The Cure for Baldness

Posted by Neel Kashkari Pimco

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rarely0925

rarely0925

American society is becoming increasingly politically polarized. Indeed, a June Pew Research Center survey found that while philosophical divisions between groups based on race, education, income, religion and gender have remained largely flat since 1987, the division based on political differences has almost doubled during that same time and has ramped dramatically since 2009.

EquityFocus BaldnesSept2012 Fig1

This trend is happening at the same time that people increasingly turn to online sources for their news. In particular, as Figure 2 indicates, non-traditional media outlets are gaining share at the expense of mainstream media, especially print newspapers. Barriers to entry for individuals creating and publishing content online are low – in effect democratizing content creation. This opens societies to a more diverse and free-ranging marketplace of ideas and opinions.

EquityFocus BaldnesSept2012 Fig2

But it also creates challenges for individual publishers: Getting noticed among the thousands of others competing for mindshare is becoming harder. This is complicated further by the use of text messages and social media services such as Twitter to disseminate information, which limit the articulation of viewpoints to very brief messages. It is difficult to distill complex ideas into a 140-character tweet.

What should an author, eager to gain attention, do in an increasingly crowded, noisy and contentious world of opinions where the most popular delivery mechanisms constrain the ability to fully articulate an idea? Simple: offer an increasingly extreme view – with a hyperbolic headline. Make as big a splash as possible by exploiting society’s increasingly insatiable demand for byte-sized information. As a result, balanced, centrist views are rarely offered and often drowned out by the shrillest voices. Traditional news organizations have recognized and are responding to this trend as well, so that they are not themselves lost in this crowded cacophony. Indeed, there is an amplifying feedback loop between our increasingly polarized society and the media.
 
Just one look at the news aggregator website Realclearpolitics.com illustrates this trend. After a Presidential candidate gives a major speech, one will inevitably find opinion editorials lumped into one of two categories: “Why the candidate was brilliant” or “Why the candidate was terrible.” Important and complex concepts are reduced to punchy (and often trite) headlines. Nuance and well-reasoned analysis are lost. Pundits, even Nobel Prize winners, can be counted on to parrot political talking points. Somehow they don’t seem to be embarrassed for reliably playing the part of mindless partisan drone. They are getting noticed – and perhaps that is all that matters to them.
 
Unfortunately, this lurch to extremes isn’t confined to the political arena. Clicking on sister website Realclearmarkets.com often reveals a similar dynamic. Rarely does one find market commentators offering moderate, balanced investment advice. More likely one will find extreme headlines designed to capture maximum attention: Stocks are dead. Bonds are dead. Gold is dead. Buy and hold is dead. Oil is dead. We are all dead.
 
In his August Investment Outlook, titled “Cult Figures,” Bill Gross explained why we at PIMCO believe that returns across asset classes will be lower in the future than they have been in the past. Some media outlets reported that Bill declared that stocks are dead, when in fact he said stocks will likely outperform bonds over the long term, but in a New Normal environment, returns across asset classes (including bonds!) will be lower than the returns to which we’ve been accustomed. “Stocks are dead” makes for a much more exciting headline than “stock and bond returns will be more moderate in the future.” And in our 140-character world, this became the sound byte of Bill’s well-reasoned and empirically substantiated argument.
 
It would be convenient if we could simply declare one asset class or one investment strategy as the solution to all investors’ objectives, but, as I’ve discussed in prior commentaries, with a future that still could be deflationary, moderately inflationary or even highly inflationary, no one asset class or investment strategy will do well in all scenarios or is appropriate for all investors. Investors need to create portfolios designed to withstand the probabilities of those various outcomes. While hyperbolic headlines may draw the most “clicks,” “likes” and “retweets” – it usually makes for poor investment advice, and if investors don’t have the time to study the nuances underlying sophisticated investment strategies, they may be taking risks they don’t understand. Fortunately, most responsible investors know that describing the optimal portfolio to balance various global economic scenarios takes more than 140 characters.
 
At the risk of exceeding my allocation of mindshare (and, if you have read this far, thank you) – let’s take a look at the three sources of stock market returns to consider what the future may hold.

  1. Earnings may grow
  2. Valuations may increase
  3. Companies may pay dividends

Considering each of these individually:

1. Earnings growth – more specifically earnings per share growth. If earnings don’t grow, but just stay flat, then this term of the equity return equation would be zero. Where do corporate earnings come from? They come from economic activity. Earnings growth for the market as a whole ultimately comes from economic growth. If an economy stops growing, corporate earnings also might not grow, but they could still be positive.

Some market commentators have remarked that there is no correlation between stock returns and GDP growth, and they therefore conclude that they are unrelated. Figure 3 illustrates the low apparent correlation between global equity returns and GDP growth.

 

EquityFocus BaldnesSept2012 Fig3

Remember, however, that our professors in statistics classes usually went out of their way to teach us that “correlation does not equal causation.” In other words: Just because two things look related does not mean one necessarily caused the other. Similarly, a lack of apparent correlation does not necessarily mean a lack of causation. Many other factors could also be at play that cause direct correlations to appear to break down.

 
So how do corporate profits relate to the growth of an economy? The income approach to measuring economic activity helps demonstrate the important linkage between economic activity and corporate profits (note: I use National Income here rather than GDP because it more directly illustrates the fundamental linkage between corporate profits and economic activity):
 
National Income = Labor Income + Corporate Profits + Rental Income + Interest Income
 
Obviously in a global economy this relationship is more complex. For example, large U.S. multinationals have been growing their earnings faster than the U.S. economy by selling products and services globally and tapping into higher growth markets. And indeed some industries are countercyclical. But the basic relationship between economic activity and corporate profits has to be correct. There is a linkage even if not strongly correlated in the short term.
 
The denominator of earnings-per-share (EPS), or share count, complicates the issue. Share issuances hurt EPS growth by diluting earnings. Conversely, share buybacks help. Some commentators have noted that increased share issuance has been a key driver that has broken down the correlation between economic growth and equity returns. Unfortunately those breakdowns usually mean equity returns have been lower than economic growth would have suggested because firms have issued shares more quickly, diluting existing stockholders. Exports and share issuance and buybacks may complicate the direct relationship between economic activity and corporate profits, but the fundamental linkage between the two is irrefutable.
 
Note that corporate profits have increased over the past several decades in part because corporate taxes as a share of GDP have fallen over time and the share of National Income that has accrued to labor has also fallen. Going back to the equation that defines National Income: If National Income grows modestly and Labor Income grows even more slowly, it is likely that Corporate Income will grow more quickly to balance the equation. We believe that there will be an easing of these tailwinds that have helped drive corporate profit growth so quickly over the past few decades. There are limits to how low corporate taxes and labor’s share of National Income can go. If we are right, that suggests future equity returns, driven by corporate profit growth, are unlikely to be as strong as in the past.
 
EquityFocus BaldnesSept2012 Fig4
 
EquityFocus BaldnesSept2012 Fig5

 

2. Valuations – P/E multiples can expand. As fear decreases and confidence increases investors are often willing to pay more for the same dollar of earnings. Hence even if earnings are flat stocks still have the potential to generate positive returns by people paying more for the same earnings. There are many measurements of earnings – last twelve months, forward twelve months, cyclically adjusted. Each has advantages and disadvantages. Overall valuations of stocks seem reasonable at today’s level in a historical context with a developed market P/E of 14 times and emerging markets at 12 times (measured by the S&P 500 and the MSCI Emerging Market index, respectively). We aren’t forecasting strong P/E expansion from here, though if left tail risks are reduced, it is certainly possible.

3. Dividends. Even if an economy were to stop growing, corporate profits were to stop growing and P/Es were to remain flat, stocks still have the potential to generate a positive return by paying dividends. Hence economic growth is not a hard ceiling on stock returns, but again the overall linkage between economic activity and corporate profits and dividends is clear. Economies that grow more quickly fuel corporate earnings that can then grow more quickly. Corporations that experience sustained growth and strong cash generation are more likely to pay and increase their dividends. In past decades when economic growth has been slower, dividends have been a larger share of equity returns than capital appreciation. Figure 6 shows equity returns by decade, broken out by capital appreciation and dividends. One can see in the slow growth 1970s dividends were a larger share of total equity returns. Given our New Normal outlook of continued sluggish economic growth, we believe investors should focus on companies with a strong ability to pay and grow their dividends.

EquityFocus BaldnesSept2012 Fig6

If the stock market as a whole has historically generated 6.6% real returns annually (per Jeremy Siegel’s “Stocks for the Long Run”) and we believe it is going to generate more modest returns going forward, in the 3%–4% range, what can equity investors do now?
  1. Active management becomes increasingly important. If we believed the equity market would provide very strong growth, then we’d believe the cheapest passive exposure to stocks would likely be enough. Unfortunately we don’t think that’s the case, so alpha generation or selecting stocks that can outperform the market as a whole, is essential to meeting overall return objectives.
  2. Look to companies that can grow faster than the market as a whole. Where a company is headquartered is not nearly as important as where it does business. The best way for a company to overcome the constraints of a slow domestic economy is to sell into higher growth economies. Sometimes companies headquartered in higher growth economies are best positioned to capitalize on them. Sometimes large multinationals are better equipped to take advantage of those growing markets. We believe investors should consider an unconstrained approach that allows investors to concentrate in the best companies, wherever they may be domiciled. In addition, some companies are able to out-compete entrenched players and take market share.
  3. Don’t overpay for companies. Look to well-run companies that sell into higher growth markets, but of course it doesn’t make sense to pay too high a price for them. We believe focusing on quality is a smart investment strategy, especially in a low growth environment with ever-present macro risks. But we believe a prudent investment approach should be anchored in a rigorous valuation framework. Sometimes buying a somewhat lower quality company at a steep discount makes more sense than overpaying for the highest quality company. 
  4. Actively manage downside risk. This is a constant refrain of my colleagues and me at PIMCO. In the next six months there are several major policy drivers that each individually could overwhelm market fundamentals: the ECB’s actions to stabilize the eurozone, the U.S. Presidential election and the U.S. Fiscal Cliff. While we believe policymakers are well-intentioned and our base case scenario avoids left tails in the near future, political factors could constrain policymakers. We believe hedging against extreme downside risks is prudent, even if it means giving up a little on the upside.

So, as you can see, the story of stocks is more nuanced than one tweet, one headline or even one discussion. It is a story of assessing risks and balancing potential outcomes – one that presents real opportunities for investors even in a lower return environment utilizing a process grounded in both solid, bottom-up analysis and top-down, macro insights. 

And yet the same hyperbolic polarization that we are seeing in our politics continues to extend to other subjects important to our lives. You may be wondering what the title of this piece, “The Cure for Baldness” has to do with equity investing. I must confess: nothing at all. I wanted a headline that would capture attention, and I know I have a lot of company among the fellow follically challenged in the investment industry.

Hyperbolic polarization during a Presidential election cycle shouldn’t be unexpected, and since we each only get one vote, for one candidate or the other, it really is all or nothing. Fortunately investing isn’t all or nothing. We can allocate to individual companies that we believe are positioned to grow faster than the market and those that we believe will be more resilient against market shocks. Given how hard people work over many years to save for their future and for their families, we believe it is worthwhile to take time to craft an investment strategy that can withstand a range of market outcomes. Reports of the death of smart investing have been greatly exaggerated (and the cure for baldness is right around the corner).

 

Past performance is not a guarantee or a reliable indicator of future results. All investmentscontain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period.  These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

This material contains the opinions of the author but not necessarily PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.