to continue to outpace gross domestic product growth, which is what has happened over the past century.
Gross's comments generated a lot of buzz on Wall Street and Main Street. And, to be sure, Gross has a strong track record, and often provides very insightful commentary. But he made some critical mistakes in his analysis. I think it's important to examine those mistakes, and show you why I (and others) think his prognosis for the stock market is wrong.
The main error involves Gross's contention that the stock market has grown faster than GDP, a trend that can't continue. "If wealth or real GDP was only being created at an annual rate of 3.5% over the [past century], then somehow stockholders must be skimming 3% off the top each and every year," Gross wrote.
"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!"
On the surface, that sounds logical—and scary. If GDP growth does remain lower than that 3.5% or so historical rate as the economy continues to deleverage, that means very poor stock returns.
But in a column on Yahoo! Finance, Henry Blodget pointed out a major flaw in Gross's logic. "Stocks have only 'appreciated' about 2% per year. That is to say, the prices of stocks, after adjusting for inflation, have only risen about 2% per year for the past couple of centuries," he says.
The rest of the return (about 4 percentage points), he says, has come from dividends. "Companies have paid out cash to their shareholders, and these shareholders have either used the cash to buy more shares (from someone else—not usually from the company) or used the cash to buy other stuff," Blodget writes. "Either way, the dividend part of the stock 'return' is then recycled back into the economy."
Ben Inker of GMO (Jeremy Grantham's firm) took it a step further in defending equities in a paper on GMO's Web site, saying that it's not just dividends that get recycled into the economy. He says that since 1929, growth in aggregate market capitalization and corporate profits have run fairly close to GDP growth, while stock returns have been much higher.
"So if aggregate market capitalization has grown along with GDP and the compound return to equities has been much faster, what gives?" he says. "Do those original shareholders control 8 times as much of economic output as they did 81 years ago?
"Of course they don't. Investors don't invest to simply accumulate wealth that is never to be spent. Workers invest to fund their retirements. Pension funds and insurance companies are obligated to service their required payouts. Endowments and foundations pay out 5% or so of their total value every year to fund the causes and organizations they exist to support. Even the entrepreneurs who seem to be intent on maximizing their wealth splash out on the occasional mega-yacht or scoop up a small tropical island from time to time."
In other words, investors don't just hoard profits and reinvest them, Inker says. They invest so they can fund future spending, and that money is recycled back into the economy.
But even if stock returns can run higher than GDP over the long term, shouldn't areas with higher GDP growth see higher stock returns? And doesn't that mean the US is in trouble if growth remains slow?
Well, Inker explains the GDP/stock return relationship this way: "In short," he says, "there isn't one. Stock returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns."
This is something I've discussed in past newsletters, via a 2009 paper published by Rajiv Jain and Daniel Kranson of Vontobel Asset Management. It examined stock market return data from 16 developed countries from 1900 to 2002, and the returns' correlation to gross domestic product growth. (The paper used data from Elroy Dimson, Paul Marsh, and Mike Staunton's book Triumph of the Optimists: 101 Years of Global Investment Returns, with updated figures for 2001-02 from University of Florida professor Jay Ritter.)
Jain and Kranson concluded that "the data clearly shows that, over long periods and when adjusted for inflation, stock market returns and GDP per capital growth are negatively correlated." At best, they added, "there is no relationship between GDP per capita and stock returns over the long term."
Ritter also looked at similar data for 19 developed countries from 1970 to 2002, and from 13 other countries, mostly emerging markets, from 1988 through 2002. The data for the first group showed a negative correlation between per-capita GDP and equity returns, Jain and Kranson say. The data for the second group shows a "marginally positive correlation."
As I noted earlier, Inker says that aggregate market capitalization growth, corporate profit growth, and GDP growth have been pretty similar in the US over the long haul. So why is there no relationship between GDP and actual stock returns?
Inker, who cited Dimson, Marsh, and Staunton's data in supporting his argument, offered an explanation: "Total corporate profits and total stock market capitalization have very little to do with earnings per share or the compound return to shareholders because new companies, stock issuance by current companies, stock buybacks, and merger and acquisition activity can all place a wedge between the aggregate numbers and per-share numbers."
In their paper, Jain and Kranson offered a few more reasons for the GDP/stock return divergence:
- GDP is Analogous to Sales; Stock Returns to Corporate Profits: GDP takes into account the value of goods and services produced in a country—regardless of the margins being earned on those goods. If a company cuts prices and margins to boost sales, it will be adding to GDP, but not doing much for profits, which drive share prices.
- Globalization: Many of the largest companies in the world sell their products and services in a number of countries, not just their home markets. So when a US firm has overseas operations that are bringing in lots of sales and profits, it's good for the company—but not included in US GDP.
- Not the "Full" Economy: The performance of private, government-owned, or newly-formed companies often isn't reflected in the stock market, but it does count toward GDP.
There are other reasons to look far beyond GDP growth, too. For instance, in emerging markets, demand may drive excellent sales growth, and, therefore strong GDP growth. But to make money for shareholders, corporations need to turn those sales into profits. For new, up-and-coming firms, it may take time to work out the kinks and become more efficient to get the most out of their sales.
All of this isn't to say that the concerns Gross and others have raised about the US economy aren't legitimate. Debt and deleveraging are and will continue to be major issues for the country, and will surely have an impact on growth.
But when it comes to the issue of the "death" of equities or the "cult of equity," I think the data and arguments offered by Inker and the other researchers I mentioned above are far more compelling than the proclamation made by Gross.
In fact, I think claims about the "death of equities" are encouraging—stories like that show that fear and low expectations are still hovering over stocks, which indicates plenty of bargains should be there for the taking. (Remember, Newsweek famously heralded the death of equities in an August 1979 cover story, just a few years before the greatest bull market in history began.)
I think that the data of researchers like Jeremy Siegel (whose US market research shows 6% to 7% real returns over both the 19th and 20th centuries) and Dimson, Marsh, and Staunton (who found similar results in many international markets over the past century) shows that those 6% to 7% figures aren't a fluke.
Sure, the return path won't be consistent—it never has been. But I expect that over the long term, we'll continue to see similar returns for the broader market. And, most importantly, investors who focus on high-quality, fundamentally sound stocks should do even better—if they stay disciplined and patient.
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