Not as Normal as You Think

Back during the technology bubble of the late 1990s, a young portfolio manager who was running a hot tech fund ripped Warren Buffett in a public forum, essentially saying that Buffett was old and foolish and failed to understand technology.  We know how that turned out.

Paying attention to Warren Buffett is an ongoing intelligence test for every professional investor.  Buffett is on my personal short list of folks whose viewpoint on investments you ignore at your peril.  Also on that list are Jeremy Grantham of GMO, Charles de Vaulx of International Value Associates, Robert Arnott of Research Affiliates and Bill Gross of PIMCO.

Given my respect for Bill Gross, often called “the Bond King”, I hate being on the other side of an investment issue from him, but there is a crucial respect in which I disagree with the core of Gross’s post-crash market predictions.

Back in mid-2009, when the markets were early in the recovery from the worst meltdown since the Great Depression, Gross went on record with his belief that the days of high market returns were over.  He termed his prediction of long-term single-digit returns on both stocks and bonds The New Normal.  Here’s what he said in June of 2009:

All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.

Gross has returned to this theme frequently, most recently this past month, as seen here.

In general, here at TGS Financial Advisors we agree that future returns will be depressed.  We are projecting 6% returns on stocks and negative real returns on bonds.  When we run long-term cash flow analyses for planning clients who hold moderate-risk portfolios, we use a return assumption of 4.28%.

Gross’s prediction of low long-term returns has value in helping us to set realistic expectations, but it is dangerous to use it to make investment decisions at any given moment.  Imagine that you took Gross’s advice in early 2009, quoted above, and concerned yourself more with the return of your money (risk) than the return on your money (return).  Can anyone doubt, amid the general doom-and-gloom, that you would have exited risk-oriented assets and moved to cash?

In doing so, you would have made a permanent, irrecoverable investment mistake.  From the intra-day low on March 9, 2009, the stock market was up more than 110% as of yesterday.  Using Gross’s New Normal projection of 5% per year on equities, so far the markets have delivered two decades worth of returns in only three years.  (I’m using a little mathematical sleight-of-hand, ignoring compounding, but you get my drift.)

The reason Gross got it (partially but crucially) wrong is the nature of market returns, which are highly variable and (at least in the short run) entirely unpredictable.  Thus it is very, very unusual for market participants to get the average long-term return, whatever it turns out to be, in any given year.

Both corporate earnings and stock market prices are an order of magnitude more volatile than the underlying fluctuations in the real economy.  Peak to trough the economy contracted by 3.8% in 2007-2009, while corporate earnings declined over 80% and stock prices over 60%.  In other words, earnings are up to twenty times more volatile than economic growth, and stock prices up to fifteen times more volatile. When the economy began to recover, both corporate earnings and stock prices rose dramatically.  (In passing, we believe it is this periodic emotion-driven exaggeration of long-term economic trends that provides us, as long-term investors, with most of our opportunities to enhance portfolio returns.)

While Bill Gross paints a picture of investors waiting patiently for long-term secular returns to slowly lift their investment boats, the reality for individual investors is the periodic necessity of making real-time decisions based on incomplete information in the midst of raging chaos and uncontrolled emotions.  In this real-world market, few investment decisions in my life have had more profound effects on the wealth of my clients than the decision we made to increase our stock holdings during the Great Panic.

All of this is a long-winded way of saying that, even if today’s Normal gives us lower returns than we would prefer, we hope to continue to find opportunities to make our portfolio returns better-than-Normal.  Among the things that are Not Normal today, we believe, is the relationship between the prices of stocks and bonds.  (Gross actually agrees with us on that.  Or perhaps vice versa.  He really is a smart guy.)


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