Bill Gross isn't entirely wrong

(MoneyWatch) COMMENTARY In his August "investment outlook," the man who has been called "the bond king" declared that we are witnessing the death of stocks. Bill Gross, founder and managing director of PIMCO, the world's largest bond fund, opens his forecast rather dramatically: "The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors' impressions of 'stocks for the long run' or any run have mellowed as well."

Gross's main argument is that the 6.6 percent real return enjoyed by stocks over the last 100 years or so is a fluke and can't continue. Indeed, the very idea that such returns could continue is akin to a chain letter or Ponzi scheme, he writes.

"If wealth or real GDP was only being created at an annual rate of 3.5 percent over the same period of time, then somehow stockholders must be skimming 3 percent off the top each and every year," Gross says. "If an economy's GDP could only provide 3.5 percent more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?"

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The end of the new normal
The accuracy of expert forecasts

Here's the problem with that analysis: Stocks can provide 6.6 percent real returns with no real growth in the economy. This is because markets don't price for growth. They price for risk! It's also worth noting that stock returns around the globe have been negatively correlated with economic growth. That's right -- faster growing countries provided below average returns, and vice versa.

Let's take a look at some of Gross' other main points (in the italicized text), some of which I completely agree with.

With long Treasuries currently yielding 2.55 percent, it is even more of a stretch to assume that long-term bonds -- and the bond market -- will replicate the performance of decades past.

This one's a no-brainer. For long-term bonds to replicate their historical real long-term return of 2.7 percent, bond yields would have to collapse. With expected inflation running about 2.5 percent, even if rates don't rise we'll see almost no real return.

Together then, a presumed 2 percent return for bonds and a historically low percentage nominal return for stocks -- call it 4 percent, when combined in a diversified portfolio produce a nominal return of 3 percent and an expected inflation adjusted return near zero.

I don't know where Gross is coming up with a 4 percent nominal return for stocks. Most financial economists are forecasting real returns in the 4-4.5 percent range, with 2 percent coming from dividends and 2-2.5 percent from growth in earnings. If we add expected inflation of about 2.5 percent, we come up with a nominal return of 6.5 to 7 percent, not 4 percent.

Those numbers, be it from Gross or other forecasters, are simply estimates. In either case, they're well below the long-term real return of 6.5 percent.

But Gross has a good point that investors relying on the stock market to provide its historical 6.5 percent real rate are likely to be disappointed. This is especially true for pension plans, which have obligations to meet. Even using the more favorable numbers from other economists in place of Gross's, a typical 60 percent stock/40 percent bond allocation would produce a real return of about 2.5 percent, well below the level most pension plans are counting on. This could leave many pension plans well short of what they need to meet their obligations, forcing them to renegotiate at best, default at worst.

The commonsensical conclusion is clear: 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.

This is a strong point by Gross. Many investors will need to plan on saving more, working longer, and spending less because the historical returns they have earned on financial assets aren't likely to be duplicated. Also, those relying on state and municipal pensions should be aware that they may be at significant risk.