The Truth About Stocks

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The Truth About Stocks

Since 1912, the inflation-adjusted total return for investments in common stocks has averaged 6.6 percent per year, compounded.  That’s 100 years of solid performance despite numerous surges and crashes. 

Any way you slice it, it’s an impressive record.

But, after more than 12 years of minimal price appreciation and weak dividend performance, many investors find themselves asking the question, “Will we ever see 6.6 percent average annual returns again?”

Some experts are now saying “no.”  One of the most notable negative voices is that of Bill Gross, managing director of Pacific Investment Management Company, the world’s largest investment management firm.1  His skepticism for the 6.6 percent figure is clear.  Not only does he think it will not be maintained, but he argues that the historic 6.6 percent real return was an aberration resulting from anomalies in the economy. 

The implications for investors are clear: 

  • You’ll have to work longer before you can retire. 
  • You may have to scale-back your lifestyle objectives when you finally get to retire.

Writing recently in The Wall Street Journal,2 Gross compares this 6.6 percent return to shareholders to the growth rate of the underlying economy.  Specifically, Gross contends, “If wealth or real GDP was only being created at an annual rate of 3.5 percent over the same period of time, then somehow stockholders must be skimming 3 percent off the top each and every year.”

Bill Gross, CEO of PIMCO

Bill Gross, CEO of PIMCO

According to Gross this 3 percent annual “excess return” went to shareholders at the expense of labor and government.  To support his argument, he includes a chart showing that real labor wage gains declined as a percentage of GDP from the early 1970s through today.  The assumption is that this 40-year decline represented a big portion of the rise in real returns seen by shareholders. 

Gross goes on to argue that the rest of the 3 percent came from lower tax rates that forced government to give up part of its share of GDP.  To bolster this position, Gross notes that corporate tax rates are now at 30-year lows when calculated as a percentage of GDP. 

Further, Gross argues that these special conditions that delivered the excess returns to shareholders won’t persist going forward.  Why?  

  • First, labor and government will be able to demand recompense for the decades of wealth lost to shareholders. 
  • Second, we'll see a significant slowing of GDP growth caused by deleveraging in what he and others have called the “New Normal” economy.

In short, if Gross is right, it would take a productivity miracle for stocks to deliver anything approaching a 6.6 percent real rate of return going forward. 

Does any of this make sense?  How should individual investors respond?  Let’s look at the facts:

Since Gross’ argument warrants attention, mostly because he’s the manager of the world’s largest bond fund, it is worth asking whether his track record on such matters warrants a lot of respect.  The fact is that he was wrong on this very issue of future stock performance just one decade ago. 

His September 2002 newsletter3 included an article titled “Dow 5,000” which offered this prediction:  “My message is as follows:  Stocks stink and will continue to do so until they’re priced appropriately, probably somewhere around Dow 5,000 and S&P 650.”

Just one month later, on October 10, 2002, the Dow Jones Industrial Average began climbing up after hitting a low of 7,197.  As we know now, this move signaled the end of “the bear market” that began in the first quarter of 2000 with the collapse of the dot-com stocks.  The subsequent rebound of the Dow to over 14,000 badly damaged Gross’ credibility for making predictions.4 

No Correlation Visible Between GDP Growth & Stock Market Returns

No Correlation Visible Between GDP Growth & Stock Market Returns

Gross is not alone.  This phenomenon of stocks rebounding just when things seemed the bleakest was repeated at least twice in the 20th century.  In both cases, a turnaround came after an extended period of sluggish economic growth, which seemed as though it would continue indefinitely. 

One rebound happened following the period of 1929 to 1942, and the other followed 1966 to 1982.  If a person had looked at those periods from the perspective of 1941 or 1981, they could have drawn the same conclusion that Gross draws today.  But of course, they would have been wrong.

To state this in terms of Techno-Economic Paradigms, both of these previous prolonged periods of under-performance were caused by the two crises that occur in every Techno-Economic Revolution.  The depression of 1929 to 1943 occurred at the transition between the Installation and Deployment Phases of the Mass-Production Paradigm.  The malaise of 1966 to 1982 reflected the decline of the Mass-Production Paradigm and the birth of the Information Paradigm. 

Today’s “Great Recession” that arguably started just before the Clinton/Bush transition in 2000, continued under President Obama from 2009 to the present.  This stock market malaise has been driven by the transition between the Installation and Deployment Phases of the Information Paradigm.  History shows that things always look grim until you hit an Inflection Point; then, you look back and wonder why you didn’t see the turn-around coming.

Another classic sign of flawed analysis is a claim that “things are different this time.”  But, things weren’t different:  

  • When automobile stocks were exploding in the 1920s.
  • Or when junk bonds were selling in the ‘80s.
  • Or when dot-coms were hot in the ‘90s.
  • Or when houses and condos in Las Vegas were being sold and “flipped” before a drop of concrete was poured six years ago. 

In every case, these exuberant markets lost steam, corrected themselves, and proved history correct after all.  As always, the burden of proof is on those who claim things are different; to date, they have a very poor batting average.

Most significantly, the conclusion that the 6.6 percent real rate of return implies equity investors were skimming 3 percent represents flawed reasoning as well.  Total return on common stocks consists of two components:  dividends and capital gains realized through price appreciation. 

Dividends received can be viewed as a kind of rent paid for the use of capital, while growth in the business and its future earning power result in price appreciation.  It’s the two components added together that deliver total return.  It’s not unlike a rental property generating a return from both rent collected and from property price appreciation.  With this understanding, it’s clear why all stocks can collectively show a total return greater than the rate of GDP growth.

S&P 500 Index: Components of Total Nominal Return

S&P 500 Index: Components of Total Nominal Return

That’s not the only flaw in this thinking.  It’s also true that economic growth measured by GDP is not a proxy for profit growth, which is the primary driver of stock prices. 

It’s commonplace for companies to see sales and profits rise two or three times faster than the rate of economic growth.  This is because cash flow has been invested back into research and development that produces new products or funds acquisitions that boost growth — and these factors boost earnings per share.

So, if we look at current stock prices, should the Dow be valued around 5,000 rather than the 13,000 we’ve seen recently?  To find out, we can apply a capitalized-profits model to find the “fair-value of equities.” 

Normally, this would involve dividing corporate profits by the current 10-year Treasury yield of 1.5 percent, and then comparing the current level of this index to each quarter for the past 60 years.  Simplistically using this approach would indicate a fair value for the Dow at an absurdly high 63,000; that’s almost five times the current level.

Obviously, that makes no sense because long-term interest rates are being kept artificially low by the Federal Reserve.  However, if we adjust the model and conservatively assume that without interference we’d have a 10-year Treasury yield of 5 percent, we get a fair value of 18,700 for the Dow and 1,985 for the S&P 500.

But, this also seems a bit high.  Why?  Because corporate profits are currently at a record high, representing about 13 percent of GDP.  It is much more conservative to assume that these will revert to the historical mean of about 9.5 percent. 

Combining this more conservative value for corporate profits with the historical norm of 5 percent for the 10-year Treasury yield gives us a very rational fair value for the Dow of 13,900 and 1,475 for the S&P 500. 

In short, even if profits fall 25 percent and interest rates more than triple from current levels, today’s broad stock market indexes are still undervalued — and that means that the warnings of Gross and others are unfounded.

In short, rather than supporting the alleged trend toward overvalued stocks headed for a precipitous decline, the reality points to undervalued equities that are likely to create huge returns as we move beyond the current transition economy into the Deployment phase of the Information Revolution.

In light of this trend, we offer the following forecasts for your consideration:

First, stocks will show roughly the same historical average returns in the future as they have in the past.  

As soon as 2014, we’ll begin to see rapid economic growth return; the exact timing will depend on policy factors that are hard to predict.  Houses will begin to move, demand for autos will grow, and sales will pick up in retail stores.  As a result, corporate profits will grow at a renewed pace, which will drive up stock prices.  As long as long-term interest rates move up, improved investor confidence will eliminate much of the pervasive “worry deficit” that’s held down “relative P/E ratios” for a decade.  Another factor contributing to equity returns will be demographics:  Domestically, solid birth rates plus immigration will create demand for more goods and services.  Although it’s true that Europe and Japan will remain stagnant due in large measure to aging and declining populations, this will be more than offset by The $30 Trillion-a-Year Opportunity of 2025 discussed later in this issue.

Second, in the coming decade, total returns on stocks should actually exceed historic norms, as the Deployment phase of the global Information Revolution takes off.  

This phase will drive the biggest boom in world history, providing the “productivity miracle” Bill Gross could evidently not imagine happening.  This boom will materialize for a number of reasons.  Here are a few:

  • This is the first time that over 5 billion people living in the developed world will take part in this type of revolution; previous revolutions have been limited to the developed world. 
  • New technologies will make low-cost energy available in enormous quantities.
  • The combination of infotech, biotech and nanotech will dramatically increase the amount of GDP that can be produced per unit of matter and energy, eliminating much of the traditional drag created by resource shortages.
  • Increasingly, the most valuable resource will become information, which can be made available to almost anyone, anywhere, at any time for free once it is created. 
  • Urbanization will make it possible to efficiently reach marginal consumers and to build the “circular economy” where waste becomes a raw material as well as an energy source. 
  • Improved quality-of-life will let people in the developing world become dramatically more productive.  This will enable them to become both valued producers and genuine consumers.  For example, simply deploying air conditioning and water treatment plants will make these people less vulnerable to climate extremes and disease so they can produce and consume more effectively.


  1. PIMCO Investment Outlook, August 2012, "Cult Figures," by William H. Gross.  © Copyright 2012 by Pacific Investment Management Company.  All rights reserved.
  2. The Wall Street Journal, July 31, 2012, "Bill Gross: We're Witnessing the Death of Equities," by Steven Russolillo.  © Copyright 2012 by Dow Jones & Company.  All rights reserved.
  3. PIMCO Investment Outlook, September 2002, "Dow 5,000," by William H. Gross.  © Copyright 2002 by Pacific Investment Management Company.  All rights reserved.
  4. The American, August 14, 2012, "Gross Folly," by James K. Glassman.  © Copyright 2012 by American Enterprise Institute.  All rights reserved.

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