Bill Gross Nov 09 comment by zerohedge

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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)

                                                45        U.S. Nominal GDP Growth vs.
                                                          U.S. Corporate Profits Growth                                  ends most long-term time periods with
                                                30                                                       R2 =.305
                                                20                                                                       much higher ones, justifying a 6.5% “Siegel
                                                 0                                                                       constant” real rate of return for U.S. equi-
                                                                                                                         ties over the past 75 years or so. It may also
                                                     -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
                                                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.
                                      1%                                                                         We, in effect, were hollowing out our pro-
                                 -1%                                     1.3% Average Annual Difference          ductive future at the expense of worthless
                                           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 –                  or

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.
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.
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R-squared (R 2) is a descriptive measure between zero and one, indicating how good one term is at predicting another.
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
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other publication, without express written permission of Pacific Investment Management Company LLC. ©2009, PIMCO                          

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