Financial Review
Anna Bernasek
Bill Gross, billionaire king of the
bond market, could be the biggest party pooper of all time. Especially as far
as the stock market is concerned. This month Gross, who runs the world’s
largest mutual fund, boldly asserted that automatic asset appreciation was a
thing of the past and equities were “dead”.
In his monthly letter to investors,
Gross said both bonds and stocks would not generate the kind of historic
returns Americans are accustomed to. According to Gross we need to work much
more or accept a lot less.
For the past few decades the
conventional wisdom has been that stocks generate substantial returns over the
long run. Experts told individual investors to invest in stocks for their
retirement. That view was backed up by analysis from Wharton economist Jeremy
Siegel who showed stocks had delivered real annual returns of 6.6 per cent
since 1912. That expectation became conventional wisdom which Gross called into
question.
“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,” wrote Gross. “The simple point
though whether approached in real or nominal space is that U.S. and global
economies will undergo substantial change if they mistakenly expect asset price
appreciation to do the heavy lifting over the next few decades.”
If Gross is right, then the
implications are far reaching. The American investment mentality has been underpinned
by ‘stocks for the long run’ for a generation. Major pieces of the economy--taxes,
investment, retirement, and lots of jobs—depend on that foundation. But does it
have to be a gloomy forecast?
What Gross says is that the
fundamentals for stocks and bonds are lousy and won’t get better any time soon.
On one hand interest rates are already so low that bonds have nowhere to go. And
on the other, slow growth gripping the world economy means equities can’t
perform.
“If
labor and indeed government must demand some recompense for the four decades
long downward tilting teeter-totter of wealth creation, and if GDP growth
itself is slowing significantly due to deleveraging in a New Normal economy,
then how can stocks appreciate at 6.6% real?” Gross asks and answers: “They
cannot, absent a productivity miracle that resembles Apple’s wizardry.”
Let’s
decode that for a minute. The downward teeter totter refers to a historic shift
of wealth and assets from the working middle class to a highly concentrated
group of stockholders over the last thirty years. And when Gross talks about
labor and government “recompense”, he means higher wages and higher taxes are
on their way.
Simple
demographics are also at work. As the baby boom generation ages and retires,
they shift out of equities and into cash and fixed income assets. Generations x
and y have become disenchanted with stocks. And the youngest Americans, known
as generation z, have nothing to invest.
We can already see the shift away from
equities. In the $11.6 trillion US mutual fund market, last year investors
withdrew money from equity funds at a faster pace than in 2010. Meanwhile US
stocks returned a total of just 1 per cent after including dividends.
According to the Investment Company
Institute: “Domestic
equity funds have had six consecutive years of withdrawals totaling $471
billion, more than expected based on the historical relationship between
returns on U.S. stocks and demand for domestic equity funds.”
For three decades, indeed a whole
generation, exceptional returns accrued to the owners of American businesses. If
that’s no longer the case, we’re at the beginning of a big structural shift.
For some high fliers the fastest way to
create wealth was to own companies, cut a few costs and then re-sell them to an
eager public. Think of presidential candidate Mitt Romney. When he was at Bain
Capital that’s a pretty good summary of what he did. But if owning a company is
no longer a golden ticket, many short term strategies will no longer pay off.
A few years of quick profits can amount
to nothing over the longer term. Americans may need to start playing a longer game,
putting emphasis on incremental, durable value creation. That doesn’t mean
phenomenal wealth can’t be created. But it will take lots of time and effort.
Many aspects of our current investment
system offer short term rewards. Compensation is still mainly tied to yearly
marks. Quarterly reporting cycles and 24-hour news reward gamesmanship while
punishing anyone intent on longer plans.
The implication of Gross’s view is that
instead of boldness and speed Americans ought to practice patience and
determination to build their wealth.
The big picture is typically cloudy. So
long as unemployment remains high wages will remain under pressure. But
companies building durable, high functioning teams that will work effectively
for decades might nudge pay upwards. Many mature businesses could well see
diminishing returns. But the irrepressible spirits of innovation and progress
may spawn unforeseen growth. So despite the apparent gloom of Gross’s wake up
call it might set the stage for long overdue changes. And that just might turn
out to be the silver lining.
