Don't Drink the Bill Gross Bond Cult Kool-Aid

NEW YORK ( AdviceIQ) -- Conventional Wall Street wisdom holds that stocks are the best for the long-run. But the so-called King of Bonds, Bill Gross, disagrees. He is wrong.

In his August 2012 Investment Outlook, the founder of asset management powerhouse Pimco argues that the "cult of equity is dead." Even after the 2008-09 meltdown and volatile times since, that cult still counsels that stocks will continue to be the best place for your money.

If you look at stocks' performance over the past 15 years, he seems to have a point. The Standard & Poor's 500 stock index is flat over that period. Going forward, Gross believes that stock investors will get far less than the 6.6% average inflation-adjusted return the S&P generated since 1912.

Gross bases his warning about lower future equity returns on the idea that both labor and government will require increased compensation for their work. That's as opposed to today's stagnant pay. Next, he points to the likelihood that economies all over the world will slow, and need to be rejuvenated. And indeed, they seem to be drooping today.

The result, according to Gross: inflation. Policymakers, he says, will attempt to inflate the global economy out of its current deflation -- and that inflation will be a lasting drag on real returns. In the inflation-ridden 1970s, stocks took a beating.

While many of Gross' conclusions make sense, a major conceptual weakness is that he overlooks the difference between stocks and bonds. A strength of some companies, especially global enterprises with great brand recognition, is they can offset inflation by raising prices. This power helps operating results and supports stock prices.

For another AdviceIQ advisor's take on Bill Gross's "cult of equity" statement, arguing that the bond guru never said stocks are dying, click here .

Pricing flexibility counteracts inflation. Just as important, a business can continue to grow during periods of inflation. Consequently, equity owners of international corporations should see increases in their dividend yields, along with growth in operating profits. Of course, nothing is guaranteed and business results depend on a great many factors. Still, many public companies increased dividends and earnings for decades, sometimes even centuries. Many investors built great wealth over a long period owning these equities.

Bonds, on the other hand, do not benefit from such flexibility. With aptly named fixed-income instruments, the coupon is frozen.

Bond owners face a very disturbing reality if Gross is correct about higher inflation. Then, central banks all over the world will adjust by raising interest rates, and bond owners will suffer capital losses. Inflation destroys bonds' value.

Bondholders did well over the past 15 years, which experienced little inflation. Owners of fixed-income assets are used to good times. A less lovely dynamic likely will occur in the capital markets if increased inflation is right around the corner.

Inflation already seems to be stirring, with the price of corn bumping up because of the Midwest drought. Yes, the cult of equity may be long gone, but stocks currently offer compelling value, especially those with strong global businesses.

--By Yale Bock, CFA, owner and operator of YH&C Investments in Las Vegas, Nev., for AdviceIQ .

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