Tuesday, August 7, 2012

“Cult of Equity”

In his August Investment Outlook posted on PIMCO’s website on July 31, Bill Gross declared that the "cult of equity is dying.” That’s a late call since the cult has been mostly dying after flourishing during the 1990s, as evidenced by the secular downtrend in valuation multiples since 2000. The bull markets of 2003-2007 and since 2009 have been widely disparaged by perma-bears, including Mr. Gross, as cyclical rallies (“sugar highs”) in a secular bear market. In any event, high-profile predictions such as this one by Mr. Gross have often been great contrary indicators. So far so good.

However, it will be some time before we know for sure whether Mr. Gross will be proven right or wrong. The question for now is whether the logic of his argument makes sense. I don’t think so. He bases his pessimistic outlook for stocks on his view that “GDP growth itself is slowing significantly due to deleveraging in a New Normal economy.” He may be right about that, but US corporations are finding more of their growth overseas. What matters is the outlook for overall world GDP and for business opportunities on a global basis.

Mr. Gross believes that because “conditions…have never been more favorable for corporate profits,” they can only get worse. The growth trend line for both after-tax corporate profits in the National Income and Product Accounts and nominal GDP in the US has been about 7% since 1960. In recent years, profits have been growing above this line, while nominal GDP has fallen below it. In my opinion, this is a sustainable divergence, assuming that overseas profit opportunities continue to outpace domestic ones. The growth trend in S&P 500 forward earnings remains around 7%.

Oddly, in his concluding paragraph, Mr. Gross contradicts his central thesis: “Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades. Financial repression, QEs of all sorts and sizes, and even negative nominal interest rates now experienced in Switzerland and five other Euroland countries may dominate the timescape. The cult of equity may be dying, but the cult of inflation may only have just begun.” In an inflationary scenario, I would think that stocks might significantly outperform bonds.

To be fair to Mr. Gross, I think his sensationalist writing style detracts from his basic message, which is that equity returns may be subpar for a while and almost certainly less than the actuarial assumptions of most pension plans. That’s a reasonable assessment, though it could be wrong too if corporations continue to find plenty of global opportunities to boost their profits, as I expect.

Today's Morning Briefing: The Draghi Code. (1) Lost in translation. (2) Shooting from his hip or good on his feet? (3) Taking Lehman off the table? (4) The ECB’s mandate is to stay in business. (5) Rescue funds to the rescue first, but ECB can help too. (6) The “conditionality” requirement. (7) Lots of skeptics, but Draghi is ready to act. (8) Industry analysts cutting H2 earnings estimates. (9) Energy and Materials are weakest. (10) Global economic indicators remain weak, led by recessionary ones in Europe. (More for subscribers.)

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