Why Bill Gross is Wrong: Innovation and Long-term Returns on Equity

Bill Gross of Pimco has just written a piece where he argues that the real return on stocks in the future will be much lower than the long-term historical average of 6.6%:

Yet the 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% 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)?

He then goes on to argue that:

The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.

In a world of slow innovation, Gross is likely to be correct.  The economy grows slowly, and it becomes difficult to justify compensating risk capital if risks are not paying off.

The calculation changes, however, if we have big disruptive innovations. Big disruptive innovations offer risk on both the upside and the downside. On the upside, disruptive innovations create a wave of high-growth companies that drive the stock market higher. On the downside, disruptive innovations offer the distinct possibility of driving existing companies out of business, once again accentuating risk.

Innovation also makes diversification across a portfolio of large stocks a much less appealing prospect, since much of the stock gains will come from small companies that grow quickly. Investors therefore have to take more risk to capture the returns, whether they like it or not.

In this view of the world, an investment in the stock market becomes a bet on innovation. Do you think that the U.S. or the global economy has another wave of disruptive innovation coming? Then buy stocks. But if you think that we are stuck in permanent stagnation mode, then stay away from the stock market.