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Economic and Market Commentary

New Age Crossroads

New York, Feb.7 (Bloomberg) – Optimism about U.S. stocks surged to a 14-year high last week, according to a poll by Investors Intelligence newsletter. The percentage of financial consultants who considered themselves bullish, or optimistic, rose to 61.8 from 61.0 the week before. Optimism hasn’t been this high since January 1987. “A lot of people are optimistic about stocks with the Fed cutting rates,” said Michael Burke, editor of the newsletter.

I was asked by the Wall Street Journal recently to participate in a four-person panel discussing the topic of “The Problem With The Herd” (January 29th edition). One of the editor’s questions asked whether there was “any time when following the conventional wisdom (was) the smart thing to do?” I was taken aback, not by my printed response (since my answers were indubitably the “correct” ones) but by those of my co-panelists which included Elizabeth Bramwell, John Rogers and John Bogle. Basically they all said “no” – the crowd was always wrong. Well, my fine feathered investor friends, the crowd can’t always be wrong. It’s the crowd that drives markets. They may be wrong at the top and wrong at the bottom, but in between the crowd is a momentum-bred monster that in turn creates its own inertia. Was the “crowd” wrong to buy stocks in the 1990s? Hardly. Many of them may have been late to the party, but the American investor is still sitting on a lot of paper profits despite the carnage in the NASDAQ over the past nine months. My answer then, to the same questions was “Sure you should follow the conventional wisdom – most of the time. In this business of investing it’s best to follow, instead of oppose – until that is – it becomes increasingly obvious that the crowd has, through its own momentum, carried prices to an extreme. That is the time to oppose, instead of conform.”

Such timing, of course, is one tricky proposition, because no one, except for my wife Sue’s favorite psychic, can consistently outfox the market and the crowd. “They don’t ring a bell,” as the saying goes and when there’s blood in the streets or sugarplums on the Christmas tree, it’s oh so hard to resist being human and joining the crowd in their fear or ravenous greed. I’m not especially good at short-term counter-trend investing, but I’ve found that by analyzing markets from a long-term secular perspective, it’s possible to decipher changes in major trends, despite the difficulty in calling precise turning points. Opposing the crowd can begin as early or as late as 1 to 2 years around major financial market turning points and still be successful. What’s necessary, as I suggested in my Wall Street Journal response, is to recognize major extremes and future secular economic forces that point prices in the opposite direction, and to forget about getting that last 1/8 of a point at the top or the bottom.

We are at just such a juncture in the stock market. I write this with reservation and trepidation and all of the concomitant fears that legitimately follow a supposed bond market guru swimming into foreign equity waters. Still, the two markets share more than a mild if somewhat jagged correlation and many of the economic forces that affect one, will influence the other. So hear me out you paper-wealthy, “stocks for the long term,” “buy the dips” stock market investors. There may be at least a few tidbits of secular wisdom that follow in these next few pages.

I begin not with talk of a recession or discussion of a V shaped vs. a U or L shaped recovery, because those are short-term cyclical calls that lead to short-term trends in market prices. With the Fed on the move, there is justification to support a claim that no matter what the shape of the recovery, as long as there is one, the stock market may have seen its worst days and months in terms of a rate of decline. Doesn’t mean the NASDAQ has bottomed but it does indicate at least an absence of carnage as long as the Fed keeps lowering interest rates.

When I speak of a juncture in the stock market though, this potential cyclical bottom is not the crossroads to which I point. I direct your attention instead to expectations of returns for the next 10-15 years – those double-digit capital gains you may have come to suppose were your birthright, and that you have already “used” to provide a comfortable nest egg for your retirement in 2020. Sorry about that – you better start saving instead.

How so? Does not the New Age Economy with its productivity miracle more or less guarantee those future capital gains? That is a critical question of course but one that could (and has) occupied numerous prior pages of Investment Outlook comment. The condensed answer is “no” – there may be a New Age Economy but its claims for New Age profit growth of 10-15% annually are fallacious. If anything, the increased accessibility to pricing information afforded by technology and the Net leads to reduced profit margins and a closer step towards perfect competition as opposed to increasingly monopolistic profits. A similar New Age argument applies to the supposed benefits of globalization which is another dominant secular trend. While increased trade should almost certainly foster higher global economic growth rates, the increased competition that it fosters spells danger for future corporate profit margins. Both of these New Age productivity-oriented trends (technology and globalization) promise then to be more consumer than business friendly and to minimize future stock market gains.

There are other more easily understood examples which point to a stock market crossroads. One of them speaks to the topic of valuation. It comes from recognizing currently high P/E ratios – yes – and low dividend yields – certainly, but also from an historical analysis of how stocks have performed given the starting line valuation of equities themselves. Would the potential capital gain growth rate on your home, for instance, vary depending on whether you paid $250,000 or $500,000 for it? Of course it would. If you paid twice the price, it would cut the annual appreciation percentage in half given an appropriately long-term time period to measure by. It was just such an analysis that was put forth in Robert Schiller’s book Irrational Exuberance that I now replicate below.

The figure is a scatter plot of the annualized ten-year return of the S&P stock index versus the price-earnings ratio, for each January going back to the early 1900s. The P/E ratio, on the X-axis, represents the beginning of the 10-year return period. Return is scaled on the Y-axis, and is estimated for years since 1990. The plots show that generally speaking, low P/Es correlate historically with high forward returns and high P/Es with low returns. The cluster of plots has a downward slant from left to right. The year 2000 is an outlier, far to the right, at around a P/E of 38, and forecast 10-year annualized return of negative 5%.  
Source: "Irrational Exuberance", by Robert J. Shiller

This chart shows a scattergram of stock returns over numerous overlapping 10-year periods of time given the P/E ratio of the market at the beginning of the 10 years. Same example as the $250,000/500,000 house except this time in the form of price/earnings ratios. It shows that if your starting point begins with the market at a high P/E, your long-term returns will invariably be reduced when compared to beginning at a low P/E. Sort of commonsensical I guess, but common sense is not what most crowds exhibit near market peaks. Irrational exuberance is more like it.

Now take a look at where we were when Schiller’s book was written in January of 2000. Although he hesitated to include the specific point himself (probably because it was too shocking) I have taken the 40+ P/E he calculated for 1/1/2000 and incorporated it in the graph. (The 40 P/E is calculated by using the average earnings for the past 10 years in the denominator.) “Off the charts!” is perhaps the most appropriate description. If history holds true to form, you can expect a negative return from stocks over the next 10 years. Start saving money, indeed!

My argument for a stockmarket crossroads is further enhanced by demographic trends that appear to be in the process of culminating. Investment Outlook readers will recognize PIMCO’s reliance for many years now on shifting population patterns to forecast long-term trends in interest rates. Consumption, housing, and savings patterns all seem to rely heavily on gradual demographic aging patterns that alter the supply and demand for investable funds. And while corporate profit growth rates may dominate stock price trends over the longer term, favorable or unfavorable demographics can certainly accentuate the trend, to put it mildly. Currently high P/Es and valuations for most stock market averages, for instance, are likely due to the peaking of the baby boomer generation in terms of their earning power and necessity to save for future retirement; they have been buying lots of stocks. Over the next few years, however, not only will boomers begin to contribute less money to mutual funds and 401K plans, but their investment vehicle of preference should gradually shift from risk-oriented stocks to income generating fixed income. Tim Bond of Barclays Capital has compiled numerous demographic studies which point to the bloom coming off the stock market’s rose. While I’m naturally suspicious of most historical, ex-post models, demographically oriented ones may hold the highest probabilities of future forecasting success if only because population trends are relatively immutable. The chart below which models U.S. demographic changes in the 35-54 year old age group (high savers) and compares it to stock market dividend yields is startling in terms of its future forecast.

The figure is a line graph of actual and demographically modeled U.S. dividend yield of the S&P stock index from 1958 to 2000, with estimates to 2010. The actual yield in 2000 is around 1.5%, down from its peak on the chart of around 5.5% in 1981. The yield begins the graph in 1958 at around 3.2%. The demographically modeled dividend yield, using a regression from 1958 to 2000, shows a smoother trajectory, peaking at around 4.8% around 1980, and beginning the chart around 3%. The projection out to 2010 is for the modeled yield to rise from a low of about 1.2% in the early 2000s to reach about almost 5% near the end of the decade.  
Source: Barclays Capital "Global Speculations", January 2, 2001

With current dividend yields near 1% for the S&P 500 index, the model suggests a return to 4-5% yields prevalent in the late 1970s. While those yields can come partially from higher payout ratios and not necessarily drastically lower stock prices, the real message of the chart is that future P/Es should be lower than they are today and if so, that stock market returns will fail to match expectations of investors used to better times.

I could go on and on and probably should for at least one more paragraph. Current stock market valuations are being supported in part by a number of dubious accounting practices that have led to earnings overstatements of as much as 30-40% annually. Peter Bernstein, in a November strategy piece, reports that over the past fifteen years, an average of 20% of reported earnings in any one year vanish five years later due to “extraordinary” write-offs. “These are not minor league numbers,” he writes, “hence how much confidence can we have in reported earnings?” Undermining confidence even further has been the use of options as a replacement for normal compensation among corporate management. The Economist magazine reports that if the cost of options were reported in American financial statements as many astute investors such as Warren Buffet believe they should be, then earnings would be reduced by an additional 20% annually. Take those wonderful earnings per share numbers then, that CNBC reports on a minute-by-minute basis, and reduce them by at least 40% to recognize future write-offs and the cost of options. The S&P 500, with a reported P/E of 25x suddenly looks more like 40x when viewed rationally or even historically. No wonder market yields are only 1%. It’s not that easy to pay dividends with phantom profits.

So you like stocks do you? You’re banking on those 10-15% annual returns to let you retire in style a few decades from now? Somehow I don’t think so. Not that bonds will be any better. With Treasury yields pressing 5%, it’s clear that double-digit returns for fixed income over the next decade are not in the cards either. Instead, investors must acclimate to a future environment of diminished expectations. While our New Age Economy may still exhibit near average historical growth rates due to enhanced productivity trends and the benefits of globalization, our New Age Markets promise nothing of the sort.

William H. Gross
Managing Director


Past performance is no guarantee of future results. All data as of 1/31/01 and is subject to change. This article contains the current opinions of the manager and does not represent a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for educational purposes and should not be considered investment advice. These charts are not indicative of the past or future performance of any PIMCO product.

Equities are subject to the basic stock market risk that a particular security or securities, in general, may decrease in value. The NASDAQ Composite Index is an unmanaged index of a broad-based capitalization-weighted index of all NASDAQ National Market & Small Cap stocks. The S&P 500 Index is an unmanaged index that is generally considered to be representative of the stock market in general. It is not possible to invest directly in an unmanaged index.

No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. This is not a recommendation or offer of any particular security, strategy or investment product, but is distributed for educational purposes only. 2000, Pacific Investment Management Company.

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