Who is right, Bill Gross or Jeremy Siegel? Answer: George Gilder

Recently, the venerable bond-house money manager Bill Gross of PIMCO published his August Investment Outlook beginning with the attention-grabbing opening sentence: "The cult of equity is dying."

Headlines in the financial media immediately began to proclaim that Bill Gross was ringing the famous "Death of Equities" bell (here's one from the Wall Street Journal, and here's another from CNBC).

The phrase "The Death of Equities" has become legendary in investment circles ever since it was featured on the cover of BusinessWeek on August 13, 1979 (image below).  You can take a trip down memory lane and re-read that cover-story from August 1979 here.

Part of the reason that 1979 declaration of the death of equities has become so famous over the years, of course, is the fact that the stock market of the 1980s and 1990s produced such tremendous returns for many investors, prompting stock-market advocates to pull it out as a warning to all those who would ever dare to call the "death of equities" again. 

The current commentary from Bill Gross is no different, especially because his August investment commentary takes specific aim at the premise of Professor Jeremy Siegel's iconic 1990s investment text, Stocks for the Long Run and its thesis that -- over long periods of time -- stocks outperform all other asset classes.  Many who are rushing to refute the arguments of Mr. Gross and defend the arguments of Professor Siegel are invoking the 1979 cover story, but we think that by doing so they may be missing an even more important point.

Our reading of his Investment Outlook notices two main arguments: 

First, he argues that -- although the long-term real return for stocks is 6.6% when you look at 100 years -- the more recent rate of return for stocks for shorter periods has been far below that, and in fact this is a return to something like a "new normal" because that 6.6% return was the product of an anomalous period of time, "a historical freak, a mutation likely never to be seen again as far as we mere mortals are concerned."

This first argument is the one that makes equity bulls angry, and the one that has them digging up the 1979 BusinessWeek and rushing to the defense of Professor Siegel.  However, in doing so many appear to have missed his second point, which he tells us is the real point of his article (in the first sentence of the section entitled "Got Bonds?").  

His second point is that the long-term returns quoted for bonds are probably just as illusory for future investors, arguing that the long-term bond return has been boosted by the anomalous decades we just went through in which yields for newly-issued bonds fell from ridiculous highs in the 1970s and early 1980s to today's nearly-invisible bond yields.  Based on that fact, and the even more important probability that profligate governments are going to be forced to inflate their way out of their problems, he issues a stern warning to anyone buying bonds that could be remotely categorized as longer term right now.

This point brings him to his conclusion, made in the final sentence of his newsletter: "The cult of equity may be dying, but the cult of inflation may only have just begun."  Inflation of the currency is devastating to the wealth of savers, as we have discussed in numerous previous posts, such as "Stand still, little lambs, to be shorn." 

To be fair to Professor Siegel, he is in agreement with those who point out the damaging effects of inflation, and the likelihood that future inflation could be ugly.  That's why he recommends equities as the only asset class that enables investors to stay ahead of the wealth-destroying effects of inflation.  We agree with him in general, which is why we have linked to his arguments in many of the posts in which we discuss this problem.

Mr. Gross argues that the faith in a long-term real return of stocks in the realm of 6.6% is misguided. He argues that the long-term growth of the US GDP has been about 3.5% over the same period of time that stocks have returned 6.6%.  "If an economy's GDP could only provide 3.5% more goods and services per year," Bill Gross asks, "then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers, and government)?"

This phrasing points to a major flaw in Mr. Gross' understanding of economics.  He is phrasing the question in a zero-sum fashion, as if the gains of one group are always at the expense of someone else, which is the classic formulation of the fixed-pie or zero-sum paradigm.  It isn't that the returns enjoyed by one segment are at the expense of the returns of the others:  government, for example, does not lose-out to the private companies that make up the stock market -- those companies pay for the government and make its budget possible in a very real sense.  Mr. Gross also spends a good deal of his essay arguing that stock returns have somehow been stolen from "laborers," which is another manifestation of zero-sum thinking.

George Gilder explodes this false view in a recently published excerpt from his new prologue to his classic text Wealth and Poverty, entitled "Unleash the Mind."  There, he argues that:

Far from being a zero-sum game, where the success of some comes at the expense of others, free economies climb spirals of mutual gain and learning.  Far from being a system of greed, capitalism depends on a golden rule of enterprise: The good fortune of others is also your own.

George's masterful argument should be read in its entirety, so that the finer points that support this argument can be appreciated.  However, it is clear enough that the growth of the business reflected in a stock return does not come "at the expense" of the laborer as Mr. Gross declares, but rather that the good fortune of the business enables the good fortune of the laborer, whose job and wages are as dependent on the continuing success of the company as they are on the existence of the company in the first place. 

When he raises the specter of inflation, Mr. Gross does not offer any real way out.  Having "dissed and dismissed" both stocks and bonds, he basically tells investors: "If financial assets no longer work for you at a rate far and above the rate of true wealth creation, then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both."  In other words, "stand still, little lambs, to take a haircut."

But we also believe that the faith in "the market" and "stocks" championed by Professor Siegel and his defenders is too simplistic.  Just as there are sub-sets of the overall economy that produce greater returns than the economy as an aggregate whole, there are sub-sets of the overall "stock market" that produce greater returns than the stock market as an aggregate whole.  We have never believed those who argued (based on their reading of the long-term charts) that you should "just index" and everything would always be fine.

This is where George Gilder's insights are so powerful and so revolutionary.  In his essay "Unleash the Mind," he argues that it is not markets that are the source of wealth and growth, but rather innovation, creativity, ideas: the mind.

He argues, "Capitalism is the supreme expression of human creativity and freedom, an economy of mind overcoming the constraints of material power," and "Creativity is the foundation of wealth."

This creativity and innovation is where investors must place their hope for escaping the scenario described by Mr. Gross.  And, while we believe that it is always important to seek out innovative companies, it is even more important to do so during periods in which the obstacles to creativity and innovation are more numerous (such as during the economically misguided period of the 1970s, and indeed during the period since roughly 2000).  This is where the criticism of Mr. Gross of the simple faith in "stocks" and "the market" is on target, especially as we appear to be in a period in which such obstacles will continue to abound.

We have produced evidence that belief in "indexing" tends to fall apart during periods of greater economic stress and malaise, including the 1970s as well as the past several years.  

We believe very strongly that long-term inflation requires ownership of shares of companies in order to stay ahead of inflation, but that just any companies will not do.  Investors must seek out exceptional businesses, creative businesses, innovative businesses -- well-run businesses in front of fertile fields for future growth.

This is a very different message from those offered by either Mr. Gross or Professor Siegel.  We would recommend that all investors check out George Gilder's new book as soon as it is released.