Monday, January 4, 2010

Pimco is Bearish and Disgusted with both Risk-Assets and US Treasuries - Alpha

The gentlemen at Pimco are some of the savviest bond investors in the world. They also are great at making actionable macroeconomic predictions and actually positioning portfolios on their outlooks (something I see too little of in the investment world - acting and holding on to your convictions!). Quite simply, Pimco's returns for 2008, 2009, and the two decades before have been stellar.

Gross and El-Erian: The Best Team Since Buffett and Munger

Well, three top thinkers have Pimco have come out with rather bearish views, and trigger-happy fund managers, euphoric little guy investors, and regulators should take note when the smart money publicly puts out its views:

1) Bill Gross, Pimco's co-founder and PM of its largest fund (the Total Return Fund is the world's largest bond fund), has these thoughts:

-"The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services."

-"Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform..."

-"This 100% overvaluation from recent price peaks of course is crude, simplistic, and unrealistically pessimistic. It implies that stocks should be at – gasp – Dow 7,000 – and that home prices – gasp – should be cut in half from 2007 levels, and that commercial real estate (Las Vegas hotels, big city office buildings that are 20% empty) should likewise face the delevering guillotine."

-"[P]olicymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey. . .
That support, of course, comes in numerous ways. Financial system guarantees, TARP recapitalization of banks, TAFs, TALFs, PPIFs – and in Europe and the UK, low interest rate term financing, semi-bank nationalizations, and asset purchase programs similar to the United States. In the case of the U.S., the amount of the implicit and explicit financial support given by policymakers totals perhaps as much as $5 trillion, which goes part way to support the $15 trillion overvaluation of assets theoretically calculated in the PIMCO model (100% of nominal GDP)."

-"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until. To date that transition is incomplete, mainly because mortgage refinancing and the purchase of new homes is being thwarted by significant changes in down payment requirements. The Treasury as well, has a significant average life extension of its own debt to foist on investors before the Fed can raise short-term Fed Funds."

-What to buy: "Where does that leave you, the individual investor, the small saver who is paying the price of the .01%? Damned if you do, damned if you don’t. Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis? . . . If companies are going to move toward a utility model, why suffer the transformational revaluation risk of equities with such a low 2% dividend return? . . . Let me tell you what I’m doing. . .I figure, why not just buy utilities if that’s what the future American capitalistic model is likely to resemble. Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom. Their growth in earnings should mimic the U.S. economy as they always have, and most importantly they yield 5-6% not .01%! In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity. Utilities and even quasi-utility telecommunication companies now yield between 5 and 6%, whereas their 10- and 30-year bonds yield less and at a higher tax rate to you the investor."

2) Mohammed El-Erian, CEO and PM, expects a second financial dip (with some odds of a second economic dip), and a long "new normal" of "below model/trend" GDP growth and stagnation:
-"We're on a sugar high... It feels good for a while but is unsustainable." [This burst of economic activity fed by government spending and near-zero interest rates will soon peter out.]

—Stocks will drop 10 percent in the space of three or four weeks, bringing the Standard & Poor's 500 index below 1,000 — though El-Erian is not predicting when.

—The unemployment rate will be hovering above 8 percent in late 2010.

—U.S. gross domestic product will grow at an average 2% or so for years to come — a third slower than we're used to.

-Many of the bulls don't appreciate just how much the government props still under the economy are masking its weakness. Instead of focusing on the fundamentals today, they're looking to the past, expecting a quick economic rebound because that's what's happened before. We're trained to think the "farther you fall, the higher you'll bounce back... We're hostage to the V."

-We've probably seen the worst of the crisis but consumers, and not just Washington, need to start spending again for the recovery to really take hold. This won't happen soon. Like in the Great Depression, Americans are saving more and borrowing less — a shift in attitudes toward family finances that Pimco thinks will last a generation. More regulation and higher taxes will crimp growth for years to come.

3) Fed Watcher Paul McCulley, a PM, presents the firm's 2010 Investment Outlook (their shared internal consensus):
-The world is uncertain, and risk assets are not looking good. Multiple outcomes are likely as "there is still uncertainty over three major issues, which in turn creates a range of possible outcomes in our forecast. Depending on how these issues progress, we’re looking at multiple potential resolutions of the inherent tension in the overall system."

-"The first issue is the peg between the Chinese yuan and the U.S. dollar, which essentially gives us a one-size-fits-all monetary policy in a very differentiated world. Progress, or lack of progress, on this issue could lead to several outcomes. If China were to let its currency appreciate, it could regain a degree of monetary policy autonomy and a better ability to manage the risk of overheating and asset price inflation. Another outcome, however, is that China refuses to let the yuan appreciate, essentially maintaining too easy of a monetary policy for itself and the developing countries that shadow Chinese policies. This would create bubble risk, particularly for assets such as emerging market (EM) equities and commodities.

The second major uncertainty is what will happen when the Fed completes its mortgage-backed securities (MBS) buying programs. We know that it will have an unfriendly effect on the interest rate markets, but we don’t know the magnitude, because it’s too hard to isolate the supply and demand dynamics between fundamentals and the stimulus programs. The key variables are the “stock” effect, or the lingering price impact of the amount of duration taken out of the marketplace, and the “flow” effect, which is the price impact when the Fed stops buying. They’ll keep the stock, but they’re just not going to be part of the flow any more.

The third uncertainty is any change in the Fed’s pre-commitment language, which is currently committed to keeping the fed funds rate exceptionally low for an “extended period.” We don’t think the Fed is going to tighten any time in 2010, but long before the FOMC (Federal Open Market Committee) actually does the deed, it will have to change its language. That could very well happen in 2010, and there is genuine uncertainty over how quickly and strongly the market will anticipate a tightening process. Our gut feeling is that the moment the Fed changes any one of its words, it’s going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination. The most important book at the Fed right now is a thesaurus, and it’s probably sitting on top of Paul Samuelson’s Foundations of Economic Analysis."

-"Sturdy growth in the emerging markets space, even if less than the Old Normal, and slower growth in the developed countries. Inflation, meanwhile, will probably be too low in the developed world because of still-huge output gaps. What the forecasts can’t tell, however, is that asset price inflation – including commodities – is becoming a more important dimension in our forecast because it’s becoming a more influential component of central banks’ reactions around the world." Note that Pimco has deep lines into many of the world central banks, and has former Fed Chairman Alan Greenspan as a special adviser.

-For Pimco's all important thoughts on portfolio positioning for 2010, read the whole piece here to the end: (summary, hug the benchmarks and go light on US and UK bonds of all sorts in relation to the EU and strong, commodity-driven EM countries, and up your cash allocation - but no word on gold or other metals)
[I don't get paid or anything from Pimco for this referral, but kudos to them for communicating strong research and convictions different than the market consensus).

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