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ICYMI: Gross Folly
This article originally appeared on The American, the online magazine of the American Enterprise Institute. The world’s most successful bond fund manager is telling Americans that stocks stink. Is he wrong again? “The cult of equity is dying,” writes Bill Gross, managing director of Pacific Investment Management Company (PIMCO), the hugely successful money management firm. His August Investment Outlook, which is extremely negative on stocks, has been the talk of Wall Street. Some suspect Gross of talking his book, but it’s worse than that. Gross runs the largest mutual fund in the world, PIMCO Total Return, with $270 billion in assets—almost all in bonds—and his antipathy to equities is nothing new. In September 2002, he wrote a piece in his newsletter headlined “Dow 5,000,” that said, “My message is as follows: Stocks stink and will continue to do so until they’re priced appropriately, probably somewhere around Dow 5,000, S&P 650, or Nasdaq God knows where.” His timing could not have been worse. On October 10, 2002, barely a month after the newsletter came out, the Dow Jones Industrial Average hit a low of 7,197 and started back up. The bear market that began in the first quarter of 2000 with the collapse of tech stocks was over. Last Friday, the Dow closed at 13,207. That’s a gain of 85 percent. With dividends, an investment in the 30 Dow blue chips has more than doubled since Gross’s forecast. He was wrong about the other indexes, too. The S&P bottomed the same day as the Dow, never coming close to 650, and is now at 1,406—up 85 percent. The Nasdaq also reversed course in early October 2002 and has since risen 173 percent. In October 2002, I took issue with Gross’s prediction in a piece titled “Why Stocks Don’t Stink,” citing the history of U.S. equities and the low valuations that were then prevailing. I advised investors not to bail out. I concluded that, not only do stocks not stink, but, “in fact, they’re enticingly fragrant.” Some might say that, as the coauthor of the 1999 book Dow 36,000, I am no better a forecaster than Gross. Fair enough. But there are two differences. First, unlike Gross, I’ve learned my lesson about the forecasting game. Dow 36,000 was a serious financial work, but it suffered from an inflammatory title and a prediction that grabbed attention but had little to do with the mainstream thesis. No more futurology for me. Second, unlike Gross, I am a believer in the long-term rationality and efficiency of markets rather than in conspiracies, name-calling, and hubris. And this is what troubles me most. A decade ago, in his “Dow 5,000" column, Bill Gross wrote: Earnings have been phonied up for years, and the market still sells at high multiples of phony earnings. Dividends and dividend increases have been miserly to say the least for several decades now, and you’ve been hoodwinked into believing the CORPORATION should hold on to them for you so that you can convert them into capital gains and save you taxes. Companies…pick you off by trading on insider information, selling shares before the bad news hits and you have a chance to get out…. Come on stockholders of America, are you naïve, stupid, masochistic, or better yet, in this for the “long run?” If Bill Gross sounds Michael Moore-ish here, it is no accident. Like Warren Buffett, his undeniable success as a financier has led to media interest in his views on economic policy. As it happens, he has been pushing hard for more government stimulus spending. “You’ve got to create a demand for labor,” he was quoted in The New York Times as saying. “The private sector is not going to do it.” Even if the government has to do it directly, “putting a shovel in the hands of somebody can be productive.” In his 2002 essay and in the one this month, Gross is especially cross with Jeremy Siegel, the Wharton professor who wrote the influential 1994 book Stocks for the Long Run. (Hence the snarky reference in the last two words of the "Dow 5,000" quotation above.) Siegel looked at nearly 200 years of U.S. financial history and showed that not only did stocks return far more than bonds, stocks were not much riskier over the long term. Siegel’s work became the basis for the theory underlying Dow 36,000. Kevin Hassett of AEI and I examined what economists call the “equity premium puzzle”—the notion that stocks seem to return more than they should, given their risks compared with bonds. We concluded that it was reasonable for stock prices to rise, at some point, to where annual returns will level off and be similar to those of bonds. That point, we said, was about 36,000 on the Dow. But to get back to Gross and his new attack on Siegel: As in 2002, Gross this month goes flying over the top in his disdain for investors, efficient markets, and, quite frankly, the capitalist system. In his piece, he makes several arguments, but the most surprising is that annual average equity returns of 6.6 percent after inflation—which, as Siegel and others have shown, have been fixtures for a century or more—are actually the result of “a Ponzi scheme.” Gross writes that the returns “belied a commonsensical flaw much like that of a chain letter.” Since real GDP was increasing only at 3.5 percent, he wrote, “then somehow stockholders must be skimming 3 percent off the top each and every year.” When I read that, I couldn’t believe my eyes. Returns to stocks have two components: Dividends and price gains. The dividends are a kind of rent that investors receive in return for their capital. The price gains are what reflect the growth in the economy. Add the two, and you get total return. Does Gross not know this? I was not surprised, then, that Siegel would set him straight. Siegel said on CNBC, “You can definitely have a return greater than GDP growth. There is nothing uneconomic about it. The thing is that capital gives out dividends, it gives out interest, it gives out return. When you add that all together, it’s going to be greater than GDP growth. Even in a non-growing economy, you have situations where return is greater than GDP growth.” (An analogy here would be an investment in rental property. As an owner, you get paid income regularly by the renter, and your home—you hope, anyway—appreciates as the economy grows.) As Sam Ro of Business Insider wrote, “It would appear that Gross has made some very basic errors in his argument.” In his newsletter, Gross calls 6.6 percent returns “an historical freak, a mutation likely never to be seen again as far as we mortals are concerned,” and he calls Siegel a “cult figure” who has perpetuated this myth. Gross has it exactly backwards. Returns are far from a “historical freak.” They are a historical persistence over long periods. The freak would be a change in underlying U.S. growth rates. And this may indeed be happening. Rather than a brisk and sharp rebound after a devastating and deep downturn, the United States is struggling along with 2 percent growth—the worst recovery in modern history, including the Great Depression, according to Edward Lazear of Stanford. And long-term forecasts suggest that such levels, or lower, could become what Gross’s partner, Mohamed El-Erian, called “The New Normal.” In my view, the Keynesian policies that Gross so adores are helping to suppress U.S. growth, which, with the proper policy changes to liberate private enterprise, could be running 4 percent. This is the thrust of the new book, The 4% Solution, which the Bush Institute has published, with chapter contributions by two dozen economic experts, including five Nobel Prize winners. One thing Gross may be correct about, however, is that investors should expect “an attempted inflationary solution in almost all developed economies over the next few years and even decades." History shows, however, that inflation is hell on bonds and much kinder to stocks. I am sympathetic with Gross on another point. Exhorting investors to hang on through the roller-coaster ride of the stock market is a losing cause. It’s too hard for most people to do, and, for that reason, I believe in taking steps such as shifting asset allocation to include more bonds than in the past—an insurance policy that might sacrifice a bit of upside return for a lot of downside protection and, overall, a smoother ride. All well and good. But Gross goes much, much farther. Corporate managers lie and cheat. Investors are hoodwinked. Wharton professors are Pied Pipers or Charles Mansons. And markets are headed for a crash. I would not go so far as to call Gross’s latest essay a buy signal, as his 2002 one was, but I would wonder whether he is just having fun or if he believes this stuff. Neither alternative is very attractive. This post was written by James K. Glassman, Founding Executive Director of the George W. Bush Institute.
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