July, 2012

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Give Bill Gross an F in Financial Physics!

By Ted Schwartz and Kevin Starkey

 

Bill Gross has always been one of the few voices that we at Capstone believe is worth listening to. The world’s largest fixed income manager got that way through solid performance over decades. His thinking is usually lucid and his worldview often intriguing. As other financial industry talking heads are peddling something and Bill sells fixed income, could he be selling something new?

That said, he seemed to fall off of a turnip truck this week. He forecasted anemic real GDP growth of 1.5% per year for the US for the next decade. We are not forecasters, so will not take issue with this gloomy forecast.  However, he went on to say that “if real GDP grows at 1.5%, then a diversified portfolio of stocks and bonds would probably grow at 1.5% as well.”

While GDP growth would certainly be correlated to expected stock returns, the 1:1 correlation that Mr. Gross throws in to the equation has been pulled from thin air. The long term growth rate of GDP is rather consistently around 3% per year. The long terms real return of stock is around 6.5% per year. In other words, stocks have historically grown at a rate far higher than GDP.

Why would this be true? Well, financial physics is about the basics of return on equity. As companies are already earning money every day as we enter Mr. Gross’ 1.5% decade, the companies have earning that are considerable to add to their bottom lines before we consider growth. Companies can 1) distribute money they earn through dividends; 2) they can use it for share buybacks that should increase stock prices; 3) they can use it for expansion, acquisitions, and debt reduction which should increase net earnings. All of these choices should yield shareholder returns well in excess of Mr. Gross prediction of GDP growth. So, even with his dire prediction, we may hope for returns that are rather paltry but well above Mr. Gross’ calculations. Stay tuned for the pitch!

Is this year going according to form?

By Kevin Starkey and Ted Schwartz

Sell in May and go away for the summer this year? Maybe not, according to data compiled by our research partner Hidden Levers. In a recent study they conducted of Election Year markets, this year has gone amazingly well to the script for election years. Hidden Levers studied election years from 1926 thru 2011 and found the first 3 months of the year had positive average returns in the S&P 500 Index for each month. Check mark for 2012! The next two months have had negative average returns historically. Check mark for again for 2012! June has had a positive average return historically. You guessed it, check mark for 2012!

 

So, what does history tell us about the balance of the year? Historically, July and August are the two best months of election year returns.  Then, they are followed by a small negative in September and a small positive in October. Then, the certainty of Election Day sets in and we have a positive return in November and December.

 

This year has played to form perfectly so far. Can that continue through the balance of the year? It seems odd when this year and period seems so different from the norm, yet it has been so predictable year to date that we would not bet against returns continuing to approximate the norm over coming months.