Gross Watch: Welcome Mr. Bond

 |  Includes: BBRY
by: Sydney Foresythe

Editor's note: Originally published on July 25, 2014

Many things have happened in the capital markets since my last post. Markets have risen... and risen some more. Commodity prices have been volatile, and reflected in various commodity users and their alternatives. With the decisive move above $100/bbl for light crude, the demand for alternative energy sources seems to breathe life into companies like Solarcity (NASDAQ:SCTY) and Tesla (NASDAQ:TSLA). They say that a rising tide lifts all ships, this is evidenced in the fact that even my dark horse company, BlackBerry (NASDAQ:BBRY), has experienced some resurgence in recent months, that is until Apple (NASDAQ:AAPL) teamed with IBM to provide Enterprise solutions and effectively be the first direct challenger to BlackBerry in this market (might be time to revisit my faith in the turnaround story that is BlackBerry). In all, there is a solid argument for an overvalued market, and reasonable expectations for a correction or worse. That has been the cry since the start of the bull market; it is infinitely more convenient to call for a correction when markets are making new highs than to justify their performance.

The principal thesis on an overvalued market is; the markets current CAPE Schiller P/E multiple of 26x is overvalued relative to the average P/E of 16X. Following this logic, as well as universal arithmetic rules, for the P/E levels to revert back to the mean, one of two things must happen:

  • Earnings must increase at a faster pace than prices
  • Prices must drop precipitously

According to investment research and most other market publications, the major earning trend this year has been anemic growth on the bottom line, lack of top line surprises, and weak guidance. These lead us to believe that the first criteria for mean reversion has little chance of coming to fruition, thus we expect the second. The ideas expressed above permeate throughout the investment community, and investors are approaching with caution. However, few have dared to challenge CAPE Schiller's P/E thesis, which has led to the subject of this blog post.

Enter fixed income guru, and co founder of the largest bond fund, Bill Gross. Over the past several months, Mr. Gross has set out to develop his BIG idea, and dispel the notion of extreme overvaluation. In this first installment of “Gross Watch”, we briefly explore Mr. Gross's thesis and its implications on valuations.

On a monthly Podcast offered by PIMCO’s founder Bill Gross, he details his views on a new normal in investing. Mr. Gross introduces a concept called the “new neutral”, this phrase is in reference to the Feds fund rate - the interest rate at which depository institutions lend reserve balances to other depository institutions overnight- it is the basis for most interest rate calculations. In his theory, Mr. Gross challenges the market assumption that the long run average of the Feds fund rate is and has been stable at around 2%. This is important to know in this instant (as it relates to relative market value) because this Feds fund rate is the assumption used as the discount factor (r) to calculate the average CAPE Schiller P/E ratio using the fundamental equation. (P=CF/R-G) PIMCO’s contention is that this rate is near zero, as is determined by various factors such as equity markets, inflation and other items that aren’t quite quantifiable as the FED would have it.

Should that be the case, the barometer with which the market is measured against is using an incorrect discount rate. Using a discount rate adjusted to reflect the near zero Feds fund rate as well as 2% inflation, the CAPE Schiller adjusted P/E average should look more like 22X rather than 16X, which would show the market to not be nearly as overvalued as otherwise thought. The new neutral feds fund rate has been put in place to stimulate 5% GDP growth, however time has shown this to have failed over the last 4 years, instead there are what people see as asset Bubbles. The expansion from 12X PE in 2008 to 26X PE just 5 years after justify Mr. Gross's implication that asset returns will be low (not catastrophically negative), even as there is a slow crawl to adopting the theory new neutral. These bubbles need the rates to stay as is in order to not be popped. A levered economy requires a low policy rate. Should rates return to 2%+, there is a significant risk of recession.

That’s been all for “Gross Watch.” Remember, in an environment such as this, with markets making new highs, it is easy to get lost in the fray and want to jump in. But remain steadfast in your belief in the old adage, “buy when there’s blood in the street.” Right now the bulls are still running, exercise patience search for value and act when the time is right.

Disclosure: No positions

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