Bill Gross Goes Searching For "Irrational Exuberance" Finds "Rational Temperance"

Tyler Durden's picture

The underlying question in Bill Gross' latest monthly letter, built around Jeremy Stein's (in)famous speech earlier this month, is the following: "How do we know when irrational exuberance has unduly escalated asset values?" He then proceeds to provide a very politically correct answer, which is to be expected for the manager of the world's largest bond fund. Our answer is simpler: We know there is an irrational exuberance asset bubble, because the Fed is still in existence. Far simpler.

From Pimco

Rational Temperance

But how do we know when irrational exuberance has unduly escalated asset values?

– Alan Greenspan 1996

PIMCO’s dear friend and former counselor Alan Greenspan coined this now famous phrase in the midst of what turned out to be a fairly rationally priced stock market in late 1996. While the market was indeed moving in the direction of “dot-com” fever three to four years later, the Dow Jones Industrial Average at the time was a relatively anorexic 6,000, and the trailing P/E ratio was only 12x. For a central bank that was then more concerned about economic growth and inflation as opposed to stock prices, risk spreads, and artificially suppressed interest rates, the Chairman’s query made global headlines, became a book title for Professor Robert Shiller and a strategic beacon for portfolio managers thereafter. Having experienced two and perhaps three bouts of significant market irrationality since Greenspan’s speech (the 1998 Asian Crisis, 2000 Dot-Coms, and of course 2007’s subprime euphoria), investors these days have their ears pressed to the ground and eyes glued to the tape for any sign of renewed irrationality. If the game is now musical chairs as opposed to Chuck Prince’s marathon dancing, it pays to be close to a chair, even as the “can’t miss” euphoria mesmerizes 2013 asset managers worldwide.

Into this academic but high-staked market fog has stepped another Fed official, this time not a Chairman but a relatively new yet similarly quizzical Governor. Jeremy Stein’s February 2013 speech has not gained the attention that Chairman Greenspan’s did, but it is remarkably similar in its intent and initial question: Governor Stein asks, “What factors lead to overheating episodes in credit markets?... Why is it that sometimes, things get out of balance?” Without mimicking Chairman Greenspan’s phrase, Governor Stein renews the quest, asking nearly a decade and a half later, “How do we know when irrational exuberance has unduly escalated asset values?”

I suppose it’s fair to criticize both queries on two grounds: 1) Although asked by Chairman Greenspan, it was never really answered in the 1996 speech. 2) If the Fed’s so smart, why are some of us still poor? Why did our 401(k)s become 201(k)s in 2009 before recovering to near peak levels currently? If they’re so smart, why the roller coaster ride, the 30% decline in home prices since 2006, and our current 7.9% unemployment rate?

Well to answer for the absent Chairman and the necessarily silent Governor Stein, the Fed incorrectly assumed that as long as inflation was benign, and future productivity prospects were near historical proportions, then asset price exuberance was an indirect and much less significant influence on economic growth. The Chairman admitted as much in a public “mea culpa” several years ago. We’re not that smart, he seemed to intone. Sometimes we make mistakes. I’m with you there, Mr. Chairman. Sometimes we all do.

So let’s approach this new paper with eyes wide open and pant bottoms close to those mythical musical chairs. Governor Stein’s speech reflects importantly on the answer to the question asked by a recent Wall Street Journal headline: “Is (the) Bull Sprint Becoming a Marathon?” Is there indeed “A Boom Time” in markets as the Financial Times queried on the heels of Dell, Virgin Media, and then HJ Heinz?

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.

But I would step now into the forbidden territory of equity pricing by presenting additional historical correlations compiled by Jim Bianco of Bianco Research – admittedly not a thickly populated academically staffed organization like the Fed, but a well-regarded one nonetheless. He points out in a recent daily release that high yield and corporate bonds are really just low beta equivalents of stocks. It appears that they are. The following charts show a rather commonsensical negative correlation of high yield spreads (and therefore future high yield returns) to stock prices.


The conclusion would be that where high yield prices go, stock markets follow, or vice versa. Narrow yield spreads in high yield credit markets appear to be accompanied by “narrow” equity risk premiums in the market for stocks, which is another way of saying that the course of future equity returns may not resemble its recent exuberant past. 3-4% high yield returns over the next few years? Why shouldn’t that logically lead to a generalized 5-6% return forecast for stocks? Admittedly, returns for both high yield and equity markets have been unduly influenced in the past few years by Quantitative Easing, the writing of trillions of dollars of Federal Reserve checks and the exuberant migration of institutions and households alike to the grassier plains of risk assets dependent on favorable economic outcomes. It is what central banks encourage and to date it has been successful. If and when that support dissipates or if the economy remains anemic, investors should be cautious and temper their enthusiasm.

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. 

IO Speed read:  

1) Chairman Greenspan’s “irrational exuberance” speech in 1996 posed an excellent question, and history provided the answer.

2) Fed Governor Jeremy Stein asks the same question in 2013 with a uni-dimensional but useful model.

3) Stein’s paper, accompanied by correlations from Bianco Research, suggests caution in today’s high yield market.

4) High yield bonds, stock prices and other risk spreads move in relative tandem.

5) PIMCO cautions “rational temperance”: be bullish if you want, but lower return expectations on all asset classes.


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bank guy in Brussels's picture

Cute girl in the bikini, but with a pic I think one should at least TRY to connect with the ZH topic ...

cf William Banzai who always makes his Asian and other babes 'fit' the thread ...

Model in your pic is Asian but not sure she is Chinese, either

willwork4food's picture

I just saw the words "irrational exuberance" and couldn't help myself...

icanhasbailout's picture

I'd invest in that asset class.

SWIFT 760's picture

Jewbux...built on lies, deception, extortion, bribery, manipulation, threats, murder, etc. 

ZIT - Zionist Israeli Terrorism officially hijacked America in 1913. 

akarc's picture

I found the post to be interesting food for thought motivating me to look inward at my own expectations re: seeking alpha and wondering if Alpha is simply not losing your ass. But then mediation is hard for me as I often swing between being overly optimistic and overly pessimistic. So post had value.

I must have missed the reference to how "JEWs" impact my investing psychology. Maybe I need to reconsider that. After all I feel quite certain that folk making the real money are are using algorthms based on bigotry and prejudice. Cause after all we know they bank  on ignorance.

Hmmmm, so now I shall experiment by  not making any decision, investment or otherwise, with out first considering the JEW factor. NOT

aka rc 

SWIFT 760's picture

Wtf is "real money" ? 

Im in a business where every godamn jew we come across tries to steal the 

instruments all the while lieing they (the jew) has the money to monetize said

instrument. We (the non-jew) avoid them at all costs. We only trust our due 

diligence with non-jews. 

I have yet to meet an honest jew. 

akarc's picture

The ultimate form of bias confirmation is to reapeat the same lie to yourself over and over again.

"I have yet to meet an honest jew."

If you avoid "Jews" at all costs I would think you have narrowed the opportunity to meet an honest Jew. In fact I wonder how you meet dishonest Jews.

SWIFT 760's picture

The nature of our business inherently attracts jews. Recently, in the past 

6 months, we have engaged with a group who is able to research (due diligence) individuals 

banking histories up to 15 years...account locations, transaction histories, deals closed, etc. 

The ultimate form of truth is repeated actions with same results. We have yet to find a jew 

who can honor their word and hold up their end of the deal. 

CPL's picture

Diligence with non-jews....what?


I do not think you know what the word means in the context that you said it.  If you are going to be a half wit bigot, least you could do is understand the vocabulary you present.



SWIFT 760's picture

I speak from our experiences. On every occasion dealing with jews they have attempted 

to steal the instrument before delivering funds. 

Due diligence is research. We have a very rigorous and exhaustive system of research 

to avoid being ripped off prior to wasting more time with jews. Our deals are high risk 

with high dollar amounts. Every bit of intel (due diligence) is critical. 



Slartebartfast's picture

Isn't it interesting that the artist actually drew Greenspan's nose about 1/3 smaller than it actually is?  And it's still HUGE?

TRN's picture

We are at the EDGE of the precipice.

Floodmaster's picture

Employment-to-population ratio give a lower unemployment rate and some other stupid charts, ageing population change everything.

Smegley Wanxalot's picture

I love the modern era. Why work when true wealth can be neatly created, stacked, and shared with friends at the push of a button in the paper tray of a printer.

Cognitive Dissonance's picture

Paper is so yesterday. Electronic ones and zeros are where it's at dude.

<I can't wait till they start pushing individual atoms around the Ponzi circle jerk.>

Smegley Wanxalot's picture

Atoms, paper, numbers minted on dead fish ...

True wealth, by any other name, smells just as sweet.

Rainman's picture

Even moar simpler : Market discounting mechanisms are way broken. Thank you, Chairsatan. 

Mercury's picture

"Irrational exuberance" was a term Greenspan used to describe a worrisome but completely natural, temporary and self-correcting market phenomenon.

Fed-induced asset inflation is completely artificial, hardly temperate and looking less and less temporary every day.

Kayman's picture

"Rational Exuberance". Hot money created by the Fed and front run by the TBTF. Not a hard concept. If Greenspan could mouth the words, then he ought to have known the punch bowl should have been taken away.

buzzsaw99's picture

It's not exuberance this time, it is called price fixing. Get your fixings.

Cognitive Dissonance's picture

Bill Gross is rapidly losing faith in the Ponzi. Time for his booster shot of hopium stat.

Bicycle Repairman's picture

Gross was part of it all.  If the monster has turned to consume him, so be it.

Cognitive Dissonance's picture

The Ponzi king rules only so long as his court supports him. I have little doubt that many other money managers are beginning to question their religion.

Time for a new Fed King along with the implict mandate to hit the gas and go go go.

Bicycle Repairman's picture

I guess Gross didn't understand that they were actually going to go after real money after j6p was tapped out.  Sorry, Bill.

TideFighter's picture

irrationality index: "6" on a scale of "9". <<LOL>>  How many assholes do I have on this ship?

Thus assuming 7,8,9 come rather quickly, and 10 being thermo-nuclear war.

Oldwood's picture

What does rational mean, and especially a rational market place? While we can define what the market place is, it is still just a lot of individuals pursuing their individual interests, all while believing that they are more rational than everyone else. We might as well be studying behaviors in a nut house.

akarc's picture

Amen. The more I read the more confused I become. The more I study, the more things make no sense. I told my wife I think my brain is broken. She says, "YA THINK!, now can we watch Dancing with the Stars Please?" 

aka rc

Kayman's picture

Think Criminal enterprise and you will see more clearly. All the rest is just words designed to confuse.

Oldwood's picture

We are behaving like our disfunctional government, seeking one more study to verify the obvious. The path is set and we are obsessing over the details of our demise because we have vitually no control over the outcome. But as you can see, while I fully realize my folly, here I am.

Bicycle Repairman's picture

These guys are talking about a world long past.

riphowardkatz's picture

perfect, you kowtow to every gov sponsored global warming nut and social secuirty actuaries but when it comes to the world's biggest bond manager or the federal reserve you throw it all out the second window. 

Bicycle Repairman's picture

Global warming is BS, in case you don't know.

gjp's picture

Searching for irrational exuberance?  Don't have to look too hard.  Look at LinkedIn, up 5% today because some no-name broker raises their already absurd price target saying this could be the next CRM!  Oh, yeah, CRM, the one that hasn't made any real money ever?  Groundhog day Internet bubble never goes away, not with BennyBux on Wall Street.

gjp's picture

Actually make that 7%.  Will check in later when it passes 10%.

tawdzilla's picture

I think what Billy Gross is trying to say is that we are beginning to run out of greater fools to flip high priced assets onto.   

fudge's picture

Declining birth rate ? i thought there was one born every minute ..

blame monsanto


Kayman's picture

" we are beginning to run out of greater fools to flip high priced assets onto. "

We ran out of greater fools 5 years ago when the Fed started buying up toxic TBTF "assets" at par. Now the Fed is buying government debt to the tune of $1 Trillion annually.  30 year debt to pay for SNAP cards.

Since the Fed is effectivelty a GSE (the TBTF shareholders will give back their shares the instant they cannot hold the hot potato) it means the ever shrinking tax base is the greater fool.   

polo007's picture

The Bernanke Reflation

Naturally, the Fed and its most vocal constituencies -- Wall Street and politicians -- see nothing much to worry about. Wall Street sees a reflation as a way to ease its credit problems, as price increases ease debt burdens and perhaps reflate housing values. Congress and the White House see a way to perhaps avoid a near-term recession, which might get them past the election.

As for the Fed, its Governors are dusting off their favorite intellectual justifications. We are told that inflation isn't as bad as it seems because "core inflation" -- which excludes food and energy prices -- isn't rising as fast as the consumer price index. However, food and energy are what most Americans are having to spend ever more of their paycheck to buy. Thus the Bernanke reflation is in part self-refuting even as a short-term recession antidote, because it robs consumers of some of their discretionary income just when the economy needs it.

Meanwhile, even the Phillips Curve is making a comeback. That's the notion -- popular before it was discredited in the 1970s -- that there is a trade-off between inflation and economic growth. In its new version, argued by Fed Governor Frederic Mishkin, the Phillips Curve doesn't exist in the long term but does in the short term. Thus the Fed can afford to open the monetary flood gates now because the slower economy could lead to lower prices later this year. Then when the economy recovers, the Fed can afford to tighten money again.

This is a beguiling intellectual construct, but it puts a great deal of weight on Fed Governors to know when to tighten again. They were supposed to do something similar in 2003-2005, but they were terribly wrong. Then as now they were also dismissing such forward-looking price signals as gold and oil and instead focusing on such misleading indicators as "core inflation" and the money supply. Mr. Mishkin may be seen as a monetary wizard at the Fed, but to investors around the world he is beginning to look more like a high-class inflationist.

The people who aren't being fooled by all this are the American people. They don't pay their bills with "core" dollar bills, and they know those dollars buy less with each passing month. This explains their rising economic anxiety -- and anger -- better than trade or job losses do, especially since the job market has remained relatively healthy. Inflation is the great thief of the middle class, as even Americans who don't recall the 1970s are learning. With its all-in reflation bet, the Bernanke Fed is gambling with their money.

Clowns on Acid's picture

Sounds like Gross has thrown in the towel. Gross admits to himself that the Fed has been able to hold "everything" together by printing and "intervening' in all markets. The Int'l CBs have long killed off any bond viglantes or Equity Index shorts.

Large fund managers can only go along with the insanity at the moment. They now acknowledge that the Fed will print to infinity and has the support of all CBs (China?). Who is going to fight that and stay alive?

Bernanke and his jackals are taking Int'l markets places that they have never been before. But as a fund manager what are you gonna do?

Just keep listening to the Fed channel on TV (CNBC) and do what they tell you. 'Cause if you don't, they will sedn Maxine Waters after you. Then what are you gonna do?

Bill Shockley's picture

Not many comments on this article which isn't a surprise given the truth of it.


The lie....


Asset Backed commercial Paper isn't backed by assets.

It's backed by Ben's digital bucks.


Good luck with that.