Investment Outlook
Bill Gross | May 2009
2 + 2 = 4
A photograph of Bernard Baruch
looms ominously on the far corner of my
PIMCO office wall. Vested, with pocket watch and protruding chin
thrust prominently
toward the observer, this well-known financier of
the early 20th century at times appears almost alive. It was Baruch
who
almost schizophrenically cautioned investors during the stock
market’s speculative blow-off in the late 20s that
“two plus two
equals four and no one has ever invented a way of getting something
for nothing.” Three years
later during the depths of economic and
financial gloom he opined just the opposite: “Two plus two still
equals
four,” he said, “and you can’t keep mankind down for long.”
Homo sapiens, as it turns out, stayed
on the deck for much longer than
Baruch envisioned – some historians having suggested that it was only
war and
not the rejuvenating economic spirits of a capitalistic peace
that eventually turned the tide – but his words, first
of caution and
then of optimism, typify the way that fortunes were, and still are,
made in the financial markets: Get
your facts straight, apply them to
the current valuation of the market, take decisive action, and then
hold on for dear
life as the mob hopefully comes to the same
conclusion a little way down the road.
I stare into Baruch’s eyes almost every day – not that we are
simpatico or kindred spirits of any sort
– but when I do, it’s as if I
can hear him almost whispering to me over the portals of time: “Two
plus
two,” he commands, “two plus two, two plus two.” The message –
fortunately, I suppose – ends
there. If you thought I was receiving
market calls from the ghost of Bernard Baruch I suspect PIMCO would
have far fewer
clients than we do today. But his lesson nonetheless
remains clear: separate reality from exuberance either on the up or
the
downside and you have the ingredients for a successful market
strategy.
Through my years here at PIMCO there have been numerous demarcation
points where Baruch’s whispers almost turned
into screams. Two plus
two screamed four in September of 1981 with long-term Treasury yields
approaching 15%, and two
plus two boomed four in 2000 when the Dot
Coms rose to prices that discounted the hereafter instead of the next
30 years.
Similarly, 2007 was a screaming mimi with the subprimes – if
only because the liar loans and no-money-down financing
were
reminiscent of a shell game, Ponzi scheme, or some other type of
wizardry that was bound to lead to tears.
2009 is a similar demarcation point because it represents the
beginning of government policy counterpunching, a period
when the
public with government as its proxy decided that private market,
laissez-faire, free market capitalism was
history and that a
“private/public” partnership yet to gestate and evolve would be the
model for years to
come. If one had any doubts, a quick, even cursory
summary of President Obama’s comments announcing Chrysler’s
bankruptcy
filing would suffice. “I stand with Chrysler’s employees and their
families and communities.
I stand with millions of Americans who want
to buy Chrysler cars (sic). I do not stand…with a group of investment
firms
and hedge funds who decided to hold out for the prospect of an
unjustified taxpayer-funded bailout.” If the cannons
fired at Ft.
Sumter marked the beginning of the war against the Union, then clearly
these words marked the beginning
of a war against publically perceived
financial terror.
Make no mistake, PIMCO had no dog in this fight, and has
infinitesimally small holdings of GM bonds as well. In turn,
the
rebalancing of wealth from the rich to the “not so rich” is a long
overdue reversal, one that I have
encouraged in these Outlooks for at
least the past several years. But promoting and siding with the
majority of the
American public in their quest for change does not
mean that as investors, we at PIMCO stand star-struck like a deer in
front
of the onrushing headlights, doing nothing to protect clients.
Our task is to identify secular transitions and to preserve
and
protect capital if indeed it is threatened. Now appears to be one of
those moments.
The threat, of course, falls under the broad umbrella of “burden
sharing” and is a difficult one to interpret
and anticipate, if only
because the concept is evolving in the minds of policymakers as well.
But clearly, as this financial
crisis has morphed from Bear Stearns to
FNMA, Lehman Brothers, AIG and now Chrysler, the claims of
stockholders and
in some cases senior debt holders have suffered.
Please hear me on this. That is the way it should be. Capitalism is
about
risk taking and if you’re not a risk taker, you should have your
money in the bank, Treasury bills, or a savings
bond, not the levered
investment of a bank or an aging automobile company. Let there be no
company too big, too important,
or too well-connected to fail as long
as the systemic health of the economy is not threatened.
Having acknowledged that, however, let me be clear that these risks,
long swept under the rug of prior Administrations,
are now rising to
a boil. The pressure to “survive well” or simply survive period is now
clearly shifting
to Wall Street as opposed to Main Street. The worm
has turned, and our President, whom I voted for and still strongly
support,
has shed his predecessor’s regal robes for a populist’s
cloak.
How does one invest during such a transition? Investors should
recognize that this grassroots trend signals –
most importantly – an
increasing uncertainty of cash flows from financial assets. Not only
will redistribution
and reregulation lead to slower economic growth,
but the financial flows from it will be haircutted and “burden shared”
by
stakeholders. In turn, the present value of those flows should
reflect an increasing risk premium and a diminishing multiple
of
annual receipts. PIMCO’s Paul McCulley, famous for a catchy phrase or
a light-bulb-generating truism, asked
a group of clients the other day
to compare FedEx and UPS to the U.S. Post Office, if it were a public
corporation.
“Which one would you pay more for?” he asked. If FedEx
deserves a P/E of 12, wouldn’t the value of the
Post Office be
substantially less? His point, and mine as well, is that as wealth is
redistributed, and the invisible
private hand of Adam Smith begins to
resemble more and more the public fist of government, then asset
values should
be negatively affected. First comes the haircutting and
burden sharing, most recently evidenced by Chrysler and soon to
be
played out via the stress testing and equity dilution of government
ownership of ailing banks. In those footsteps,
however, will follow a
slower rate of economic growth, not just in the U.S., but worldwide as
heretofore libertarian
capitalism is bridled, saddled and taught to
trot instead of gallop over the investment plains.
This Outlook is not to bemoan this transition, but to recognize it.
Slower growth can be a public good if it avoids
the cataclysmic
effects of double-digit unemployment, escalating foreclosures, and
fear of financial insecurity. But
the Obama cannon shot will have
financial consequences. Do not be deceived by the euphoric sightings
of “green
shoots” and the claims for new bull markets in a multitude
of asset classes. Stable and secure income is still the
order of the
day. Shaking hands with the new government is still the prescribed
strategy, although it should be done
at a senior level of the balance
sheet. If the government indeed becomes your investment partner, you
should keep
the big Uncle in clear sight and without back turned. Risk
will not likely be rewarded until the global economy stabilizes
and
the Obama rules of order are more clearly defined.
The ghost of Bernard Baruch still counsels that 2 + 2 = 4, but the
repercussions of getting something for nothing
should dominate the
hopes that mankind will get off the deck and revert to a mean or
median standard representative
of outdated political and economic
philosophies. Mohamed El-Erian’s and PIMCO’s “new normal” should
trump
green shoot exuberance for years to come.
William H. Gross
Managing Director