Investment Bill Gross Outlook November 2009 Midnight Candles A cold wind from the future blows into my beyond. Those of you much younger must nighttime bedroom, more often than not wonder what has come over me, yet I was during those midnight hours when fear young once too. I remember as a teenager dominates and hope retreats to a nether- camping out under the stars with friends world. This wind is a spectre, an oracle of wondering aloud at the mystery of it all, darkness and eventual death, not easily dis- knowing the reaper was far off in the dis- missed. Once merely a whisper, its decibels tance, so far away that death was more intensify with the advancing years. It will a philosophical discussion point than an be heard, this reaper – this grim reaper, yet impending reality. In my thirties, I recall in the nights when it howls the loudest I standing in front of a mirror in my physical fight back, silently screaming for it to get prime and instructing my image that I out, to leave me alone, to let it all be a bad would never grow old, that I somehow dream. It never is. Shakespeare’s Macbeth would live forever, that I, the me, the ego, expressed it more subtly: “Out, out, brief would be eternal. Now when I face the candle!” Yet the finer words provide no glass my eyes avoid the unmistakable con- solace; the final act is always the same. clusion: I am everyman – everyone that ever was and ever will be. This world will Those of you in your sixties and older outlast me. know of what I speak; even during daylight hours you read the obits and notice that What to do? Enjoy these senior years and contemporaries have passed into the take advantage of the gifts I have been Investment Outlook given – a healthy 65-year-old body, an price appreciation for decades. Stock and amazing job where I can still make a vital home prices went up – then consumers liq- contribution, a wonderful wife who shines uefied and spent the capital gains either by brightly and muffles the sound of my borrowing against them or selling outright. nighttime intruder. Still there is no accep- Growth, in other words, was influenced on tance of Macbeth’s or any of our “dusty the upside by leverage, securitization, and deaths.” At midnight there is only fear and the belief that wealth creation was a func- rage – rage against this night whose wind tion of asset appreciation as opposed to will one day take us all. the production of goods and services. American and other similarly addicted An investment segue is a tough one this global citizens long ago learned to focus on month: markets whistling past the grave- markets as opposed to the economic foun- yard? A vampire economy? A ghostly dation behind them. How many TV shots correction ahead? Pretty lame, so I’ll jump have you seen of people on the Times straight into a discussion of why in a New Square Jumbotron applauding the an- Normal economy (1) almost all assets nouncement of the latest GDP growth appear to be overvalued on a long-term numbers or job creation? None, of course, basis, and, therefore, (2) policymakers need but we see daily opening and closing to maintain artificially low interest rates and market crescendos of jubilant capitalists supportive easing measures in order to keep on the NYSE and NASDAQ cheering the economies on the “right side of the grass.” movement of markets – either up or down. My point: Asset prices are embedded not Let me start out by summarizing a long- only in our psyche, but the actual growth standing PIMCO thesis: The U.S. and most rate of our economy. If they don’t go up – other G-7 economies have been signifi- economies don’t do well, and when they cantly and artificially influenced by asset go down, the economy can be horrid. November 2009 Page 2 To some this might seem like a chicken and when not, they fall below the best fit line egg conundrum because they naturally appearing in the chart. Notice as well that move together. For the most part they do – in a normally functioning economy and should. As pointed out in a recent New growing at 6-7% nominal GDP, that profits York Times article titled “Dow Bubble?,” grow at the same rate. (At growth distribu- stocks and nominal GDP growth should be tion tails there are substantial distortions.) correlated because profits and nominal And if long term profits match nominal GDP are correlated as well. Witness the GDP growth then theoretically stock prices PIMCO Chart 1, researched by Saumil should too. Parikh, which covers a time period of 50 years. Granted the R2 correlation is only Not so. What has happened is that our .305, but that is to be expected – profits are “paper asset” economy has driven not only also a function of the respective entities stock prices, but all asset prices higher than that feed at the GDP growth trough – cor- the economic growth required to justify porations, labor, government and other them. Granted, one must be careful of be- countries – and when corporations and ginning and ending data points in any their profits are ascendant they do well; theoretical “proof.” Such is the fallacy of Jeremy Siegel’s Stocks for the Long Run ap- Chicken and Egg proach which begins at very low PEs and Corporate Profits, 12-Month Growth (Percent) 55 50 45 U.S. Nominal GDP Growth vs. 40 35 U.S. Corporate Profits Growth ends most long-term time periods with 30 R2 =.305 25 20 much higher ones, justifying a 6.5% “Siegel 15 10 5 0 constant” real rate of return for U.S. equi- -5 -10 -15 -20 ties over the past 75 years or so. It may also -25 -30 -4 -2 0 2 4 6 8 10 12 14 16 18 be a weakness of the New York Times Nominal GDP, 12-Month Growth (Percent) Source: National Income and Product Accounts, “Dow Bubble” article where the authors Bureau of Economic Analysis, PIMCO Chart 1 claim that since the Dow Jones average was Page 3 Investment Outlook at 4,000 in 1995, that a 100% step-for-step valuation growth rate for all U.S. assets correlation with nominal GDP growth since 1956 vs. corresponding economic since then would produce a reasonable growth. Several interesting points. First of valuation of 7,800 – not the current 10,000. all, assets didn’t always appreciate faster than GDP. For the first several decades of Having said that, let me introduce Chart 2 this history, economic growth, not paper a PIMCO long-term (half-century) chart wealth, was king. We were getting richer by comparing the annual percentage growth making things, not paper. Beginning in the rate of a much broader category of assets 1980s, however, the cult of the markets, than stocks alone relative to nominal which included the development of finan- GDP. Let’s not just make this a stock cial derivatives and the increasing use of market roast, let’s extend it to bonds, leverage, began to dominate. A long history commercial real estate, and anything that marred only by negative givebacks during has a price tag on it to see if those price recessions in the early 1990s, 2001–2002, stickers are justified by historical growth and 2008–2009, produced a persistent in- in the economy. crease in asset prices vs. nominal GDP that led to an average overall 50-year apprecia- This comparison uses a different format tion advantage of 1.3% annually. That’s with a smoothing five-year trailing another way of saying you would have Gonna Take Me Higher been far better off investing in paper than 8% 7% 5-Yr Trailing Annual Growth Rate factories or machinery or the requisite 5-yr Compounded Annual Growth 6% of Total Assets in the U.S. Deflated Rate Difference (Percent) 5% by Nominal GDP 4% components of an educated workforce. 3% 2% 1% We, in effect, were hollowing out our pro- 0% -1% 1.3% Average Annual Difference ductive future at the expense of worthless -2% -3% 56 60 64 68 72 76 80 84 88 92 96 00 04 08 paper such as subprimes, dotcoms, or in Nominal GDP, 12-mo Growth (Percent) Source: Federal Reserve Flow of Funds, PIMCO part, blue chip stocks and investment Chart 2 November 2009 Page 4 grade/government bonds. Putting a com- corporate and high yield bonds as well, pounding computer to this 1.3% annual should be thrown into this overpriced outperformance for 50 years, produces a vortex more resemblant of a black hole double, and leads to the conclusion that the than American-style paper wealth capital- return from all assets was 100% (or 15 tril- ism. This is where it gets tricky, however, lion – one year’s GDP) higher than what it because policymakers, (The Fed, the theoretically should have been. Financial Treasury, the FDIC) recognize the predica- leverage, in other words, drove the prices ment, maybe not with the same model or in of stocks, bonds, homes, and shopping the same magnitude, but they recognize malls to extraordinary valuation levels – at that asset prices must be supported in least compared to 1956 – and there could be order to generate positive future nominal payback ahead as the leveraging turns into GDP growth somewhere close to historical delevering and nominal GDP growth norms. The virus has infected far too many regains the winner’s platform. parts of the economy’s body, for far too long, to go cold turkey. The Japanese This 100% overvaluation from recent price example over the past 15 years is an excel- peaks of course is crude, simplistic, and lent historical reference point. Their unrealistically pessimistic. It implies that quantitative easing and near-0% short- stocks should be at – gasp – Dow 7,000 – term interest rates eventually arrested and that home prices – gasp – should be cut equity and property market deflation but in half from 2007 levels, and that commer- at much greater percentage losses, which cial real estate (Las Vegas hotels, big city produced an economy barely above the office buildings that are 20% empty) should grass as opposed to buried six feet under. likewise face the delevering guillotine. The current objective of global policymak- Some of these price adjustments have ers is to do likewise – keep the capitalistic already taken place, and to be fair, patient alive through asset price support, Page 5 Investment Outlook but at an “old normal” pace if possible, At the center of U.S. policy support, six feet or 6% in U.S. nominal GDP terms however, rests the “extraordinarily low” above the grass. or 0% policy rate. How long the Fed remains there is dependent on the pace of That support, of course, comes in numer- the recovery of nominal GDP as well as the ous ways. Financial system guarantees, mix of that nominal rate between real TARP recapitalization of banks, TAFs, growth and inflation. My sense is that TALFs, PPIFs – and in Europe and the UK, nominal GDP must show realistic signs low interest rate term financing, semi-bank of stabilizing near 4% before the Fed nationalizations, and asset purchase pro- would be willing to risk raising rates. grams similar to the United States. In the The current embedded cost of U.S. debt case of the U.S., the amount of the implicit markets is close to 6% and nominal GDP and explicit financial support given by must grow within reach of that level if policymakers totals perhaps as much as policymakers are to avoid continuing $5 trillion, which goes part way to support debt deflation in corporate and household the $15 trillion overvaluation of assets the- balance sheets. While the U.S. economy oretically calculated in the PIMCO model will likely approach 4% nominal growth in (100% of nominal GDP). China, interest- 2009’s second half, the ability to sustain ingly, is taking another approach, throwing those levels once inventory rebalancing equivalent trillions into their real economy and fiscal pump-priming effects wear off is to make things as opposed to support debatable. The Fed will likely require 12–18 paper, if only because exports are at the months of 4%+ nominal growth before heart of their economic growth and they abandoning the 0% benchmark. haven’t caught the American virus or suffered, I suppose, a “paper cut.” Here is another way to analyze it. It seems commonsensical that because of asset November 2009 Page 6 market value losses over the past 18 stay low: Asset appreciation in U.S. and months, the Fed must keep future real and other G-7 economies has been artificially nominal interest rates extremely low. elevated for years. In order to prevent Because 401(k)s have migrated to 201(k)s, prices sinking even lower than recent and now 301(k)s, the negative wealth effect downtrends averaging 30% for stocks, must be stabilized in order to reintegrate homes, commercial real estate, and certain the private sector into the current economy. high yield bonds, central banks must keep Renormalizing risk spreads – stock, invest- policy rates historically low for an ex- ment grade, and high yield bonds among tended period of time. If policy rates are them – is another way to describe this artificially low then bond investors hoped for foundation for future growth. should recognize that artificial buyers PIMCO estimates that this process is of notes and bonds (quantitative easing perhaps 80–85% complete, which provides programs and Chinese currency fixing) the potential for a sunny-side, right-side of have compressed almost all interest rates. the grass outcome, although still with New But while this may support asset prices – Normal implications. Still, investors must including Treasury paper across the front admit that without the policy guarantees of end and belly of the curve, at the same time the Fed, Treasury, and FDIC, as well as the it provides little reward in terms of future continuation of punitive 0% short-term income. Investors, of course, notice this in- rates that force investors to buy something, evitable conclusion by referencing anything, with their cash, that risk spreads Treasury Bills at .15%, two-year Notes at may widen again, not stabilize. less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momen- This somewhat detailed analysis on Fed tum, this is all a Treasury investor can funds policy rates should return us to my expect. What you see in the bond market is beginning thesis as to why they need to often what you get. Broadening the concept Page 7 to the U.S. bond market as a whole (mort- with abnormally low policy rates. Rage, IO Podcast… gages + investment grade corporates), the rage, against this conclusion if you wish, To download Bill Gross’ IO Podcast, check total bond market yields only 3.5%. To get but the six-month rally in risk assets – pimco.com or iTunes.com. more than that, high yield, distressed mort- while still continuously supported by Facebook… Stay up to date on gages, and stocks beckon the investor Fed and Treasury policymakers – is likely PIMCO with Facebook. Search “PIMCO.” increasingly beguiled by hopes of a at its pinnacle. Out, out, brief candle. twitter… V-shaped recovery and “old normal” Stay in touch with PIMCO. market standards. Not likely, and the William H. Gross Search “PIMCO.” risks outweigh the rewards at this point. Managing Director Investors must recognize that if assets appreciate with nominal GDP, a 4–5% return is about all they can expect even Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of 840 Newport Center Drive the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Newport Beach, CA 92660 R-squared (R 2) is a descriptive measure between zero and one, indicating how good one term is at predicting another. 949.720.6000 This article contains the current opinions of the author but not necessarily those of the PIMCO Group. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2009, PIMCO pimco.com IO088-102009.
Pages to are hidden for
"Bill Gross Nov 09 comment"Please download to view full document