Posts Tagged ‘PIMCO’

Bill Gross, Investment Outlook, December 2008

Wednesday, December 3rd, 2008

In his latest Investment Outlook, Bill Gross, head honcho at PIMCO, discusses the advent of transitioning from the levering world of pre-2008 into the delevering world we now find ourselves in. He points out that in the “new” world we should no longer apply the measures of the past for concluding that stocks are cheap, and that it is a transgenerational idea we need to retool for.

Q ratio

Stock Price Deflation

Gross points out the “Q” ratio and Robert Shiller’s 10 year average P/E ratio (above) as evidence that stocks are arguably cheap, but goes on to discredit the reliability of these indicators, saying:

“Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:

  1. Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios - the ability of companies to make money by making paper - are coming down, not going up. In addition, the availability of cheap financing - absent government’s checkbook - will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.
  2. Globalization’s salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU’s approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America’s capitalistic model.
  3. Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.
  4. The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to - that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

In a recent article we noted that the trailing P/E ratio of the S&P500 had ticked up in the year-to-date to November 10, 2008, while the overwhelming majority of global equity markets had experienced substantial P/E compression. This suggested that the E (for earnings) had declined as much as P (for price)in the S&P500. Is the S&P500 due for P/E compression?

You may read the Bill Gross’ Investment Outlook newsletter in its entirety here.

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McCulley: The Paradox of Deleveraging will be Broken

Monday, November 24th, 2008

Paul McCulley, Managing Director and Portfolio Manager, PIMCO, earlier this year wrote a landmark discussion piece titled, “The Paradox of Deleveraging,” in which he postulated that the deleveraging of the credit market would have a profoundly negative impact that only a government sponsored plan could subdue, as no other party could be big enough to slay the affliction of credit abuse in the housing, investment and banking industries. Here is the follow up:

I’ve only written this essay once since the Kansas City Fed’s annual symposium in late August.1 But it hasn’t been because I’ve been lazy. Rather, I’ve been working virtually around the clock ever since, in my day job as head of PIMCO’s Money Market and Funding Desk. On Wall Street, this desk is frequently viewed as a backwater, a temporary home for new MBAs getting their feet wet before moving on to higher-value-added desks, or a retirement home for those with more senior moments than fresh ideas.

That’s never the case here at PIMCO, even though a number of now PIMCO partners spent their first days trafficking in the money markets and I, of ever-graying hair, still make my home here in the early hours of the day. Money markets frequently are a backwater, except when they are not, in which case they are cascading rapids. Liquidity pressures inevitably are the precursor of solvency and/or going-concern problems. Just ask Wall Street’s independent investment banks.

We here at PIMCO have always known this. Accordingly, we’ve always been conservative beyond conservative in our money market operations, on both sides of the balance sheet - no asset-backed commercial paper (ABCP) for us, and no tri-party repo without regard to collateral types or haircuts either. Meat and potatoes only, no fancy garnishes necessary. But the meat and potatoes must be cooked properly.

Hence, the work load of PIMCO’s money market and funding desk. My new deputy, Jerome Schneider, hit the ground running in early August, a most propitious time, just before the global money markets became not just cascading rapids, but roaring waterfalls. The financial world will never be the same after the U.S. Treasury and Federal Reserve’s fateful decision of the weekend of September 13-14 to stand aside as Lehman Brothers plummeted to death on the rocks below.

Whether that decision was the right one or not, we will never know. Yes, I know that many are quick to take the Treasury and the Federal Reserve to task, maintaining that the on-going global financial crisis - and, thus, growth crisis - would not be nearly so severe if Lehman had been tossed a life line. I simply don’t know. What I do know is that the global financial system was fundamentally broken long before Lehman’s watery death.

Thus, I believe the powerful, systemic policy responses that have unfolded in the post-Lehman world were destined to come about. Lehman was but the unfortunate tipping point. My heart still aches for the pain suffered by my many friends there. Fate is not always fair and at times, is arbitrary and capricious.

But what ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern.

To understand the nature of this systemic malady, we need to return to first principles. Bear with me, please; this is going to be a bit academic. But, I submit, it was the loss of understanding of first principles that lies at the heart of the on-going paradox of deleveraging, which is the proximate cause of the on-going downward spiral of asset and debt deflation.

The Nature of Banking
When I studied the origins of banking in college, we started with the Medici Family of 15th century Italy. I’m quite sure banking existed long before then, just that I haven’t studied it. But regardless of the origins of banking, its founding premise has always been the same: In normal times, the public’s collective, ex ante demand for access to at-par, immediately-available bank money is always greater than the sum of the public’s individual, ex post demand for access to such liquidity.

Thus, the genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund - with the possible exception of a money market fund - could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity, as so elegantly described by John Maynard Keynes:

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment.

For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money.”2

Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”

*
Liquidity on demand at par for their depositors, because of the safety net underwritten by the sovereign, yet
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The ability to invest in longer-dated, more risky, not-always-at-par loans and securities, because the existence and credibility of the public safety net systemically renders the public’s ex post demand for liquidity at par below the public’s ex ante demand.

Yes, banking with a sovereign safety net against deposit runs is a really cool business. Indeed, the difference between the public’s ex post and ex ante demand for at-par liquidity could be called the banking system’s “float,” similar to that of a Buffet-style insurance company.

But since it’s a really cool business and since the sovereign providing the liquidity safety net is a de facto equity partner in the business, the sovereign quite rationally wants a say in how the business is run - the degree of leverage, corporate governance, risk management controls, etc. Kinda like I do when I pay the insurance premium on my 19-year old son’s car. Jonnie doesn’t like it, and neither do bankers. Or would-be bankers.

Thus, both bankers and would-be bankers have, from time immemorial, sought to get the benefits of the sovereign’s liquidity safety net without shouldering the associated regulator nuisance. And I’m sure that 19-year old sons and daughters, too, have been doing the same for just as long.

Over the last three decades or so, the growth of “banking” outside formal, sovereign-regulated banking, has exploded, in something that I dubbed the Shadow Banking System.3 Loosely defined, a Shadow Bank is a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits. These liabilities could be shares of money market mutual funds; or the commercial paper of Finance Companies, Conduits and Structured Investment Vehicles; or the repo borrowings of stand-alone Investment Banks and Hedge Funds; or the senior tranches of Collateralized Debt Obligations; or a host of other similar funding instruments.

The bottom line is simple: Shadow Banks use funding instruments that are not just as good as old-fashioned sovereign-protected deposits. But it was a great gig so long as the public bought the notion that such funding instruments were “just as good” as bank deposits - more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in Shadow Banks than conventional banks.

And why did the public buy such instruments as though they were “just as good” as bank deposits? There are a host of reasons, not the least of which was lust for yield. But most fundamentally, Keynes again gives us the systemic answer (his italics, not mine):

“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention - though it does not, of course, work out quite so simply - lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuations which are in no way relevant to the prospective yield. Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organized investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

Thus investment becomes reasonably “safe” for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are “fixed” for the community are thus made “liquid” for the individual.

It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.”4

And so, Keynes provides the essential - and existential - answer as to why the Shadow Banking System became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time it held: Shadow Bank liabilities were viewed as “just as good” as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies.

Until, of course, convention was turned on its head, starting with a run on the ABCP market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie and Freddie in July, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a Shadow Bank!

And indeed that is unambiguously the case, as evidenced by the on-going partial re-intermediation of the Shadow Banking System back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining Shadow Banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.

The new conventional wisdom: levered capitalism is good, and made even better with a bit of socialism to protect the downside.

Well Maybe
I’m quite sure that last sentence is not going to sit well with some of you. It’s not supposed to sit well. It doesn’t sit well with me, I must acknowledge, nay confess. Like most of us, I’ve always had a separation in my mind between strictly capitalist activities and strictly public activities. Not that the demarcation is always clean. But it’s a useful way of thinking.

As far as I know, the place where I buy my fishing tackle is a capitalist outfit. If we customers don’t buy enough rods and reels, the owner will go broke; his operation is simply not systemically important enough to be bailed out by the taxpayers, including my neighbors who don’t fish. In contrast, the local Department of Motor Vehicles, sometimes called the DMV, is unambiguously not a capitalist outfit, but a public outfit. It cannot go broke, as evidenced by our tolerance of its fluctuating service level, because it provides a public service that the private sector can’t provide. To be sure, AAA can get you new plates for your car, but you can’t renew your driver’s license at the AAA; for that, you have got to go to the monopoly called the DMV.

Well actually, that’s not entirely true, either. The DMV is actually an oligopoly, with offices in many surrounding neighborhoods. And rumor has it here that the service is a lot quicker at the San Clemente office than the Costa Mesa office, which serves Newport Beach. So the consumer does have the choice of driving to San Clemente, a form of time arbitrage versus going to the Costa Mesa office. However, rumor also has it that this rumored better service in San Clemente is so widespread that, as Yogi Berra might say, the San Clemente office has become so popular nobody goes there anymore.

But you get the point: there is private enterprise and there is public enterprise. And then there is banking, a hybrid of the two. There is no way ‘round this, for good or bad, because fractional reserve banking depends upon the sovereign’s safety net against liability runs, a safety net that the private sector definitionally can’t universally supply. In this sense, the safety net is like national defense: we all need it, but since nobody individually has the incentive to pay for it, we collectively tax ourselves to pay for it.

Yes, sometimes we collectively end up paying $800 for military toilet seats, as was the case about 25 years ago. But that doesn’t change the proposition that public goods do exist, and a stable system of intermediation of private savings into private investment is indeed a public good. The maturity transformation power of a fractional reserve banking system provides an unambiguous benefit to society and as such, must be underwritten by society.

Bottom Line
I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey.5 But I don’t need to do that any more: we’ve collectively lived it and are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.”6 Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it “creeping socialism” and was interrupted by an irate, older man in the back of the room bellowing, “It ain’t creeping socialism, it’s galloping socialism!” I really didn’t have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn’t lost on me or anybody else in the room.

And it is not lost on Washington, DC either, I can assure you. If the sovereign must backstop a private sector activity that produces a public good, then the sovereign will, at least in a democracy, rightfully demand both bottom-up and macro-prudential rules to harness the greed that lubricates the invisible hand of capitalism. Yes, the visible fist of government and the invisible hand are presently engaged in a massive arm wrestling contest in the provision of financial services. And the fist is winning.

At least for now. Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I’m sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that’s okay, I think. In the end, we really don’t want to turn our banking system into the DMV. At the same time, we also don’t want our banking system to be nothing more than a betting parlor.

Or, in the famous words of Keynes again:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Paul A. McCulley
Managing Director
November 13, 2008

You can download a complete PDF here.


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New Audio Resource at GreenLightAdvisor.com

Saturday, November 8th, 2008

Top of this webpage

Now you can listen to the Investment Outlook and Commentary from Bill Gross (PIMCO), Vanguard Funds’ Portfolio Managers, and others on GreenLightAdvisor.com’s Audio Resources page.

This month, Bill Gross presents his latest investment outlook, Kenneth Volpert from Vanguard discusses the Credit Crisis, and Dominic Frisby, from MoneyWeek interviews Hugh Hendry of Eclectica Asset Management.

Enjoy!

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Audio Resources

Thursday, November 6th, 2008

PIMCO



Vanguard


Doninic FrisbyCommodity Watch Radio Hosted by Dominic Frisby, MoneyWeek



FT.com Logo View From the Markets


Audio blog of Doug Tengdin, CIO, Charter Trust Co.


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Is There a Bull Market Somewhere?

Wednesday, September 24th, 2008

Bill Gross, PIMCONot likely, according to PIMCO’s Bill Gross. In his most recent Investment Outlook, Gross, reasons and opposes (for now) the idea that in the very different worlds of Louis Rukeyser, Jim Cramer, and Jim Grant, “There’s always a bull market somewhere!”

While he does agree that there are always stocks, bonds, and currencies that can be found to be going up, while markets are going down, Gross cautions:

So the lesson must be to go forth and find the bull market, wherever it is. Almost always – but NOT NOW, because in a global financial marketplace in the process of delevering, assets that go up in price are rare diamonds as opposed to grains of sand. For the past several months our PIMCO Investment Committee blackboard has continued to display the following lesson plan:

What Happens During Delevering

  1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
  2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
  3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.

Essentially, Gross’ thesis is that as the GSEs, banks, investment banks and global hedge funds delever their balance sheets, they also lower the prices of all securities that can be arbitraged within the marketplace. 

The 10% year over year decline in prices has not been witnessed since the great depression, and that is a red flag.

a 10% aggregate asset price decline does more than make us all 10% less wealthy. Because many of these assets are leveraged and margined, the more they decline, the more frequent and frenzied the margin calls, and if the additional cash flow is not provided, not only an asset liquidation but a debt liquidation follows. It is the debt liquidation that potentially turns a stagnant/recessionary economy into something much worse.

Where has my bull market gone?

This rare event of systematic debt liquidation is the central issue in both the US and globally. If central bankers are unable to take effective measures, the campfire could turn into a forest fire, and a mild asset bear market could turn into a destructive financial tsunami. Gross points out that even they and their SWF and central bank counterparts who have been doing their part to stem the tide, and in some cases bought into debt issues too early, only to see those issues now priced “underwater,” are now reluctant to make additional commitments.

Paulson and Bernanke have consulted PIMCO regularly throughout the credit market debacle, and have apparently acted on some of that advice as well as that of others like Pershing Square’s Bill Ackman, who floated a Frannie bailout plan prior to the Fed’s that was eerily similar.

Paul McCulley stated in late July, that the only thing that was viable given the delevering of the market that was well underway, was for government to lever up its balance sheet, much the way it is proposing to this week, with the $700-billion TARP plan.

Gross too, re-iterates and lobbies for this in his newsletter most recently published newsletter:

common sense can lead to no other conclusion: if we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions.

Gross concludes:

Now that the Fed has spent 12 months proving that it “knows something…knows something,” it is time for the Treasury to do likewise.

(note: these ideas were published well before the Fed/Treasury realized the need for a far reaching solution)

Is there a bull market somewhere?

There is, but those assets are “rare as diamonds, as opposed to grains of sand,” according to Bill Gross.

Investment Outlook, Bill Gross, September 2008

Source: PIMCO

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Credit Crisis Observations

Tuesday, September 23rd, 2008

Niels Jensen and Jan Wilhelmsen of Absolute Return Partners (www.arpllp.com) produced an informative analysis of the credit crisis and provide the following observations. Here is our summary:

Loans and Mortgages are getting much harder to come by on average, globally.

This has bold and negative implications for property prices everywhere.

Observation # 1

It all began with housing and it will end with housing.

The current overhang caused by the tightness of credit (mortgages) will take years not months to unwind and housing prices will not begin to rise again until this occurs.

Observation# 2

Don’t trust central banks to always do the right thing.

Evidence suggests that while their intent seems to be genuine, central banks around the world have not been very effective at taming inflation. For example, simply raising interest rates in the underlevered economies of the BRIC countries has been futile, since most consumers and companies do not employ credit to the extent that those of us in the west do.

In the case of the BRIC countries, it appears the problem does not consist of sustaining growth, but rather containing growth. China, for instance, has a record of under-reporting both real and nominal GDP growth, and may have only recently more accurately stated inflation owing to the fact that they could not hide from skyrocketing oil and food prices.

Observation # 3

Policy mistakes are likely to be repeated.

The US is currently at risk of making the same policy making mistakes Japan made 10-15 years ago. US residential property prices have risen more during 2000-2006 boom than did the Japanese during the late 80s boom.

Japan too, though more rapidly, reduced the cost of money dramatically to fend off its crisis.

Japan bailed out many of its institutions and used taxpayers money to fund the activity of fixing the ‘unfixable,’ and this could have profound implications for the US GDP growth in years to come.

Observation # 4

The golden era of investment banks is over.

The biggest independent investment banks have just become banks. The US investment banking business is becoming more like Canada’s where the business is dominated by the large schedule “A” chartered banks and America’s “free” market just became a little more socialist. How ironic…The folding of GS and MS into banks also has valuation considerations for the venerated firms as their revenues and earnings are sure to decline under the auspices of Fed regulation. Further de-levering also has negative implications for the market as it entails more liquidation. Hopefully this will be done in an orderly fashion now that the conversion is underway.

Observation # 5

The final shoe hasn’t dropped yet.

There is more to come. For instance, the financial system has yet to deal with $1-trillion in Alt-A securities and further degradation of the CDS market and counter-party risks.

Absolute Return Partners states that the commodity bull is just the final leg of the liquidity super-cycle: take a look the Economist’s VAR-VAR-Voom chart.

Observation # 6

Leverage is ‘dead’ but capital is not.

Global savings rates now exceed 20%, except in the US, and while this is a positive for global stability, the question remains about whether investors are willing to invest money where it is most needed, the shore up the world’s banks. Failing that, property prices will need to stabilize before we can expect better times.

Observation # 7

The end of the crisis looks further away than it did a year ago.

Its complicated, very complicated.

Commodity price induced inflation has made it hard for policy makers to reduce interest rates. Despite this, interest rate cuts may not be the magic bullet and in 20 of the 36 countries recently surveyed by Morgan Stanley, real short-term interest rates are currently negative.

At this point the $700-billion Treasury/Fed proposal appears to be a solid response, as does the stimulus injections of cash into markets around the world.

This problem remains possibly years away from being done with.

Observation # 8

Traditional risk management has lost its way.

Paul McCulley of Pimco touched on the subject in the July 2008 issue of Global Central Bank Focus:

“[...] every levered financial institution - banks and shadow banks alike - decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense. At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed.”

In fact, while it is known that PIMCO was regularly consulted by Secretary Paulson, it was Paul McCulley who rightly proposed in his newsletter during the summer, that the only real solution would consist of the formation of a new government agency to create a market to thaw frozen or cemented assets.  This would be the only viable long term solution.

Conclusion

Where is the opportunity? According to Absolute Return Partners, real value is to be found in credit instruments. This is where the most damage has been inflicted and it is where the biggest bargains are to be found in today’s markets.

What would you rather own? Equities which trade at 15-20 times earnings or credit instruments trading at a fraction of that cost? Deutsche Bank estimates that senior secured loans are trading at an implied PE ratio of 5-less than a third of the cost of equities.

You may read the full original version, at Observations on a Crisis, Courtesy John Mauldin

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PIMCO Co-CEO: When Markets Collide

Sunday, August 31st, 2008

About a month ago, Charlie Rose interviewed PIMCO’s Mohamed El Erian. El Erian is one of the country’s most successful money managers. He’s the co-CEO of the Pacific Investment Management Company, better known as PIMCO which oversees more than 829 billion dollars. He previously led Harvard University’s endowment to substantial returns on investment. In the interview, which is available below, Charlie Rose speaks to him about his new book “When Markets Collide” and how he sees the global economy today.

View Part 1, Click Play

View Part 2, Click Play

View Part 3, Click Play

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Posted in Banks, China, Credit Markets, Economy, Emerging Markets, Financials, Fixed Income, Gold, India, Investment Strategy, Markets, Monetary Policy | No Comments »

The Paradox of Deleveraging

Friday, August 1st, 2008

This week, John Mauldin features the thesis by Pimco’s Paul McCulley, on the subject of the deleveraging of the financial system. Here are a few excerpts:

The Paradox of Thrift:

For me, a simple concept brought this realization: the paradox of thrift. For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

On Monetary Easing:

But monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

Read the complete article here - The Paradox of Deleveraging, Paul McCulley

Source: John Mauldin

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When Markets Collide: Barron’s interviews el-Erian, Pimco’s co-CEO

Sunday, June 8th, 2008

June 2, 2008 - Pimco’s Co-CEO and co-CIO, Mohamed el-Erian discusses his new book, When Markets Collide, with Barron’s, which puts today’s market accidents in a unique perspective. Both the Barron’s interview and his book are must reads. Here is an excerpt: 

When Markets Collide

What are the biggest things people missed? 

Under a “just-in-time” risk-management mindset, people waited for the turn before taking risk off the table. Hubris took over. People believed these new derivative products would allow you to reposition your portfolio after the turn as opposed to preemptively. But that wasn’t a possibility with credit products and subprime, and losses were huge. People misinterpreted what these instruments can do, and didn’t retool significantly.

Who’s the poster boy for this way of thinking? 

The book quotes Chuck Prince, [the former CEO] at Citibank, on the front page of the Financial Times, words to the effect that when the music stops it will be messy, but as long as it’s playing he’s on the dance floor dancing. Within weeks the music stopped and people couldn’t get off the dance floor. In many of these sophisticated firms, the traders did things that neither the middle nor the back office could support, and the result was very big losses. It’s like pipes in your house that are very old. Every once in a while, one will rupture below and you have a very messy cleanup.

When Markets Collide: Investment Strategies for the Age of Global Economic Change, Mohamed el-Erian, co-CEO, Pimco

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Bill Gross: Hmmmm? (Investment Outlook June 2008)

Monday, May 26th, 2008

May 26, 2008 - Pimco’s Bill Gross makes a most humorous analyses, drawing parallels that the hordes are marching on the new Rome (America), and that its time to act. Make sure you read this must read, the June 2008 Investment Outlook, by Bill Gross. At the end, Gross puts forth his recommendations.

What this country needs is either a good 5 cent cigar or the reincarnation of an Illinois “rail-splitter” willing to tell the American people “what up” -”what really up.” We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate’s preacher - Democrat or Republican - should be a significant factor in how we vote. We care more about who’s going to be eliminated from this week’s American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher’s seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have - we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.)

It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome - better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America’s wealth migrates into foreign hands hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense or self importance on a geopolitical scale, that our allies are dropping like flies. “Yes we can?” Well, if so, then the “we” is the critical element, not the leader that will be chosen in November. Let’s get off the couch and shape up-physically, intellectually, and institutionally-and begin to make some informed choices about our future. Lincoln didn’t say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we’ve been doing a pretty good job of that for a long time now.

Bill Gross - Investment Outlook - June 2008 - “Hmmmmm”

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