A Gross Misconception

August 3, 2012

Bill Gross is someone we respect greatly and we have been following his career for years.  He co-founded Pacific Investment Management and runs the world’s largest bond mutual fund, PIMCO Total Return.  He recently released an Investment Outlook piece, titled Cult Figures, and we wanted to share our opinion on his thoughts in today’s show.

In this piece, Mr. Gross shares his opinion that stock investors should rethink their pattern of holding stocks for the long run, as the cult of equities seems to be a thing of the past.  He says, “Now in 2012, an investor can periodically compare the return of stocks for the past 10, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously “safer” investment than a diversified portfolio of equities. In turn it would show that higher risk is usually, but not always, rewarded with excess return.”

Got Stocks?
Mr. Gross points to a 6.6% real return from stocks since 1912.  He wonders how a real return of 6.6% makes sense when real GDP was only being created at an annual rate of 3.5% over the same period of time.  He claims that the stock market has acted as a Ponzi scheme, somehow shaving off 3% each and every year and giving it to stockholders.  However, he is using flawed logic to reach this conclusion.  The relationship between stock market returns and GDP is not perfectly linear and correlated.  GDP is a measure of economic output; stock prices and returns are based on expectations of future cash flows.

He also states that “real wage gains for labor have been declining as a percentage of GDP since the early 1970s, a 40-year stretch which as yielded the majority of the past century’s real return advantage to stocks”.  However, this chart shows that standards of living have risen enormously over the last century, in great part due to increased production and advances in technology.  GDP growth has been faster than population growth, giving every human being more resources than ever before in history.  So, this isn’t necessarily an issue of exploiting laborers.  It is more an issue of exponential productivity gains, which is a good thing.

Got Bonds?
Mr. Gross states that it is a stretch to assume that long-term bonds will replicate the performance of past decades, with long Treasuries currently yielding 2.55%.  We agree.  While we have been in a declining interest rate market, it is inevitable that we will see the opposite in the future.  When we do go into a period of increasing interest rates, the value of currently held bonds will decrease.  Bond holders may have to sell at a discount. Given the number of “bubbles” we have seen in the market in the past, this should be a bit of a warning about the possibility of a bond bubble.

What’s the Alternative?
A portfolio consisting of purely equities or purely bonds will not help an investor reach his or her goals.  While we do not agree with everything Mr. Gross says in his commentary, he has provided us with some reflection on the problems with relying on any one asset class to consistently provide favorable returns.  Exclusively investing in stocks, bonds, or cash is never the answer.  You must diversify.  Put together an investment plan, save 15-20% of your gross wages, and find a risk tolerance and diversification that fits for you.

We would love to hear your thoughts on Mr. Gross’s Investment Outlook.  Please comment below or post on our Money-Guy Facebook page!

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