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.