Skim away (Long run return to equities...)

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-equityearnings ratio).

This ain't no disco...

NEW YORK (AP) -- Wall Street is now worrying about the companies usually seen as safe havens.

After an early rally Wednesday, investors succumbed to concerns about disappointing earnings and the market ended the day with a loss. Falling consumer stocks weighed most heavily on the Dow Jones industrial average, which slid 122 points.


Falling orders at Cisco Systems Inc. were adding to investors' anxiety. The world's largest maker of computer networking gear said after the end of trading that orders showed a sharp drop in January. Investors have been pumping money into tech stocks since the start of the year believing those companies would be less likely to see demand fall as businesses looked to cut costs with equipment upgrades.

Nasdaq 100 futures were down more than 1 percent after Cisco's report.


"There's so much uncertainty right now that investors are looking for any clues that the economy may be starting to stabilize and turn around," said Michael Sheldon, chief market strategist at RDM Financial Group.

"Safe havens?"  "...pumping money into tech stocks?"  "...looking for clues the economy may be stabilizing and starting to turn around?"

Stocks might be fairly or even a bit low-valued now on historical measures, but if people are really thinking in the terms these quotes suggest, they haven't factored in the next couple of years of the economy, or they are REALLY believers in the---admittedly existent, for a change---competence of the current administration to deal with a truly daunting situation, and its ability to lead the world in dealing with it.   In the words of the Talking Heads.... this ain't no party, this ain't no disco, this ain't no foolin' around!

So, buy some at this level if you're concerned about being left behind in a turnaround... but save some for Dow 6000.... and some more for 5000 if we get there...irrational despair, and plain old illiquidity and overleverage, of which there is likely some left, leading to rational despair, should make things overshoot on the downside at least once...