Where the Bonds King went wrong
An article by Pimco executive Bill Gross erred in many ways, but one thing he got entirely right: The investment class is taking more and more of the economic pie from U.S. workers.
Last week, a foofaraw exploded over an article written by Bill Gross, co-chief investment officer at Pimco, the world's largest bond-based mutual fund.
Gross claimed that stock returns over the past 100 years – real annual returns (in other words, returns minus inflation) were on average 6.6 percent, and aren't coming back.
Past returns, Gross asserted, were based on a Ponzi scheme, in which certain stocks beat the benchmarks only because the cult of devotees snapped them up them at ever-increasing prices.
Since, in his opinion, the number of these cult followers is gradually decreasing, the steady up-trend of stocks they cause wil disappear. Shares just won't do as well as they used to.
It’s basic supply and demand, and the dial is pointed down.
Gross' argument is a simple one: A stock market cannot provide returns at a rate greater than the growth of a nation's economic pie. If GDP grows between 3.0 and 3.5 percent per year, stock market returns cannot exceed this rate over the long term. If it does grow faster, its share of the economy will reach unreasonable proportions.
Not everyone agreed with Gross.
Henry Blodget was an enthusiastic tech analyst, and in the heady '90s he was practically the poster boy of the dot-com bubble. Since that bubble burst, Blodget has straightened up and evened out, and today is much more professional and level-headed.
Blodget claims that Gross is mistaken – and for a simple enough reason. A solid chunk of the returns provided by the stock market actually stem from dividends provided through current profits. Ergo, stock market values don't grow more than 6.6 percent per year. Their expansion is significantly more subdued.
The case of Easy and Simple Company
Blodget is right, and it's easy to demonstrate this. For the purpose of example, let's describe a very simple company. We’ll call it Easy and Simple Company, LLC.
All ESC owns is a single building rented out for the long-term with a contract linked to the consumer price index. The company has zero debt, and its entire annual profit is distributed to shareholders as a dividend.
Such companies actually do exist. You’ve probably heard of them. They are called real estate investment trusts (although, generally speaking, they must distribute as dividends to investors close to 90 percent of their annual profits, not 100 percent).
If, for example, Easy and Simple Company is known to generate a regular net, after-tax investment return on assets of 6 percent, and the company's share price will reflect the real underlying economic value of its assets, the company's shares will trade at a price that will generate an annual yearly dividend of 6 percent on the stock purchase price.
Furthermore, its stock won't rise over time faster than the increase in the value of the underlying asset.
What benefit does the investor receive in this pared down, easy-to-comprehend case? They get a steady real cash flow of 6 percent per year and a share price that grows at the speed of inflation.
This asset's contribution to GDP growth is negligible, since the cash flow it generates at the end of the year holds steady from the cash flow produced at the beginning of the year. Consequently, the stock's contribution to GDP is identical year in and year out – and still the investor receives his regular 6 percent return on investment.
This, faithful readers, is where Gross slipped up. Corporate profits are included in GDP, inasmuch as when they are given to investors as a return in the current period they don't contribute to the growth of future corporate profits, but they certainly can produce an investment yield that that is greater that the GDP growth rate.
When a company doesn't grow
Now, let’s take another example: A company trading at a price-earnings ratio of 10 and distributing half its profits as investor dividends. It certainly can provide a return of 10 percent per year even if its profits aren't growing at all. Investors will receive half of the 10 percent return in cash and another five percentage points in increased share value of the company. Here as well, the profits of the company are part of GDP, though part of the company's profits that are distributed to investors don't contribute in any way to GDP growth, and still the return from the investment is greater than the pace of GDP growth.
A bond market savvy like Gross should know that a stock market investor doesn't need a company’s profits to grow before he can see a nice return on his investment. In fact, it's just like a bond investor doesn't need the company he's invested in to experience profit growth in order to see a return on his investment principal.
All around the world, there are companies with stable profits that just aren’t growing. These companies’ bonds provide returns of between 3 and 4 percent per year, and their dividends are between 5 and 6 percent per year. Just like we said, these bond investors don't need to seen an increase in the coupon value of their bonds in order to enjoy returns on their investments. At the same time, they can also enjoy some current cash flows. Similarly, a shareholder doesn’t need to see his share price rising in order to enjoy a return on investment of between 5 and 6 percent per year.
Additionally, a shareholder has a chance of protecting his investment from the effects of inflation, which bonds denominated in nominal terms do not provide to their holders. The surplus risk associated with stock ownership in relation to bonds is reflected in a surplus return. This kind of investor only requires profit stability, a well-established policy on company dividends and avoidance of the market's animal spirits, which can haphazardly increase and decrease stock prices.
The beat-down workers
So where is Gross right, and in what way does he even find himself sharing the position held by Warren Buffett, a true believer in stocks?
Growth in corporate profits can't exceed GDP growth in the long run. If it did, some shareholders would gorge themselves on economic pie while other participants in the economy starve. There is a limit to how big of a slice of economic activities can fall into the hands of shareholders. Maybe this is the source of confusion.
Wall Street has fallen prey to idol worship, and the golden calf is profit growth. Both company executives and directors are blinded by dollar signs, forcing them to stumble into horrific business decisions and confusing both investors and industry commentators. If the appearance of growth is all that matters, then investing in stocks in a zero-growth environment would appear to be a bad idea.
This is a fundamental mistake.
A stock that is traded with a low price-earnings ratio (in other words, with a high rate of profit), and that has a stable degree of profitability and an appropriate level of dividends, can yield better returns over the long term than those produced by bonds. It's clear that this kind of stock will struggle to compete with rapidly growing companies and the returns these companies can provide.
But remember that the companies with relatively rapid growth rates are also the ones with much higher prices. Consequently, an ill-timed investment with them will have a much higher price as well. If their growth flatlines (because growth cannot continue indefinitely) the price of a bad investment decision will be particularly painful.
There is one graph in Gross’ article that is very interesting. It shows the relative share of labor income – meaning workers’ salaries – as part of total GDP for the years 1960-2010.
This is where the real action is. This is the stage upon which the working class’s painful drama is set. While the average man struggles, the shareholders reaps the rewards.
The relative share of wages as part of the GDP pie in the 1960s was between 50 and 54 percent. It then declined and has hit a low of 44 percent in recent years. It continues to hold steady at this rate.
This is the biggest drama that has occurred in the American economy in the past 50 years. Corporate profits grew at a more brisk pace than GDP for a simple reason. In addition to the growth caused by the burgeoning economic pie, the slice taken by company shareholders grew faster, because they also chewed off a chunk of the slice that went to workers' wages.
This is a longtime phenomenon. Its specter haunts the American economy and is responsible for one of its serious structural flaws. It fosters inequality, since workers’ incomes and standards of living are sinking while an ever-smaller cadre of top earners reap the benefits.
Some people say that because of public shares and pension funds, workers will get back whatever they lose. This is a major mistake.
The primary asset of tens of millions of Americans is their salaries. They own very few company shares, if they own any shares at all. The fact that their eroding earnings means great stock market returns is as interesting them as much as a head of lettuce. What does the stock market have to do with them?
What they do care about, these workers will bills to pay and a mortgage to face and a family to answer to, is the 10 percent reduction in their wages in recent years. Their day to day lives, and their ever-stretched pocketbooks, set the foundation for the recent protests across America. In the long run, a situation that is good for companies but bad for citizens just isn’t stable. It certainly has no place in a democratic state.
Gross' article is worth reading not because of the controversy it has stirred up, but because what is contained within it but never made the headlines: The manner in which wealth has shifted from workers to shareholders.
The writer is the CEO of Psagot Compass Investments. Nothing in this article should be construed as a recommendation to sell or buy securities or as financial advice whatsoever. Any investment should be made solely in consultation with your investment advisor.