At the height of the dot-com era, with the Nasdaq trading at
5,000, the airwaves were filled with predictions of even bigger
gains to come. One prediction that called for "Dow 36,000" was a
sure sign that stocks were headed for trouble. Bubbles get pricked
right at the time of maximum confidence in future gains.
Of course, it works the other way as well. Stocks have delivered
very little for investors since 2000, and according to some polls,
more than 80% of individuals simply don't trust stocks. Even some
of the pros are getting pessimistic on the long-term viability of
stocks. Bill Gross, the well-respected head of PacificInvestment
Management Co. (PIMCO), has been making the rounds, emphatically
declaring that stocks are dead and that you need to prepare for
zero gains in the years ahead.
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You can read about Gross' comments
in this Op-Ed piece
he penned for
TheWall Street Journal
.
In a nutshell, Gross argues that if theeconomy is only going to
grow at a tepid pace in the years ahead, then there's no way that
stocks can continue to achieve the 6.6% historical gains we've
seen. In effect, he's suggesting that stocks are likelyovervalued
simply because they have been rising faster than thegross domestic
product (
GDP
) has grown over the past 30 years.
Put simply, I think Gross is dead wrong. Here's why…
If you read the Op-Ed, then you mightspot some flawed
assumptions, and I'm surprised Gross is overlooking them. The
biggest flaw: Gross is equating economic growth with the No. 1
driver of stock prices:profit growth. Simply put, 2%GDP growth does
not equal 2% profit growth.
Companies have been operating in the context of 0% to 4% GDP
growth every year for the past three decades. Yet in most years,
companies have seen sales and profits rise at a faster pace,
perhaps two or three times the rate of economic growth.
How can that be? Well, it's not that companies retainearnings
and then redeploy those profits into several outlets. Sure, they
can issue dividends, but most corporatecash flow has been
re-applied into research and development efforts thatyield new
products, funds acquisitions that boost growth, or buy back stock.
In each instance, these measures can boost earnings per share.
Profits drive stock prices…
Let's use a specific example. Suppose an industrial company
generated $10 billion in sales and generated $600 million infree
cash flow . And let's assume that cash flow is used to buy another
business for $600 million. Note thatshares outstanding didn't rise,
but sales and profits will now be higher to the extent that the
newacquisition boosts the numbers on theincome statement . Roughly
speaking, we're talking about a 6% gain in per share profits --
and, presumably, the stock price.
In fact, like a shark that keeps swimming even as it sleeps,
companies have a natural imperative to pursue any measures that
will boost earnings per share. (Executive compensation in the form
of stock options is almost always tied to this metric.) That's why
companies often sell assets and then re-deploy the funds into new
products or companies that yield better growth prospects.
The magic of the dollar
Another point: Gross is simply ignoring the effect ofinflation .
GE (NYSE:
GE
)
or
IBM (NYSE:
IBM
)
earn so much more today than they did 40 years ago, in part because
the value of the dollar inflated in value over that time. Of
course, if Gross said that stock price gains -- adjusted for
inflation -- may be muted for the foreseeable future, well, that is
at least a more reasoned argument. But he's not saying that, and as
noted above, that premise may not hold water anyway.
Gross hints that we're on the cusp of an era of high inflation.
Maybe he's right. But he can't have it both ways. Either theeconomy
has too much slack and will grow at a weak pace (and evidence
minimal inflationary pressures), or growth will pick up -- raising
inflation concerns. In effect, he's predicting a return to
"stagflation" that we saw in the 1970s. It's notable, though, that
the 1970s was the only decade of the 20th century that saw
sustained inflation and anemic growth. So maybe Gross is right, but
history says that's unlikely.
Demographics are key...
Gross makes another key point, which is either way off the mark or
should be of great concern to you if he's right. He suggests we are
now locked into an era of very low economic growth because the
biggest economies in the world are simply too mature and too
uncompetitive to find ways to grow. Yet is that really the case?
Here in the United States, the population continues to expand,
thanks to immigration and organic family growth, and there's no
reason the economy can't grow even faster than the population.
Think about it... A larger population opens up new business
needs. A mid-sized city that couldn't support a high-end retailer
like
Tiffany & Co. (NYSE:
TIF
)
or a Porsche dealership eventually can as the population grows.
Opening a store creates more jobs for that city. Yes Europe and
Japan are stagnating -- but it's in large part because they have
flat population growth. Here in the United States, the demographics
remain quite favorable.
The one thing Gross got right
Here's where Bill Gross got it right. Whenever stocks have made a
strong run, subsequent results are quite subdued. It may be
disheartening that the major averages are below levels seen back in
2000, but you should also know that stocks made a remarkable upward
move from the early 1980s until 2000. A long hangover was likely
inevitable. Yet you could argue that we've paid for that, as seen
by a lost decade for stocks, and we may be closer to the nextbull
market than many suspect.
Action to Take -->
Sure, it's pretty dark out there. The economy has slowed, and you
shouldn't be surprised to see anotherrecession in the next 12
months. That kind of pall tends to color investors' moods, so
Gross' downbeat take on equities is getting a lot of media play
right now.
Yet soon enough, perhaps in 2013 or 2014, the economy may take
on a fresh glow. The housing sector will likely pick up. Auto
makers will likely move a lot more metal to meet growing demand.
Retailers will likely see brisk traffic in their stores. And
corporate profits will likely grow at a robust pace -- which, as I
mentioned before -- are what really drives stock prices in the long
run.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.