Stocks have no place in PIMCO’s “New Normal”
In the world of the “New Normal,” stocks appear to have none of the return potential they have had over at least the past fifty years. Their returns, at about 5% annually, will be little better than one might expect from government bonds. Although a key feature of NN, the explanation of why stocks will do so poorly vs. their past performance isn’t really fleshed out. What little justification there is contains a number of clearly incorrect assumptions.
Yet the New Normal has gotten a lot of favorable publicity. And the premier bond house in the US appears to believe it.
The (strange) argument for this point of view
For what it’s worth, the “New Normal” argument for low stock returns is as follows:
1. economies around the world will have nominal growth of about 3% annually for an extended period of time. There will be no exceptions. Previously fast-growing emerging countries have based their expansion on exporting to the US; they will be unable to find a substitute source of growth and will, therefore, stagnate.
2. a country’s stock market mirrors its GDP, meaning corporate profit growth and stock market gains don’t exceed the rate of GDP expansion by very much. Therefore, the argument goes, stocks are unlikely to have nominal returns of more than 5% per year. What country’s GDP? Unclear, but it really doesn’t matter much, since no place will be growing.
3. since stocks will offer limited scope for capital gains, investors should concentrate on dividend-paying equities.
The conclusion seems to me to be much too pessimistic about stocks, even if the NN’s bleak assumptions about world economic growth prove to be well-founded.
Where it goes wrong
Where does the NN analysis of equities go wrong? –in a number of places. But the key one, I think, is the belief that the stock market mirrors the GDP of the country where the stocks are traded.
How is this incorrect?
Only the best and the brightest are publicly traded, not the whole economy
Any country has a number of corporations, partnerships and sole proprietorships that make up its corporate sector. Generally speaking, only the strongest, most profitable and fastest growing firms satisfy stock exchange listing standards and also generate enough investor interest to launch a public offering. New firms are typically brought to the market, and added to representative stock market indices, on a regular basis. Older, flagging, firms are routinely eliminated from the indices and sometimes delisted entirely. In other words, stock markets tend to feature the best and the brightest, not mirror GDP.
Not all sectors are in the stock market…
It’s common around the world for large chunks of the local economy to have little or no stock market representation. In the case of the US, for example, it’s hard to find any sign at all of real estate, construction or, nowadays, autos, among publicly traded equities.
This fact is also clearly illustrated in Europe. The largest economy in the EU, by a margin of about 25%, is Germany. The UK and France are more or less tied for second place. Yet the London stock market has been, for at least the thirty years I’ve been aware of it, several times the size of Frankfurt’s.
…and not all markets limit themselves to one country
Very little of Germany’s GDP is listed. In contrast, partly because of its colonial past, London is home to a large number of global companies, much of whose business lies outside the UK.
Hong Kong is another example. Nowadays, its importance comes from the mainland Chinese firms listed there, not the local banks and utility companies.
The US market is still another. At least a third of the S&P 500’s revenues come from abroad. A significant number of NYSE companies are actually global enterprises whose primary listing is elsewhere, but who trade here through American Depository Receipts. Many foreign firms also trade on the “pink sheets.”
S&P profit growth has historically been way ahead of US GDP growth
Again, regarding the US, Bloomberg recently reported that profit growth of the S&P 500 averaged more than six times the growth of US nominal GDP over the past sixty years. (This may be somewhat of an apples-to-oranges comparison, since many S&P 500 members have large non-US operations. But one could substitute world GDP for US and still get a ratio of S&P growth to GDP growth far north of one.)
All in all, there doesn’t seem to be much empirical evidence in support of the “New Normal” description of the way stock markets work. And there are lots of examples of stock markets working contrary to the way PIMCO supposes.
In addition, my observations are that:
Flat stock markets don’t mean you can’t make money
Some US stock market observers are beginning to liken the current period for the S&P as similar to the second half of the Seventies–in the sense that the overall market was trendless for several years but was still a stock picker’s paradise. Smaller companies, the move to the suburbs, women taking a greater role in the workforce, the rise of specialty retailing–all these were ideas that led to stocks that generated spectacular profits. This was the heyday of the Fidelity Magellan fund, as well as of many small capitalization specialists.
Difficult times have in the past also been sharp spurs to innovation. I keep coming back to think about laid-off exotic metals scientists at the end of the Cold War who used their skills to create the modern golf club industry.
What might today’s trends be?–maybe Gens X and Y, commodities, emerging markets exposure, tourism, evolution of the internet, netbook/smartphone.
Will the rest of the world just lay down and die?
No one knows. But why would it?
We can observe that in the post-WWII era emerging economies have had a very difficult time in turning from export-led growth to expansion based on cultivation of domestic demand. What we don’t know is what role the continuing voracious appetite of US consumers for imported goods has played in this difficulty.
If we argue that events follow the path of least resistance, it’s even possible that emerging economies have failed to mature because the US consumer has always been there. It could be that, with the US consumer absent, emerging economies will make surprisingly strong progress in rebalancing GDP. Certainly, both China and Brazil have already recently made dramatic economic changes in short periods of time. It may turn out that those who argue for global economic stagnation have just misidentified the stumbling block to emerging nations’ progress as being one of political will rather than external circumstances.
How could adherents of the New Normal not have a better grasp of what stock markets are and how they work? I guess we live in an age of heavy asset-specific specialization and the NN people know about as much about stocks as I do about bonds. But from where I sit, the risks in holding stocks are about what they always have been. Bonds, on the other hand, have lost the appeal of the secular decline in interest rates we have had worldwide since the early Eighties. Given, also, that there are so many bond believers convinced that interest rates cannot rise, bonds seem to me particularly vulnerable to any signs of economic growth.