03 Aug 2012 Are Stocks Dead?

Comments by Bill Gross and others of late have rocked the status quo and tested commonly held investment tenets. On Tuesday Gross proclaimed in his monthly outlook column that “The cult of equity is dying.” “Like a once-bright-green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of ‘stocks for the long run’ or any run have mellowed as well.” He’s right on the latter observation anyway.

Every so often the media or some media darling declares an end to the reign of stocks. Perhaps the most famous, or infamous, occurred in 1979 when BusinessWeek magazine declared the “Death of Equities.” Of course, at the time, there were very very few people who would disagree. Stocks had averaged a dismal 3.2% annual return for the decade. In fact there were few people who had something positive to say about much of anything.

The year of 1979 was difficult for Americans. Our country was deeply politically divided. Leadership under President Jimmy Carter was less than inspiring. Inflation raged between 10 and 14%. The top marginal tax rate was 70%. And in late 1979 52 Americans were dragged from their US Embassy in Iran to be held hostage for 444 days. The BusinessWeek cover might as well have replaced “Equities” with “Optimism” as dead.

But America and stocks would rebound with impressive and unprecedented force. Ronald Reagan re-inspired our nation to hopefulness. He eliminated crippling regulations, cut spending (in his first term) and cut taxes. Paul Volker strangled inflation from the monetary system with no less than draconian measures, by modern standards. And a little square of silicone thing known as the Intel 8088 processor came to market as the brains of the first model 5150 IBM PC, starting at $1,565, marking the naissance of the Information Age.

Things don’t happen in a vacuum. With all due respect to Mr. Gross, it is pretty easy to make the case that stocks have suffered mightily these last few years. In fact, stock market returns as measured by the S&P 500 have fallen significantly in the last decade.

But let’s remember the historical context of the last ten years. We have experienced a devastating technology and dot.com bubble burst, two major wars, a collapse in the housing market, major terrorist attacks on our soil, corporate malfeasance and the commensurate weight of new burdensome regulations (Enron and others), a financial crisis and near-meltdown in 2008, with new regulations, skyrocketing federal spending, national debt in excess of the nation’s production of goods and services, the commensurate loss of our AAA credit rating, unemployment above 8%, and a country more politically divided and angry than any time since the civil rights movement of the 60’s and 70’s(perhaps more so).

The last ten years have been rife with uncertainty and downright fear – an ideal climate for bonds, particularly US Treasuries. People flock to the safety of Treasuries when all other forms of investing are in peril. Mr. Gross of course knows this. As co-founder and co-chief investment officer of Pacific Investment Management Co., the world’s largest bond managers Mr. Gross, from an obvious point of self-interest, says that stock investors should rethink the age-old investing mantra of buying and holding stocks for the long run. He says consistent, annual returns from stocks are a thing of the past. It is a revelation to me that stock market returns ever presented consistent returns in the real world.

Mr. Gross says that stocks operate much like a Ponzi scheme, showing returns that have no real bearing on reality. He points out that stocks have averaged annual gains of 6.6% (adjusted for inflation) since 1912. He asks if economic growth (GDP) ran at about 3.5% over that period, then stockholders have been “skimming an extra 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)?” he asks.

Jeremy Siegel, author of the book Stocks for the Long Run faults Gross’ logic that stock returns can’t exceed GDP growth. He says “Capital has to give you a return above growth. Even in a no-growth economy you’re going to get some growth on capital, so it’s not an anomaly, it’s not inconsistent to get that phenomenon.”

Siegel acknowledged that stocks have been flat for a long time but said that’s not sufficient reason to declare them dead. “I will grant that the last 10-12 years have been poor years. We started from the most overvalued market that we had in the last century [result of the Information Age boom of the 90’s] and we’ve gone to not the most undervalued one but a market is valued lower than the long-run average.”

Gross goes on to say “together then, a presumed 2% return for bonds and an historically low percentage nominal return for stocks — call it 4%, when combined in a diversified portfolio produce a nominal return of 3% and an expected inflation adjusted return near zero,” he says. “The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.”

Mr. Gross is no stranger to pronouncing markets dead. His last post mortem for stocks was in 2009. About the same time he pronounced Treasuries a bubble ready to burst with horrible consequences. Since then the 7-10 Year Treasury index is up 16%. Oh and stocks; since his pronouncement in February of 2009, the S&P 500 is up an annualized 19.4%. If the stock market could speak, it might well quote the inimitable Mark Twain in saying “reports of my death are greatly exaggerated.”

In many ways, the stock market represents the true measure of our collective optimism. Companies and their stock trade on expectations about the future; particularly expectations of future earnings. Benjamin Graham, the Father of value investing, said that in the short term the stock market is a voting machine and in the long run, a weighing machine. In other words, stock prices represent investors’ votes or opinions of how company earnings will fare in the future. The acutal results provide the ‘weight’ or true measure of their results.

Today, we find both measures to be well below historical potential, but that is not the fault of stocks or the companies they represent. If American stocks do indeed die, it will not be by natural causes. The culprits will be the devolution of our political system that increasingly derives its power by division, a system of entitlement that has surpassed our ability to pay for it, smothering debt, and crippling taxes and regulations. The old addage is indeed true, as goes GM [insert: the stock market], so goes the country.