Why Investors Should Pay No Heed to Bill Gross's 'New Normal'

Pimco's Bill Gross
Pimco's Bill Gross

Bill Gross, the leading proponent of the "New Normal" -- the idea that stocks will return just 3% a year for the foreseeable future -- has been wrong over and over again. So why does anyone pay attention to his predictions?

Stocks have been a fantastic place to be since the start of 2009. In that year, the S&P 500 stock index rose 23%, and in 2010 it added another 13%. But in a February 2009 interview I did with Gross for BloggingStocks, he moaned about how stocks were a terrible place to invest in a slow-growth environment.

His argument was that since common shareholders were at the bottom of the liquidation hierarchy -- meaning they're the last in line to collect when a bankrupt company is liquidated -- they take all the risk and can get left with nothing if things go wrong.

He was right about one thing -- growth since has not been robust at all. GDP grew 2.8% in 2010, and it's forecast to be up only 2.6% in 2011 and 3.2% in 2012, according to Bloomberg. But the key thing to track isn't the overall economic growth; it's the growth of earnings. And Gross miscalculated on that front. For example, earnings grew to a record $1.66 trillion in 2010, while corporations piled $2 trillion in cash their balance sheets.

He Couldn't Have Been More Wrong

Moreover, corporate earnings aren't just bigger than ever. They've also grown faster than Wall Street expected. According to Bloomberg, more than 70% of companies exceeded analysts' profit estimates in the third quarter of 2010, marking the sixth straight period that so many companies beat projections, the longest stretch since at least 1993.

Gross's argument about shareholders getting stiffed works out really well when companies go bankrupt. Unfortunately, he has been a bit off in his prediction about corporate health. Many companies that were looking troubled two years ago have just finished their best year in history. Gross couldn't have been more wrong.

Gross gladly talks to anyone in the media and uses that platform to scare people away from stocks and into bonds. Why bonds? At $1.24 trillion under management (as of Sept. 30, 2010), Gross's PIMCO is the largest bond fund in the world. And Gross's gloom has worked -- boosting that asset pile by 58% since February 2009.

Trailing the S&P 500

Those who watch CNBC know that PIMCO sponsors a segment called the Bond Report -- featuring Tea Party match-lighter, Rick Santelli, whose famous rant against bailing out people with mortgage problems took place a week before my interview with Gross.

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It doesn't matter that bonds are a mediocre investment -- his PIMCO Total Return was up 8.4% in 2010, far less than the S&P 500's 13% return. What matters to Gross is that the pile of assets under PIMCO's management keeps growing. And with an average expense ratio of about 1%, PIMCO reaps $12.4 billion in fees from them.

He may have convinced himself that stocks will grow 3% a year for the foreseeable future, but his forecasting error has been huge, and the public ought to be discounting severely what he says. And if the Fed starts to raise interest rates to keep inflation in check, all those PIMCO investors will be in for a world of hurt as bond prices plunge.