At the height of the dot-com era, with the Nasdaq trading at 5,000, the airwaves were filled with predictions of even bigger gains to come. One prediction that called for “Dow 36,000” was a sure sign that stocks were headed for trouble. Bubbles get pricked right at the time of maximum confidence in future gains.

Of course, it works the other way as well. Stocks have delivered very little for investors since 2000, and according to some polls, more than 80% of individuals simply don’t trust stocks. Even some of the pros are getting pessimistic on the long-term viability of stocks. Bill Gross, the well-respected head of Pacific Investment Management Co. (PIMCO), has been making the rounds, emphatically declaring that stocks are dead and that you need to prepare for zero gains in the years ahead. 

You can read about Gross’ comments in this Op-Ed piece he penned for The Wall Street Journal.

In a nutshell, Gross argues that if the economy is only going to grow at a tepid pace in the years ahead, then there’s no way that stocks can continue to achieve the 6.6% historical gains we’ve seen. In effect, he’s suggesting that stocks are likely overvalued simply because they have been rising faster than the gross domestic product (GDP) has grown over the past 30 years. 

Put simply, I think Gross is dead wrong. Here’s why…

If you read the Op-Ed, then you might spot some flawed assumptions, and I’m surprised Gross is overlooking them. The biggest flaw: Gross is equating economic growth with the No. 1 driver of stock prices: profit growth. Simply put, 2% GDP growth does not equal 2% profit growth.

Companies have been operating in the context of 0% to 4% GDP growth every year for the past three decades. Yet in most years, companies have seen sales and profits rise at a faster pace, perhaps two or three times the rate of economic growth. 

How can that be? Well, it’s not that companies retain earnings and then redeploy those profits into several outlets. Sure, they can issue dividends, but most corporate cash flow has been re-applied into research and development efforts that yield new products, funds acquisitions that boost growth, or buy back stock. In each instance, these measures can boost earnings per share.

#-ad_banner-#Profits drive stock prices…
Let’s use a specific example. Suppose an industrial company generated $10 billion in sales and generated $600 million in free cash flow. And let’s assume that cash flow is used to buy another business for $600 million. Note that shares outstanding didn’t rise, but sales and profits will now be higher to the extent that the new acquisition boosts the numbers on the income statement. Roughly speaking, we’re talking about a 6% gain in per share profits — and, presumably, the stock price.

In fact, like a shark that keeps swimming even as it sleeps, companies have a natural imperative to pursue any measures that will boost earnings per share. (Executive compensation in the form of stock options is almost always tied to this metric.) That’s why companies often sell assets and then re-deploy the funds into new products or companies that yield better growth prospects.

The magic of the dollar
Another point: Gross is simply ignoring the effect of inflation. GE (NYSE: GE) or IBM (NYSE: IBM) earn so much more today than they did 40 years ago, in part because the value of the dollar inflated in value over that time. Of course, if Gross said that stock price gains — adjusted for inflation — may be muted for the foreseeable future, well, that is at least a more reasoned argument. But he’s not saying that, and as noted above, that premise may not hold water anyway.

Gross hints that we’re on the cusp of an era of high inflation. Maybe he’s right. But he can’t have it both ways. Either the economy has too much slack and will grow at a weak pace (and evidence minimal inflationary pressures), or growth will pick up — raising inflation concerns. In effect, he’s predicting a return to “stagflation” that we saw in the 1970s. It’s notable, though, that the 1970s was the only decade of the 20th century that saw sustained inflation and anemic growth. So maybe Gross is right, but history says that’s unlikely.

Demographics are key…
Gross makes another key point, which is either way off the mark or should be of great concern to you if he’s right. He suggests we are now locked into an era of very low economic growth because the biggest economies in the world are simply too mature and too uncompetitive to find ways to grow. Yet is that really the case? Here in the United States, the population continues to expand, thanks to immigration and organic family growth, and there’s no reason the economy can’t grow even faster than the population.

Think about it… A larger population opens up new business needs. A mid-sized city that couldn’t support a high-end retailer like Tiffany & Co. (NYSE: TIF) or a Porsche dealership eventually can as the population grows. Opening a store creates more jobs for that city. Yes Europe and Japan are stagnating — but it’s in large part because they have flat population growth. Here in the United States, the demographics remain quite favorable.

The one thing Gross got right
Here’s where Bill Gross got it right. Whenever stocks have made a strong run, subsequent results are quite subdued. It may be disheartening that the major averages are below levels seen back in 2000, but you should also know that stocks made a remarkable upward move from the early 1980s until 2000. A long hangover was likely inevitable. Yet you could argue that we’ve paid for that, as seen by a lost decade for stocks, and we may be closer to the next bull market than many suspect.

Action to Take –> Sure, it’s pretty dark out there. The economy has slowed, and you shouldn’t be surprised to see another recession in the next 12 months. That kind of pall tends to color investors’ moods, so Gross’ downbeat take on equities is getting a lot of media play right now.

Yet soon enough, perhaps in 2013 or 2014, the economy may take on a fresh glow. The housing sector will likely pick up. Auto makers will likely move a lot more metal to meet growing demand. Retailers will likely see brisk traffic in their stores. And corporate profits will likely grow at a robust pace — which, as I mentioned before — are what really drives stock prices in the long run.