Bill Gross Has Thoughts
On the Post-Bubble Market
There are worse things than having the fellow who manages the nation's biggest mutual fund as a pen pal.
Bill Gross, manager of the $64.1 billion PIMCO Total Return Fund among others, is the bond world's biggest celeb -- but not just because of competitors' asset envy. The Total Return Fund's oldest share class started in 1987 and Mr. Gross hasn't trailed his average peer in any calendar year since, according to Chicago researcher Morningstar Inc. The Fund's 9.5% annualized gain over the 15 years ending Aug. 31 matches the S&P 500.
All told Mr. Gross, who co-founded Newport Beach, Calif.-based PIMCO in 1971, oversees the management of more than $280 billion in fixed-income assets. He's also the only fund manager to win Morningstar's fixed-income manager of the year honor twice, in 1998 and 2000. In a post-bubble market where the bond-investor ranks have swelled and been cheery, interest in his often-bold views and moves has spiked.
Mr. Gross agreed to answer a few questions via e-mail. With stock funds finishing6 their worst two-quarter stretch in more than 30 years, he sees reason for more equity losses ahead. Mr. Gross stands by his recent assertion7 that given paltry corporate earnings, stocks aren't fairly valued above Dow 5,000 -- more than 30% below today's levels. Last week fellow bond guru Dan Fuss rebutted8 this dreary argument, but only time will tell which is right.
Where is this market headed? Will rates tick up and does a bond fiend like Mr. Gross own any stocks today? We got some answers.
1. Where are we, how did we get here, and where are we going?
Let's break that complex question into two parts.
First, where are we and how did we get here? Well, during the third quarter, investors continued to flock to the safety of U.S. Treasury bonds amid anxiety about sluggish global growth, the integrity of corporate accounting and [corporate] governance practices, as well as a potential U.S. war with Iraq. Treasury yields fell as much as 128 basis points [1.28 percentage points], with the 10-year Treasury yield plunging to 3.69%, its lowest level in more than 40 years. Fueled by the Treasury rally, the broad U.S. bond market returned just over 4% during the quarter while riskier assets such as stocks and high yield bonds continued to struggle.
The virtual shutdown of the corporate bond market during July did nothing to calm worries about a slide back into recession. Prices fell and new issuance slowed to a trickle as the high-profile bankruptcy of WorldCom and downgrades in the energy/utility sector reinforced lenders' risk aversion. While corporates subsequently recovered some of these losses, events later in the quarter such as the bankruptcy of U.S. Airways, defaults by Conseco and Marconi and the downgrade of J.P. Morgan Chase & Co. were painful reminders that weak profits and a lack of investor confidence still plagued the sector.
But, our ole' faithful Treasuries continued their outperformance from the prior quarter as the appeal of high quality, liquid assets proved irresistible to worried investors.
Now, for part two of your question: Where are we going? This always makes me think of the proverb that says, "Prediction is extremely difficult ... especially when it's about the future." So, as difficult as it is to predict in this environment, here's what I think.
The modest U.S. recovery from 2001's recession will be sustained over the next year, with growth of 2.5% to 3%. The consumer/household sector will hold fast while the battered business sector heals, allowing the U.S. to avoid a "double-dip" recession.
The U.S. will be the driver of global aggregate demand, with little help from weaker economies in Europe, Japan, and the emerging markets. Inflation will be benign as excess capacity world-wide and weak domestic demand in Europe and Japan constrain price pressure.
2. What's your outlook for interest rates and the economy for the next 12 months?
Interest rates will remain the same or lower for a long time. The Fed will not take back any of its substantial easing over the last year. U.S. fiscal policy will remain stimulative with tax cuts and deficit spending. We do not expect a major shift in interest rates. While Treasury yields are at 40-year lows, a modest recovery will restrain upward pressure on rates. The initial deflationary impact of a war with Iraq would exert downward pressure.
3. For several years now prognosticators have touted bargains in the battered high-yield market. What's your take there?
High-yield bonds will begin to do well as stocks begin to do well. They both are highly correlated to how the economy is doing. It is still too early to get excited about the high yield sector. It's time will come, but not right now. I remain cautious because prospects for continued weakness in corporate profits and cash flow suggest the potential for continued price pressure on this sector.
4. Many stock-fund managers might refute your Dow 5000 thesis on the grounds that it relies on the past and distant past being prologue. They might also say that companies will start or raise dividend payouts as the economy improves. What's your response?
My study was based on nearly 100 years of data and what it says is that in order for stocks to outperform bonds in the long run those stocks would need to be appropriately priced ... and that appropriate price is a Dow in the range of 5000. It's not a prediction, merely a study from which many theories, and discussions, will and have evolved.
When you think about it though, Dow 5000 is not that far-fetched actually. Back in late 1996 when [Federal Reserve Chairman] Alan Greenspan suggested the market was irrationally exuberant, that was basically where the Dow was and where Dow earnings were. So, if it was irrationally exuberant then, it's hard to believe that a Dow at 5000 is that depressing now. [The Dow closed at 6422.94 on Dec. 5, 1996 when Mr. Greenspan first publicly used the phrase "irrational exuberance" relative to the stock market.]
And it's the groups that don't pay dividends that will probably take us there. The study goes back over the past 50 to 100 years and basically suggests that the reason why stocks have done so well for the past century has been not only that they have exhibited growth, but primarily because they started with a high dividend yield.
You know, back in 1900, 1950, or 1981, 1982, those markets started with dividend yields of 4%, 5%, and 6% and now we have dividend yields below 2% for the most part. The Dow's a little bit more than that. But these dividend yields have been a fundamental part of total returns on the stock market for a long, long time. Unless we have higher dividend yields and, therefore the Dow at 5,000, which would produce a dividend yield of 3.5%, then perhaps we're not at fair value.
And, of course, dividend yields are all contingent on earnings of these companies and we don't see earnings on a major upswing any time soon.
5. Do you buy the idea that there's a bubble in real-estate prices and if so, on what grounds?
I believe there are "regional" real-estate bubbles, like, for example, here in Southern California. Do I think there is a "national" bubble? I don't think so, but one may be in the works. Mainly just pockets of bubbles, at this point, scattered around the country.
But if there is a national bubble, it would be an adolescent bubble that is being nurtured and promoted by Mr. Greenspan. Mr. Greenspan, effectively, is trying to bridge us to a new day in corporate America by giving a positive wealth effect to the household sector [by supporting the] property [market with low interest rates].
So, he's fighting a busted bubble with a new bubble, because he has no alternative. You see, if you don't have some spark somewhere that causes people to be enthusiastic about life, then our economy goes into a Japan syndrome.
6. Ben Graham said most investors should have some of their money in stocks and some in high-quality bonds at all times, simply rebalancing between the two when performance skews their target allocation. How would you allocate between stocks and bonds if you were investing for a goal that's five, ten or twenty years away?
The question of a proper allocation is a very personal decision based heavily on a person's risk tolerance, their age, retirement goals and objectives. These things are best determined in a one-on-one meeting with a financial planner or a broker. Nevertheless, to give you an answer, I'll rely on my old trusty rule of thumb that says a good starting point for the percentage you should be in bonds is a number relatively close to your age.
7. Are you still completely out of stocks in your personal portfolio, and when (or if) you do invest in stocks, what funds or companies would you favor?
Yes, I'm still completely out and I think it will be quite a while before I get comfortable with the idea of getting back in.
Write to Ian McDonald at ian.mcdonald@wsj.com9
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