Bill Gross of PIMCO, the authority on bonds (or so they say) announced earlier this month that the days of investing in equities for the long run (you know the sales slogan of Merrill Lynch, Morgan Stanley, Edward Jones, and company) is over.
Now, does it surprise us that the head of the the largest bond fund in the world is suggesting stocks are toast insofar as they are a long term investment/savings strategy? Does it surprise you that a blog dedicated (at least in part) to alternative asset classes would be talking about it? Now that we have everyone's self interest out of the way, lets get into what's interesting about Bill Gross' comments in his proclamation.
What is a Stock
No this won't be a mundane introduction to the subject of what stocks are. If you need that kind of help, you've come to the wrong place. But lets keep in mind that stocks represent ownership in a corporation, and as such their value should be connected to the value of that company. Why is that important?
6.6%, Not too Shabby, but Not too Sustainable either
Bill Gross is a smart guy. Well, he understands economics, so that makes him cool in my book. Outside of that he could be a a complete idiot (somehow I doubt it).
Within his announcement, Bill Gross made a sharply astute observation. He noted that stocks returned an inflation adjusted 6.6% return since 1912. And this point is the statistic that keeps the investment salespeople and stock brokers in business. Sounds pretty good right? Where do I sign up?
Well, not so fast. Bill Gross also noted (though subtly) that this sort of growth is only possible if some other portion of the economy is giving something up. There's a very large economic concept at play here. I've talked about efficiencies before, but I've been somewhat reserved in the discussion of Pareto Efficiencies.
For those who just said “well I didn't really want to read the Insurance Pro Blog today anyway,” no worries, I'm not about to break out into too much dorkdom. Pareto Efficiency can be explained (more or less, at least to the degree any reader today would need to understand) in less than a minute.
In order for something to reach a pareto efficient point, we must have a condition where making one side better, makes the other side worse. Think of it this way. Let's pretend there are only 10 $1 bills in the word and it's the entire world's money supply. Let's say you have $8 and I have $2. In order for me to have $3, you'll need to lose a dollar and then have $7. Whatever system made this reality has reached a pareto efficiency.
Why this is Important
This whole pareto mumbo-jumbo is important when we think about the 6.6% return stocks have captured for the past 100 years for two important underlying reasons.
It's not Linear
The problem with historical data is you can time the market with it. Sure we can show that from point A to point B stocks grew by 6.6%. But that doesn't mean anyone actually capitalized on that move.
Nor can we infer that if I get in today, I'll be up 6.6% by this time next year. Here's the other disconcerting thing no one in the invest sales game is willing to accept (let alone understand): we don't have enough economic data to suggest any of it is replicate-able.
Say what? We have 100 years of data. Good for us. We have one really large data set. We don't happen to have multiple sets from which to pull historical information. 100 Years may sound impressive, but realistically it's just 1 data point.
Fundamentals would Suggest it won't Work Out
Bill Gross also astutely pointed out that over the same time period, the economy itself grew 3.5%. This means that if we can assume our market economy is successful at bringing us to a pareto optimal point (which is a key assumption to all models built by macro economists when it comes to analyzing our economy) than the only way stocks can outperform the economy as a whole, is for someone else must be losing. It's the only way to explain the 3.1% premium.
In other words, if public companies are becoming better off, some other sector (non public companies, non-profits, consumers, or government) must become worse off–again, assuming a pareto efficiency.
The Big Picture Take Away
Rather than dive into the gory details and bore everyone to tears, let's apply our new (or newly refreshed) understanding of pareto efficiencies to sum up the really important 3,000 ft above message at hand.
If public companies cannot continue to disproportionately benefit from our market economy, or we cannot grow our economy by more than it's current 100 year growth rate (and there's another macro economic theory that would suggest it's highly unlikely we will) then the the stock market will not continue to grow at the rate we've seen over the past 100 years.
Now, I've said it before and I'll say it again. The play on stocks is not in the buy and hold strategy, it's in the trade.
We've pointed out several times before that no one gets the returns quoted by investment salespeople because no one can invest in the indexes themselves. The stock market is an investment tool and you can certainly take advantage of it. But if your approach is simply to buy things you think will be around for a long time and appreciate in value, you may be underwhelmed by the results.
Short term, it's fine. Long term, we're with Bill Gross, there are better options.