Tuesday, August 7, 2012

The Cult of Equity?

Bill Gross, not coincidentally the world's largest bond manager, at the worst time in the cycle to hold bonds, thinks future equity returns will be terrible (although long-term bonds will also be terrible.)

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. 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. 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. Private pension funds, government budgets and household savings balances have in many cases been predicated and justified on the basis of 7–8% minimum asset appreciation annually. One of the country’s largest state pension funds for instance recently assumed that its diversified portfolio would appreciate at a real rate of 4.75%. Assuming a goodly portion of that is in bonds yielding at 1–2% real, then stocks must do some very heavy lifting at 7–8% after adjusting for inflation. That is unlikely. If/when that does not happen, then the economy’s wheels start spinning like a two-wheel-drive sedan on a sandy beach. Instead of thrusting forward, spending patterns flatline or reverse; instead of thriving, a growing number of households and corporations experience a haircut of wealth and/or default; instead of returning to old norms, economies begin to resemble the lost decades of Japan

I don't quite get his argument. The long run return from stocks is a combination of profit income - the share of corporate profits in the economy, including dividends - plus capital appreciation. It is not just the economy's growth rate in isolation.

In any case, pronouncements of the death of equities usually tend to be a buy signal for stocks. In the longer run, I think we could see more legal and institutional change in the nature of the economy that affects stocks, but that is likely decades off.

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