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8/14/2019 Bill Gross Investment Outlook Feb_01

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February 2001

Investment Outlook

How so? Does not the New Age Economywith its productivity miracle more or lessguarantee those future capital gains?That is a critical question of course butone that could (and has) occupied numer-

ous prior pages of Investment Outlookcomment. The condensed answer is no there may be a New Age Economy butits claims for New Age profit growth of10-15% annually are fallacious. If any-thing, the increased accessibility topricing information afforded by technol-ogy and the Net leads to reduced profitmargins and a closer step towards perfectcompetition as opposed to increasinglymonopolistic profits. A similar New Age

argument applies to the supposed ben-efits of globalization which is anotherdominant secular trend. While increasedtrade should almost certainly fosterhigher global economic growth rates,the increased competition that it fostersspells danger for future corporate profitmargins. Both of these New Age produc-tivity-oriented trends (technology andglobalization) promise then to be moreconsumer than business friendly and to

minimize future stock market gains.

There are other more easily understoodexamples which point to a stock marketcrossroads. One of them speaks to thetopic of valuation. It comes from recog-nizing currently high P/E ratios yes and low dividend yields certainly, butalso from an historical analysis of howstocks have performed given the startingline valuation of equities themselves.

Would the potential capital gain growthrate on your home, for instance, varydepending on whether you paid $250,000or $500,000 for it? Of course it would.If you paid twice the price, it would cut

We are at just such a juncture in the stockmarket. I write this with reservation andtrepidation and all of the concomitantfears that legitimately follow a supposedbond market guru swimming into foreign

equity waters. Still, the two marketsshare more than a mild if somewhatjagged correlation and many of theeconomic forces that affect one, willinfluence the other. So hear me out youpaper-wealthy, stocks for the long term,buy the dips stock market investors.There may be at least a few tidbits ofsecular wisdom that follow in these nextfew pages.

I begin not with talk of a recession ordiscussion of a V shaped vs. a U or L shapedrecovery, because those are short-termcyclical calls that lead to short-termtrends in market prices. With the Fed onthe move, there is justification to supporta claim that no matter what the shape ofthe recovery, as long as there is one, thestock market may have seen its worstdays and months in terms of a rate ofdecline. Doesnt mean the NASDAQ has

bottomed but it does indicate at least anabsence of carnage as long as the Fedkeeps lowering interest rates.

When I speak of a juncture in the stockmarket though, this potential cyclicalbottom is not the crossroads to whichI point. I direct your attention instead toexpectations of returns for the next10-15 years those double-digit capitalgains you may have come to suppose

were your birthright, and that you havealready used to provide a comfortablenest egg for your retirement in 2020.Sorry about that you better startsaving instead.


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the 40+ P/E he calculated for 1/1/2000and incorporated it in the graph. (The 40P/E is calculated by using the averageearnings for the past 10 years in thedenominator.) Off the charts! is perhaps

the most appropriate description. If historyholds true to form, you can expect anegative return from stocks over the next10 years. Start saving money, indeed!

My argument for a stockmarket crossroadsis further enhanced by demographictrends that appear to be in the process ofculminating. Investment Outlook readerswill recognize PIMCOs reliance formany years now on shifting population

patterns to forecast long-term trends ininterest rates. Consumption, housing,and savings patterns all seem to relyheavily on gradual demographic agingpatterns that alter the supply and de-mand for investable funds. And whilecorporate profit growth rates may domi-nate stock price trends over the longerterm, favorable or unfavorable demo-graphics can certainly accentuate thetrend, to put it mildly. Currently high

P/Es and valuations for most stockmarket averages, for instance, are likelydue to the peaking of the baby boomergeneration in terms of their earningpower and necessity to save for futureretirement; they have been buying lots ofstocks. Over the next few years, however,not only will boomers begin to contributeless money to mutual funds and 401Kplans, but their investment vehicle ofpreference should gradually shift from

risk-oriented stocks to income generatingfixed income. Tim Bond of Barclays Capitalhas compiled numerous demographicstudies which point to the bloom comingoff the stock markets rose. While Im

Source: Irrational Exuberance, by Robert J. Shiller

Annualized ten-year real return (%)

Price-earnings ratio for January of year indicated

20

49

19

2021 50

894748

82185451 88

52

5345

8642

43848524

8380

22 81797844

772575

33231776

3215

3541

57

56

04

4087*3416

74

1408

380739 3105

608161

36

0059

01

02

2937

66

65

00

6869

67

7372

70

7113

091012

11

6203

0628

6430

63

85*

96*97*

91* 95*93*92*82*

89*94*83*

84*88* 90*

86*98*

99*

26

58 219746

55

5

0

5

0

-5

0

5 10 15 20 25 30 40

the annual appreciation percentage inhalf given an appropriately long-termtime period to measure by. It was justsuch an analysis that was put forth inRobert Schillers book Irrational Exuber-

ance that I now replicate below.

This chart shows a scattergram of stockreturns over numerous overlapping 10-yearperiods of time given the P/E ratio of themarket at the beginning of the 10 years.Same example as the $250,000/500,000

house except this time in the form ofprice/earnings ratios. It shows that ifyour starting point begins with themarket at a high P/E, your long-termreturns will invariably be reduced whencompared to beginning at a low P/E. Sortof commonsensical I guess, but commonsense is not what most crowds exhibitnear market peaks. Irrational exuberanceis more like it.

Now take a look at where we were whenSchillers book was written in Januaryof 2000. Although he hesitated to includethe specific point himself (probablybecause it was too shocking) I have taken


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naturally suspicious of most historical,ex-post models, demographically orientedones may hold the highest probabilitiesof future forecasting success if onlybecause population trends are relatively

immutable. The chart below whichmodels U.S. demographic changes inthe 35-54 year old age group (high savers)and compares it to stock market dividendyields is startling in terms of its futureforecast.

vanish five years later due to extraordi-nary write-offs. These are not minorleague numbers, he writes, hence howmuch confidence can we have in reportedearnings? Undermining confidence even

further has been the use of options as areplacement for normal compensationamong corporate management. TheEconomistmagazine reports that if thecost of options were reported in Americanfinancial statements as many astuteinvestors such as Warren Buffet believethey should be, then earnings would bereduced by an additional 20% annually.Take those wonderful earnings per sharenumbers then, that CNBC reports on

a minute-by-minute basis, and reducethem by at least 40% to recognize futurewrite-offs and the cost of options. TheS&P 500, with a reported P/E of 25xsuddenly looks more like 40x whenviewed rationally or even historically.No wonder market yields are only 1%.Its not that easy to pay dividends withphantom profits.

So you like stocks do you? Youre banking

on those 10-15% annual returns to let youretire in style a few decades from now?Somehow I dont think so. Not thatbonds will be any better. With Treasuryyields pressing 5%, its clear that double-digit returns for fixed income over thenext decade are not in the cards either.Instead, investors must acclimate to afuture environment of diminishedexpectations. While our New AgeEconomy may still exhibit near average

historical growth rates due to enhancedproductivity trends and the benefitsof globalization, our New Age Marketspromise nothing of the sort.

William H. GrossManaging Director

With current dividend yields near 1% forthe S&P 500 index, the model suggests areturn to 4-5% yields prevalent in the late

1970s. While those yields can comepartially from higher payout ratios andnot necessarily drastically lower stockprices, the real message of the chart isthat future P/Es should be lower thanthey are today and if so, that stock marketreturns will fail to match expectations ofinvestors used to better times.

I could go on and on and probably shouldfor at least one more paragraph. Current

stock market valuations are being sup-ported in part by a number of dubiousaccounting practices that have led toearnings overstatements of as much as30-40% annually. Peter Bernstein, in aNovember strategy piece, reports thatover the past fifteen years, an average of20% of reported earnings in any one year

Source: Barclays Capital Global Speculations, January 2, 2001

6

5

4

3

2

1

0

58 6 1 6 4 6 7 7 0 7 3 7 6 79 82 85 88 91 9 4 9 7 0 0 03 0 6 09

Actual and demographically modeled dividend yieldU.S. market (regression 1958-2000)


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Past performance is no guarantee of future results. All data as of 1/31/01 and is subject to change. The return on both individualsecurities and mutual fund investments will fluctuate and the value of an investors shares will fluctuate and may be worth more orless than original cost when redeemed. This article contains the current opinions of the manager and does not represent a recommenda-tion of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article isdistributed for educational purposes and should not be considered investment advice. These charts are not indicative of the past orfuture performance of any PIMCO Fund.

Equity funds are subject to the basic stock market risk that a particular security or securities, in general, may decrease in value. TheNASDAQ 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 ingeneral. It is not possible to invest directly in an unmanaged index.

For additional details on PIMCO Funds, contact your financial advisor to receive a prospectus that contains more completeinformation, including charges and expenses. Please read the prospectus carefully before you invest or send money. PacificInvestment Management Company, 840 Newport Center Drive, P.O. Box 6430, Newport Beach, CA 92658-6430, www.pimco.com, 1-800-927-4648.

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 educationalpurposes only. 2000, Pacific Investment Management Company.

PA814.2/01

bill gross investment outlook feb_01

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