Stocks are Dead! A "Gross" Mistake if You get Suckered in this Gloomy Forecast

by on August 1, 2012

in Public, Value Investing Tips & Articles

Be fearful when others are greedy and be greedy when others are fearful

- W.E.Buffett

Bill Gross of Pimco, the bond man himself, writes in his monthly market analysis that the "cult of equity" is over, and the consistent long term returns for stocks since 1912 will be viewed as a historical freak.

Gross follows David Rosenberg from Gluskin Sheff who declared yesterday that the equity cult is over.

These pronouncements come as equity funds suffered their biggest outflows in the last two years. For the week ended July 25, investors pulled $11.5 B net from equity funds (mutual funds and etfs) and $3.5 B in taxable bond funds, according to Lipper.

Clearly, investors are hesitant about stocks and more comfortable with bonds, despite historically low bond yields and a guaranteed loss of capital in bonds as interest rates pick up. Therefore, it is quite likely that Gross’ and Rosenberg’s predictions would be received in sympathy.

But they are wrong.

Gross’ arguments to support his prediction are profound on the surface but completely misleading and erroneous. He questions how one part of the over all economy (stock appreciation) can consistently outpace the GDP. Clearly, as he says, this can’t continue, otherwise the stock owners will end up owning the world! Henry Blodget picks apart his arguments writing for Yahoo Finance, when he points out the difference between appreciation and returns. Blodget also points to the fact that the bulk of long term returns in equities have come from dividends.

There are structural reasons why equities return more than bonds, and these haven’t changed

Anyone who has an elementary knowledge of how businesses are organized knows that the capital structure is essentially made up of debt and equity. The company produces value, or a return, on this total capital. Return on the debt is essentially limited by two factors – the agreed upon cost of debt, as in the coupon on the bonds, and the limitation of the risk of default given to the debt holders by giving them preferential ownership of the company assets over the stock holders.

Bond holders are more likely to collect on their investment in the event the company goes bankrupt as they are first in line to take over the assets. Stock holders may be left with very little, or nothing. Since they bear unlimited risk of total capital loss, they demand higher returns then the bond holders.

In most cases, the risk of default for a company is low, therefore stocks have value.

In fact, the higher the debt a company carries, more default risk is priced into the stock, and the potential rewards or returns from owning the equity is higher. The capital structure of a company gives leverage to the stock holders.

Other way to say this is for a company that has both debt and equity holders, if the total capitalized value of the company rises in direct proportion to the GDP, the value of the debt component will rise less than the GDP rate, while the equity component will rise at a greater rate. This is assuming the capital structure remains constant.

Gross will be right in his estimate that the overall stock market returns (assuming he is talking about real returns after inflation) will be lower than the past, only if the overall capital structure of US businesses tilt more heavily to equity and reduce their use of debt financing.

But debt is and has been a cheaper way to finance a business. Unless this changes (let’s say the interest rates go up a lot and the inflation remains low), companies will continue to use debt.

If Gross is Right, Index funds’ days are numbered

Eventually, you can’t get outstanding returns by doing the same thing that every one else is doing. If there is indeed a structural change in the economy going forward that reduces equity returns for many decades to come, investors will continue to pull their money out of equity funds, which are in most cases closet index funds.

However, no one is suggesting that the overall business growth will be negative or some sectors will not see a growth while others decline. In fact, it is very likely that some good companies will continue to do better then the competition and gain market share, while similar companies that are not well managed might lose market share and go out of business.

Being selective and picky about your investments will serve you well and will beat picking random stocks or not caring at all about where you invest (i.e. buying the whole market through an index).

But of course, Bill Gross is wrong as stated above.

Be greedy when others are fearful

This is the whole thesis of value investing. The idea that "this time it is different" keeps rearing its head every few years or decades, and every time it gets shown up as bunk. Details may change, but the very basic principles of good business and solid stock selection remain true as ever. Forget history and you are doomed to repeat it. Going beyond the clichés, I do want to point out to you that you are weighing two things as you decide to invest in stocks today

  1. On one hand, the historically validated and time-tested fact that buying undervalued stocks outperform the market, and
  2. On the other hand, another historically validated and time-tested observation that most economic predictions are wrong

Ironically, the Fact #1 works better when majority of the investors (the herd) ignores the Fact #2 and makes their investment decisions based on short term emotional triggers.

What will you do?

Is the market cheap today or is it expensive?

I get asked this question a lot and I find it an interesting question on many different levels

  1. First, if you are investing in individual stocks, you should be more concerned with whether the stock you are buying is cheap or expensive
  2. Even in expensive markets, there are always sectors/industries/companies that are cheaper than they ought to be
  3. Well picked stocks will stand up well in ALL market conditions, because they have much more than the overall market driving their performance. For example, a good solid growing business, some identifiable macro economic trends, etc. Before you protest that economic trends are unreliable, I would submit that some trends are more reliable then others. For example, I have not yet found anyone disputing that the proportion of retirees in US is set to grow in coming years, or that a growing Chinese population will consume more food and other resources.

You need to ignore the market and focus on the business. This will help you find stocks that continue to generate outstanding returns in the future and help you make confident investment decisions.

Leave a Comment

Investaup August 1, 2012 at 3:07 pm

@arohan Where can you find a return. Saving accounts, problem is the market has scared the retailer away greed, bonuses, dis information

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arohan August 1, 2012 at 3:39 pm

@Investaup The only way to do this is to do your own due diligence and be very selective

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Investaup August 1, 2012 at 3:49 pm

@arohan Always do arohan. Ignore pundits first rule. Research and post you thoughts honestly. Buy and hold growth. Trade the noise.

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arohan August 1, 2012 at 4:16 pm

@Investaup Sounds like a plan! I always say that if you have a process, you will do well. It does not have to be perfect

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saikjpkvcy8 August 1, 2012 at 5:50 pm
rbesprit August 1, 2012 at 7:08 pm

@arohan Thanks for the link! I scanned briefly but will look at more in-depth tonite.

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arohan August 1, 2012 at 7:14 pm

@rbesprit Sounds good. Have a great evening!

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rbesprit August 2, 2012 at 8:48 am

@arohan Agreed++ “U can’t get outstanding returns by doing same thing every one else is doing.”

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arohan August 2, 2012 at 10:01 am

@rbesprit Glad you like it :-)

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rbesprit August 2, 2012 at 8:50 am

@arohan Pers opinion is ppl are underutilizing strategies & overemphasing indiv stocks & funds. Tho conservative, strategic covered calls…

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rbesprit August 2, 2012 at 8:52 am

@arohan Quantitative indexing is key, also refined & specific buy/sell criteria. Also advantages w/ uncovered calls in ESOs & Restricted stk

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rbesprit August 2, 2012 at 8:54 am

@arohan I am personally 10% ALT, 30% EQ, 30% GLOBAL & 30% FI. Successfully.

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arohan August 2, 2012 at 10:13 am

@rbesprit Assuming Global is mostly equities, it looks solid. do you do lot of etfs?

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rbesprit August 2, 2012 at 3:51 pm

@arohan Not a lot, but part of strategy. Trade using 50 day weighted avg, all momentum based

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rbesprit August 2, 2012 at 3:54 pm

@arohan Sector must remain+ or reallocated to TIF.

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rbesprit August 2, 2012 at 9:02 am

@arohan Last thing: Tax benefits of bonds can’t be dismissed. Income arbitrage also works if approached correctly.

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arohan August 2, 2012 at 10:10 am

@rbesprit As investments, I do not like bonds at this time, although they can be a good part of a specific strategy

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AAAMPblog August 2, 2012 at 2:51 pm

Great post Shailesh. Sometimes I wonder how someone so famous could be so dumb!  But then you look around and see these large institutions failing with these “smart” people at the wheel.  The fact that Bill Gross doesn’t understand capital markets is quite disturbing!

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ShaileshKumar August 2, 2012 at 3:40 pm

 @AAAMPblog Disturbing? I say that is what helps individual investors stand a chance :-) Frankly, these guys trust their computers and models more than they trust common sense.
 
On some level he may be putting this up as a pr piece to trump up more business for bonds, which is Pimco’s bread and butter. It is interesting to watch various sites looking over the history of Gross’ stock predictions and finding they have been consistently wrong. Prof. Siegel of Wharton has pointed out that Gross called for Dow 5K and it is sitting at almost 13K now. It is now war of words between them on financial media so it keeps things interesting

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AAAMPblog August 2, 2012 at 4:08 pm

You might be right about it being a PR piece.  So he is either dishonest or doesn’t understand the capital markets. Either way, it’s disturbing!

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ShaileshKumar August 2, 2012 at 11:24 pm

 @AAAMPblog He seems to be a great contrarian indicator for stocks http://finance.fortune.cnn.com/2012/08/01/bill-gross-stocks/

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pbanik August 3, 2012 at 9:00 am

Brendan O’Boyle,  a Seeking Alpha contributor, also wrote an article about this topic:
The Death Of Equities? Hardly, Mr. Gross
http://seekingalpha.com/article/775401-the-death-of-equities-hardly-mr-gross
 
That being said, I don’t think it’s a wise strategy to place all of your investment capital in bonds or stocks, but a mixture of both, along with fixed income instruments. The reason is financial markets fluctuate over time. Investment grade bonds, along with quality undervalue dividend paying stocks, plus cash and fixed income instruments, make this a more sound asset allocation strategy. I like to have at least some cash on hand for emergency situations and to pay expenses as they arise. I believe it was  Benjamin Graham’s Intelligent Investor recommend no more than 75% or no less than 25% of an investment portfolio in stocks or bonds. Of course, the best strategy is to wait and take advantage of each market when it is most advantageous to the investor. There’s nothing wrong biding your time on the sidelines waiting for the right opportunity, keeping your money in cash. Stocks tend to outperform bonds in the long run.  I posted this in my reply to Brendan O’Brien’s article, but I will repost this for the benefit of your readers who may not be Seeking Alpha members.
 
Are Stocks Really Riskier Than Bonds? (Updated for the latest Year)
http://www.investorsfriend.com/stocksriskierthanbonds.htm
 
My reply to the risk involved, there is always going to be some level of risk involved with investing, unless you’re invested in a guaranteed investment (like a GIC (guaranteed investment certificate)), but even a GIC is probably not a very good investment, for the simple fact, that the rate of return will probably be less than the rate of return over the course of the investment. 
 
Do you have any opinions about REITs, royalty income trusts or Master Limited Partnerships (MLPs)? They can prove to be lucrative in terms of the yield, but you have to look beyond that, and see if the payout ratio is sustainable. I have my doubts and concerns over stocks where the payout ratio exceeds 100%. I think REITs are required to pay out at least 90% of their income as dividends in exchange for their tax status.  I’ve been thinking about investing in REITS, royalty income trusts,  and MLPs, in addition to stocks and bond,  but I have to check about tax considerations first, not to mention withholding tax considerations. France (30%) and Switzerland (35%) are examples of countries where I think the withholding tax is signficant for foreign investors. 
 
http://www.triplet.com/80-10_faq/80-40_tax.asp
http://www.google.ca/url?sa=t&rct=j&q=&esrc=s&source=web&cd=6&sqi=2&ved=0CHcQFjAF&url=http%3A%2F%2Fwww.deloitte.com%2Fassets%2FDcom-Global%2FLocal%2520Assets%2FDocuments%2FTax%2FTaxation%2520and%2520Investment%2520Guides%2F2012%2Fdttl_tax_highlight_2012_Switzerland.pdf&ei=xcobUN7EEcTXqgGrsYCQAw&usg=AFQjCNGPjVBK_2cZDAHhivtdsckzJif8dA&sig2=vnd4q0GPw4zo_5OHas8dRA
 

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ShaileshKumar August 3, 2012 at 10:30 am

 @pbanik One needs to choose the asset allocation that they are comfortable with.
As for REITs, royalty income trusts and MLPs, just look at them as another type of asset. For example, REITs fill in as the part of your portfolio you allocate to Real Estate. MLPs will fill in energy or whatever the MLP is about. Outside of that, you will worry about the specific tax and other specific considerations on these securities, but for me these considerations only come into play once I have decided to buy one of these securities

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