Asking PIMCO founder Bill Gross his opinion of stocks is like asking the late Steve Jobs his opinion of Windows. The response may be as predictable as it is smart and incisive. Not only did Gross take on stocks as an investment, he directly called out long-time stock advocate Jeremy Siegel of the University of Pennsylvania Wharton School for promoting unrealistic expectations of future equity yields. The analyses of stock investing by both Gross and Siegel should be taken seriously by anyone who cares about estimating future equity returns.
In characteristically subtle fashion, Gross noted in his August PIMCO Investment Outlook column that stock investment is a fading cult resembling a Ponzi scheme buoyed by past returns that were a "historical freak, a mutation likely never to be seen again." The most compelling point made by Gross is that the assumption of a 6.6% real rate of return on equities in an economy that is only growing by 2-3% is logically unsustainable.
Such a rate of return would imply that the majority of economic growth in society would be swallowed by equity investors. Any productivity gains would have to be allocated to equity owners at the expense of bond holders and workers who would merely tread water or lose ground as the economy expands.
Gross is right. A 6.6% real rate of equity return in perpetuity implies that bond investors and/or workers are saps whose risk aversion and ignorance lead to a wealth transfer to equity investors. But this is more or less what occurred in the 20th century in the United States. Siegel's book Stocks for the Long Run notes that an investment of $1 in T-bills grew to $18 between 1926 and 2001, while a $1 investment in stocks grew to $1,606. Presumably this is because T-bills are less risky than stocks. If so, then there should be at least a few examples of long-term stock underperformance. Siegel noted one in his book—between 1831 and 1861. We've already experienced a second.
I asked Wade Pfau, associate professor at the National Graduate Institute for Policy Studies, to calculate the long-run opportunity cost of bond investment versus equity investment. We assumed that in each period a 30-year bond is issued at prevailing interest rates (long-term government bond plus 1%) and that amount is invested for the next 30 years in a portfolio of large-cap stocks while paying off the bond as an amortized loan (as if it were a mortgage). All final wealth values are inflation-adjusted. Think of it as taking out a mortgage on a paid-off home and investing the proceeds in stocks for the duration of the mortgage.
Our results represent the wealth transfer from bond investors to equity investors within each 30-year period in the United States. If markets are efficient and long-run risk is real, then bond investors should have outperformed equity investors some of the time. The results reveal a bad century for American bond investors, but also a surprising trend toward market efficiency.
The Depression ruined a stock investor's scheme of selling bonds to buy stocks if they started between 1928 and 1931. Those who borrowed $100 in 1932 earned $901 by 1962 after investing in stocks and paying off the loan. Those who borrowed $100 in 1993 saw their equity investment grow to $1,064. Investors who borrowed $100 in bonds and invested in stocks earned a remarkable $1,156 after 30 years if they began in 1942 and $1,192 if they began in 1943.
This high-water mark for the bond/stock arbitrage strategy hasn't been matched since, and one might argue that high global economic and political risk made stock markets less attractive during the mid-20th century. Since then, the arbitrage strategy has declined in a nearly linear fashion to the point where there were no years where the strategy yielded more than $200 between 1959 and 1974 and in 11 of these 16 years an investor either lost money or gained less than $100. High equity returns in the 1990s again lifted gains to $532 for investors who borrowed $100 in 1975, but declined to just $16 by 1981. A quick glance at the graph suggests that the wealth transfer from bond to stock investors has declined over the last 50 years and may now represent a much more modest premium for long-term stock investors.
