Bill Gross Thinks All Assets Appear to Be Overvalued Long-Term

Bill Gross has a must-read piece out for his monthly Investment Outlook called “Midnight Candles.” He begins the piece with allusions to his advancing years (Gross is now 65) and the mortality he feels because of it – pretty sobering stuff. Gross then abruptly segues into his investment outlook, leaving one with the distinct impression he is suggesting there is something ephemeral in the global financial system’s status quo ante.

To solve the problem, Gross suggests maintaining artificially low interest rates to maintain pumped up asset prices. This is a perverse conclusion I reject categorically. But his analysis leading up to this is right on the money. And the line he takes to make the transition to his thinking is right out of Credit Writedowns’ playbook.

I’ll jump straight into a discussion of why in a New Normal economy (1) almost all assets appear to be overvalued on a long-term basis, and, therefore, (2) policymakers need to maintain artificially low interest rates and supportive easing measures in order to keep economies on the “right side of the grass.”

Let me start out by summarizing a long-standing PIMCO thesis: 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. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them. How many TV shots have you seen of people on the Times Square Jumbotron applauding the announcement of the latest GDP growth numbers or job creation? None, of course, but we see daily opening and closing market crescendos of jubilant capitalists on the NYSE and NASDAQ cheering the movement of markets – either up or down. My point: Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up – economies don’t do well, and when they go down, the economy can be horrid.

This, my friends, is the dreaded asset-based economy. It is the same financial model which has led us to mountains of debt and repeated bubbles and extreme financial instability. I have said in the past that aggregate debt levels as measured by ratios like debt to nominal GDP should remain constant to the degree that the capital used to generate that growth is efficiently allocated. However, we have seen a ballooning in debt, which suggests that we need far more capital to generate a unit of growth than we did a generation ago. Gross makes similar arguments, focusing instead on assets instead of debt (liabilities).

First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Again, these themes echo something I recently posted on, namely the hollowing out of America’s middle class from downsizing and outsourcing. See my post “A conversation with Stephen Roach on Charlie Rose“ in which the juxtaposition between a Stephen Roach interview circa 1996 and one from this past week makes plain the long-term problem.

Gross comes to a very different conclusion to all of this than I come to. He says, faced with a potential collapse in nominal GDP growth, the answer is to feed the patient more of the asset price elixir to wean him off his drugs. Cold turkey would lead to depression (i.e. death – that makes the tie to his lead in plain).

This is where it gets tricky, however, because policymakers, (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. The Japanese example over the past 15 years is an excellent historical reference point. Their quantitative easing and near-0% short-term interest rates eventually arrested equity and property market deflation but at much greater percentage losses, which produced an economy barely above the grass as opposed to buried six feet under. The current objective of global policymakers is to do likewise – keep the capitalistic patient alive through asset price support, but at an “old normal” pace if possible, six feet or 6% in U.S. nominal GDP terms above the grass.

My conclusion is different. I have said before that I also think cold turkey would lead to disaster (see my post “Confessions of an Austrian economist"), but I am under no illusion that we need to keep supporting the asset-based economy indefinitely. Our goal should be to use government stimulus as cover to eliminate malinvestments and downsize bloated sectors of the economy like financial services. This is one reason I am in favor of introducing a comprehensive too-big-to-fail (TBTF) resolution process to allow big banks to fail and breaking up TBTF financial institutions.

Going back to Gross, he concludes that his policy preference for maintaining is supportive of asset prices in the medium-term but not so supportive that we are going back to the gold rush of yesteryear.

If policy rates are artificially low then bond investors should recognize that artificial buyers of notes and bonds (quantitative easing programs and Chinese currency fixing) have compressed almost all interest rates. But while this may support asset prices – including Treasury paper across the front end and belly of the curve, at the same time it provides little reward in terms of future income. Investors, of course, notice this inevitable conclusion by referencing Treasury Bills at .15%, two-year Notes at less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momentum, this is all a Treasury investor can expect. What you see in the bond market is often what you get. Broadening the concept to the U.S. bond market as a whole (mortgages + investment grade corporates), the total bond market yields only 3.5%. To get more than that, high yield, distressed mortgages, and stocks beckon the investor increasingly beguiled by hopes of a V-shaped recovery and “old normal” market standards. Not likely, and the risks outweigh the rewards at this point.

While I disagree with Gross, his is a very good piece if you want to know which way the wind is blowing. I have linked to it below.

Enjoy.

Source

Midnight Candles – Bill Gross, Pimco

Comments

[Graham and ...:]

"All" assets can't be overvalued, because you need to have one "common denominator." But it could be "all but one."

Oct 27 03:08 PM

[Mad Hedge F...:]

So do I. In view of today’s dreadful market performance yesterday, I am repeating my GLOBAL RISK ALERT issued on October 14. Every asset class, including stocks, Treasury bonds, currencies, commodities, and precious metals, got slaughtered across the board today. The liquidity surge may be taking a pause. Keep in mind that if you are running big longs here, you are swimming at the deep end of the pool.When everything is working, and my portfolio is firing on all 12 cylinders, I pinch myself and ask “Is this real? What can go wrong?” I’m reminded of the slave whose task it was to remind conquering Roman generals “All glory is fleeting.” Virtually all of my recommended core longs in gold, silver, Canadian, New Zealand, and Australian dollars, Brazil, Russia, India, South Korea, Taiwan, Vietnam, and junk bonds are at or near highs for the year. I called the bottom in Natural Gas within 40 cents, and mercifully baled on my one short in US government bonds, the TBT. What we are seeing is a global surge in liquidity as cash emerges from the bomb shelter, squints at the day light, and then rushes to buy the first thing it can find. Everything is going up, regardless of fundamentals. It is the proverbial tide that is lifting all boats. You can make a lot of money in these conditions, but there is no way of knowing if this will last for one week, or another year. But they can go on much longer than you think. In the last two liquidity driven markets I traded, Japan in the eighties and NASDAQ in the nineties, fundamental analysts railed against the tide for years, claiming that stocks were overvalued, each call getting their office moved ever closer to the elevator and men’s bathroom. When someone finally did throw the switch on these markets, it got dark amazingly fast. Tokyo went out at an all time high on the last day of 1989, and then dropped a staggering 45% in January. NASDAQ plunged just as fast from its 2000 top. The one thing we can all be certain about is that the survivors have vastly improved their risk control after our recent crash. Make hay while the sun shines, but keep your finger hovering over that mouse. The level of risk now is definitely much higher than it was in March. When the next real downturn starts, it could resemble a flash fire in a movie theater.

Oct 27 05:20 PM

[The Simple ...:]

What Gross advocates, and US policy makers appear to be counting on, is something analagous to Voltaire's famous remark that "the art of medicine consists in amusing the patient while nature cures the disease." Which is to say, they are buying time for what they hope will be a natural recovery. Reduction of excess debt through steady inflation, gradual repayment, manageable default rates, etc.

Oct 28 02:23 PM

[Mark Bern:]

The problems of this approach are evident: without velocity of money there is not inflation, stimulus money is promoting the addition of new debt rather than repayment, and default rates aren't falling in line either (check out the FDIC problems with not being able to keep up with failing banks). On top of all this the Administration is piling on more federal debt, as are state governments in the name of propping up the economy. Yes, they probably should be trying to help the economy, but government spending is all we have and it is the least efficient sort there is. It ends up being a deferral of debt to future generations, and in massively larger quantities to boot. At some point, buyers and holders of US Treasuries are going to wake up and start selling.

Then is when I want to be invested in gold, silver and TBT. I see no hope for the dollar in a few years from now. Actually, China will probably provide the catalyst, come to think of it. If they see the writing on the wall (continuing decline in the US$) they will decouple their currency from the dollar and then watch out!


On Oct 28 02:23 PM The Simple Accountant wrote:

> What Gross advocates, and US policy makers appear to be counting
> on, is something analagous to Voltaire's famous remark that "the
> art of medicine consists in amusing the patient while nature cures
> the disease." Which is to say, they are buying time for what they
> hope will be a natural recovery. Reduction of excess debt through
> steady inflation, gradual repayment, manageable default rates, etc.

Oct 28 04:05 PM

[User 353732:]

1. The world made a Faustian pact with the USA : consume and we will lend; import and we will finance; inflate and we will inflate with and we will all pretend that we have real, sustainable high quality global growth, which will justify ever higher asset prices which will support more borrowing to consume forever.
2. Now the price for stealing from the future, for deriding historical financial truths and traditional economic virtues ,for undeserved and unearned instant gratification, for cascading entitlements and for serial delusions must be paid. The soul has been sold; the proceeds consumed.
Now the surrender of the soul is being demanded and the policy response is " let us one last depraved and deranged party and maybe the devil will get tired and go away" ?
There are some laws that cannot be broken and contracts that cannot be repudiated without paying a severe penalty. The US and much of the West is about to discover this.

Oct 28 05:03 PM

[Ricard:]

Excellent article, enjoyed the debate.

I'm not sure if there is any real disagreement. It's quite possible to apply Gross's solution (which if I read correctly is a heavy dose of inflation) as cover for your solution of cleaning up mal-investment.

Gross seems to be advocating life support, whereas you seem to be advocating surgical solutions. I would imagine both are necessary if the patient is in critical condition.

Oct 28 10:59 PM

[blanco-dee:]

Don

Oct 29 12:18 AM

[Robert Mart...:]

Ed:

Great post, as usual.

I especially like Bill Gross's description of how asset appreciation has substituted for productivity over the last two decades. You noted that this is what led to the hollowing out of the industrial base (good point).
The U.S. has been so addicted to debt-fueled consumption that we traded our economic foundation and our children's future for a McMansion and a flat-screen TV. It reminds me of the drunk father who lets his kids go hungry so he can buy another drink. Sadly, this metaphor is not too much of a stretch.
Our neglect of the industrial base is matched by our neglect of labor: Instead of addressing our dysfunctional educational system, we simply hired people outside of the U.S. As you pointed out in your article about Stephen Roach, seekingalpha.com/artic... American corporations have become reliant on global labor arbitrage to cut costs. You point out, however, that outsourcing has NOT caused the hollowing out of corporate America. Outsourcing may be beneficial or destructive for a corporation--it depends on execution.

Unfortunately, however, downsizing and outsourcing HAS hollowed out the American middle class, as you note above. So "What's good for GM" is no longer "what's good for America." I missed this nuance the first time I read your article, and you make a CRITICAL DISTINCTION: corporations and citizens have divergent interests, and what now HELPS the corporation now HURTS the American middle class. This is the disconnect I describe in "The Deflation of the American Dream". seekingalpha.com/artic...

This disconnect between workers and corporations is playing out in the political realm lately, with pay cuts for CEOs, and a general sense of populism and re-regulation. But American political power may not be sufficient to help the middle class via job creation. After all, the CEO of a multinational firm has primary allegiance to the corporation, and not to America. Thus, multinational giants may not be so easy to rein in, and "global labor arbitrage" will continue to dominate global capitalism.
_______________________
On another note, I'm glad you acknowledge the difficulty of a "cold turkey" solution to the asset bubble. We are in a very different world than the one Paul Volker faced in the early 1980s. Inflation was high and asset prices were depressed, so higher interest rates caused a deep recession, but it was a normal, cyclical slump.

Today circumstances are different: Raising rates would curb future inflation, but would cause a cascade of defaults, deflation, and more defaults. Most alarmingly, higher rates would make the U.S. budget deficit difficult (if not impossible) to service.

Although I'm an optimist by nature and by choice, it is tough to see the light at the end of this economic tunnel. The light is a VERY long way off, and America must adapt in radical ways to rebuild its economic foundation.
________________________
Against this pessimistic backdrop, Mad Hedge Fund Trader points out our bizarre predicatment:

"Everything is going up, regardless of fundamentals. It is the proverbial tide that is lifting all boats. You can make a lot of money in these conditions, but there is no way of knowing if this will last for one week, or another year."

The steady rise of stocks puts pressure on asset managers to keep up with the Joneses. You MUST buy in a bull market or you put your job at risk. So PMs hold their nose and buy.
This is the 'reflexivity' George Soros so aptly described. Trends in capital markets often reinforce trends in fundamentals, and it all becomes a giant feedback loop (either positive or negative). As long as stocks go up, we have a positive feedback loop that delays the inevitable (and potentially makes it much worse).
I really cannot see a way out of this mess. I really can't. I can't see a political solution or a capital markets solution. Monetary and fiscal policy can ease the pain, but we are headed for disaster.
Thanks for indulging my pessimistic rant.Be well,Rob

Oct 29 12:21 AM

[contango:]

"wealth creation was a function of asset appreciation as opposed to the production of goods and services"

That sums it all up for me.

Oct 29 12:50 AM

[Brian McMorris:]

Ahhh... for the good old days of really high interest rates (ala early 1980s) when taking on debt was painful, and so to be avoided. Those high interest rates kept the public from piling on the debt. Now, in this super low interest rate world we live in, what is the cost of debt? Bring it on. The more the better!

I agree with Gross and many other "smarter-than-me" economics types who conclude that the only way out of this low interest rate world that encourages deep debt, is even more debt!

It is very counter-intuitive, but when asset prices collapse, as they did from 2007 to 2009, the ONLY solution is to reflate by creating new debt to raise the asset prices back up. And because the private sector lenders have had their secured assets squished (thereby threatening the existence of the lender), the only entity to issue new debt is the government. I admit, it IS perverse.

It is the "popping balloon" paradox. If a balloon is blown too full of air, is it better to prick the balloon with a pin and get a loud, and maybe painful / frightening "POP", or should the air be let out slowly with a controlled whoosh?

Once the government reflates the economic balloon (by devaluing the dollar and reflatng asset prices), it might be better to slowly deflate the assets again (returning the dollar to its normalized stable level), by SLOWLY selling debt back to the market (through Treasury auctions). This will have the effect of raising interest rates SLOWLY, which will have the sulbrious effect of increasing the value of the Dollar (as more people want the better paying govt debt).

What is clear is that asset prices, relative dollar value and interest rates are all directly interconnected. For a truly strong dollar and weaker asset values, we need nice high interest rates again. 1980s anyone?

Oct 29 01:44 AM

[Brian McMorris:]

Mad Hedge: since we are citing the blow off tops of the 1980s (Japan) and the 1990s (Internent boom), let us remember that both markets saw very high P/Es before their downfall (100 for the TOPIX and 50 for the NASDAQ). This market, during a historically low period of interest rates which run inverse to the market P/E, is still less than 20. When it gets above 30, I will start worrying about another "blow off top".

Lets talk again when SP500 is over 2000 (not calling for that tomorrow, but not too worried until we get back above early 2008 levels.


On Oct 27 05:20 PM Mad Hedge Fund Trader wrote:

> So do I. In view of today’s dreadful market performance yesterday,
> I am repeating my GLOBAL RISK ALERT issued on October 14. Every asset
> class, including stocks, Treasury bonds, currencies, commodities,
> and precious metals, got slaughtered across the board today. The
> liquidity surge may be taking a pause. Keep in mind that if you are
> running big longs here, you are swimming at the deep end of the pool.When
> everything is working, and my portfolio is firing on all 12 cylinders,
> I pinch myself and ask “Is this real? What can go wrong?” I’m reminded
> of the slave whose task it was to remind conquering Roman generals
> “All glory is fleeting.” Virtually all of my recommended core longs
> in gold, silver, Canadian, New Zealand, and Australian dollars, Brazil,
> Russia, India, South Korea, Taiwan, Vietnam, and junk bonds are at
> or near highs for the year. I called the bottom in Natural Gas within
> 40 cents, and mercifully baled on my one short in US government bonds,
> the TBT. What we are seeing is a global surge in liquidity as cash
> emerges from the bomb shelter, squints at the day light, and then
> rushes to buy the first thing it can find. Everything is going up,
> regardless of fundamentals. It is the proverbial tide that is lifting
> all boats. You can make a lot of money in these conditions, but there
> is no way of knowing if this will last for one week, or another year.
> But they can go on much longer than you think. In the last two liquidity
> driven markets I traded, Japan in the eighties and NASDAQ in the
> nineties, fundamental analysts railed against the tide for years,
> claiming that stocks were overvalued, each call getting their office
> moved ever closer to the elevator and men’s bathroom. When someone
> finally did throw the switch on these markets, it got dark amazingly
> fast. Tokyo went out at an all time high on the last day of 1989,
> and then dropped a staggering 45% in January. NASDAQ plunged just
> as fast from its 2000 top. The one thing we can all be certain about
> is that the survivors have vastly improved their risk control after
> our recent crash. Make hay while the sun shines, but keep your finger
> hovering over that mouse. The level of risk now is definitely much
> higher than it was in March. When the next real downturn starts,
> it could resemble a flash fire in a movie theater.

Oct 29 01:53 AM

[Brian McMorris:]

It is very popular right now to make this point. But the conclusions are all wrong. "Asset Appreciation" does not lead to "hollowing out of industrial base". To the contrary: the extra strong dollar of the 1980s and early 1990s (which enjoyed high and declining interest rates in a period where the USA enjoyed supreme military dominance as the Cold War was won) was the source of this "hollowing out". Because high interest rates discourage asset appreciation (due to discounted cash flow modeling), one definitely does not cause the other.

The observations are actually offset by about a decade; but one sows the seeds for the other. Declining interest rates during a period of a strong dollar WAS BOUND to create an environment of increasing hard asset valuations (real estate). This is due to basic cash flow valuation methods that make assets bought cheaply during a period of high interest rates, more and more valuable as interest rates decline. Refinancing is the vehicle for this and will cause those same assets to rise in value as interest rates to service a mortgage / debt decline. The greater the leverage applied, the more the increase as a percent of equity. It is basic financial math.

But there is a linkage between interest rates and economic strength. The damage to the "industrial base" has already been done by high interest rates and resultant strong currency (as long as the underlying economy is strong, as America's was in the 1980s during the Cold War defeat of the USSR). Strong currency equals expensive labor as compared to other nations with weak currencies (Japan in the 1970s and 80s and China today). Those weaker economies may even elect to keep their currency artificially weak as their economies grow and strengthen. They do so by indexing their currency to that of their key export trading partner (America). And this "currency indexing" then leads to the "hollowing out" witnessed the past 20 years. That is the true cause of competitive disadvantage, not asset appreciation.

The two trends are independent of each other. It is a big mistake to link them in any way.




On Oct 29 12:50 AM contango wrote:

> "wealth creation was a function of asset appreciation as opposed
> to the production of goods and services"
>
> That sums it all up for me.

Oct 29 02:13 AM

[contango:]

I think what Bill is suggesting is that Asset Appreciation has/is becoming a substitute for growth in production of Goods and Services.

The government is feeding the asset appreciation addiction to pump up the economy and that may be the only way to "fix" GDP in the short term.


On Oct 29 02:13 AM Brian McMorris wrote:

> It is very popular right now to make this point. But the conclusions
> are all wrong. "Asset Appreciation" does not lead to "hollowing out
> of industrial base". To the contrary: the extra strong dollar of
> the 1980s and early 1990s (which enjoyed high and declining interest
> rates in a period where the USA enjoyed supreme military dominance
> as the Cold War was won) was the source of this "hollowing out".
> Because high interest rates discourage asset appreciation (due to
> discounted cash flow modeling), one definitely does not cause the
> other.
>
> The observations are actually offset by about a decade; but one sows
> the seeds for the other. Declining interest rates during a period
> of a strong dollar WAS BOUND to create an environment of increasing
> hard asset valuations (real estate). This is due to basic cash flow
> valuation methods that make assets bought cheaply during a period
> of high interest rates, more and more valuable as interest rates
> decline. Refinancing is the vehicle for this and will cause those
> same assets to rise in value as interest rates to service a mortgage
> / debt decline. The greater the leverage applied, the more the increase
> as a percent of equity. It is basic financial math.
>
> But there is a linkage between interest rates and economic strength.
> The damage to the "industrial base" has already been done by high
> interest rates and resultant strong currency (as long as the underlying
> economy is strong, as America's was in the 1980s during the Cold
> War defeat of the USSR). Strong currency equals expensive labor as
> compared to other nations with weak currencies (Japan in the 1970s
> and 80s and China today). Those weaker economies may even elect to
> keep their currency artificially weak as their economies grow and
> strengthen. They do so by indexing their currency to that of their
> key export trading partner (America). And this "currency indexing"
> then leads to the "hollowing out" witnessed the past 20 years. That
> is the true cause of competitive disadvantage, not asset appreciation.
>
>
> The two trends are independent of each other. It is a big mistake
> to link them in any way.
>
>

Oct 29 02:46 AM

[bbro:]

S&P 500 to GDP is below the historical median for a low inflation
environment (less than 4% year over year)....also Debt to GDP
while important gets thrown around a lot they are fruits but apples to
oranges...like comparing your mortgage to your income.....

Oct 29 04:40 AM