Bill Gross Investment Outlook Dec_06

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InvestmentOutlook BillGross

December 2

Reality Check

Reality is a delicate abric. You canthandle the truth was a amous JackNicholson courtroom one-liner, suggestingthat even in the ace o hard acts, peopleresort to sel -deception in order to protecttreasured illusions. How else to explaina recent poll by CNN that 54% o therespondents believed that OJ did notmurder his wi e and Ron Goldman? Howelse to explain that 77 o 100 U.S. Sena-tors authorized Bush to invade Iraq underthe pretense o Saddams potential use o

weapons o mass destruction against theAmerican public? I can only conclude thati reality is so delicate, subject to distortioneven by a clear majority, then the lessonis that you should handle it care ully or atthe least be prepared or the taste o skimmilk instead o cream as we are warnedin the caption above.

This question o the true percentage o

butter at is a critical one in todays fnan-cial marketplace. Risk assets ranging romprivate equity all the way down to two-year Treasury Notes have been repricedin recent months/years under the assump-tion that uture economic and fnancialasset price volatility will be ractions ohistorical levels. Globalization, the greatmoderation, central bank transparency,

and fnancial innovation leading to thehedging and there ore the smoothing orisk are all cited as explanations or whycurrent and uture risk spreads shouldremain compressed. It is not hard to acceptthese apparent realities; in act, Im some-what o a believer mysel . I Bernankestransparency allows bond investors tomore accurately time uture Fed behavior,then why shouldnt the risk premium ortwo-year Treasuries be less than it wasin the 70s and 80s when investors had

to guess at the signifcance o Fed openmarket maneuverings? I globalizationand the sharing o growth benefts with

ormer emerging market nations such asBrazil lead to the apparent sel -sustaininggrowth o their dollar reserves, then whyshouldnt their bond spreads over Trea-suries be in the 100-200 basis point rangeinstead o 1,000-2,000? I accept thesenew realities even within the context o a

cautionary note that stability breeds insta- bility and/or that a cyclical slowdown canquickly turn perceived cream into skimmilk as it always has. Our conceptualmilkmaid can churn her barrel as ast asshe can, but its hard to manu acture butterwhen an economy slows below the pointthat historically sustains proft and jobgrowth and there ore minimizes risk.

Things are seldom what they seemSkim milk masquerades as cream

H.M.S. PinaforeGilbert & Sullivan


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Investment Outlook

December 2006

But I write today not to expound on thecyclical economic outlook nor to unneces-sarily repeat observations o prior Invest-ment Outlooks conceding that risk spreadsare compressed and potential alpha gener-

ation likely anemic. Most o us wouldagree with that reality subject as withOJ to inevitable illusions to the contrary.What I would like to speak to now is thecurrent pricing (overpricing) o certain riskassets even under the idyllic conditions ocontinued Fed transparency and global-ization and all o the other componentswhich may have seemingly producedcream out o skim milk. My initial point isthat asset pricing itsel is a delicate abric,as I o Dow 5000 ame would be the frst toadmit. Volatility and growth rate assump-tions dominate risk asset prices as dopresumption o uture real interest rates,liquidity, etc. The list o variables, i notendless, is certainly long and there oremore and more subjective the urther oneventures out on the pricing limb. I, andIm sure you as well, am always amazedat the pundits who claim that certain just

released in ormation is already priced into the markets. How do they know andwho did they ask? Even i they did, woulda 54% OJ majority opinion be proo thatit was so? I suspect not and that is whyinvestment management is partially art,partially science, and at least a small partBS. But there are certain points in moredefnable, less BS-able asset markets thatapproach certainty i only because theyare more mathematically based. When theFed cut interest rates to 1% in June o 2003,I could guarantee you that they could onlycut them 100 basis points more. When 10-year yields on Japanese JGBs hit .35% at thesame time, I could almost guarantee youthat their incredible bull market run was

coming to an end. NASDAQ 5,000? Easy inretrospect, but harder at the time, i only because the mathematics o value were being biased by the phantasms o hope.The oor was 5,000 points below, but the

ceiling somewhere in the wild blue yonder.

Because the bond market is more math-ematically oriented than riskier assetmarkets, it stands to reason that a quest orcertainty and reality in fnancial marketswould begin there. Fed Funds at 1%, JGBsat .35%, and ?. Where is the present daycounterpart where one could claim thatprices could go no higher or risk spreadscompress no urther? We are beginning tofnd such evidence in the investment gradecorporate bond market, the narrowingspreads o which are displayed in Chart 1. While a rather obvious 25 or 35 basispoints to 0 analogy could quickly beadvanced here, a fner, more preciseanalysis emanates rom the quantita-tive dissection o a new derivative creditproduct retailed to institutional buyers

Chart 1

Source: Markit Portal, JP MorganFinancial Times, Nov 8, 2006

40

35

30

25

20

Credit Cream?Credit Indices, Annual Premium for

Five-Year Protection (Basis Points)

Oct 2006 Nov

Dow Jones CDX

iTraxx Europe


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under the sticker known as a CPDO orconstant proportion debt obligation.Without too much explanation, thesemultibillion-dollar instruments leverinvestment grade indices up to 15 times

the amount invested and o er or haveo ered a spread o 200 basis points overLIBOR with a AAA rating. Hard to passup I suppose, recognizing that AAA secu-rities are by defnition blue chip with rare,only infnitesimally small annual de aultrates. But this AAA rating is subject tonumerous (more numerous than usual)subjective assumptions on the part o therating services and in turn vulnerable toquicker downgrades than your normalAAA GE credit rating (there GE, Ive paidyou back.) My purpose in bringing up theCPDO, however is not to denigrate therating sources or to praise GE, but to statethat under PIMCO quantitative modeling,current investment grade CDX spreads,shown in Chart 1, can only narrow by 3or 4 more basis points be ore these CPDOinstruments can no longer earn a AAArating or o er such an attractive 200 basis

point spread. More importantly, increasing

multiples o leverage beyond 15x nearcurrent yields spreads cannot maintaineither a AAA rating and/or the 200 basispoints in yield spread that have made thisderivative so attractive and in turn helped

to rein orce a declining trend in all creditspreads over the past ew months. Theincreasing use o leverage, in other words,at least as applied to this particular area,appears to have run out o its magicalability to increase returns. Investmentgrade corporate spreads there ore are notlikely to narrow urther. The perceived atcontent in this supposed AAA cream, isas high as its going to get, and skim milkmay eventually be the reality.

This is a critical analysis because iextended to other asset markets, it beginsto imply that the leverage potency orecent years is reaching a peak, even ieconomic and fnancial market volatilityremains idyllic. One gains confdence inthis conclusion by applying what is knownas a Kelly risk analysis popularized ina recent book titled, Fortunes Formula

by William Poundstone. The heart o theKelly risk ramework, used long ago bythe way, by my old math pro essor riendEd Thorpe o blackjack counting renown,is to defne how much o your wealth youshould expose to repeated trials o a bet

or which there are avorable oddso winning. Given an historical alpha-generating trade or instance, such as acorporate bond spread above a certainpresumptive level, how much leverage can be applied be ore the chances o losingall your money dominate the outcome?PIMCO quantitative whiz Steve Schulistpresented the ollowing summary anal-ysis to the PIMCO Investment Committeerecently as shown in Chart 2.

Old WorldNew World

Chart 2

Note: The plot above shows excess return above the risk-free rate bytaking increasing exposure (leverage when investment is greater than100%) to a risky asset. In the "Old World" scenario, the risky asset offers200 bp of risk premium (expected return above the risk-free rate) andhas volatility (standard deviation of expected return) of 500 bp. In the"New World" scenario, the risky asset offers 50 bp of risk premium andhas volatility of 250 bp.Source: PIMCO, Steve Schulist

A l p h a

Paradigm Shift

Investment in Risky Asset

0% 200% 400% 600% 800% 1000% 1200%

10%

9%

8%

7%

6%

5%

4%

3%

2%

1%

0%


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IO Podcast

As a reminder, listen to this IO Podcast(at no cost) in a few days at pimco.comand iTunes.com.

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Its conclusions, under the new worldassumption o todays low volatilityand narrow asset risk spreads, rein orcein general what I have o ered to be thecase with the CPDO in specifc. There is

a maximum leverage point, 7-8x in thisexample and eerily re ective o todayshedge und proclivities, beyond whichreturns can be maintained only withincreasing and signifcant expectationso fnancial loss. We estimate that themaximum alpha an average hedge undcan generate in todays marketplaceutilizing a broad array o fnancialassets which average a 50 basis pointrisk premium, displayed in Chart 2, is 200 basis points. Any attempt to go urther bylevering up an already 8x levered port olioincreasingly risks signifcant and in somecases, total loss o principal.

And so? No gloom and doom messagehere. Ive already endorsed the rudimentso our new age fnancial marketplacesubject to one o and normal cyclical

corrections. But we are approaching limits.And just as distortions o mass and timeenter physicists equations as objectsapproach the speed o light, so too cancream mutate i its price or spread morphs

rom old world to new world to unworldlylevels. I cant guarantee this reality OJlurks, it seems even in the fnancial markets.But I have a strong sense that the abilityto lever any or all asset returns viaincreasing leverage is reaching a climaxand there ore, that CPDO, corporatecredit spreads, and more importantly,sophomoric assumptions o utureassets returns in all markets may requiresome uture compromise, as the currentmasquerade o high asset returns gradu-ally morphs rom cream to skim milk.

William H. GrossManaging Director

Past performance is no guarantee of future results. This article contains the current opinions o the author but not necessarilythose o Pacifc Investment Management Company LLC. Such opinions are subject to change without notice. This article has been

distributed or educational purposes only and should not be considered as investment advice or a recommendation o any particularsecurity, strategy or investment product. In ormation contained herein has been obtained rom sources believed to be reliable, butnot guaranteed.

Each sector o the bond market entails risk. The guarantee on Treasuries and Government Bonds is to the timely repayment o principaland interest, shares o a port olio that invest in them are not guaranteed. With corporate bonds there is no assurance that issuers willmeet their obligations. Investing in non-U.S. securities may entail risk as a result o non-U.S. economic and political developments,which may be enhanced when investing in emerging markets.

The Dow Jones CDX is a series o indices that track North American and emerging market credit derivative indexes. The purpose o thecombined indexes is to track the per ormance o the various segments o credit derivatives so that the overall return can be benchmarkedagainst products that invest in similar products. The iTraxx Europe credit de ault swap (CDS) index. Consisting o 125 re erenceentities, the iTraxx Europe CDS index allows investors to gain exposure to various tranches o a diversifed port olio o the most liquidinvestment grade European corporate re erence entities.

No part o this article may be reproduced in any orm, or re erred to in any other publication, without express written permission o Pacifc Investment Management Company LLC. 2006, PIMCO. IO054-112706

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Bill Gross Investment Outlook Dec_06