Note to Bond King: Check Your Math

by Seth J. Masters, AllianceBernstein

August 6, 2012

The Wall Street Journal published an article on August 1 headlined: “Bill Gross: Equities are Dead.” In fairness to Gross, what he actually wrote in his August “Investment Outlook” was, “the cult of equities is dying.” We agree with most of Gross’s argument—but not with his unsupported forecast of extremely low  stock returns.

Let’s take a look at Gross’s claims:

1) Gross notes that bonds have outperformed stocks for the last 10, 20 and 30 years. With long US Treasuries currently yielding 2.7%, it is unlikely that bonds will replicate the performance of decades past.

We agree. That is why stocks are attractive today relative to bonds. Bonds—having outperformed—are now unusually expensive and have low expected returns going forward. By contrast, stocks—having performed poorly—are cheaper than normal and are likely to significantly outperform bonds over the next 10 years.

2) Gross argues that US stocks can’t maintain their 6.6% average annualized real return over the last 100 years. The 6.6% real equity return was 3% higher than real GDP growth, with shareholders gaining at the expense of labor and government. Labor and government must demand some recompense for wealth creation, and GDP growth itself must slow due to deleveraging.

We agree. We are now in a lower return environment. The question is, how low? Let’s concede that stocks will grow in line with real GDP. Over the long haul, real GDP growth primarily reflects population (growing a little over 1%) and productivity (growing just above 2%). That would give us a projected real equity return of maybe 3%—less than half the historical 6.6% rate.

3) Gross asserts that stocks will have a nominal return of 4%.

This is where Gross’s math gets fuzzy. Why this sudden switch to nominal instead of real returns? Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%. The scenario is possible, but hardly likely. Just assuming that inflation runs at a relatively tame 3% with below-normal real GDP growth of another 3%, we’d have nominal equity returns of 6% or so. That looks quite attractive when you get just 2.7% for holding long bonds to maturity.

In our recently published paper “The Case for the 20,000 Dow,” we show that with reasonable assumptions we can get returns in the 6% to 7% range and that the Dow hits that target in five to 10 years. We will also lay out our argument in an upcoming blog post.

Most investors today are very concerned about equity volatility, and for good reason. But there is another risk that should concern investors: the risk that their investments will not keep up with inflation and meet their goals. As investors balance short-term market risk against the long-run risk of falling short of their objectives, we think an appropriate allocation to equities continues to improve the likelihood for success.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer of Asset Allocation and Defined Contribution Investments at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.