"Come on, stockholders of America. Are you naive, stupid, masochistic, or, better yet, in this for `the long run'? Stocks are losers, and anyone who owns too many of them will be losers too." -- Bond fund manager William H. Gross, Sept. 5, 2002
That cheeky challenge appears in a controversial paper in which Gross--aka the King of Bonds--argues that the Dow Jones industrial average should be at 5000. Until it gets there, he argues, investors should dump stocks and buy bonds. Is Gross, whose flagship PIMCO Total Return Fund is up 9.7% this year, just drumming up business--or does he have a point?
Gross makes an intriguing case that stocks may be overvalued and remain troubled for the next two or three years, but it's hardly convincing. His reasoning, which assumes a "neutral" view on the economy and unchanged interest rates, goes like this: High corporate dividend yields were a much bigger contributor than corporate earnings to the 6.7% average annual gain in stock prices over the past century, after inflation. Moreover, given the recent accounting games that have gone on of late, many companies' earnings will continue to be "illusory." If history is any guide, he figures dividends need to climb to 3.5%, from 1.7% now, before stocks are a better buy than bonds.
That means either dividends must jump sharply or stocks must slide in order to bring the relative valuations between stocks and bonds back into line with long-term trends. While Gross isn't predicting the Dow will hit 5000, he concludes: "Stocks stink and will continue to do so until they are appropriately priced."
Could be. But there are holes in his argument. For one, Gross dismisses the impact of taxes on dividend payouts. Since World War II, changes in the tax code have prompted investors to prefer capital gains instead of dividend income. While dividends haven't followed a straight path since then, the yield on Dow stocks has fallen since the early 1980s.
Partly as a result, dividends are less important now than they were. Many companies and investors favor using spare corporate cash for stock buybacks or to reinvest profits instead of paying dividends. Microsoft Corp. and many other high-tech companies don't pay dividends. Neither does Berkshire Hathaway Inc., yet its stock has been enormously successful and remained flat this year while the Dow dropped 15%. It's a stretch to suggest that the market needs to return to a higher yield just because that's where it once was.
Moreover, dividend-paying heavyweights, such as oil producers and auto makers, no longer dominate the major market indexes, which they did as recently as the 1980s. They have been replaced by nondividend payors, such as Microsoft, and dividend lightweights, such as Intel Corp. In fact, of the companies in the Standard & Poor's 500-stock index, about 365 pay dividends.
Gross harkens back to Federal Reserve Chairman Alan Greenspan's December, 1996, warning of "irrational exuberance" in the stock market. He argues that earnings are about the same now as then, but stocks are appreciably higher. That's true, but look at the interest-rate environment. The 10-year bond yield then was nearly 6.5%; now, it's 4%. And Treasury bill rates have come down, from 4.9% to 1.7%. Lower interest rates raise the value of stocks vs. bonds.
Investors now may be more focused on trying to sort out the corporate profit picture than worrying about dividends. But as Gross points out, most major foreign stock markets already have dropped back to 1996 levels--even though dividend yields are higher than in the U.S. "If the U.S. followed [them], Dow 5000 is not ridiculous at all," says Gross.
Given the floundering economy, corporate misdeeds, and global unrest, valuing the market is admittedly a tough job. But equity investors can only hope the King of Bonds is wrong about stocks.
Boston-based Smith writes about finance.
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Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
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