William H. Gross wrote a very interesting Investment Outlook piece that he begins with “The cult of equity is dying.” He argues that the century long 6.6% real return of stocks will not persist into the future. However, I don’t understand the logic in one of his arguments.
Over the past 100 years, real GDP growth has been 3.5% per year, but stocks have returned 6.6% per year. Gross likens the 3% excess for stocks each year to a Ponzi scheme. “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)?” Gross goes on to explain that if this persists into the future, the rule of 72 tells us that stock owners would double their advantage every 24 years and would eventually own everything.
The flaw in this logic is that stocks pay a slice of their returns in the form of dividends. These dividends get spent in the economy. Some dividends get reinvested into stocks, but that means that some other stock owner sells shares and receives cash that is then spent in the economy. The net effect is that all dividends are spent. As long as the capital gains of stocks don’t grow faster than GDP growth, there is nothing unsustainable about total stock returns (including dividends) exceeding GDP growth.
Gross isn’t telling us to sell our stocks. “Common sense would argue that appropriately priced stocks should return more than bonds.” He goes on to say “If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that.”
Gross’s main argument is that we should expect stocks to outperform GDP by much less than 3%. He may be right about this; I have no opinion. However, I disagree that 3% outperformance is necessarily unsustainable.