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Bill Gross On Dead Cats And "Flattering" Bull Markets

Tyler Durden's picture




 

Bill Gross lost "Bob" this week. The death of his cat sparked some longer-term reflection on the hubris of risk-takers, the mirage of magnificent performance, and the ongoing debate in bond markets - extend duration (increase interest rate risk) or reduce quality (increase credit risk). As the PIMCO boss explains, a Bull Market almost guarantees good looking Sharpe ratios and makes risk takers compared to their indices (or Treasury Bills) look good as well. The lesson to be learned from this longer-term history is that risk was rewarded even when volatility or sleepless nights were factored into the equation. But that was then, and now is now.

 

Via PIMCO's Bill Gross,

Bob

There is a tragic end to all living things: They stop living. Our Maine Coon “Kitty” of 14 years stopped living last week. Her name was “Bob” and one of the sweetest animals that anyone could have had. I don’t think she minded having a boy’s name, at least she never mentioned it. We brought her home one afternoon after visiting our 3rd cat show in as many months and asked the inevitable question – what shall we name her? Struggling for an appropriate label for a brown and black cat that to be honest looked more like a dog, and having just seen the Richard Dreyfuss and Bill Murray comedy of the same name the night before, I said “What about Bob?” We all laughed, but it stuck. She was Bob.

 

Aside from sleeping, Bob loved nothing more than to follow me from room to room making sure I was OK. It got to be a little much at times, especially when entering and exiting the shower. I’m not a particularly shy guy, but then why was a female cat named Bob checking me out all the time? Her obsession carried over to the TV, sensing when I was on CNBC and paying apt attention no less. I often asked her about her recommendations for pet food stocks, and she frequently responded – one meow for “no,” two meows for a “you bet.” She was less certain about interest rates, but then it never hurt to ask.

 

But before Bob, there were a number of loving pets in the Gross household. Most of you have had some as well; loved, and then lost them. For the Grosses there was Honey the golden retriever of all time, or at least the 20th century champion. She roamed the neighborhood in the more relaxed 1980s, bringing home stale loaves of bread like they were floating ducks on a pond. It wasn’t the bread so much (although it was that), as it was the praise for a good “find” and a pat on the head. Honey also loved rocks, some so big that it seemed her jaws would crack from the weight. Retrievers love retrieving, even if they’re loaves of bread or rocks. And then there was Wiggles and Daisy and Budgie – lovable pets every one of them and perhaps just as importantly – pets that loved us. I know you’ve had some too. So here’s to them and here’s to Bob. We buried her ashes in the backyard. Her gravestone reads just – “Bob”. What a girl, what a kitty girl that Bob.

Stanford’s Professor Emeritus William Sharpe was one of the originators of the capital asset pricing model, a class I took on the way out the door at UCLA’s Anderson School of Management and barely passed. A “C-” in business school is really an “F.” Guess I flunked it. He had another idea later known as the “Sharpe ratio” or, as amended, the “information ratio.” His logic said that higher returns from riskier assets such as stocks or high yield bonds must in some way be measured against their up and down volatility, and his ratio tries to do that for entire asset classes measured against Treasury Bills as well as individual portfolios measured against various indices. The higher the Sharpe ratio the better in general, and a ratio of .5 was generally considered an acceptable measure of an asset’s expected return vs. Treasury Bills or a manager’s ability to outperform an index over time via the “information ratio” hybrid.

 
Chart 1, courtesy of an exhaustive study by CreditSights, shows Sharpe ratios for various asset classes over the past 15 years. All assets shown in the chart exhibited positive Sharpe ratios. In a sense this is just a history lesson. The chart says that even when volatility (risk as commonly accepted) is accounted for, when those sleepless nights during 2000’s dotcoms or the panic of 2009 is factored into the wrinkles on your aging face, that you were better off holding anything but cash. Well yes, such is the long-term history of capital markets as we know them. “Assets for the long run” would make for a thin but rather informative book. Write one!

But on one of those thin pages the prospective author should introduce the caveat that the past 15 or even 30 years have been a rather remarkably short and non-volatile period of time, and future Sharpe ratios or other measures of risk/return may not exceed Treasury Bills in the same amount as before. A rather familiar graph of 10-year Treasury yields as shown in Chart 2 would hint at this. What I hope the reader will note is not only the dramatic decline in yields since the early 1990’s but the relative linear (non-volatile) path that they followed. Granted, for other asset classes such as stocks, there was 1987 and the aforementioned dotcoms and subprimes, but the linear path is clear: higher asset prices over long periods of time generated in part by the steady decline of 10-year Treasury yields to a 2012 bottom of 1.39%. A Bull Market almost guarantees good looking Sharpe ratios and makes risk takers compared to their indices (or Treasury Bills) look good as well. The lesson to be learned from this longer-term history is that risk was rewarded even when volatility or sleepless nights were factored into the equation. But that was then, and now is now.

 
So wait! There comes a point where prospective returns relative to risk don’t ensure such optimistic outcomes. While there’s always an element of subjectivity to all predictions – future profit margins, forward Shiller P/E’s?, normalized real interest rates, geopolitical rest/unrest, etc. – there should be at least some objectivity and common sense. Chart 3, provided by CreditSights as well (good firm), provides a basis for that common sense. In the bond market, there is a measure of risk/return known as “yield per unit of duration.” Duration is a standard measure of price risk relative to interest rate changes – the lower duration the less the price change (generally). But shorter duration (maturity) bonds usually have lower yields!
 
 
This doesn’t seem to be very helpful for a bond investor at first blush. It implies that if you want more return than a Treasury Bill and a positive Sharpe ratio, then extend your duration. Yet “how much to extend?” would be an active manager’s question. Chart 3 provides some perspective although as noted, no positive conclusions, other than today is different than the past 15 years!
 

What Chart 3 implies is that today’s reward relative to risk – yield per unit of duration is more or less half of what it has been for the past 15–20 years. In order to get the same yield today for a single unit of duration for AAA, BBB, and HY bonds, an investor has to take twice the price risk! Since duration and correlated maturities are simply measures of interest rate risk, that may simply be pointing out that yields are historically low, and yes – they still are. But in order to capture other elements of return such as credit, curve, volatility and currency, the average bond investor must generally attach those elements of “carry” to a bond with a duration. Swaps, CDS, and FRN’s provide a partial escape but for the cash investor, today’s yield per unit of duration is only half of the markets’ 15–20 year historical measure, and that is very, very low dear reader.

How to confront this? There are at least two ways at the extreme, I suppose. Either double your position – double your duration – and maintain the same yield as historically noted or maintain or even lower your duration as a concession to an overpriced market that may continue to suffer increasing yields and lower prices. Do you want to “double up to catch up” as Vegas blackjack dealers used to encourage me, or are you willing to suffer the lower yields, wait for “mean reversion” as do some of our competitors, and hope that the client cash outflows don’t cash you out before you have a chance to play another game? Future Sharpe ratios and investment management firms hang in the balance.

Well, as Bill Sharpe’s contemporary Harry Markowitz? pointed out long ago, investing is a process of compromises involving diversification, and many times the compromise provides a return relative to risk that is more “efficient” than any other. If a portfolio were to seek a high Sharpe ratio using a Markowitz efficient portfolio, what might it look like today?

PIMCO recommends overweighting credit and to a lesser extent volatility and curve. Underweight duration. Although credit spreads are tight, they are not as compressed as interest rates, which are now in the process of normalization. While PIMCO agrees with Janet Yellen that such normalization will be a long time coming (the 12th of Never?), probabilities suggest that as the Fed completes its Taper, the 5–30 year bonds that it has been buying will have to be sold at higher yields to entice the private sector back in. The 1–5 year portion of the curve, beaten up recently due to Fed “blue dot” forecasts and Yellen’s “six months after” comments, should hold current levels if inflation stays low, but 5–30 year maturities are at risk. Overall, because 2014 should be a relatively positive growth environment, carry trades in credit, curve and volatility should produce attractive Sharpe/information ratios. Return expectations however, for all unlevered assets and Markowitz generated portfolios will be in the low- to mid-single digits.

And what would Bob have meowed? Well, like I wrote, she was always more certain about pet food stocks, but then maybe kitty heaven has given her some additional insight. I shall have to ask her in my dreams. Sometimes dreams come true you know.

“Bob” Speed Read

1) High Sharpe ratios have been due to a long-term bull market. They will be lower in future years, as will asset returns.

2) Yields per unit of duration are historically low – half of their 15–20 year averages as shown by CreditSights.

3) Favor credit spreads and to a lesser extent, curve and volatility carry trades.

4) Treasure your pets and all living things. Eventually we all stop living.

 

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Thu, 04/03/2014 - 12:09 | 4621424 PartysOver
PartysOver's picture

How's the biatch slap fight been with El Erian.  Haven't heard much lately.

Thu, 04/03/2014 - 12:16 | 4621442 whatsinaname
whatsinaname's picture

Is Bill Gross losing his mind ? 

Thu, 04/03/2014 - 12:32 | 4621473 BandGap
BandGap's picture

No, I think he's finding out there is more to his mind than working the bond market.

This is either scary or fascinating. I think he has some vision as to what the future holds and is talking about what he believes is the most important thing about being here - life.

Slow train running off a very high bridge. Values change.

 

Thu, 04/03/2014 - 12:37 | 4621488 maskone909
maskone909's picture

oh billy

 

why cant you just shut up and collect your bonus.  your ruining it for all your pals!  im on my way to home depot now.  they have a sale on ingersol rand nail guns.

your friend,

 

MR Yellen.

Thu, 04/03/2014 - 13:09 | 4621588 Mrmojorisin515
Mrmojorisin515's picture

+1

 

I agree.  I think Mr. Gross had a revelation that what he does isn't really that special and that he himself isn't that special.  By having this, it proves to me that he is an actual human.  Not like some of the others that continue to think of themselves as doing "gods work".  Bravo Mr. Gross, even if you are more then set for the rest of your life.

Thu, 04/03/2014 - 12:22 | 4621444 Fredo Corleone
Fredo Corleone's picture

$15.5 billion in outflows from PIMCO funds in Q1 '14.

Gross has little to say of merit, these days. A number of shareholders apparently agree.

Thu, 04/03/2014 - 12:34 | 4621477 BandGap
BandGap's picture

Maybe it's something else, like actually buying something before the shitstorm hits.

Thu, 04/03/2014 - 12:14 | 4621434 PlusTic
PlusTic's picture

Talking about Sharpe Ratios in markets with non-normal return distributions (all of them are) is kinda like talking about competence and Obama...they just don't go together!

Thu, 04/03/2014 - 12:16 | 4621439 FieldingMellish
FieldingMellish's picture

"Yields per unit of duration are historically low" ... and they will be lower still in the near future. Cannot finance $17T with rising rates and into a declining economy. No way, Jose (or Bob).

Thu, 04/03/2014 - 12:53 | 4621541 Pool Shark
Pool Shark's picture

 

 

I think this is where Bill might be wrong. He hopes to withstand the outflows and take advantage of better prices later, but I suspect we haven't seen the lows in yields just yet...

 

Thu, 04/03/2014 - 13:12 | 4621604 knukles
knukles's picture

Yet...

"It's just not weird enough, yet."
    -The Good Doctor, HST

Thu, 04/03/2014 - 12:22 | 4621452 Gandalf6900
Gandalf6900's picture

Nuts!...

Thu, 04/03/2014 - 12:42 | 4621500 Cacete de Ouro
Cacete de Ouro's picture

Who gives a fuck about his cat, what about his returns? This is fuckin' ridiculous, what passes for investment advice

Thu, 04/03/2014 - 12:45 | 4621509 PlusTic
PlusTic's picture

His whole career was one big bond bull mkt...hard to find much alpha in there...they did a genius job at marketing themselves tho

Thu, 04/03/2014 - 12:49 | 4621523 Yancey Ward
Yancey Ward's picture

I propose that PTTRX may have to fall to $100 billion of assets under management before the stock market tops out.  The game being played here is get as many people into stocks before turning out the lights.

Thu, 04/03/2014 - 12:57 | 4621548 Pool Shark
Pool Shark's picture

 

 

Then, after the crash, all that panicked money will flow back into bonds.

This is how the fed will get away with tapering.

Zirp: "To Infinity and Beyond!"

 

 

Thu, 04/03/2014 - 13:52 | 4621791 elwind45
elwind45's picture

Can I have a second red pill for later

Thu, 04/03/2014 - 13:17 | 4621626 Squid Viscous
Squid Viscous's picture

All these momo stocks getting demolished... what will Cramer say tonight? 

 Let me guess-  he will have the same shit eating grin, and talk about his vast knowledge of oil/gas E&P's and consumer staples, like you should have been in them all along... 

Thu, 04/03/2014 - 13:42 | 4621745 disabledvet
disabledvet's picture

105 million for a house in Los Angeles.

I saw no mention of that here for some reason.
It wasn't next to your place Bill?

Just imagining the commission on that sale is something.

Thu, 04/03/2014 - 14:14 | 4621917 CHX
CHX's picture

Bonds are dead men/cats (you choose) walking, IMHO. Good luck Billy, you'll need it.

Thu, 04/03/2014 - 14:20 | 4621947 perelmanfan
perelmanfan's picture

It's code. Yesterday was the dead cat bounce. Got it.

Thu, 04/03/2014 - 14:21 | 4621956 Black Warrior W...
Black Warrior Waterdog's picture

At least Bill still has his hair.

Thu, 04/03/2014 - 20:59 | 4623507 BillGrossJr.
BillGrossJr.'s picture

I'm like, soooo allergic to cats, and Bob made me sneeze big time, and he bit Mr. Crescenzi at my birthday party. Check out our new Canada Index ETF at www.canada.pimco.com

Thu, 04/03/2014 - 21:05 | 4623520 Dutch
Dutch's picture

I was going to go all "TMI" about Bob the cat, but maybe Bill shares more easily with the rest of us through his writings, than he does with the people at work. I'm with BandGap, this is kind of fascinating.

I will say that I would much rather hear about Bill's personal loss than Warren's "little ole me, master of the universe" schtick, which got old a long time ago. And the time we get with those little four legged creatures is very special, r.i.p. Bob. After a reasonable amount of time, Bill, go to the shelter, there are so many little ones that need good homes. Win-win for you, your family, and the adoptee, too.

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