Living in a Macro World

Thursday, August 2nd, 2012

by Cullen Roche, Pragmatic Capitalism

We are increasingly living in a macro world.  What I mean by that is that the world is becoming a smaller and smaller place due to technological change and the increasingly interconnectedness of globalization.  The result is that the macro occurrences in other parts of the world influence the domestic economy like never before.  And the investment world is being forced to adapt to this massive shift in the landscape.  So what we’re seeing is less micro and more macro.  We’re seeing the myth of stock picking lose momentum and we’re seeing investors veer increasingly towards investment products that are more broadly diversified in an attempt to reduce systematic risk and eliminate unsystematic risk.  This is in large part why the ETF world is surging in growth and mutual funds and stock picking are becoming a thing of the past.  I think this trend is likely to gather more and more momentum over the years and that the myth of Warren Buffett (the value buy and hold stock approach) will die out.

I think this chart from Goldman Sachs via Bondsquawk is quite telling with regards to macro trends going forward.  It’s recent in nature, but will only become more pronounced in future decades:

“According to Goldman Sachs US Economics Analyst, equity markets have become increasingly responsive to macroeconomic news releases ever since the financial crisis took place in 2008. The bond markets on the other hand have always had a close eyes on the US macroeconomic news.”

It’s a macro world and you’re living in it.  The funny thing is, I had a reader ask me today whether I could recommend a macro investment book…I looked at my bookshelf and rattled my small brain around in my head and came up with nothing.   Someone better get on that….There’s gold in them thar hills.

Copyright © Pragmatic Capitalist

Tags: Bond Markets, Capitalist, Domestic Economy, ETF, Funny Thing, Gold In Them Thar Hills, Goldman Sachs, Interconnectedness, Investment Book, Investment Products, Investment World, Macro Trends, Macro World, Macroeconomic News, Massive Shift, Occurrences, Systematic Risk, Technological Change, Us Economics, Warren Buffett, World Influence
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Bill Gross and Mohamed El-Erian in Depth (Part Two)

Monday, November 7th, 2011

Part two of Consuelo’s exclusive double interview with two of the investment world’s biggest stars! Bill Gross and Mohamed El-Erian, Co-Chief Investment Officers of money management powerhouse PIMCO, sit down together to discuss outlook and strategy.

Here is the full transcript for Part Two of this in depth interview with Bill Gross and Mohamed El-Erian.

October 28, 2011

CONSUELO MACK: This week on WealthTrack, part two of WealthTrack’s exclusive interview with two of the world’s most influential investors. PIMCO’s Great Investor Bill Gross and Financial Thought Leader Mohamed El-Erian sit down together to discuss their investment strategies in the “new normal” world- next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. This week we are continuing our exclusive conversation with PIMCO’s two influential Financial Thought Leaders, Bill Gross and Mohamed El-Erian together. It is a rare occasion to be able to interview them side by side, and as you will see they are a fascinating study on how a successful partnership works. Since 2008, they have been co-chief investment officers of one of the world’s leading money management firms, Pacific Investment Management Company- PIMCO- which Gross co-founded in 1971. El-Erian is also CEO and is expanding the firm from its very large bond roots into stocks, commodities, ETFs, and passive as well as its core active strategies. Gross’ legendary PIMCO Total Return Fund, which he has led to the top of the bond world in performance and size since 1987, will soon have an ETF clone, actively managed by him.
El-Erian a former head of Harvard’s endowment and fifteen year veteran of the IMF, was also a top ranked emerging markets bond fund manager during his early years at PIMCO. He now co-manages the PIMCO Global Multi-Asset Fund which, as its name implies, can invest anywhere in the world, in multiple assets through passive indexes and actively managed PIMCO funds. According to Morningstar, it is the first PIMCO fund to be formally run in a team format and it also has an innovative tail risk hedging strategy to cushion it in down markets- it could be a model for the firm itself!
El-Erian and Gross are hedging their bets in all sorts of ways. They are working overtime to understand what El-Erian calls the string of once unthinkable macro events of recent years, which he and Gross believe are having a huge negative impact on the markets and investment results. They are also preparing for an even weaker “new normal” slow growth and low return environment than they envisioned for the developed world back in 2009. We pick up the conversation discussing this year’s uncharacteristic underperformance of Gross’ PIMCO Total Return Fund. I asked Gross if this time feels different than the few other years when the fund fell behind.

BILL GROSS: Well, the underperformance has been more substantial. Let’s be honest about it. And so it feels different. The problem this year is the Total Return Fund for the first six to seven months was set up for a new normal type of economy and now we’re in the new normal minus and so the shift, which propelled treasury prices and treasury yields lower, was actually very quick and very sudden. It was related, to some extent, to the debt ceiling crisis which occurred a few months ago and the lack of confidence in the United States. Surprisingly, when it was downgraded to double A plus, treasury did the best and that was because, I think, the recognition on the part of investors that the ability to address the deficit, that the ability to basically produce growth going forward was limited, as opposed to new normal-ish. And that was the big problem, I think, that the Total Return Fund had in terms of adjusting so quickly.

CONSUELO MACK: So you’ve rebalanced, as Mohamed said in a recent interview, The Total Return Fund. So the last I looked you had 16% in treasuries. Given what you’ve just told me about the new normal minus, are you increasing your treasury exposure? I mean, what are you overweighting now in the Total Return Fund?

BILL GROSS: Well, we’re overweighting mortgages. The mortgages are “agency guaranteed.” Not an explicit guarantee, but an implicit guarantee that becomes more and more explicit as the years and verbal guarantees go by.

CONSUELO MACK: So like Fannie and Freddie?

BILL GROSS: Fannie and Freddie. Those are mortgages which yield three to 3.5 percent. Sounds very low, but you know, compared to a five year treasury at 1.25 percent, that’s a nice attractive spread. And so mortgages have been over weighted. They’re not treasuries, but they’re treasury related. They’re, in our opinion, very safe double A plus, AAA type of assets and that’s one area where we’re hoping to pick up yield without sacrificing quality.

CONSUELO MACK: So the other stuff like financial services bonds, like Citigroup bonds or some of the emerging market bonds, are those things that you are now underweighting? So have you done a risk off trade pretty much in the Total Return Fund?

BILL GROSS: No. The risk off has basically been evidenced by increasing the treasury overweighting as a counterbalance to the risk. We haven’t really sold our JP Morgan or our Wells Fargo assets in terms of the financially related credits, nor have we sold the emerging market countries. We’re a believer in the emerging market growth. We’ve certainly tried to counterbalance that with a higher concentration of treasuries and I think that’s working out fine.

CONSUELO MACK: You know, Mohamed, I have to ask you, “When Markets Collide” which was your bestselling and really wonderful book that came out several years ago which was, again, very prescient, and one of the things that you talked about on WealthTrack a couple of years ago after that book that came out was that one of the lessons that you’ve learned from the financial crisis is the unthinkable can happen. So when I just hear Bill describing the fact that treasuries rally after the debt is downgraded in the U.S. – so what are the other big, unthinkable things that are happening, that are affecting PIMCO’s investment outlook and strategy?

MOHAMED EL-ERIAN: You know, I used to keep a list of unthinkables, but it got so long that now I keep it to the last three months. Because just think what has happened over the last few months. We’ve had, as Bill said, the US government flirt with default. The biggest bond market in the world. Unthinkable. We’ve lost our AAA from one rating agency. Unthinkable. We have now three European countries in the elite club, the Eurozone, rated as junk. One is rated worse than Pakistan. Unthinkable. We have Switzerland that has made its name as the safe haven to take steps to stop being a safe haven. They say we don’t want to be a safe haven anymore. All these are unthinkables. If we were having this interview a year ago and I said, “in a year’s time this is what would have happened” I would have doubted myself on every single one of them. I would have doubted myself even more on all of them and yet they’ve happened. Why? The system is trying to tell us something. What the system is trying to tell us that there are major global realignments. I tell my wife, “It’s like the tectonic plates shifting.” Okay? You get lots of earthquakes and things and things realign. And we’re going through a major realignment. And it’s happening slowly.

CONSUELO MACK: It is? It feels awfully fast to me.

MOHAMED EL-ERIAN: Well, let me give the example. So let’s take the example of treasuries. This a situation where PIMCO was right on three of the four issues that are critical to the valuation of treasuries, but the fourth one became so large. So treasuries are determined by the outlook for growth. If you remember, consensus was up here, we were down here. Consensus came towards here. Treasuries are dictated by the outlook for policies and we’ve been saying for a long time, don’t expect the Fed to raise rates. It is floor to zero for a long time. That has happened.
Treasuries are also determined by the credit outlook and we’ve been expressing concern about the credit outlook, and sure enough, the U.S. lost its AAA. But there was that fourth element which was the flight to quality. So PIMCO’s view was, why not gain what treasuries give you in AAA countries instead? Why not go to Norway? Why not go to Germany? Why not go to Australia? Why not go to Canada where you can get the same interest rate exposure without credit? And what happened because of all of these unthinkables is that suddenly the flight to quality became dominant. People didn’t care anymore. Bill has this notion of your cleanest dirty shirt- that people are willing to wear their dirty shirt if they view it as the cleanest dirty shirt.

CONSUELO MACK: So the U.S. treasuries are the cleanest dirty shirt?

MOHAMED EL-ERIAN: Are the cleanest dirty shirt. Right. And that is a little bit of a driver of the unthinkable. For us it’s been an important reminder to push ourselves even harder in terms of thinking of what else can happen out there. And I think that that is the challenge for everybody. We’re navigating these major changes. The markets are going to romance very short term things. How else do you explain to someone that in the last 15 minutes of trading the Dow can move by 400 points on a policy headline?

CONSUELO MACK: Try high frequency trading, up to 70% of U.S. market volume now. That’s not policy, that’s technological reality in the markets.

MOHAMED EL-ERIAN: Correct, but lack of conviction, right? So when you don’t have the conviction, when you don’t have the anchors, all it takes is you tip it a little bit and then everybody takes you one way, and then suddenly you tip it the other way and everybody tips it the other way because we’ve lost our anchors. We’ve lost the conviction because the U.S. is going through the unthinkables and Europe is going through the unthinkable. And that is the world that all investors have to navigate through and it’s an uncomfortable world, it takes you out of your comfort zone, but you have no choice. That’s the reality of today’s world.

CONSUELO MACK: So do fundamentals still count, Bill?

BILL GROSS: Well, they do, but fundamentals are being distorted in the financial markets and have been actually for ten or twenty years, but even more so now. You know, fundamentally, you could say that with inflation at 2.5 to 3 percent, that 10 year treasury deserves to be at 3.5 to 4 percent. That would be the historical relation. Fundamentally, you could say that the policy rate that Ben Bernanke’s Fed fund level should be at 2 to 2.5 percent. That would be the historical relation to inflation, but fundamentals have been thrown out the door, certainly because the economy hasn’t recovered. Unemployment is at nine percent, etcetera. The Fed must do something, but also the series of quantitative easings, the One, the Two, the Twist, you know, have produced distortions in the market that are not really relative to historical example or historical fundamentals, so it becomes a question not just of diagnosing value.
You know, we’d be the first to say that treasuries are overvalued relative to what they’re offering the investor class, but in addition, you have to observe where they’re going to be from the standpoint of policy technicals. Will the Fed stay at 25 basis points for the next five years? And if so, then it’s certainly to an investor’s advantage instead of accepting 25 basis points for successive periods of time for the next five years to buy a five year treasury at 1.25 percent. And so it becomes a question not just of fundamentals, but of determining policy maker choices and policy maker decisions going forward and that’s a delicate balance.

CONSUELO MACK: What do you say to individual investors now who have basically grown up thinking that they should be in the stock and the bond markets for their retirement savings and that that’s what we should depend on? Can they depend on it?

MOHAMED EL-ERIAN: So we tell them it’s right to feel unsettled. Right? Because again, you know, we are going through major structural change.

CONSUELO MACK: Right.

MOHAMED EL-ERIAN: Right? And there are these shifts and you’re going to feel uncomfortable. It’s like someone in the middle of an earthquake. They’re going to feel uncomfortable, but the answer is not necessarily abandon the city, but rather understand what’s going on and understand what is fragile and what is valued- because if you understand and have the right mindset, you can navigate. We did something, luckily, on the business side that has helped us a lot. Back in ’08, ’09, we invited a professor from the London Business School to come and speak to us. He made his reputation, his name is Don Sull, by looking at why successful companies split into either remaining successful or not. And it’s really interesting. It’s not because they don’t recognize the paradigm shift. Companies are very good at recognizing when the world is changing. It’s what do they do next. And the biggest trap that a company can fall in, the biggest trap that an investor can fall in is that they recognize the shift, but then they become hostage to what is called “active inertia.” Active inertia is active in the sense that you do something, but inertia you’re doing more of the same, but your world is changing and, therefore, you have to evolve with it. And therefore, you know, the message that we tell investors is you’re right to feel unsettled. Okay? That’s because the world is changing, but understand that that requires you to also evolve with it. I’ll give you an example.

CONSUELO MACK: So tell us how do we adapt as investors? And I know one of your specialties is emerging markets. You ran one of the top emerging market bond funds here for seven years. How do we adapt? What should we be doing with our portfolio today?

MOHAMED EL-ERIAN: I’ll tell you what we did at PIMCO. First, we made sure we have the best sector and country specialists. So you want to have the best people there that are looking at the world from a bottom up perspective. But that’s not enough. You need to compliment it with a top down. You need to ask them every single day, are your choices and what you like and not like consistent with the growth dynamics that we’re seeing? Are they consistent with balance sheet? Balance sheet is absolutely critical to navigate an earthquake. Are they consistent with the policy choices that the policy makers are making right now? So what we try to do is bring the best bottom up expertise complimented with a lot of thinking. Bill and I sit through four days a week, three hours of an investment committee where we discuss these things over and over again to try and get it right. And it’s hard work, but there is no alternative. Right?

CONSUELO MACK: Well, PIMCO is also diversifying into other asset classes, and into equities, and you’re doing ETFs, the Total Return Fund is going to have a new ETF, which is a whole other topic. But back to the original question is how do we as investors- I know how PIMCO is adapting, but how do we as investors adapt our portfolio? What should we be doing differently?

MOHAMED EL-ERIAN: So first, be very clear about what your objectives are. Second, be very clear what your risk tolerance is. Third, recognize that the answer today to your objectives are solutions, not products. Investors make the mistake of thinking only in products space, but you need a more holistic solution. Fourth, be very clear as to how much volatility you’re willing to stomach because volatility has this nasty tendency of encouraging you to do something stupid at the wrong time. Right? Then you can put together a portfolio. It would mean being more global than you are today. Much more global. It would mean understanding that the asset classes are transforming. For example, the S&P today relies to a great extent on what’s happening overseas. It’s no longer domestic.

CONSUELO MACK: Right. Forty percent of revenues are overseas. Right.

MOHAMED EL-ERIAN: And don’t be hostage to the familiar. So we have a tendency of saying, I’m only going to invest in this name because I’ve seen it. Well, you know what? There are certain names, as Bill mentioned, that are coming up in the rest of the world that are as attractive and they are the big names of tomorrow; and therefore, it’s important to target tomorrow as opposed to yesterday.

CONSUELO MACK: So Bill, same question to you. So how do we adapt to the new reality as investors? How should we be positioning our portfolios?

BILL GROSS: As Mohamed is suggesting, you need to go global. You need to think in, to some extent, in non-dollars based. The world revolves around the dollar. The dollar is the reserve currency, but to the extent that it depreciates relative to other currencies and relative to stronger growth economies over time, then other economies and other assets that are in non-dollars base might be a significant advantage. It doesn’t mean, you know, take your entire portfolio and put it into Brazil and into the Brazilian real, but it means an investor probably, if they want a higher return, they’re going to have to go to those parts of the world and those currencies which offer a higher rate of return. So I think that would be critical. And last, as Mohamed has suggested, you simply have to know what your risk parameter is. We’re fond of quoting a phrase from Will Rogers that says, “At certain periods of time, you should be more concerned about the return of your money, as opposed to the return on your money.” We try and do both here, but importantly, during a period of uncertainty, during a period of slow growth in the developed world or no growth in the developed world, certainly the return of your money is critical going forward. You don’t want to lose 10 or 20% of it because you’re behind the eight ball going forward.

CONSUELO MACK: So Mohamed, specifically you co-manage PIMCO’s Global Multi-Asset Fund, a fund of funds. So how are you positioning it? What are you overweighting in PIMCO’s Global Multi-Asset Fund?

MOHAMED EL-ERIAN: So importantly, this is a go anywhere fund.

CONSUELO MACK: Yes.

MOHAMED EL-ERIAN: It can do equities, it can commodities, it can do fixed income all in the liquid space. Even more critically, it’s a fund that has tail hedging in it. Now, tail hedging is something that’s very familiar to people as individuals, but not as investors.

CONSUELO MACK: So explain what it is.

MOHAMED EL-ERIAN: So when we buy car insurance, we tail hedge. We ask the question, “What deductible do you want?” Five-hundred, a thousand, two-thousand? We don’t buy car insurance because we think we’re going to crash the car, because if we’re going to crash the car we shouldn’t be driving. We buy car insurance because there’s a small probability of a really bad event and we want to know whether we can limit our losses in that world.
So the global multi-asset strategies, what they do is they incorporate within the construction of the portfolios this tail hedging. And you see how it worked during the third quarter, which was a terrible quarter and it really does kick in to limit the downside in that. How are we positioned relative to where most people are? We’re much more global. Secondly, we look for equity risk, but very high up the capital structure.

CONSUELO MACK: So senior credit, for instance? I mean, preferreds?

MOHAMED EL-ERIAN: So senior credit. So what a lot of investors sort of don’t think about, they think of equity risk only coming in equity. If you buy commodities, you’d be amazed how much equity risk there is in commodities because commodities are also correlated to growth, just like equities are. So in certain states, commodities can offer you a better claim on the upside than equities do. We are overweight in emerging market bonds. We overweight local bonds in emerging markets where we think that you are earning both a high interest rate and you have a potential for capital appreciation. We are diversified in currency as you can suspect from what Bill just said. And we look at this actively.
So there are three of us who run this fund, Vineer Bhansali, Curtis Mewbourne, and myself, and we’re each responsible for a different part of it, but we consult every single day and position it accordingly. What we’ve been doing recently is we’ve been increasing our gold exposure. We had taken it down significantly as gold peaked. We thought it had gone too far. Now we see potential. We think that we are still in a very volatile period. We are going to have many bouts of risk off. And people are going to look for hedges and increasingly gold is starting to enter as part of an asset allocation, so we have been increasing gold. And we have been shifting out of the U.S., which has outperformed in the equity space, to certain emerging economies that were initially hit hard not by their fundamentals, but by the amount of capital that came out. So this is a continuous repositioning to reflect valuations and also our secular views.

CONSUELO MACK: One Investment for long term diversified portfolio, I ask all our guests this at the end of WealthTrack interviews. So Bill Gross, what should we all own some of in a long term diversified portfolio?

BILL GROSS: Certainly bonds.

CONSUELO MACK: Certainly bonds?

BILL GROSS: Yes.

CONSUELO MACK: Broad category.

BILL GROSS: Because bonds, high grade bonds not necessarily treasuries, but single A and double A corporate bonds, provide an acceptable return relative to inflation. Not an historic return, but an acceptable return relative to inflation. In an uncertain world of slow to no growth in the developed world, it seems to me that investment grade bonds of multinational corporations, single A or double A corporations which yield three to four to five percent, are certainly low, but acceptably high relative to inflation and relative to the alternative. So for a longer term investment, for a five, ten, fifteen year type of investment, a single A or double A corporate bond. And for those that are earning a Wall Street as opposed to Main Street income, municipal bonds in the single and double A category are very attractive as well. They yield more than U.S. treasuries, which is an historical twist, so to speak. So I’d recommend both of those.

CONSUELO MACK: Mohamed, what is your One Investment for a long term diversified portfolio?

MOHAMED EL-ERIAN: So how to supplement Bill without repeating Bill, that’s really hard. Anything that has the three characteristics of very strong balance sheet, exposure to emerging market growth, and income. So either dividends, etcetera. So lots of companies meet that criteria.

CONSUELO MACK: So stocks or bonds?

MOHAMED EL-ERIAN: Right. So think of a Microsoft with a three percent plus dividend, exposed to emerging markets, sitting with a ton of cash would be an example of a company like that. There are many examples of companies like that. There are countries, sovereigns that have these characteristics. Right?

CONSUELO MACK: Such as?

MOHAMED EL-ERIAN: Brazil. Sitting with $300-billion of reserves, having good growth prospects on there, and paying an interesting carry or interest income, if you like- what Bill referred to in terms of high quality companies, high quality municipals. So these characteristics one finds in quite a few different places and you can build a portfolio on that that allows you to sleep at night, gives you income, and also because it has so many buffers in terms of the balance sheet, can navigate this enormous volatility

CONSUELO MACK: So Bill Gross, thank you so much for joining us. Mohamed El-Erian, what a treat to have the Dynamic Duo from PIMCO here on WealthTrack.

BILL GROSS: Thank you for coming.

CONSUELO MACK: Thank you.

MOHAMED EL-ERIAN: Thank you very much.

CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term as well. This week’s Action Point: Consider the investment themes emphasized by Bill Gross and Mohamed El-Erian. First, think international, that’s where the growth is. Second, think quality, of business, balance sheet, and credit, whether it’s a company or a country. Third, consider emerging markets in particular for all asset classes including stocks, bonds and currencies. Both Bill and Mohamed recommend holding local currency bond funds, not dollar denominated ones, to protect against future dollar declines.
Next week we are going to delve deeper into emerging markets with two experts: Matthews Asia Funds’ chief investment officer, Robert Horrocks, and Payden Rygel’s emerging markets bond fund strategist Kristin Ceva. Both are also successful fund managers. Thank you for watching and make the week ahead a profitable and a productive one.

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Bill Gross and Mohamed El-Erian: In Depth on Outlook and Perspective

Wednesday, October 26th, 2011

Two of the investment world’s biggest stars! Bill Gross and Mohamed El-Erian, Co-Chief Investment Officers of money management powerhouse PIMCO, sit down together for an exclusive WealthTrack two part series.

Here is the full transcript of Part One:

Consuelo Mack WealthTrack – October 21, 2011

CONSUELO MACK: This week on WealthTrack- when these two speak, the investment world listens. Two of the world’s most influential investors sit down together for a WealthTrack exclusive- PIMCO’s co-chief investment officers, Great Investor Bill Gross and global Thought Leader Mohamed El-Erian together next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Every week on WealthTrack, we try to bring you the best minds in the business to make sense of an increasingly complex and fast changing world. This week we have two of them, who work closely as a team, but rarely if ever appear on television together. They are doing so exclusively on WealthTrack for the next two weeks. One is Bill Gross, the man widely known as the bond king for his stellar management of the world’s largest bond fund, the nearly $250 billion dollar PIMCO Total Return Fund, which has outpaced bond market indices and the vast majority of competitors over the past 5, 10, and 15 year periods. Much to Gross’ chagrin, the fund is seriously lagging the pack this year- more on that later.
The other is Mohamed El-Erian, former head of Harvard’s endowment, 15 year veteran of the International Monetary Fund, once top-ranked emerging markets bond manager, who is now CEO and shares the co-chief investment officer title with Gross at Pacific Investment Management Company, known simply as PIMCO, the firm Gross founded in 1971. Both Gross and El-Erian are legendary for the sheer scope of their activities, insights and influence. Both multitask as money managers, analysts, commentators and advisors to clients, businesses and governments. Each writes and speaks several times a week. Bill now tweets daily, and has over 40,000 followers.
In the last month alone, they have covered topics ranging from the European debt crisis to the value of a college education to the Occupy Wall Street movement. And Bill has written a now widely covered Mea Culpa to clients for his lagging Total Return Fund performance explaining that he didn’t anticipate the “global flight to quality triggered by the European debt crisis and the politically induced deterioration in this country’s growth outlook.” His biggest mistake was not having any U.S. Treasury bonds when the world decided it wanted nothing but. The very competitive Gross went on to say that “there is “no ‘quit’ in me or anyone else on the PIMCO premises. The early morning and even midnight hours have gone up, not down, to match the increasing complexity of the global financial markets.”
I started by asking them to update PIMCO’s now widely quoted and accepted 2009 prediction that the U.S. and the rest of the developed world had entered a “new normal” economic environment of slow growth and sub par investment returns. It turns out they believe recession is now a very real risk.

BILL GROSS: In the United States, perhaps, we’re still at a one to two percent growth rate and that’s for the third quarter. The fourth quarter is problematic going forward based upon a very weak consumer, based upon real wages that haven’t really kept pace certainly with profits and with other growth metrics, and the spending power of consumers being 65 to 70% of the total growth in the United States. And so consumer dependent, but consumer weak. So that means that in the United States we might be inching close to a zero to one percent level going forward. We might be what approaching stall speed and perhaps Mohamed can speak to that concept.

CONSUELO MACK: So Mohamed let me ask you, because speaking of risks, the European debt crisis is a risk that you’ve been writing about now and kind of more and more vehemently in recent months. So how big a risk is the Eurozone crisis to the global economy and markets?

MOHAMED EL-ERIAN: It’s a big risk. I mean, we have to remember the Eurozone is the biggest economic region in the world. It also has a lot of banks, and therefore, if it struggles there will be implications. And what’s ironic about the Eurozone crisis that it didn’t need to get this bad. Bill has a wonderful analogy. You know, you start with an infection in the toe and you don’t diagnose it properly, you don’t treat it properly. The next thing you know your leg is infected. You don’t do anything about that. Next thing you know other parts. And suddenly your vital organs are threatened. So that’s what has happened in Europe.

CONSUELO MACK: So are the vital organs threatened in Europe? I mean, we’re that close to a critical condition?

MOHAMED EL-ERIAN: So what is the market telling us? The market is telling us they’re worried about the banks in the core. They’re worried about French banks. What’s the market telling us? That they’re getting nervous about the credit rating of certain countries like France. Even Germany’s CDS, the credit default swaps, at one point were well above 100, they went up to 120. So the indications are from the market to the Europeans, please get your act together because this infection is spreading and if you’re not careful, it’s also going to affect the rest of the world.

CONSUELO MACK: Now, you’ve talked about that Europe needs a circuit breaker and you haven’t seen a circuit breaker yet. And I have to admit, you know, who would have thought that U.K. Prime Minister David Cameron says that the European leaders need to take a big bazooka approach to this problem. So what kind of a circuit breaker do we need? What’s missing?

MOHAMED EL-ERIAN: So it’s not only Prime Minister Cameron, I mean, even Trichet, the outgoing governor of the European Central Bank, went to the politicians said this is now a systemic crisis. You need two things. First you need a circuit breaker to slow things down, which means that you need firewalls and you need to protect the banking system and the really big countries, which are Spain and Italy.

CONSUELO MACK: So what is a circuit breaker? What kind of financial instrument is that?

MOHAMED EL-ERIAN: So in the case of the banks, you need three things. You need, first, the ECB to provide liquidity which they’re doing. Secondly, you need to put equity in and third, you need to improve the asset side.

CONSUELO MACK: So put equity into the banks?

MOHAMED EL-ERIAN: Into the banks.

CONSUELO MACK: So you want the ECB to buy bank stocks?

MOHAMED EL-ERIAN: No, that would have to come from what’s called the EFSF, which is more a fiscal operation than liquidity. Then you need something else and we’ve talked about it. You need Europe to have its moment of truth. Europe needs to make a political decision. What does it want to look like in five years time? Does it want to look like a fiscal union where Germany is willing to pay for the others or is it a smaller, but stronger Eurozone? That is that decision that it needs to make. It needs to have its moment of truth because unless you tell people you’re going, they’re not going to stick with you. Right? So you need both a circuit breaker and a vision as to where it’s going.

CONSUELO MACK: So you’re asking a lot from the Eurozone. So what is the reality that you two are depending upon to invest in as far as what do you think is the real situation that we’re dealing with as far as Europe solving this crisis? Doing what Mohamed says, Bill. Or the fact the facts on the ground are not what he recommending right now?

BILL GROSS: Well, our sense is that Euroland will solve it, but in solving it that doesn’t necessarily mean that we return to the old normal. It simply means that we don’t spiral downward in terms of a debt deflation or in terms of a big R, such as we had in Lehman Brothers. You know, solving the Euroland crisis is just a big piece of the entire puzzle which is really represented by structural problems that will take a long time to correct and which haven’t been addressed by policy makers, not only in Euroland, but in the United States as well.

CONSUELO MACK: So let me ask you about this because you two have become increasingly vocal on policy issues and on political issues. And Bill I’m going to quote you. In a recent Investment Outlook, you said that “Long term profits cannot ultimately grow unless they are partnered with near equal benefits for labor. If Main Street is unemployed and under-compensated, capital can only travel so far down Prosperity Road.” And your solutions are more government enhanced and expanded unemployment benefits or benefits for the unemployed and also by American policies. So what does this have to do with managing money?

BILL GROSS: Well, it has a lot to do with managing money because the solutions or lack of solutions read down significantly to government yields and to risk speaks, obviously, to equity markets where growth and the potential for growth is discounted. So all of it comes back to a price, so to speak, in terms of financial assets.

CONSUELO MACK: And Mohamed, I’m going to ask you the same question because you two are on the same page and you had a recent editorial in the Huffington Post where you said, “Listen to the Occupy Wall Street movement.” You liked it to the Arab Spring. You say, “It’s part of a worldwide drive for greater social justice and in the U.S. it is about a system that privatized massive gains and socialized huge losses. The result is a growing gap between the haves and have nots in today’s America.” And given what Bill just said as well, why do these issues matter to PIMCO and its clients?

MOHAMED EL-ERIAN: So they matter a great deal. If you bring in an equity investment manager, I suspect he or she would be very frustrated today. They’ll say no matter how hard I work in figuring out what the company’s outlook is like, in differentiating, everything is treated the same. One day is risk on, one day is risk off, and all the work that I do, all my training is not paying off. He or she would be absolutely right. Why? Because today the markets, and therefore a client’s, capital is being influenced to a huge extent by policy makers. It is the macro issues, the policy issues that are governing markets today. Markets hate that. We are much more comfortable looking at bottom up issues as a society, as an industry. But the reality is, you know, we’re now sitting in a back seat of a car that is being driven erratically by policy makers. They’re arguing among each other. They’re not even looking through the windscreen. They’re not telling us where they’re going and somehow we have to stay in that car. So it’s really important to understand. Now, when it comes to policy issues, and Bill always reminds the Investment Committee, it’s very important to distinguish between what is likely to happen and what should happen.

CONSUELO MACK: Yes.

MOHAMED EL-ERIAN: Right? And we spend a lot of time on both. What’s likely to happen; and then what if there is a policy reaction, as there will most likely be, what does that policy reaction look like? So whether we like it or not, we as an industry and we as investment managers who have an oath responsibility towards our clients have to understand the policy making process.

CONSUELO MACK: What do you think is likely to happen with policy, Bill, about what you’re saying is the underemployed and the inequality between the haves and the have nots?

BILL GROSS: Well, the most important fact, I think, to recognize is that policy makers are limited in terms of their options going forward. And we can talk about fiscal policy and that has to do with deficits or reducing deficits.

CONSUELO MACK: Well, start with the Fed, for instance.

BILL GROSS: And it has to do with the Fed on the monetary side. The Fed having limited options going forward- I mean, they’ve brought interest rates basically down to zero and they did several years ago. They’ve gone through QE1, QE2, and now Operation Twist and all of those have basically tried to reduce the cost of interest and expand the discounted value, so to speak, of risk assets. To a certain extent, that’s been successful. But now as we approach zero for many treasury maturities it’s obvious that there are limitations going forward and that the policies themselves have produced some aberrations that are unfriendly to markets and to citizens.

CONSUELO MACK: And you’ve actually been critical of the Fed. “Helicopter Ben,” as you’ve called him, and saying that, in fact, the policies of zero interest rates have helped Wall Street and have helped the banking industry, but have actually really hurt Main Street. I mean, savers are getting the shaft.

BILL GROSS: Exactly.

CONSUELO MACK: But that’s the reality that we’re dealing with as investors, right? I mean, I don’t know what you’re recommending. What are you recommending the Fed do instead?

BILL GROSS: Well, we’re suggesting there’s not much that they can do. I think it would be unrealistic to have them raise interest rates in order to recreate the six percent era of CDs. That would certainly constrict the economy and produce a new recession. But from this point forward, monetary policy and Ben Bernanke, I think, is limited in terms of their option choices, which means that the economy itself is depended upon structural solutions as opposed to fiscal and monetary solutions which have been the old recipe for regenerating an economy.

CONSUELO MACK: So let’s talk about the structural issues, Mohamed. And I know there have been three issues that you two have talked about in your writings. And you call them “structural roadblocks” that are pressuring domestic wages and employment. One is globalization. It’s hollow developed economy labor markets. Technology has outdated entire industries that produce physical, as opposed to cloud oriented goods and services. And aging demographics is favoring savings, as opposed to consumption. Now these strike me as three structural issues that policy– I mean, how can we change globalization, technology, you know, this is the buggy whip manufacturers of old, and the aging demographics? I mean, I wish I could reverse it, but I’m not going to get younger.

MOHAMED EL-ERIAN: I wish it too.

CONSUELO MACK: So what policies can begin to address those structural roadblocks?

MOHAMED EL-ERIAN: So the reason why we came up with this concept of the new normal was to try and signal that the system is not going to reset in a cyclical manner. That there are major structural forces that for a while were hidden, they were masked by a tremendous amount of leverage. And credit and debt entitlement. And once we came to the end of this great age of debt, we would have to address to our structural realities.

CONSUELO MACK: And you two were absolutely right on about warning about this, seeing this wind, these hurricanes coming.

MOHAMED EL-ERIAN: Right. So part of the reaction is to recognize that it’s not just about stimulating demand. It’s about also seeing what you can do on the structural side. So there’s lots we can do. We can do better on the housing. Housing is critical to this country. It impacts how people feel about their wealth because it’s such an important part of wealth. If people are upside down on their mortgages and they can’t refinance, etcetera, they can’t take advantage of the low interest rates. They can’t even move to where it drops off. Second, our labor market- we have a real structural issue in our labor market. We have long term unemployment at record level. We have 25% of the 16 to 19 year olds unemployed. At that age you go from being unemployed to being unemployable. Credit. We have this funny situation where the big companies can get credit, but they don’t need it and the small ones that depend on the banks have no credit. Infrastructure. So we have lots of structural issues that we can address in order to help overcome these bigger issues that we have to accept. Right? And the point PIMCO has been making over and over again since 2009 is don’t depend on a cyclical recovery. It’s not going to happen. This is much harder. It requires much longer work. It requires a certain amount of political commitment because structures take a long time, and let’s diagnose the issue properly. Now, unfortunately, we wasted two years as a society.

CONSUELO MACK: The last two years?

MOHAMED EL-ERIAN: The last two years.

BILL GROSS: You know, this debate between Republicans and Democrats, whether or not it’s beneficial to reduce the deficit and ultimately produce a balanced budget or whether it’s beneficial to expand the deficit, a la Paul Krugman, and inject the government into the solution. It’s a critical debate. Perhaps it will have to wait until 2012, but it’s one in which we think the government’s balance sheet almost by necessity has to be substituted for the private balance sheet because private investors and private corporations are basically unwilling to take a chance. That’s one of the problems of capitalism. When the animal spirits diminish to a certain point that capitalism is unwilling to take risk then, it seems to us, that policy makers, from the standpoint of the public balance sheet, have to be willing to fill that in. And that speaks to the housing market, as Mohamed just suggested. It speaks to infrastructure spending. Let’s ask is the private market really willing to repair our roads, to repair our bridges, etcetera? Probably not unless sufficiently incented. And if not, then it’s the public sector’s responsibility to fill in the gap in a very valid and useful way going forward for the next five or ten years.

CONSUELO MACK: So my reading of the current political climate is that the debate is not going your way and that the debate seems going to be towards deficit debt reduction which is not more spending.

MOHAMED EL-ERIAN: So first, I don’t know which way the debate was going. I hope there was clarity. One of the problems is we seem to be flip-flopping.

CONSUELO MACK: We do.

MOHAMED EL-ERIAN: And not getting anywhere. The investment implications are consequential. And remember, there are two parts of the world that are having that new normal. There’s the Western world, which is stuck with too much debt; and there is the emerging markets that have the ability to take on debt, but not the willingness to take on debt. And investors have to look at this and decide what’s the right thing to do. So when you are investing in the West, in the over-indebted West, the best way for new investments to evolve is if there’s growth. Growth is the perfect way to safely delever. But we’re not going to see growth because of the structural impediments.

CONSUELO MACK: Here? In the developed world we’re not going to see growth?

MOHAMED EL-ERIAN: We’re not going to growth, enough growth to get us out of our debt issues. So as an investor, whether you like it or not, you’re making an assumption of how society is going to deal with its debt issues. And we’re seeing a whole range of responses. In the case of the United Kingdom, they are implementing austerity on a voluntary basis. They have decided to spend less in order to pay off their debt. It has implications for equities. It has implications for debt.
In the case of Greece there’s no doubt, certainly in my mind, that they’re going to default. So as an investor you want to know that that’s how they’re going to respond. The U.S. has taken a very different path and Bill has written a lot about it. It has decided to financially repress us by keeping interest rates very low in order to do what you and Bill were talking about, which is to transfer money and wealth from savers to debtors. Now, as an investment management firm, it’s very important to have a view as to what regime is going to implemented where you invest your money because it has massive implication for the capital structure. So regardless of what should happen, right, the fact that we are in this new normal where growth is not going to be enough, it has massive implications. Similarly in the rest of the world. Suddenly we’re seeing to use the wonk-ish term- countries like Brazil move from being a credit risk to an interest rate risk. So they are changing paradigms and that provides massive opportunities for investors who understand it.

CONSUELO MACK: So they’ve been raising rates, and now there’s a possible, and cutting rates.

MOHAMED EL-ERIAN: To lower rates.

CONSUELO MACK: Right, to lower rates.

MOHAMED EL-ERIAN: So in the past, people would say, wow, if the West sneezes then Brazil is going to end up not only with a cold, but probably in the hospital. That’s not the case today anymore. The balance sheets are so solid, okay, and the flexibility is such that they have many more responses they can implement. So when PIMCO, you know, the reason why we come up with this and the reason why we make a point of trying to analyze them in different parts is because the investment implications are profound.

CONSUELO MACK: Right. So what are your working assumptions, Bill, in the U.S. for starters? What is the working assumption?

BILL GROSS: Well, the working assumption, in terms of growth for the next six to twelve months, is a zero to one percent number. And it could tip based upon what we call stall speed, but it’s basically no growth whatsoever.

CONSUELO MACK: And so, therefore, what kind of assets do well in that kind of an environment?

BILL GROSS: Well, at these levels of prices and these levels of yields actually not very many. You know, certainly risk assets don’t do well in a low growth or a no growth environment. And risk assets being stocks, which depend on growing earnings, or even high yield bonds which depend upon basically the maintenance of profitable cover or profitable spreads. Really, the attractive investments in a no growth or low growth world, it’s a high quality AAA or double A plus treasury. T

The problem with treasuries, however, is that their yields are so low.

Let me give you an example of the frustration of not only PIMCO, but the investor class from this point going forward. If there is going to be no growth, if safe assets are the safe haven, what will they return to the investor? A TIP or an inflation protected security is the best evidence of this. They trade at negative yields. In some cases for a five year TIP, for instance, at a minus 60 basis points. That’s a definitive statement. It means that over the next five years, an investor in a five year TIP will not be able to keep up with purchasing power. It means that, yes, they’ll be compensated for the CPI or for inflation, but in return they’ll sacrifice a minus 60 basis points in the process. So an investor looking to stay up with inflation and to basically just stay even with purchasing power cannot do it in a TIP market. And basically, if there’s no growth they’re taking lots of risk in order to try to do it in the equity market. So it’s a frustration, not just for PIMCO, but for the investor class in which it says, we’ve come down in terms of yield so far that the returns going forward are certainly not the double digits that you’re used to over the past ten or twenty years, but maybe closer to zero, to one, to two percent going forward and that’s a distinct change.

CONSUELO MACK: Next week we will continue our exclusive interview with PIMCO’s dynamic leadership duo. We’ll find out where in the world they are finding better than “new normal” returns, including some specific investment ideas.
At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point: learn from Bill Gross’ recent mistake and don’t make big investment bets. Bill’s mission as a professional investor is to beat his benchmarks and his peers, which he has done brilliantly over the last 20 years. But in order to do that, he sometimes makes big market bets, like being entirely out of U.S. treasuries in the second quarter when they became the only game in town. Individuals’ objectives are to build and preserve capital over time- they don’t have to beat the markets or peers. And they are better off being broadly diversified all the time, with disciplined and regular rebalancing.

For those of you who want to see our WealthTrack interviews ahead of the pack, including the second part of our conversation with Bill and Mohamed next week, subscribers can now see our program 48 hours in advance on our website. To sign up, go to wealthtrack.com. Thank you for watching and make the week ahead a profitable and a productive one.

Tags: Biggest Stars, Bill Gross, Bond Fund, Bond Manager, Bond Market, Chief Investment Officer, Chief Investment Officers, Consuelo Mack, Full Transcript, International Monetary Fund, Investment Management Company, Investment World, Investor Bill, Mohamed El Erian, Money Management, Money Managers, Multitask, Outlook, Pacific Investment Management Company, Perspective, Powerhouse, Sheer Scope, Thought Leader, Wealthtrack
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Dennis Stattman: Stocks are the Best Game in Town – “Invest in Real Businesses”

Friday, July 29th, 2011

Here is the complete transcript of this interview:

CONSUELO MACK: This week on WealthTrack, how Great Investor Dennis Stattman is navigating the great divide between the slow growing developed world and the fast growing developing one; paper based assets and hard real assets; bonds and stocks. BlackRock Global Allocation Fund’s Dennis Stattman on managing a bifurcated investment world is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. We have said many times in the past that in this global and interconnected world we live in, money will flow to where the growth is and will leave where growth is lagging. The developed world- Europe, the U.S., and Japan- are all in the lagging column right now. According to independent research firm ISI Group, over the past 8 years China’s nominal GDP, that’s with inflation included, has accelerated 250%. In contrast, U.S. GDP has expanded only 40%, the Eurozone’s a mere 25% and Japan’s nominal GDP has actually contracted 5%.

Recent figures show China’s economy is still booming as are many other developing nation’s, whereas the mature economies of the West and Japan- with their heavy levels of government debt, unemployment, aging populations and slow recovery from a series of real estate, banking and credit bubbles- are laboring. According to many economists, the debt reduction, or deleveraging process as it is known in the trade, will be particularly painful and lengthy, taking several more years. As a recent article in The Economist put it, “get used to it!” What’s an investor to do?

That’s where this week’s Great Investor guest comes in. We last talked to Dennis Stattman, lead portfolio manager of BlackRock’s Global Allocation Fund at the beginning of this year. Given the rapid escalation of world events, we decided we better get an update. Stattman, who once worked at the World Bank, had the prescience to join the now $55 billion plus fund at its inception, way back in 1989. Since then, the fund has had only three down years and has outperformed most stock and bond markets, as well as the majority of its peers, with less than stock market volatility, achieving a primary goal. It’s done it with a broadly diversified portfolio of 700 plus individual stocks, bonds, alternative investments and cash invested around the world. I began my visit with Stattman by asking him why he thinks there is something artificial about the current market environment.

DENNIS STATTMAN: Treasury bond prices have been heavily influenced by the purchases that the Federal Reserve has been making, and they’ve been quite explicit about this. They want Treasury bond prices higher and yields lower than they otherwise would be. And in the end, all fixed income prices and yields are influenced by the Treasury market; and so when the Treasury market is artificially high in terms of price and low in terms of yield, that tends to influence all fixed income security prices. And in fact, since fixed income securities compete with other assets, that tends to influence all asset prices. And we believe that asset prices have been held higher than they otherwise would have been because of the Fed’s purchases.

CONSUELO MACK: So therefore the rally that we’ve seen in what we now call ‘risk assets’ that Ben Bernanke has said was one of the reasons that he did the QE1 and QE2, so in fact, you’re saying the risk assets are artificially inflated.

DENNIS STATTMAN: They could well be. Now, to different degrees, and we happen to think that the Treasury bond market is the most inflated, and the stock market has a more questionable amount of inflation in its prices.

CONSUELO MACK: So what happens now that the Fed at least will not be actively buying Treasury securities, at least the new issues, that they’re going to be turning over their portfolio, right? And replacing, as the Treasuries that they hold on their balance sheet mature, they’re going to continue to buy, to replace those with Treasuries, is that correct? So we’ve still got some stimulus going on, even though the QE2 officially ended?

DENNIS STATTMAN: They’re maintaining, we believe, the size of their portfolio, but they’ve told us they’re not going to be increasing the size of it. So our sense is that having been through a program where they were buying approximately one-tenth of a trillion dollars worth of per month, that when you take away the growth in demand that they’ve been providing, that the Treasury market’s going to have to find another buyer. And if it’s not a foreign buyer, then it’s going to need to be a domestic buyer. And we have not, for some time now in this country, been self-financing. And it might take higher interest rates to do that.

CONSUELO MACK: And when do we start to see that pressure building?

DENNIS STATTMAN: Well, I certainly hope rates are going to go higher, not just in order to reward savers. But if rates don’t go higher, that would probably be associated with a very weak economy, and perhaps even financial trouble again, some place in the world; for example, in Europe. So our hope is that higher rates would be accompanied by at least a decent economy. And I think if we have a decent economy, we will have higher interest rates.

CONSUELO MACK: Okay, so let’s talk about a decent economy. Are we going to have a decent economy, and if so, when?

DENNIS STATTMAN: We’d love to see something far more dynamic than we’re seeing. But so far, we haven’t seen employment strengthen enough to, for example, reduce the average length of unemployment, which is distressingly high. So what we think we will continue to see is a world in which the developing economies outgrow the developed economies, and where the developed economies struggle to get back to trend growth.

CONSUELO MACK: But the theme is that you felt that we’ve got a bifurcated world, essentially; that they’re not the haves and the have-nots, but the rise of the rest. Where are you seeing the rise of the rest, that’s most noticeable, and what are the areas that you think that we should be paying particular attention to, as investors?

DENNIS STATTMAN: Well, clearly China, India, Brazil. And those are very well-known stories, but they’re powerful stories. And these are not stories that are going to change every three or six months. These are decade or multi-decade-long stories.  It’s simply a case that production, jobs, income and wealth are spreading much more broadly around the world. And in fact, what’s generating those jobs and income and wealth growth is increasingly domestic consumption in some of those countries, especially China.

CONSUELO MACK: How risky is the China story, and the fact that so many of us seem to be banking on China as kind of the driver of world growth in the 21st century?  And what are the risks to that scenario?

DENNIS STATTMAN: Surely when loan growth is as robust as it has been, in China, and where lending policies are influenced by many different levels of government, you’re going to have some very questionable sorts of loans created. But at the same time, the growth of the banks’ assets, to some degree, means that the portion of them that are troubled from a year or two years ago, is not as overwhelming as it otherwise would be. We should also keep in mind that China is a country of financial surpluses, and surpluses on the one hand are associated sometimes with growth that is so fast that there are problems created. But at the same time, surpluses are surpluses, and they can absorb losses.

CONSUELO MACK: What are the surpluses that you’re talking about that you think can provide a cushion to China, even in the case of some sort of a downturn, or at least a slowdown?

DENNIS STATTMAN: Well, let’s keep in mind that China generates a high level of savings, a high level of trade surplus. It has the world’s highest foreign exchange reserves, by far. And it’s in a position to use some of those reserves, and that power to generate financial assets to repair, when there’s some problems. And also if a growth rate of 10 or 11% turns into a growth rate of 7 or 8%, it’s still a growth rate.

CONSUELO MACK: Let’s talk about another controversial statement that you made, and that is that government bonds are not safe. Whose government bonds are not safe, and why are they not safe?

DENNIS STATTMAN: Well, we believe that most government bonds are safe in terms of the nominal value of them- in other words, that most of them will pay their interest and pay their coupons on time. Might not be every single one of them, and we can think of some countries in Europe that are very questionable at this point.

CONSUELO MACK: So Greece and Spain and Portugal and Ireland are?

DENNIS STATTMAN: I would say at least Greece and Portugal are in serious question, and of course, they’re small enough to be manageable. The big question is probably Spain. And if Spain were to get into trouble, people would look around for the next country to worry about. And let’s hope that the trouble stops before it gets to Spain not being able to meet its obligations.
But I think more to the point is simply something like U.S. Treasury bonds. A 10-year Treasury yields a little over three percent these days. And what that really means is that’s like a stock that sells at a PE ratio in the thirties, but has no growth. And this is before inflation and before taxes. And we are right now, as a nation, facing a big deficit that has a large cyclical component. And that cyclical component is also occurring at the same time there is a tidal wave of demographic-related spending that is just starting to happen and will grow and grow and grow.

CONSUELO MACK: The Baby Boomers, social security, Medicare.

DENNIS STATTMAN: Exactly. That will grow for the rest of our lifetimes, and we don’t, as a nation, yet have much of a plan about how to pay for it. And given that we’re starting with very low interest rates, a low but rising rate of inflation, very low real interest rates. The real interest rates on a Treasury inflation-protected security with a maturity of ten years are less than one percent. It seems that there are risks of inflation and risks of higher interest rates that one is not really compensated for today.

CONSUELO MACK: Now, the Chinese, for instance, hold a lot of Treasury securities.

DENNIS STATTMAN: Yes.

CONSUELO MACK: U.S. Treasury securities. And even though they’re diversifying, supposedly, into some sovereign debt of European countries and whatever, but good luck to them in that area, so you know, I mean, what’s the alternative? If, as far as kind of the traditional use of Treasuries in portfolios has been for liquidity reasons and also a defensive, kind of a non-correlated asset, what do you substitute for the traditional role that Treasuries have played in most of our portfolios?

Tags: 8 Years, Best Game, Brazil, Commodities, Consuelo Mack, Debt Reduction, Economists, Eurozone, Global Allocation, Government Debt, Great Divide, Independent Research Firm, India, Investment World, Isi Group, Levels Of Government, Nominal Gdp, Portfolio Manager, Rapid Escalation, Real Assets, Recent Article, Wealthtrack, World Europe
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Weakness May Present Buying Opportunities

Friday, July 1st, 2011

Weakness May Present Buying Opportunities

Monthly Strategy Report June 2011

by Alfred Lee, CFA, DMS, Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee[at]bmo.com

“Sell in May and go away,” so goes the old adage in the investment world. Does the saying however have any validity or does it exist simply because it rhymes? Undoubtedly, those investors that followed the saying this year would have come out ahead with the major equity markets around the globe experiencing a sizable sell-off over the last several weeks. A number of recent macro-economic events are causing investor sentiment to take a turn for the worse, at least for the short-term. For example, the S&P/Case-Shiller 20 City Index¹ fell back below its crisis low, U.S. jobless data is waning and the end of the second instalment of quantitative easing2 (QE2) is upon us. On the homefront, the implications of a weakening U.S. economy have investors concerned, as it may have supply chain impacts on the U.S. and Canadian trade. In addition, the CME Group Inc.’s recent margin requirement hikes to cool pricing of a number of commodities have also led to the softening of the Canadian equity market. With these concerns in the market, in addition to weaker expected growth out of China and Japan, the second and third largest economies in the world respectively, many of the global equity indices have fallen below or have traded near its 200-day moving average (MA), a key technical support level. Over the last several weeks, we have received a number of emails inquiring whether this technical event would have long-sustaining bearish implications on the market. We view the market as being characterized by three main time horizons. The first, and longest, is the secular cycle, which can last several business cycles and is caused by large global demographic shifts. The next timeframe is the cyclical cycle, which is largely defined by the business cycle itself. The last, and shortest, of the cycles is the trading cycle which is largely driven by investor sentiment and trade order imbalances. In our view, the current equity market weakness, remains contained in the trading cycle, with shorterterm traders selling and longer-term investors looking for buying opportunities. As such, we believe the current weakness to be a bull-market correction, provided equity markets don’t plummet aggressively below the 200-Day MA, an event which would cause the sentiment of longer-term investors, who are currently buyers, to also turn bearish and thus trigger additional selling.

As we mentioned in our Trade Opportunity Report, “June Weakness”, we don’t subscribe to the notion that “selling in May and going away” is a winning strategy that can be implemented effectively year after year. However, we do acknowledge that equity markets exhibit some seasonality, with June being one of the weakest months in terms of historical average performance. Additionally, the summer tends to have lower volume levels than other months. Therefore, we do to a degree believe there is some truth to the notion that investors have a tendency to pare down risk assets in favour of more defensive assets before summer.

Tags: 200 Day Moving Average, Alfred Lee, Asset Management Inc, Business Cycles, Canadian, Canadian Equity, Canadian Market, City Index, Commodities, Demographic Shifts, Economic Events, Global Equity, Investment Strategist, Investment World, Investor Sentiment, Jobless Data, Largest Economies In The World, Margin Requirement, Old Adage, Qe2, Strategy Report, Structured Investments, Time Horizons
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Fundamental Wins Over Cap-Weighted Indexing, Demonstrates Rob Arnott

Sunday, May 29th, 2011

Rob Arnott, chairman of Research Affiliates, which is famous for bringing fundamental indexing to the investment world, on why this method is superior to traditional cap weighted indexing. His contrarian method which ‘sells whatever is most newly beloved and buys whatever is most newly feared and loathed’ is gaining admirers. He says it delivers 2-3 per cent value add in the developed markets and 3-4 per cent in small companies and emerging markets.

[My firm, Plexus Asset Management, is the South African licence holder for the Research Affiliates Fundamental Indexing (RAFI) over here, and we are seeing very significant outperformance vs the market cap equivalent indices. Do contact me if you want to access the Johannesburg Stock Exchange by means of RAFI technology.]

Click here or on the image below to view the clip.

Rob Arnott, chairman of Research Affiliates, which is famous for bringing fundamental indexing to the investment world, on why this method is superior to traditional cap weighted indexing. His contrarian method which ‘sells whatever is most newly beloved and buys whatever is most newly feared and loathed’ is gaining admirers. He says it delivers 2-3 per cent value add in the developed markets and 3-4 per cent in small companies and emerging markets.

[AA Note] In Canada, RAFI Fundamental Indices are available through mutual funds sponsored by Pro-Index Funds, and ETFs sponsored by Claymore Investments. [AA Note]

Source, Financial Times, May 25, 2011.

Tags: Aa, Admirers, Asset Management, Canadian Market, Claymore Investments, Emerging Markets, ETFs, Financial Times, Fundamental Indexing, Index Funds, Investment World, Johannesburg Stock Exchange, Licence Holder, Market Cap, Mutual Funds, Outperformance, Rafi, Research Affiliates, Rob Arnott, Source Financial
Posted in Canadian Market, ETFs, Markets | Comments Off

Soros Backed IPO Adecoagro (AGRO) Provides Hard to Find Access to Farmland

Wednesday, January 26th, 2011

by Trader Mark, Fund My Mutual Fund

No matter what you think of George Soros’ politics, he has his nose in all the right places in the investment world.  I’ve long bemoaned the lack of avenues to invest in farmland for the regular investors – indeed aside from Argentina based Cresud (CRESY), I don’t think there is another option – but this week’s slate of IPOs brings us Adecoagro (AGRO).  This sort of thing won’t be hot money, but if you give me a 40 year horizon, I say arable land (or water) will be the best investments on earth.   And I’m not the only one:

• [Jun 5, 2008: NYTimes: Food is Gold, So Billions Invested in Farming]
• [Jun 14, 2008: Bloomberg: Farmland Reaps Bonanza for TIAA]
• [Jun 2, 2009: The Economist - Outsourcing's 3rd Wave - Buying Farmland Abroad]
• [Dec 31, 2009: Bloomberg - Ethopian Farmers Lure Investor Funds as Workers Live in Poverty]

Meanwhile I am sure all the attention in the short term will go to the hype machine that is the IPO of Digital Media.

—————————–

The English website can be found here

Adecoagro is currently one of the leading companies in the production of food and renewable energy in South America. Present in Argentina, Brazil and Uruguay, our main activities include the production of grains, rice, oilseed, dairy products, sugar, ethanol, coffee, cotton and cattle meat.

Since its creation in 2002, the company´s growth was based on the implementation of a sustainable efficient production model, working on its own land and managing risk through diversification.

Unfortunately, there is a lot of exposure to the politically unstable country of Argentina, but that has not stopped investors from giving Cresud a rich valuation.

Bloomberg gives us a closer look at the company

• Adecoagro SA, a farmland venture in South America that’s backed by billionaire George Soros, plans to raise as much as $429 million in an initial public offering in the U.S. as food prices surge. As much as 21.4 million new and 7.14 million existing shares will be offered for $13 to $15 each, the Luxembourg-based company said today in a U.S. Securities and Exchange Commission filing.
• The company’s main shareholders include Pampas Humedas LLC, an affiliate of Soros’s Soros Fund Management LLC, which owns about 34 percent and will reduce its stake to about 21 percent after the offering.
• As part of the offering, a subsidiary of Qatar’s Doha-based sovereign fund, which already owns 6.5 percent of Adecoagro, may buy as much as $100 million of the stock. The IPO is scheduled to price on Jan. 27, according to data compiled by Bloomberg.
• The company said in the filing it plans to use $230 million of the proceeds to build a sugar-cane processing plant in Brazil and may spend about $145 million on “the acquisition of farmland and capital expenditures required in the expansion of our farming business.”
• The new sugar mill in Ivinhema city, Brazil, will process 6.3 million tons of cane by 2017, more than doubling Adecoagro’s capacity to 11.5 million tons a year. The company said it may also use cash and more debt to fund the construction of the Ivinhema mill.
• Adecoagro grows rice, coffee, soybeans, wheat and corn in about 288,000 hectares (712,000 acres) of farmland, an area that’s bigger than Jacksonville, Florida. It owns 38 farms in Brazil, Argentina, and Uruguay that’s valued at a combined $784 million, the filing said.
• Adecoagro said it owns 21 farms in Argentina, 15 in Brazil and two in Uruguay. It operates rice processing facilities, has a dairy operation with 4,500 cows, owns two coffee processing plants, seven grain and rice conditioning and store plants and two sugar and ethanol mills.

IPOFinancial per TheStreet.com has more data:

• The company has seen its sales explode, with a CAGR of 48% from 2007 to 2009 and +38% improvement in the first three quarters of the year. Among the key factors for growth has been sales in corn and soybean, which are up +112% and +77%, respectively, in the first nine months of 2010 from the comparable period in 2009. That being said, the largest segments by total revenue remain rice and ethanol, the latter of which will expand production following the allocation of IPO proceeds.
• At first glance, it may be puzzling as to why a company growing so fast, with a reasonable debt structure, is still not recording an accounting profit. In reality, AGRO has had to incur non-cash expenses that have skewed its earnings. Even though higher food and cattle prices have increased sales, the accounting benefit is somewhat offset because the markup in total inventory value has made depreciation expenses much higher.
• In the first nine months of 2010, it incurred more than $100 million in charges as a result of faster depreciation and amortization. It also ran into a problem in its sugar market last year, as sugar prices fell by 50% from their early 2010 high of $30 before making a late-year recovery to a 30-year high.

No position

Copyright (c) Trader Mark, Fund My Mutual Fund

Tags: Arable Land, Argentina Brazil, Billionaire, Bloomberg, Brazil, Cresud Cresy, Dairy Products, Emerging Markets, energy, Ethanol, Farmland, George Soros, Gold, Hot Money, Hype Machine, Initial Public Offering, Investment World, Investor Funds, Leading Companies, Managing Risk, Oilseed, Production Model, Tiaa, Unstable Country
Posted in Brazil, Energy & Natural Resources, Gold, Markets, Oil and Gas | Comments Off

Hemlines and Investment Styles (Howard Marks – September 2010)

Saturday, September 25th, 2010

This article is a guest contribution by Howard Marks, Chairman, Oaktree Capital.

Memo to: Oaktree Clients
From: Howard Marks
Re: Hemlines and Investment Styles

While the details change, the pendulum-like fluctuation of investment styles is a constant. Fear versus greed, pursuit of safety versus aggressiveness, stocks versus bonds, and growth versus value are just a few examples of the areas in which we see this take place. In this way, the investment world proves the wisdom of Mark Twain’s observation that, “History doesn’t repeat itself, but it does rhyme.”

The limits of the pendulum’s swing are fixed, and it tends to move back and forth over the territory between them. This occurs because (a) people tend to take trends to extremes, (b) neither extreme of the pendulum’s arc represents a perfect or permanent solution, and (c) there’s no place else to go in these regards. Thus the best way to view investment trends may be through an analogy to hemlines: all they can do is go up and down, and so they do. The style mavens call for short skirts, and people fall into line, raising hemlines until they’re as high as they can go. And then they drop (and so forth).

The reasons behind the rise and fall of investment fashions rarely repeat exactly, in that the details, timing and effects vary from instance to instance. But the underlying process is a recurring one. For example:

An idea is born when an undervalued asset is discovered.

Its undervaluation attracts attention, as do pioneering investors’ early gains.

• Its popularity rises, attracting more and more adherents, even as undervaluation moves to fully valued.
• It turns into a mania or “bubble,” and price becomes immaterial.
• Eventually, the last potential buyer becomes convinced and comes on board.
• With no one else left to convert to the trend, the bubble of overvaluation is ripe for bursting.
• When followers experience the first price declines, disillusionment sets in.
• One-time devotees flee en masse, and the bubble turns into a crash.

This cycle of discovery, mania and crash is best summed up by the most useful of all investment adages: “What the wise man does in the beginning, the fool does in the end.” This memo will be about recurring patterns, the history of stocks and bonds as I know it, and the adage’s applicability to that history.

A Brief History of Stocks

A significant milestone occurred in October 2008, attracting a lot of attention. For the first time in almost fifty years, it was reported, the dividend yield on the Standard and Poor’s 500 stock index was equal to the yield to maturity on the U.S. 10-year Treasury Note. People knew this meant stocks had cheapened, but it took an understanding of history to grasp the real significance. The truth is that stocks, like other investment media, tend to go in and out of style, and this was just one more example of the latter.

Prior to the 1950s, common stocks were viewed as a speculative, inferior (i.e., junior) asset class. For that reason, stocks had to pay higher yields than bonds in order to attract buyers; of course a riskier asset should yield more. In fact, most states had laws restricting holdings of stocks in fiduciary portfolios. This attitude toward stocks largely traced from the speculative stock bubble in the 1920s – featuring high-margin buying, bucket shops and shoe shine boys sharing stock tips – which collapsed in the Crash of ’29. Poor economic and market performance stretching from 1929 to the end of World War II further contributed to the skepticism toward stocks.

It was only after WW II that economic performance began to support optimism. Brokerage firms led by Merrill, Lynch, Pierce, Fenner and Smith trumpeted the merits of stocks. Equity investing became widespread, and “customers’ men” in local brokerage offices delivered stock investing to a great many households: I remember my mother buying 10 shares of Columbia Gas and 15 shares of Chock Full of Nuts around 1959.

I also remember a brochure on “growth stock investing” that Merrill put out in the mid-1960s, touting the desirability of rapid earnings growth and the strength of companies like IBM, Xerox, Avon, Coke, Texas Instruments and Johnson & Johnson. This idea grew into “nifty-fifty” investing, a true mania adopted by many of the large banks, among others. Ballyhoo took over from logic – excitement from value-consciousness – and these growth stocks’ prices reached 80 and 90 times earnings.

The nifty-fifty stocks were tested – and found wanting – when the tide went out in the 1970s. Prosperity shifted to recession. The Arab oil embargo, a period of strong cost-push, and self- reinforcing cost-of-living adjustments created hyperinflation to which few people saw a chance for an end. Those growth stock p/e ratios went from 80 or 90 to 8 or 9. And stocks, Wall Street and the general economy went through a truly dreary decade, culminating in a Business Week cover story entitled “The Death of Equities,” in August 1979. For evidence of the cyclicality of attitudes toward stocks, consider its final paragraph:

Today, the old attitude of buying stocks as a cornerstone for one’s life savings and retirement has simply disappeared. Says a young U.S. executive: “Have you been to an American stockholders meeting lately? They’re all old fogies. The stock market is just not where the action is.”

In the investment world, lows in sentiment usually coincide with lows in price, and the late Seventies were no exception. Because of the dreadful environment, you could buy an existing company in the stock market for less than it would cost to start one. I was fortunate to become a portfolio manager in mid-1978, and thus to benefit from the subsequent recovery of investor psychology from its nadir.

In general (albeit with some prominent exceptions), the last half of the twentieth century was marked by the rise of a cult of equities, and the last quarter century was probably the best ever. From 1979 through 1990, the S&P 500 averaged an annual return of 15.4% and showed losses in only two years (4.8% in 1981 and 3.1% in 1990). Economic prosperity, rising corporate profits, a trend among consumers toward borrowing to spend, and the subsidence of inflation and interest rates all made for a most hospitable environment.

When the stock market’s performance improved even further in 199 1-99, with an average return of 20.6% and no down years, the fawning kicked up a notch. From the low of 7 reached in 1980, the p/e ratio on the S&P 500 eventually exceeded 33 in 1999. The market’s dramatic performance led to steady increases in the capital allocated to equities, and eventually to the tech stock bubble. It culminated in books such as the fact-based Stocks for the Long Run and the more fanciful Dow 36,000. If you asked institutional investors what return they expected from stocks going forward, I think just about all would have said 11%.

An aside: investors consistently seize upon above average returns as an encouraging sign and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point. But rarely do they ask what gave rise to those good returns, or what it implies for the future. In essence, stock ownership conveys the benefits of owning a corporation, and stock appreciation should be powered by increases in profits. Thus long-run returns should reflect corporate growth. But as Warren Buffett has pointed out, “. . . people get into trouble when they forget that in the long run, stocks won’t appreciate faster than the growth in corporate profits.” Although that growth is the underlying source of equity profits, it is often overshadowed and obscured in the short run by trends in valuation. People took that 17.6% gain as an encouraging sign, overlooking the fact that it stemmed primarily from the rise of p/e ratios described above and thus was unlikely to continue unabated. Rather than healthy performance that could be extrapolated, this swollen return should have come as a warning that valuations were unsustainable and likely to regress toward the mean. But investors consistently fail to recognize that past above average returns don’t imply future above average returns; rather they’ve probably borrowed from the future and thus imply below average returns ahead, or even losses. The tendency on the part of investors toward gullibility rather than skepticism is an important reason why styles go to extremes.

Tags: Adherents, Aggressiveness, Analogy, Constant Fear, Devotees, Disillusionment, Fluctuation, Greed, Hemlines, Investment Styles, Investment Trends, Investment World, Mark Twain, Mavens, Oaktree Capital, oil, Pendulum, Permanent Solution, Price Declines, Rise And Fall, Short Skirts, Stocks Bonds, To Extremes, Wise Man
Posted in Energy & Natural Resources, Gold, Markets, Oil and Gas, Outlook | 1 Comment »

MIT’s Andy Lo: Markets are Adaptive, Not Efficient

Thursday, September 23rd, 2010

WealthTrack’s Connie Mack interviewed MIT’s Andy Lo. Here for your review are the video and transcript. Lo discusses his ‘Adaptive Market Hypothesis‘ which in a nutshell, challenges Modern Portfolio Theory’s ‘Efficient Market Hypothesis.’ Lo contends that markets are not efficient, but rather adaptive.

Click play to watch.

CONSUELO MACK: This week on WealthTrack: fasten your seat belts. Our Financial Thought Leader, alternative investment manager and MIT professor Andrew Lo, says the market’s volatility and uncertainty is here to stay. Strategies for riding the financial roller coaster are next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Do you feel that the financial markets are more unpredictable and arbitrary than ever? Well it is not your imagination! Unless you lived during the Roaring Twenties and the Depression-era thirties, you have never seen anything like it, until now.

Take a look at this chart provided to us by this week’s Financial Thought Leader guest. It shows the historical volatility of a broad-based stock market index from 1926 to the present. Notice the wide and wild swings at the beginning, the twenties and thirties, followed by the relative calm for the decades in between- the historical average of market volatility is 14.5%- and then the astonishing pick up in market volatility during the last couple of years. This week’s guest says “fasten your seatbelts,” the roller coaster ride will continue.

One of the true treats of WealthTrack is our ability to talk to some of the most creative and original thinkers in the investment world. And today’s guest is right up there with the best of them. This week’s Financial Thought Leader is Andrew Lo, PhD economist, professor of finance at the MIT Sloan School of Management, director of MIT’s Laboratory for Financial Engineering, and author of numerous articles and several books, including A Non-Random Walk Down Wall Street . Professor Lo also puts his ideas to work as an investor. He is the founder and chief scientific officer of AlphaSimplex Group, an investment firm whose slogan is “adaptive strategies for evolving markets.” In recent years, the firm has introduced several mutual funds under the name of its parent company Natixis, which are designed to help investors protect themselves in these ever evolving markets by limiting their portfolio risk and volatility. We will provide a link on our website, wealthtrack.com.
I asked Professor Lo to talk about some of the biggest changes he sees in the markets, starting with what he calls internet time.

ANDREW LO: We are living in Internet time now, and I mean that not just as an analogy but literally in the sense that, because of the Internet, information is transmitted at lightning speed, whereas before it would take weeks or months for certain kinds of news to get out. Nowadays it’s reflected almost instantaneously and this has dramatic implications in how financial markets operate and how we react to those kinds of surprises. Over the last two or three years, I think we’ve been on this volatility roller coaster ride where traditional investments that offered relatively traditional kinds of risks are now really unpredictable in the kind of volatility that they provide to investors.

CONSUELO MACK: Such as which kind of investment? Stocks and bonds?

ANDREW LO: Well, yeah, for example, let’s take stocks. You know, the S&P 500 traditionally has had a volatility of around 15% per year. Well, during the fourth quarter of 2008, the volatility reached as high as 85%. At 85% annual volatility, there’s a good chance that an investor can lose all their investment over the course of a few days. I don’t think anybody could withstand that kind of a risk. Fortunately it doesn’t last very long, but for the periods where volatility spikes, it’s tremendously disruptive for investors. And that’s really a relatively new phenomenon.

CONSUELO MACK: So when you say it’s a new phenomenon- now there’s a sentiment on Wall Street, in fact, that the kind of volatility that you just alluded to in 2008, 2009, that that’s over and essentially that we’re back to a normalcy that we’ve had for the last 40 or so years. You’re not sure that’s the case though, right?

ANDREW LO: No, I’m not. I think that it is over until it’s not, and so a good example of this is what happened in the beginning of this year. It looked like we were heading to calmer waters. It looked like the market was recovering. Certainly, last year was a good year for the stock market, and things were going pretty well until April and May, and what happened then was Greece. Now, certainly people knew that Greece had a debt problem even as early as, you know, three or four years ago, but it didn’t become a public problem until April and May. And during that period of time, the market volatility spiked yet again, and so next year it may not be Greece. It may be Spain. It may be Portugal. It may be emerging market debt. It may be gold. It may be something that will cause the public to fly to quality and safety.

CONSUELO MACK: i.e., Treasuries.

ANDREW LO: That’s right.

CONSUELO MACK: Which they’ve been doing.

ANDREW LO: And in fact, Treasuries have been remarkably volatile themselves in terms of the money flowing in and out. In fact, as we know, Treasuries have had negative yield for periods of time over the last couple of years. I mean, negative yield is a remarkable phenomenon. It basically says that I’m willing to lose money over the course of the next three months in order to put my money in U.S. Treasury securities, and that’s a sign that there is genuine fear in the marketplace. When you have this kind of fear, markets are very unpredictable and moreover, the volatility of volatility becomes an important factor.

CONSUELO MACK: Listening to you, I’m getting terrified.

ANDREW LO: I’m sorry.

CONSUELO MACK: Essentially, but here you are. You’re a PhD economist, and you are a behavioral economist as well as a risk management expert. So if uncertainty like that you’ve just described is going to be part of our life for the foreseeable future- correct? Then how do we deal with the risks of uncertainty as individual investors? What can we do to protect ourselves, aside from withdraw from the markets?

Tags: China, Commodities, Connie Mack, Consuelo Mack, Efficient Market Hypothesis, Financial Engineering, Financial Roller Coaster, Historical Volatility, Investment World, Management Director, Market Volatility, Mit Sloan School, Mit Sloan School Of Management, Modern Portfolio Theory, Natural Gas, Professor Andrew, Relative Calm, Roller Coaster Ride, Seat Belts, Sloan School Of Management, Stock Market Index, Thought Leader, Wealthtrack
Posted in China, Gold, Markets | Comments Off

Uncertainty Changing Investment Landscape (PIMCO)

Wednesday, August 4th, 2010

This article is a guest contribution by Richard Clarida, EVP, and Mohamed El Erian, CEO and Co-CIO, PIMCO.

Federal Reserve chairman Ben Bernanke’s characterization of the economic outlook as “unusually uncertain” has attracted much attention, and rightly so. It speaks to the immediate impact of a series of ongoing national and global realignments whose effects are consequential but not yet sufficiently appreciated.

At a fundamental level, the unusual uncertainty reflects the disruptive combination of deleveraging, reregulation, structural unemployment and other ongoing structural changes.

The phenomenon is not limited to the U.S. It is also visible in other industrial countries. Just look at the latest inflation report issued by the Bank of England, which points to unusual dispersion in policymakers’ expectations for such basic economic variables as growth and inflation.

It is the shape of such dispersion that strikes us as particularly important. It seems that, wherever we look, the snapshot for “consensus expectations” has shifted: from traditional bell-shaped curves – with a high likelihood mean and thin tails (indicating most economists have similar expectations) – to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).

We should all feel sorry for policymakers who face such distributions. The probability of a policy mistake is materially higher, especially as policy measures are subject to lags. What is less appreciated is the extent to which this changing shape of distributions affects conventional wisdom in the investment world, together with the rules of thumb that many investors have come to rely on.

We can think of five implications, some of which are already evident while others will only be obvious over time.

First, investing based on “mean reversion” will be less compelling. Even though flatter distributions with fatter tails have means, the constituency for mean reversion investing will shrink as those means will be much less often realized in practice. A world where the realized return rarely equals the expected valuation creates a bigger demand for liquid, default-free assets; it also lowers the demand for more volatile asset classes such as equities. These shifts are already taking place.

Second, frequent “risk on/risk off” fluctuations in investors’ sentiment are here to stay. Investors, based on 25 years of rules of thumb that “worked” during the great moderation, thought they knew more about the distribution of risk than they in fact did. This led to overconfidence during the bubble. The crisis reminded investors that these rules of thumb are less useful, if not dangerous.

With declining confidence in a reliable set of investing rules, markets have become more susceptible to overreactions to daily news and are, therefore, more volatile. Just think of the number of triple-digit days in the Dow.

Tags: Bank Of England, Changing Shape, Clarida, Consensus Expectations, Conventional Wisdom, Economic Outlook, Economic Variables, Evp, Federal Reserve Chairman, Federal Reserve Chairman Ben Bernanke, Fundamental Level, Industrial Countries, Inflation Report, Investment Landscape, Investment World, Mean Reversion, Mohamed El Erian, Policy Measures, Rules Of Thumb, Structural Unemployment
Posted in Markets, Outlook | Comments Off