Bill Gross’ latest investment outlook is up at PIMCO and he echoes the theme everyone is now talking about – irrational exuberance. He goes into great depth, saying that we are at about 6 on a scale of one to ten when measuring asset price irrationality. But he advises staying the course and expecting lower returns.
Just yesterday, Ben Bernanke gave a full-throated defense of the Fed’s easy money policy but gave voice to the concerns that Fed Governor Jeremy Stein voiced about “reaching for yield”, a term I have used often.
Bernanke referenced the risks but waved them off almost immediately.
Another potential cost that the Committee takes very seriously is the possibility that very low interest rates, if maintained for a considerable time, could impair financial stability. For example, portfolio managers dissatisfied with low returns may “reach for yield” by taking on more credit risk, duration risk, or leverage. On the other hand, some risk-taking–such as when an entrepreneur takes out a loan to start a new business or an existing firm expands capacity–is a necessary element of a healthy economic recovery.
This is not what Janet Yellen did in 2010 when making the same kind of defense of the Fed’s easy money. She ended her speech saying
Will future regulators and monetary policymakers be accused of bursting 10 of the past 2 asset bubbles?
These dangers are real. But the events we’ve recently lived through make it clear that we have no choice but to embark on this road. We’ve all been asked, “Didn’t you see this mortgage disaster coming? Why didn’t you do anything about it?” Our task now is to implement intelligent policies to contain future bubbles and credit binges, and to make sure that those that do occur inflict a lot less damage on the economy. Next time I hope we can say, “We did see it coming, and we did something about it.”
It might be lip service since Yellen is a dove, but it’s a good deal more hawkish than Bernanke’s testimony. And remember, this is two years after Yellen’s speech, meaning two years further into the Fed’s easy money policy.
So, it’s clear that Bernanke is dovish as I said in my post yesterday on Bernanke’s testimony.
On the effects of this dovishness, Gross comments:
Governor Stein, as does PIMCO, suggests caution. On a scale of 1-10 measuring asset price “irrationality”, we are probably at a 6 and moving in an upward direction.Admittedly, Stein never ventures into the netherworld of stock market prices or leveraged buyouts. He appears to know better. What he does stake claim to however is a thesis for high yield spreads with the implication that other credit markets bear similar consequences. His initial starting point is that the pricing of credit is primarily an institutional as opposed to a household decision making process. Individuals may become unduly irrational when it comes to buying high yield ETFs or mutual funds, but it is the banks, insurance companies and pension funds, to name the most dominant, that influence the price of credit – high yield bonds – and by osmosis, investment grade corporates, municipals, and other non-Treasury risk credit assets. From this initial premise, he then points to recent research by Harvard’s Robin Greenwood and Samuel Hanson that suggests that while credit spreads are helpful future guides, that a non-price measure – the new issue volume (and perhaps quality) of high yield bonds – is a more trustworthy input. To quote: “When the high-yield share (of issuance) is elevated, future returns on corporate credit tend to be low.” And because of financial innovation and easier regulatory changes, institutional buyers such as banks, insurance companies and pension funds tend to match the mountains of issuance with an exuberance that eventually can be labeled irrational. Stein’s bottomline is that recent evidence suggests that we are seeing a “fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.” In fact, investors bought over $100 billion of high yield and levered loan paper last year, a record level even exceeding the ominous levels in 2006 and 2007. Shown below in Chart 1 is a history of CLO issuance, admittedly a subset of high yield, but one which illustrates the supply pattern Governor Stein is leery of.
Now at this point, I suppose readers expect yours truly to jump all over the Governor’s speech/premise and to advance my own more learned thesis. Not really. With previously expressed reservations about the prescience of the Fed (or any of us!) I applaud his attempt to answer the initial 1996 question. I think Governor Stein’s speech was a little uni-dimensional, and a little too supply and model driven as opposed to behaviorally influenced, but I liked it, and PIMCO agrees with its conclusion. Corporate credit and high yield bonds are somewhat exuberantly and irrationally priced. Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile. Still that doesn’t mean you should vacate your portfolio of them. It just implies that recent double-digit returns are unlikely to be replicated and that when today’s 5-6% high yield interest rates are adjusted for future defaults and recovery values, that 3-4% realized returns are the likely outcome. Just this past week the Financial Times reported that global corporate default rates are inching higher just as companies with fragile balance sheets sell large amounts of debt. Don’t say Governor Stein didn’t warn you.
I used to work in high yield and still follow that market. All aspects of the market are now questionable. Leveraged loan and high yield volumes are at record highs. High yield spreads are low. And deal multiples i.e. leverage is high. Even in Europe, high yield is going gangbusters. Banks, of course, are feeding at the trough. All of this speaks to excess.
The question for Gross and other bond (and equity) investors is what to do about it. After all, this has been going on for some time now.
PIMCO’s and Governor Stein’s “rational temperance,” in contrast to excessive historical bouts of “irrational exuberance,” simply counsels to lower return expectations, not to abandon ship. PIMCO is a global investment manager – not one with a perpetual frown or even an ever-present half empty glass – but one which hopes to provide alpha and above market returns while still standing tall in the aftermath of future irrational bouts of exuberance. We join with Governor Stein and perhaps Alan Greenspan in encouraging not an exit but a reduced expectation. Credit spreads nor interest rates cannot be artificially compressed forever, nor can stock prices rise perpetually on their coattails. Be rational, be optimistic if so inclined, but temper it with a commonsensical conclusion that we have seen something similar to this before, and that previous outcomes seldom matched the exuberance.
For an investor – especially a fund manager – missing the upside can be a career-ending proposition. Ergo Gross recommends staying fully invested and trying as best as possible to ride through the rough spots, cognizant that the overall returns will be lower as a result. I would also add that entry points are critical then. There is no point in getting in late and chasing return by going overweight momentum sectors or asset classes. Rather, we should expect better performance by overweighting when sectors and asset classes have underperformed and have good prospects.
Is this the hallmark of a secular bull market? I don’t think so.