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Managers Dispute the Death of Equities

What Morningstar’s fund analysts are hearing about Bill Gross’ views on stock returns.

Morningstar Advisor, 10/12/2012

This article originally appeared in the October/November 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The Issues
PIMCO Total Return PTTRX manager Bill Gross made headlines for declaring, “The cult of equity is dying.” Gross’ statement was reminiscent of a legendary 1979 BusinessWeek cover story proclaiming the death of equities, a prediction that turned out to be inaccurate as equities embarked on a multidecade rally. Certainly, there are plenty of macroeconomic concerns that have made investors pessimistic about future equity returns. The prolonged European debt crisis, the U.S. fiscal state, and turmoil in the Middle East have kept market volatility high. Many investors are still reeling from severe losses during the financial crisis. According to Morningstar fund-flow data, investors have yanked nearly $91 billion from equity mutual funds in the trailing year through July while pouring more than $216 billion into taxable- and municipal-bond funds. Still, equity ETFs have seen $81 billion in inflows in the same period. And the prospect of rising interest rates and inflation makes the picture for fixed income murky. Many managers remain confident in equities’ long-term potential.

The Points

  • Gross says that long-term Treasury bonds have returned more than equities over the past 10 to 30 years with less risk, defying the logic that higher-risk securities tend to deliver bigger rewards. He takes issue with the widely accepted 6.6% expected real return for equities described in Jeremy Siegel’s Stocks for the Long Run, arguing it’s not sustainable in an environment where GDP growth has slowed substantially.
  • Ben Inker of GMO argues that GDP growth and stock returns are not correlated. While he admits the past 12 years have been rough for equity investors, he says that they were a necessary part of the healing process that’s brought down valuations since the peak of the technology bubble. He concedes that this process is ongoing and could include a few more years of muted returns as equity valuations revert to normal levels. However, slower GDP growth is no reason to anticipate lower equity returns, and Inker still believes equities will be priced at levels that can produce strong long-term returns.
  • In a Wall Street Journal op-ed dated Aug. 14, A Random Walk Down Wall Street author Burton Malkiel says that investors who have moved money from equities to bonds are hurting their chances of meeting retirement needs. With fixed-income securities unlikely to meet retirement goals, Malkiel suggests that the only solution is to increase equity exposure.
  • Clyde McGregor of Oakmark Equity & Income OAKBX says that, while equities are subject to more daily price volatility than bonds, volatility isn’t the same as permanent loss of capital. He’s moved the portfolio away from bonds, which he perceives as riskier in the current environment, and has favored equities, which he thinks have higher risk adjusted expected returns.

“The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned. The simple point, though, whether approached in real or nominal space, is that U.S. and global economies will undergo substantial change if they mistakenly expect asset price appreciation to do the heavy lifting over the next few decades.”
Bill Gross

“Whether GDP growth in the U.S. and other developed economies is going to be slower in the future is not, in and of itself, a reason to expect a lower return to equities.”
Ben Inker

“Bonds are thought to be lower-risk investments; we believe that, at today’s prices, long-term bonds are very risky.”
Bill Nygren
Oakmark Funds

“The good news is that it is not all doom and gloom for investors. Stocks appear inexpensive, particularly if earnings remain strong. Margins are near all-time highs, companies are running lean, and balance sheets are incredibly healthy and flush with cash.”
Jeff Kautz
Perkins Investment Management



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