Few investors are as well-respected as PIMCO's Bill Gross. The stellar returns of PIMCO Total Return Fund flow in part from Gross' ability to anticipate and profit from changes within the bond market. Fortunately, it's not only PIMCO investors who can benefit from Gross' insights. In his monthly market commentaries-available in the Bond Center of PIMCO's Web site (www.pimcofunds.com) or in MorningstarAdvisor.com's Due Diligence Center-he lays out his views for prospective bond and stock returns.
Gross hasn't been bullish on the U.S. economy or on stock prices for years, so it isn't surprising he isn't positive now. "I know that since September 11th, the financial environment has become increasingly risky," he writes in his October letter. "That must be so, if only because this war is being fought partially on American soil."
Unlike some bolder commentators, Gross isn't ready yet to predict a recovery. "In an environment of increasing economic/financial risk, PIMCO's stance will focus first on protection of principal and secondarily on increasing return. Granted, it has never paid to bet against America, but the current war introduces new variables that will likely change asset relationships for years to come."
Perhaps the most interesting part of Gross' current market forecast is that it's substantially the same as the one he espoused in June at the Morningstar Investment Conference. At that gathering, many managers were optimistic that the markets would rebound within a year or two. Gross was one of the few to strike a more somber note, warning that we could be in for an extended period of diminished expectations.
What follows are excerpts from his speech.
A More Subdued Economy
"We're moving into an age of what I call diminished expectations. The days of the 10% to 20% returns and expected returns are over. We're moving into a more subdued economy, where economic growth is not 4% or 5%, but will remain close to 2% once we move out of our current slowdown/recession.
"Why do I say that? Let me cite just a brief history of how we got to this point in terms of the global economy. For the past 10 years, we have been a global economy that has focused on two extraordinary occurrences. One, the process of globalization as borders have come down, NAFTA being an excellent example. Two, the belief that new technology would produce economic growth, corporate-profit growth and total returns at levels far and above what we'd experienced over prior decades.
"That was the New Age economy. The problem was that, like all good capitalistic economies and societies throughout time, it went to excess. That's what capitalists do. They either get too depressed or too exuberant, and they overdo the situation and produce bubbles in various forms and various fashions. I think most of us would agree that we've had a bubble in the Nasdaq. We've had a bubble in terms of consumption, as we drove savings rates down from 7% and 6% to minus 1%, where they stand today. And we've had a bubble in terms of the dollar, as almost all of the world's investment has come into the United States to fund our trade deficit at 4% of GDP.
"And now we're in the process of deflating these bubbles. Not necessarily popping them but deflating them, bringing them back down to more rational levels. For instance, the consumption bubble, which drove down the savings rate from a 6% historical level down to a negative 1%. At some point, the savings rate has to move back into positive territory.
"We dis-saved because we were able to sell 100 shares of Cisco at $75 a share to pay for that second car or the second home or simply the vacation that we wanted to take. We no longer can sell 100 shares of Cisco at $75. In fact, we now have to sell four times or five times as many shares to get the same amount. The inability to continue to dis-save through the wealth effect suggests that Americans at some point have to begin saving again.
"And as we begin to save again, to actually put money in the bank as opposed to selling shares of Cisco, then the economy moves down in terms of its growth rate. Instead of a 4% or 5% growth rate, we now have a 2% or 3% growth rate.
Probable Expected Returns
"Now what does that mean for the markets, for bonds and for stocks going forward? In the bond market, what you see is pretty much what you get. For instance, in 1981, when we had 14.5% long bonds, over a 30-year period an investor was going to get 14.5% on a simple interest basis. And now, 20 years later, that 30-year bond is a 10-year bond, and it's priced at about 130, which implies about a 1.5% annual total return on top of that 14.5%. So long bonds have returned about 16% over a 20-year period of time, but most of it was given to you right at the start.
"What does that mean? It means that with the long bond at about 5.5%, that's about what you're going to get. That's certainly diminished expectations, if I've ever seen them. That's certainly much less than what you've gotten used to in terms of the bond market and in terms of PIMCO Total Return. Our products have provided 10% plus returns over a longer period of time. Those are gone.
"What does that mean for stocks going forward? To me, 5% bonds sort of indicate the territory where the stock market will wind up. Was it a coincidence that when bonds were returning 14.5% in 1981, that stocks went on to provide returns of 18% to 20% over that same period of time? Not really. Bonds were the setup.
"If we're in a period of diminished expectations, I would suggest that you pay attention to your structures and keep your fees as low as possible in a 5% world. Yes, hire a four-star or a five-star Morningstar portfolio manager, but don't spend what you don't have.
"The structure of investing is not well-advertised. But structure actually is the foundation of investing. Let me give you an example that we all know about, Warren Buffett. Most of us know about Buffett's philosophy, how he focuses on franchise value and likes to buy cheaply. But that's Buffett's philosophy. That's the second part of investing. Buffett's structure is quite brilliant, one that that he talks about but doesn't really advertise.
"His structure started when he bought insurance companies, which provide the benefit of utilizing reserves that are basically interest-free. When Buffett bought Geico and General Re, he was buying a structure-the ability to borrow at a 0% interest rate and to employ those funds within the cocoon of an insurance company. When you combine Buffett's brilliant philosophy with his brilliant structure, it's no wonder that the man has his billions.
"Similarly, PIMCO has a structure. The ability of PIMCO to outperform the market comes in part from philosophy, but in part from structure as well. My structure, to a certain extent, includes the willingness and the ability to sell liquidity and short-term volatility and bring that to the bottom line. We have a structure in place at PIMCO that I believe imparts a good 30 to 40 basis points a year of the 100 to 150 basis points that we bank on and promise clients.
"Perhaps the most important structural decision that an individual can make or that an advisor can make for a client has to do with the structure of fees. Fees are just as important as those five or four stars that Morningstar puts at the top of their page.
"In this day and age, in which returns are less than double digits, those 1% fees make a whale of a difference in terms of the realized returns going forward. Think about it. When you sell a house, you pay a 6% commission. If, on average, the American homeowner has a 40% equity position within the home, that 6% commission is 15% of the housing net worth of that individual, and in many cases, of the entire net worth of that individual.
"The same example holds with fees for investment products. If, going forward, bonds and stocks are able to return 5% a year, then a 1% fee to a manager is 20% of the return going forward. That's staggering."
Olivia Barbee, CFA, is the editor of MorningstarAdvisor.com.