Why Bill Gross is Wrong: Innovation and Long-term Returns on Equity

Bill Gross of Pimco has just written a piece where he argues that the real return on stocks in the future will be much lower than the long-term historical average of 6.6%:

Yet the 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?

He then goes on to argue that:

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.

In a world of slow innovation, Gross is likely to be correct.  The economy grows slowly, and it becomes difficult to justify compensating risk capital if risks are not paying off.

The calculation changes, however, if we have big disruptive innovations. Big disruptive innovations offer risk on both the upside and the downside. On the upside, disruptive innovations create a wave of high-growth companies that drive the stock market higher. On the downside, disruptive innovations offer the distinct possibility of driving existing companies out of business, once again accentuating risk.

Innovation also makes diversification across a portfolio of large stocks a much less appealing prospect, since much of the stock gains will come from small companies that grow quickly. Investors therefore have to take more risk to capture the returns, whether they like it or not.

In this view of the world, an investment in the stock market becomes a bet on innovation. Do you think that the U.S. or the global economy has another wave of disruptive innovation coming? Then buy stocks. But if you think that we are stuck in permanent stagnation mode, then stay away from the stock market.

Comments

  1. Both you and Gross assume that that stock prices are necessarily strongly correlated with GDP. They are not.

    What they ARE correlated with is corporate profits, which have some correlation with GDP, but not a strong one. Profits are that portion of firm revenue kept by the equity holders, i.e. not paid to debt holders, suppliers and employees. You can easily imagine a world where returns on equity improve while revenue stays constant– if debt holders, suppliers and employees get less.

    See, for example http://www.virtus.com/vsitemanager/Upload/Docs/6141_GDPwhitepaper.pdf

  2. Infostack says:

    I believe there is a strong correlation between the out-performance of the markets in the 1980s-90s and competition within the telecom sector. This competition (break up of AT&T and digitization of long-distance along with significant new applications) gave rise to the pricing foundations of the internet. The latter were Bell monopoly pricing reactions of expanding local calling areas and implementing flat-rate access which gave rise to commercial ISPs that predated the www. The www kicked the Wintel model into hyperdrive and all that silicon scaling and low-cost long distance scaled the digital wireless boom of the late 1990s. The only problem is that we started remonopolizing our telecom sector 16 years ago and bandwidth pricing is 20-150x greater than it should be. In an economy depending on knowledge network and information exchange and ecommerce I believe this bandwidth barrier is the single biggest deterrent to real growth and innovation. The markets under-performance is tightly correlated with this remonopolization.

    • On the Income-Side, GDP is split between wages, return on capital and taxes.
      So, even in a zero growth environment there is (and usually there is) a positive return on capital without a Ponzi-Scheme.

      This does not mean, of course, that stock prices always rise, because expectations are traded.

  3. I have great respect for Bill Gross and his economic view of the world but on this issue he has missed the side of the barn. Equity holders enjoy a higher return due to an equity risk premium that results from companies issuing debt. Just like real estate investors enjoy higher leveraged returns due to debt, so do equity investors. Debt holders agree to revceive lower returns as a result of being higher in the capital structure and having greater certainty of return of capital. Equity holders don’t eventually control all the capital in the market since the pool of equity is constantly being adjusted as dividends are paid out and equity is repurchased.

  4. Investors must (not) so consistently profit at the expense of others, for if the economy grows by 3.5%, so must their consumption from that 3.5% they skim off. The total return may be 7% but they can only see that if they reinvest all their proceeds meaning their consumption would fall as a proportion of gdp, so they have a 3.5% growth in their investments and a 3.5% growth in their consumption. If they had any less, they would move into bonds as the uncertainty would not be worth bearing. Growth may slow as population slows so we may not see 7% in the future (or 3.5% on bonds), but can still grow with productivity and innovation.

  5. The guys at Macrofugue made a compelling argument for both short-term and long-term long U.S. equities position about a month ago. Very worth the read. http://macrofugue.com/the-real-cult-of-equity

  6. You did not not effectively address Mr. Gross’ arguments here. Profit margins are high, and all of the long-term valuation measures (CAPE, Q-ratio, etc.) indicate low future returns.

  7. There’s another possibility you’re missing: that we have disruptive innovation that pumps growth but the stock market becomes irrelevant, because stock becomes obsoleted as a way of funding companies. Equity was invented millenia ago and comes down from at least Roman times, it’s ripe to be replaced with some new innovation. Look at the rise of private equity and how many large companies stay private these days. Look at new companies that are trying non-hierarchical, flat structures, better ways of organizing how people work together. With all this innovation coming, I highly doubt the stock market itself can survive some disruptive innovation, particularly considering how most stock markets have become casinos that little resemble what the real functions of equities should be.

Trackbacks

  1. [...] – NY Times Knight Algo Nightmare Dents Market as Trader Sounds Alarm – Bloomberg Why Bill Gross is Wrong: Innovation and Equities – Innovation and Growth Now it the wrong time to flee stocks – MSN Money Gold miners [...]

  2. [...] –Innovations and Stocks: Michael Mandel takes issue with Bill Gross‘s assertion that long-term returns on stocks will be lower in the future. “Big disruptive innovations offer risk on both the upside and the downside. On the upside, disruptive innovations create a wave of high-growth companies that drive the stock market higher. On the downside, disruptive innovations offer the distinct possibility of driving existing companies out of business, once again accentuating risk. Innovation also makes diversification across a portfolio of large stocks a much less appealing prospect, since much of the stock gains will come from small companies that grow quickly. Investors therefore have to take more risk to capture the returns, whether they like it or not. In this view of the world, an investment in the stock market becomes a bet on innovation. Do you think that the U.S. or the global economy has another wave of disruptive innovation coming? Then buy stocks. But if you think that we are stuck in permanent stagnation mode, then stay away from the stock market.” [...]

  3. [...] Editor’s Note: This item is cross-posted from Innovation and Growth.  [...]

  4. [...] have suggested that the Gross pronouncement is a good reason to buy.  For trading purposes that may be correct. But I don’t see it as a long-term buy [...]

  5. [...] Why Bill Gross is Wrong: Innovation and Long-term Returns on Equity (innovationandgrowth.wordpress.com) [...]

  6. [...] Why Bill Gross is Wrong: Innovation and Long-term Returns on Equity (innovationandgrowth.wordpress.com) [...]

  7. […] Why Bill Gross is Wrong: Innovation and Long-term Returns on Equity (Michael Mandel) […]

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