Bill Gross: Bernard Baruch Was Right, Two Plus Two Still Equals Four

In PIMCO Managing Director Bill Gross's monthly market commentary for May 2009, the 'Bond King' comments on how to ascertain a successful market strategy in the current economic environment:

A photograph of Bernard Baruch looms ominously on the far corner of my PIMCO office wall. ...This well-known financier of the early 20^th century...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.” ...

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. ...His lesson...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 [cautionary statement] 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.” ...

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...

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...

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...

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.

Comments

[CautiousInv...:]

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...

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...

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.

______________________...

Obviously Bill Gross anticipates the emergence of a significantly different economic and financial landscape.........and it is a work in progress with further development to unfold. In his words are concerns of higher taxes and increased levels of regulation which will increase capital costs and brake the pace of investment.

Because it is a work in progress, caution is urged when viewing green shoots of economic recovery as these shoots.........and second derivatives.....are taking place on ground liikely to shift in unfavorable direction. Taking this further, are the shoots sustainable without the benefit of massive fiscal stimulus and unprecedented monetary policy........or they dependent upon these actions and likely to wilt once steps are taken to reign in these policy initiatives?

May 06 08:13 AM

[relaplan1:]

Bill Gross misses the point with regard to Chrysler. He seems to favor treating Chrysler like a welfare commodity rather than a business transaction. Clearly he favors non-stakeholders over those with a vested interest.

Whether the government was so stupid to give Chrysler bailout money only means the non-stakeholders had greater access to that money than the investors.

May 06 12:26 PM

[bbowen7:]

Bill Gross is one of the brightest observers of financial trends. His focus on President Obama's comments, “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.” is a bit too strong. To the extent that he was referring to recalcitrant bond-holders, it is an extreme example with which most people would agree. But Gross is right - the claims that Obama and Geithner do not want to be in the banking, insurance, and car businesses are suspect. And the energy and healthcare businesses to boot.

May 06 02:56 PM

[HCSKnight:]

Have to say Im disappointed with the perspective Bill. Agree, whether equity or bond holder, markets are first and always places of risk.

However, I dont recall their being any numbers or financial "accounting" in the Constitution, or discussed in the Federalist Papers. There was however quite a bit about government taking and rule of law.

That's the secular transition I think most important you should, correctly, identify...

May 07 11:17 PM

[Luis de Agu...:]

This is indeed sage and important analysis, common for Mr. Gross. One wonders however how far from mean reversion Mr. Gross considers us presently. Reporting in November '08, David Ranson, research director for Wainwright Economics, saw the market turning and advised of a January surprise, “After what looks to be an awful fourth quarter, the economy could snap back as early as the New Year."

Now the talk is of a possibly jaunty W formation, supplemented by much hand wringing about a new era of delevering and a “new normal” for valuation. So many conflicting ways on what to weigh to assess value, but where could reversion be?

Wainwright's April Equity-Market Outlook selects three different benchmarks with their pros and cons for valuing the US stock market. The report compares stock prices with a number of benchmarks such as earnings and dividends to determine how cheap or dear the market is, and how to choose a benchmark (warning: gold appears). After assessing 1926 through the present, Wainwright concludes:

"The ratio of stock prices to gold offers advantages as a market valuation indicator that are not available from the two most popular traditional indicators, the P/E ratio and the price-to-dividends multiple. Unlike the P/E ratio, it can never give absurd results as in the case at present, where the most recent quarterly earnings result was deeply negative. And its discriminatory power is superior to that of the P/D ratio. According to the current estimates, the stock market was about 60% below its long-term trend at the end of March."

With a market within long jump of a 37% appreciation from recent bottom, regression to mean as calculated by Wainwright appears within sight. From there another sprint to 50%? There’s where (for possibly differing reasons) Gross/El-Erian and Ranson find common ground in “new-nomralandia,” with Ranson projecting severe inflationary climate to put the damper on inflation-phobic equities, these managing an 8% per-annum average gains years out.

Luis de Agustin
Wainwright Economics

May 13 03:03 PM