Investment Outlook
Bill Gross | April 2005
Everything You Wanted to Know About The Universe But Were Afraid to Ask
This is the way the world ends
Not with a bang but a whimper
The Hollow Men, T.S. Eliot (1925)
It all started with a big bang they say, and will end with a subzero Celsius whimper....
Remember Dow 5000? I sure do and if I should ever forget, there is always someone nearby to remind me of that “singularity” when I temporarily lost my mind. It only lasted for a split second, although my current investment universe is still in the process of cooling, condensing, and spewing forth lots of additional hot gas. I dare bring this topic back up because like a true scientist, I have examined the evidence and have come up with a theory that explains Dow 5000 in the negative—why we haven’t gone there. My mistake, I am convinced, lies in underestimating the depths to which real interest rates would fall. Back in 2002, although the Fed was in the process of dropping short rates like a rock, there was nary a hint from Greenspan or the PIMCO war room that nominal short rates would sink to one percent, and that real yields would go subzero, resembling the depths of outer space. They did, and they have barely climbed back up to zero percent real. The real yield decline, of course, expanded profit margins especially for finance-based companies, and led to equally unimagined levels of cash flow which increased corporate “margins of safety” rendering Dow 5000 not only unnecessary as a level of “value,” but out of date in what would prove to be an entirely new world of lower real interest rates. Stocks had found their wormhole and managed to survive the great freeze.
There are two parts to the above “mea culpa,” however, and the future for stocks and other asset categories depends more heavily on one of them than the other. Granted, lower yields exploded profits and cash flow like the first seconds of existence nearly fourteen billion years ago. But, if my mistake had simply been in underestimating forward earnings, it would have little bearing on the future since, if they can go up, they can go down, and no one is gonna be perfect in the timing or magnitude of future earnings waves. The real key to avoiding Dow 5000, however, and in fact the reason we now reside above Dow 10,000, is that real interest rates came down and are expected to stay down.
Our own Paul McCulley, even before he rejoined PIMCO in 1999, made the amazingly simplistic but powerful distinction between disinflation’s journey and its destination. The journey, he suggested, .... continued >>>>
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