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Stock Is Dead?

Bill Gross says the 'cult of equity is dying.' Is he right?

Shannon Zimmerman, 09/06/2012

Bill Gross' name may be synonymous with bond investing, but PIMCO's co-founder and CIO isn’t shy about weighing in on equities. During the keynote address that kicked off the 2011 Morningstar Investment Conference, Gross suggested that, with interest rates at anemic levels and with inflation essentially having nowhere to go but up, income-seekers should favor high-quality dividend-paying stocks over most flavors of fixed income. Gross mentioned energy concern Southern Company SO as one contender for investment dollars that might otherwise flow to fixed income. He also gave Johnson & Johnson JNJ a buy rating in his guise as an equity analyst.

Some in the audience seemed surprised by Gross’ equity-centric comments, but that probably owed to his candor about the prospects for bonds. When the manager of  PIMCO Total Return PTTRX--with assets in excess of a quarter trillion dollars--touts stocks over bonds, that's newsworthy even if the suggestion he made seemed merely sensible at the time.

This Year's Model
It seems sensible now, too. Yes, even the sturdiest of stocks will subject investors to more volatility than will investment-grade bonds. Yields on five -, seven-, and 10-year Treasuries are currently negative in real (inflation-adjusted) terms, though, and the 30-year Treasury bond pays a whopping 0.50%. Yields on corporate bonds are also paltry. The iShares iBoxx $ Invest Grade Corporate Bond LQD exchange-traded fund currently pays around 4%, but that’s in nominal, not real, terms. Those inclined to stretch for yield by stepping down the credit-quality ladder and into a high-yield vehicle such as SPDR Barclays Capital High Yield Bond JNK ETF will be rewarded for their effort with a nominal payout of around 7%. That's a tidy sum relative to what's on offer in other areas of the bond market. Yet given the asset class' historically high risk, many prospective high-yield investors may wonder if, on an absolute basis, 7% is sufficient reward for the risk that comes with investing in junk bonds.

Topnotch actively managed mutual funds in Morningstar's intermediate-term bond category aren’t faring any better in terms of yield, either. Dodge & Cox Income DODIX sports a Morningstar Analyst Rating of Gold and a barely there nominal payout of 2.5%. Fidelity Total Bond FTBFX and Gross’ own PIMCO Total Return have also earned Gold analyst ratings. Currently, those long-term keepers nominally yield 3.3% and 3.8%, respectively.

Long Live Stock
It’s a different story among equities, dividend-payers included. Despite a rally among income-producing stocks so strong that some are using the B word to describe it, disappointed fixed-income fans can still find compelling opportunities with attractive risk/reward profiles.

Johnson & Johnson, for example, currently yields roughly 3.5%, and trades in line with most of its historical price multiples. Daimler AG DDAIF, Sanofi ADR SNY, and Novartis AG NVS all pay out in excess of 4%. Yes, those are nominal figures. The share prices of those companies imply upside potential, though, with each firm trading at a double-digit discount to the fair value estimates of Morningstar equity research.

Yet even though the advice Gross gave in 2011 still seems sound, he’s no longer offering it. With his characteristic gift for overstatement (and a newfound knack for Romantic poetry), Gross declares flatly in his most recent Investment Outlook, "The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors' impressions of 'stocks for the long run' or any run have mellowed as well."

Gross doesn’t have particularly high hopes for bonds, either. In his view, the prognosis for long-term Treasuries especially is, sticking with his metaphor, even more morbid.

Death, Be Not Proud
Is Gross right? It rarely pays to bet against him, but as we’ve seen, the year-over-year percentage change in his outlook can be substantial. Judging from flows into stock funds, moreover, the equity cult seems to be alive and kicking.

True, flows into bond funds have utterly swamped flows into equity vehicles in recent years. Also true, redemptions have been torrential for actively managed domestic-equity funds for several years running (though the hemorrhaging there seems to be subsiding). All told, Morningstar estimates that investors sent some $152.3 billion to equity mutual funds and ETFs between January 2009 and July 2012. Add flows into funds of funds, such as target-date offerings, and asset-allocation or "balanced" funds and the flows figure rises to $441.7 billion.

In the aftermath of the financial crisis, equity cultists are also becoming wealthier and perhaps smarter, too. In the trailing three years through August 2012, the merely average fund in Morningstar’s large-blend category has gained an annualized 11.4%. The passively managed Vanguard 500 Index VFINX, on pace for a fourth consecutive year of gains, has returned 13.5% annualized during the three-year period. The typical investor in Vanguard 500 Index has fared even better, gaining nearly 2 percentage points more than the fund’s total return as gauged by dollar-weighted results. (Dollar-weighted, or investor, returns account for money flows into and out of funds.)

Moreover, while the ride has been rocky in the aftermath of the financial crisis, investors have been compensated for the risks they’ve taken by investing in equity vehicles. The average large-blend fund, for example, currently sports a trailing three-year Sortino Ratio--a volatility gauge that penalizes poor performance during downturns--well above the peer group’s historical average. That’s also true of the typical mid-cap blend and small-blend fund.

Equity valuations don’t look especially stretched either, at least not among large-caps. On an asset-weighted basis, SPDR S&P 500 SPY trades at a discount, albeit a modest one of 8%, to Morningstar’s fair value estimates of the stocks that comprise the S&P 500 Index. The iShares S&P 500 Value Index ETF and its iShares Russell 1000 Value Index sibling sport slightly larger discounts. Each trades roughly 12% below a rollup of their components’ estimated fair values, a markdown steep enough to garner an ETF Valuation Rating of undervalued.

Then, too, selective cases for individual stocks are almost always there for the making, a point that Gross himself would surely acknowledge. PIMCO, after all, does equity-fund business, too. Equity assets at the firm are dwarfed by the amount of bond-money PIMCO runs, but as with the industry at large, they’ve been increasing, too. Live long and prosper, equity cultists.

Shannon Zimmerman is an associate director of fund analysis at Morningstar.
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