Investment Outlook
Bill Gross | October 2006
Empty Nesting/Successful Investing
My days of parenting have come to a swift conclusion – but I remain a Dad. My son, Nick, went to college in early September and one night the house was full of young energy (albeit the negative teenage kind – thrusting to break ties that bind) and the next night there was just a fifty/sixty something sense between Sue and I that whispered/screamed “What the hell just happened?” It was our first night of empty nesting and with it came the realization that our days of parental instruction were primarily over, to be replaced by the lessons of other professors – university, street, and worldly oriented – but not domiciled in Laguna Beach, California. Our last bird had left its nest, had flown his coop.
Having experienced the same trauma with our older kids Jeff and Jenn – now in their early 30s – our personal version of an instruction book titled, Learning to Live Without Kids and Enjoying It More, has at least partially been written. “Give them space – give yourself space” – would be one of my primary recommendations, but always remind them that you love them and that you remain a committed Mom and Dad if not a parent. Planning a life without kids, however, requires more than space or physical separation. My experience and observation with the trauma surrounding mother/father goose and the inevitable separation from their gaggle is that once gone, parents worry too much about their progenies’ happiness and not enough about their own. First of all, who has 60 years left to live and who has 20-30? Let’s get the priorities straight – me happy first, you happy second. But in addition, I think it’s important to recognize that your grown kids’ happiness is really their responsibility, not your own. Too many ex-parents feel guilt over their mistakes of overbearance or underattendance in the development of their kids’ early years, when if anything, their only real bite off Eden’s apple was naked creation itself. Kid’s unhappy? People just grow that way you know. Springtime buds, summer leaves, naked winter branches, and then the cycle begins again; so it will be with them. You cannot protect grown children from the pain of living – well-intended gifts of frankincense and myrrh aside.
All of this is easy to write and intellectualize of course. Diet books abound, but obesity is on the rise. To suggest that I don’t suffer right along with my adult kids, that I don’t wonder if they’re safe, if that flight got in on time, if that career is progressing, if those grandchildren are any closer to conception would be to deny that I remain a Dad, that I love them and wish the best for them. But I try to remind Sue and myself that we’re no longer parents and that each night when we turn out the lights, our priorities are but inches, not hundreds or thousands of miles away. Empty nesting goes better that way.
While my nesting views might not be universally accepted I sense there is an internal logic to at least the thrust of them that is centuries old. Generation after generation, when confronted with life’s changes, think they have discovered pearls of wisdom when in fact, the pearl has been out of the oyster and in plain view for civilization’s duration. While investing is a rather recent art compared to the beginning of time, similar inevitabilities exist when it comes to making money. I was reminded of that when reading a comment by Legg Mason’s Bill Miller who in turn was passing on the wisdom of two-time world poker Champion Puggy Pearson when it comes to gambling. “Ain’t only three things to gamblin’,” Pearson said, “knowing the 60/40 end of a proposition, money management, and knowing yourself.” Those rules, I thought, looked incredibly similar to my own philosophy inscribed in Everything You’ve Heard About Investing Is Wrong, written 10 years ago, except mine were derived from blackjack and a UC Irvine mathematics professor, Ed Thorpe. Blackjack, and by implication investing, could be conquered I wrote, by identifying opportune moments when the odds favored the player as opposed to the dealer and by altering the size of the bets accordingly. I also devoted an entire chapter to an investor’s personal alarm clock and the necessity for understanding not only human nature but also your own individual behavior within the web of mass psychology.
Now my point here is not that I slept in this territory first – as a matter of fact, it’s just the opposite: universal truths are by definition – universal. Granted, the science of investing has had its pioneers such as Markowitz, Black/Scholes, and notable others; but the art of investing has been obvious for as long as there was money to invest. Identifying winning securities/scenarios, wagering appropriately according to risk/reward, and being able to meld mass/individual psychology into an evolving game plan are the likely keys to the kingdom.
I write this within the context of an Investment Outlook if only to focus myself, fellow PIMCO professionals, and interested readers on current strategies and portfolio weightings which are odds on to add Alpha to portfolios now and over the context of a cyclical/secular horizon. My three investment keys in a sense beg the question as to how to identify a 60/40 bet, how to approach risk/reward, and how to master human psychology. Pioneers such as Fischer Black, Myron Scholes, and Harry Markowitz in fact gave us clues as to how to solve the puzzle, but there is no one way, of course. 60/40 bets can be identified via individual security selection, macro tops/down analysis, or many things in between. Risk/reward analysis depends on investors’ proclivities for gain, pain, and inherent volatility. This could take a textbook to explain and I still wouldn’t be finished. But let me condense this lesson plan into two succinct ideas that incorporate PIMCO’s investment philosophy and style that hopefully has already been incorporated into our/your genetic makeup.
Currently, PIMCO’s best 60/40 bet is a cyclical one that proposes that the Fed is done and ultimately will have to lower interest rates in order to restimulate an asset based/housing led economy that has been its primary growth hormone in recent years. With inflation leveling off at admittedly unacceptable levels and the domestic economy moving towards a 2% real growth rate or less in the next year or so, the Fed at some point in 2007 will be forced to cut short rates. Don’t ask us when or by how much yet. A lot will depend on the evolution of the domestic housing market and the equally important maturation of the global economy sans U.S. consumer imports and perhaps sans hyper investment spending in Asia. We will monitor daily. But with the ongoing uncertainty of why 10-year Treasuries should yield 4.65% in a 5.25% Fed Funds world, we feel more comfortable with the observation that the front-end of the U.S. Curve is only valuing a 40 basis point cut in FF by September of 2007. Like I suggested above, we’re not sure how much it should be but we’re comforted by the fact that in effect we’re only paying a 40 basis point premium in the form of a lower 4.85% yield in order to find out what’s behind Monte Hall’s/Ben Bernanke’s door #2. The U.S. bond bull market, which began almost two months ago, remains in its infancy but the best way to play it is via durations above index and concentrated in the front-end of the curve. Importantly, although other central banks remain focused on raising short rates another 25 or 50 basis points, global bond markets usually follow the U.S. lead and we expect the same pattern this time as well with a mild exception in Japan, and slightly different curve dynamics in Euroland.
My second principle of successful investing alludes to the importance of determining how much moolah to put on the table at any one time. Texas hold’em players are familiar with the gambit of “all in” but bond managers rarely come from Texas and never put it ALL on the table. Au contraire, actually. They hug indexes to the extreme and are generally content with minute amounts of positive alpha. In a PIMCO client conference speech this March and an Investment Outlook write-up of the same month, I suggested that the wave of the future for bond managers was to psychologically distance themselves from index hugging and begin to accept additional daily volatility. That was not quite the way the Wall Street Journal put it in a recent article accompanied perhaps by the last picture of yours truly with a mustache. The Journal used the headline term “risk” while I was adamant in the interview that risk and performance volatility were not the same. Bond managers are paid not to lose money and it will probably ever be thus; but they’re also paid to outperform and justify their fees – returning more to clients than themselves. In a low yield/single digit return world, increased daily volatility which with skill leads to increased Alpha should be considered by bond managers and accepted by clients as a wave of the future should they choose to outperform in the same magnitudes as in prior years. The weightings of our front-end U.S. curve bets, therefore, as well as future durations should be viewed in this light.
Change is an inevitable part of life, whether it comes in the form of empty nesting and learning to be Moms and Dads instead of parents, or an acceptance of new realities in investment markets. As Bill Miller, Puggy Pearson, Ed Thorpe, and yours truly would suggest, investing well can be simplified into three basic rules, which require an ongoing subjective analysis of changing market environments. Today’s bond market environment suggests longer U.S. durations accented by the more volatile but potentially higher reward bet of the front-end of the curve. And while PIMCO would never go “all in,” there’s no doubt that we’re recommending “raising” daily volatility in an effort to capture more chips.
William H. Gross
Managing Director
pimco.com |
