Bill Gross goes a step further in his August Investment Outlook, writing that not only should we not expect big returns from equities any time soon, maybe we should never expect them again.
“The cult of equity is dying,” the founder and co-CIO of Pimco begins his monthly commentary, which goes on to call the 6.6% historical real return from stocks that many investors have taken for granted a “Ponzi scheme.” (Gross has a penchant for the term, previously slapping the Ponzi moniker on Fed policies like QE2.)
The argument goes something like this: $1 invested in the S&P 500 in 1912 turned into more than $500 adjusted for inflation by 2012, but that 6.6% rate of return came with real GDP only running at a 3.5% clip annually. Gross says that “somehow stockholders must be skimming 3% off the top each and every year,” and that those profits must have come at the expense of lenders, laborers and the government.
Gross allows that appropriately-priced stocks “should” offer better returns than bonds. From the outlook (emphasis in original):
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. Companies typically borrow money at less than their return on equity and therefore compound their return at the expense of lenders. If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that.
via PIMCO | Investment Outlook – Cult Figures
But wealth creation has been declining as a percentage of real GDP for decades, and short of a “productivity miracle that resembles Apple’s wizardry,” Gross does not see how stocks can keep up that historical 6.6% return.
Those who think the “Bond King” was just ripping the equity market can take solace in the fact that Gross also has harsh words for bonds. “It is even more of a stretch to assume that long-term bonds – and the bond market – will replicate the performance of decades past,” he writes.
Momentum-chasing investors are setting themselves up for a fall he warns, if they try and extrapolate future performance from the 30-year bull run in the bond market.
What’s the magic bullet? Central bankers like Ben Bernanke and Mario Draghi will try to inflate their way out of a low-return environment, a strategy that should kill long-term bonds Gross says. The latest effort along those lines could come this week, with the Federal Reserve and European Central Bank both holding monetary policy meetings.
While the Fed may hedge by hinting at new action but waiting for its September meeting, expectations are high for the ECB to do something big, after Draghi said last week he will do whatever it takes to support the euro.
Wasif Latif, vice president of equity investments at USAA, still believes in stocks, and thinks that a big liquidity-driven rally based on central bank action later this week could send lower-quality companies flying higher. That would give USAA, which focuses on quality, a chance to buy companies that tend to trail those type of rallies and show strength when the market is in a more defensive mode. USAA finds that businesses with strong balance sheets and durable franchises may not be the strongest when stocks are in rally mode, Latif says, “but they hold their own in more difficult markets.” One area he likes: health care. The sector, which has struggled in the face of political and regulatory uncertainty for several years, should regain its place alongside consumer staples and utilities as a go-to haven for investors seeking safety and yield. Pfizer‘s second-quarter earnings, which rose 25% Tuesday despite sliding sales of Lipitor, offer a good example of why.
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