Everybody who makes any investment decisions (like what to do with the money in your IRA or other retirement account) needs to understand something that Bill Gross, managing director at PIMCO and involved in the running of the PIMCO Total Return bond fund (PTTRX), the world's largest, with a market capitalization of $263 billion as of the market close yesterday, apparently does not. Namely, that one should not expect the long run rate of return on ownership of stock to be equal to the growth rate of GDP, or even of the economy's capital stock. Gross (quoted by CNBC online):
The 6.6 percent real return belied a commonsensical flaw much like that of a chain letter or yes - a Ponzi scheme," he says. "If wealth or real GDP was only being created at an annual rate of 3.5 percent over the same period of time, then somehow stockholders must be skimming 3 percent off the top each and every year."
"If an economy's GDP could only provide 3.5 percent 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)?"
It's remarkable that someone in finance is conceptualizing the returns to capital as "at the expense of others (labor, lenders, and the government)". (I'm not implying that that's never the case...) I guess it is part of his main misconception, that returns beyond the rate of growth of the capital stock must be somehow at the expense of other sectors, rather than any kind of return to capital based on its productivity, or scarcity, or similar economic factors. What Gross fails to understand is that the economy does not necessarily invest all of the returns to capital in growing the capital stock, and thus growing potential GDP; some of these returns are, if you like, "skimmed off the top" and consumed. For publicly traded companies, for example, this can take the form of dividends returned to shareholders. Doing a more precise accounting of where firms' profits go, in terms of new capital formation, dividend payouts and other ways of getting cash to investors, and so forth, and comparing it to long-run stock market returns, seems like a worthwhile exercise. It's one I'm not especially well-equipped to do although I suspect it would begin with a (salutary for any investor) review of financial accounting---in particular, how to interpret corporate income statements and balance sheets. And I suspect many economists have done versions of it. [Added Aug. 2nd 2012: I think that dividends and distributions are not really the key here: investors might reinvest dividends (supporting the stock price, and tending to increase market returns), or sell stocks and consume some of the proceeds without reinvesting (reducing overall market returns). The main point is as stated above, that economy-wide, all of the returns to capital should not be assumed to be reinvested.] But it's shocking that someone managing money at this scale (or any scale, actually!), even if it's mostly not equities, doesn't have their mind around this basic fact.
That doesn't mean I necessarily endorse the 6.6% real returns mentioned by Gross for US equities over the last century, as a reasonable expectation of (very) long-run returns to US stocks...I would need to see how the calculation is done, and of course, past performance is no guarantee of future returns... But when I saw Gross' statements linked on major financial information websites, I felt like I had to say something. Brad DeLong explains in more detail. He also makes the point that the earnings yield of the S & P 500 is currently around 7.7%, and in a further post, points out that the yield using the past 10 years' earnings, smoothed, is around 4.5%, which together with an (historically reasonable) assumption of 2% real earnings growth, suggests to him that around 5% real returns to equity is a reasonable expectation (unless you expect a collapse in earnings, or price-to-