The Short Supply of Assets

Fantastic chart and data here from Citi Research showing the issuance of various securities over the last 10 years in the Eurozone, US and Japan.  It’s interesting to note the surge in treasuries that has occurred since the collapse in the GSEs and the so-called AAA bubble in real estate.  It’s also interesting to note the decline in net issuance.  In other words, the supply of asset issuance continues to run at a level well below pre-crisis levels.  That might explain at least some of the broad upward pressure on assets in general.

Here’s more excellent commentary from Citi:

“The blue/grey bars quantify the net issuance of securities across broad asset classes on a rolling 4-quarter basis in the Eurozone, the US and in Japan. The orange bars capture the effects of central bank interventions. The red line is the net amount of issuance left after those interventions – in other words, it is a proxy for the change in the size of the universe of securities that investors can buy.

As you would expect, the chart shows a surge in net government debt issuance in 2009-10 as fiscal deficits ballooned. These have fallen back over the last couple of years but remain significantly higher than before the crisis.

The surge in corporate issuance of bonds since 2007 is perhaps less intuitive, considering that companies have generally run their balance sheets very conservatively, cutting capex and M&A. However, a big shift from loan to bond funding has more than compensated for that. Net equity issuance remains a relatively small component. There was a brief flurry of equity issuance in 2009-10, but as leverage has come down corporates have reverted to the more normal pattern of retiring shares on a net basis.

The biggest shift has been the drop in net issuance from financials and GSEs (like Fannie Mae and Freddie Mac). Having dominated securities markets before the crisis, their net issuance has dwindled to next to nothing in recent years.

Adding up the bars (still ignoring CB interventions in orange) shows that the growth in the investible universe has slowed from around $3.5-4tn annually before the crisis, to less than $2.5tn over the last couple of years. In other words, the rate of expansion of financial securities has slowed by more than $1tn. That’s a pretty penny, when you think about it.

When the effect of central bank interventions (quantitative easing and LTROs3) in orange is subtracted, the reduction in the supply of new assets available to financial investors becomes even more dramatic:

Apart from a brief period in H1 2011 (where markets incidentally did not perform particularly well), the investible universe of financial assets has grown by less than $2tr per year over the last three years – half the run-rate that we were used to. In fact, in some quarters net issuance of securities been virtually zero.  We think this ‘supply effect’ on financial markets of central bank interventions is widely underestimated.”

Notes on Gundlach: Link to slides at the end

We've heard this question before

For starters, this isn't the first time the investor class has questioned whether they should own bonds at all. The last era during which this was an open question was 1997 - but for different reasons.

In 1997, bonds and stocks were positively correlated. When bonds went down, stocks did too. But when bonds went up, stocks went up even more. And so why bother with the bonds at all, went the thinking.  US bond yields in 1997 were 6%, so you can just imagine how much higher the expectations were for stock returns then!

Jeff loves the Japanese comparison and uses it here - in 1989, the year the Nikkei (Japan's stocks) peaked, Japanese government bonds were also yielding 6% - obviously Japanese bonds were the (much) better buy then versus stocks.

No bond bubble

America does not "over-own" bonds."Raise your hand if you own a Treasury mutual fund for yourself or your clients..."  No hands go up in the entire room (maybe out of embarrassment or because the salads were served).

If anything, relative to the rest of the developed world American households over-ownstocks and are perhaps equal to the rest of the world in terms of bond holdings.  The below chart is Net Worth in Financial Assets by Country, the black portion of the bar is bond ownership and the dark blue is equities:

There's no bubble in bonds. Gundlach is amused by those claiming that the bond market is on the verge of some kind of imminent collapse. "They're dead wrong."

Why do American households own so much stock compared to other countries? Gundlach believes that the massive wealth polarization in our country versus other countries plays a role - so much of our wealth is concentrated amongst the very rich, who tend to own stocks.

QE and ZIRP are a New Way of Life

Gundlach laughs whenever the Fed Minutes come out or a governor speaks and people search for clues about the end of monetary stimulus or accomodative low rates. Not happening this year or next.

Publicly made comments and dissent is just talk.  The entire world is embarking on what Gundlach refers to as "the circular financing scheme". The below slide shows how just about every single country in the world is currently running a trade deficit at the same time - "How is this even possible?"  The answer is the circular scheme being perpetuated around the world (Bank of Japan, Bank of England, the ECB and the Fed are all expanding their balance sheets at the rate of 3.5% of GDP per annum). "This is what Krugman says is the answer to five millennias-worth of human struggle. Maybe he's right but it seems a little too easy."

See below, that's central bank balance sheets, January 1995 through January 2013:

He mentions that Ben Bernanke has publicly stated he sees "no observable negative consequences" from this activity and that Janet Yellen is even more dovish, has made comments about allowing this to run through 2025 if need be.

The trade deficit is what's supporting the US economy and the Fed's purchasing is the only thing keeping interest expense low enough to allow the government to continue running a trillion dollar deficit. We know that the only glue holding this altogether right now is that the interest we're paying on government debt is manageable - no one is going to pull that chair out from under us on purpose.

Combine this with the state of the labor market and you know the Fed is going nowhere. When they say that they're pondering the end of QE, Jeff says "Of course they're pondering it, gee I would hope so!" but this does not mean they are considering an exit right now. He believes the exit will look like a run-off of the existing treasury and mortgage bond portfolio as the bonds the Fed holds mature - but not an outright sale of the portfolio.  "There's a better chance Bernanke buys every Treasury bond in existence before he ever sells a single one"

Gundlach breaks out the fan favorite slide - Bernanke's Wheel of Fortune:

All of the options in yellow have already been attempted.  Gundlach says that of the remaining, default is not going to happen and the long-rumored "print and pay" that the policy bears fret about is "not timely."  He says print and pay may happen someday but we're simply not there yet, too early. He mentions that removing the tax benefit from muni bond interest for ultra-high net worth households is likely which keeps him cautious about the muni market in general. Entitlement reform would be nice - but when you poll Americans you realize that this has the support of only 10% of the population (about the same percentage as believes in Bigfoot) and so it won't happen - you could never get elected.

How to play continuation of the Fed's policies

So if we know that QE and ZIRP are here to stay for the time being, is the answer stocks or bonds?  Jeffrey says stocks maybe but bonds definitely. He notes that quantitative easing has had no effect on the commodities complex (CRB index) but the "transfer mechanism has weirdly benefited stocks."

The below is the cumulative effect of QE on the stock market:

But it is the bond market that has the real "put" he says, and not the stock market.  Quantitative easing "goes right through the heart of the bond market."  Which is one of the reasons why Gundlach is back to buying longer-dated Treasurys with some of his portfolio.

Speaking of the labor market...

...it still sucks no matter what the headlines say. The participation rate is alarming. The old people won't retire (they can't) and the one thing you can't fake - employment-to-population - has not improved.  On top of which, right now we've got 40 million Americans age 65 and older. In 15 years we'll have 70 million age 65 and older! This large, aging population, he argues, is a bullish factor (or at least a supportive one) for the bond market.

Three key charts illustrating the age and participation problems in the US labor force (click to embiggen):

The bottom line is that this jobs picture is not conducive for any kind of ZIRP or QE exit anytime soon, hence continued support for the bond market.

What to do in the bond market

So if you agree that bonds are the bigger beneficiary of ZIRP-forever, what can you with a bond portfolio? Some key points Gundlach makes:

Investors have been spoiled by bond indexing - because it has worked. Here's the total return of the long bond vs the S&P etc over the last 40 years:

But those days are over.

If you look at the major bond indexes (like the Barclays Aggregate) they are overloaded with Treasurys which have the lowest yields. Average durations for the Aggregate index have remained around 5 or so - interest rate risk hasn't gone up, in other words - but yields-to-maturity have collapsed to around 2%. There's not much in the traditional index left to scrape up, in essence. This is the anti-passive, anti-bond ETF argument.

So being selective will work better than just going with the index going forward.  In the below slide, perhaps the most important, Jeff shows how the "non-traditional" sectors of the market differ greatly from the more mainstream, developed ones in terms of yield. These outside-the-index areas are where there is still fruit left on the trees:

Jeff mentions that the single best area of investment grade fixed income right now is dollar-denominated emerging market corporate bonds. He still favors non-agency MBS but these credits will continue to be bid higher and then disappear, un-replaced.

He believes that when private financing (non-Fannie, non-Freddie) does return to the mortgage markets, it will create tremendous opportunities for bond investors.

He mentions bank loans being an interesting area for opportunity as well. The caveat is that the higher yield stuff should be paired with something like a Treasury for risk management purposes (barbell strategy?). I should note that DoubleLine is launching a floating rate bank loan fund shortly.

He also likes high yield corporate as he believes default rates should stay low given balance sheet strength - even if profit margins mean-revert lower. In this regard, Jeffrey agrees with John Hussman that 70%+ is probably the peak for the cycle and unsustainable. This shouldn't hurt corporate bonds, however, the impact on stocks is debatable.

A word on Japan

Jeffrey mentions that Japan is important to watch for several reasons. He calls it the "Pace car for stock market peaks, weird policy responses and currency debasement."  He sees it as a template for how the rest of the world will deal with deflation and demographic issues. When queried about the Japanese stock rally, he mentions that he went bullish on Japanese equities last November and people told him him he was an idiot. A big time "Republican center of influence guy" emailed him"Don't you know that Japan is where capital goes to die?"

Looking forward, Jeff says it's hard to imagine that the 50% rally in the Japanese market just stops on a dime and reverses itself to the downside.

Besides, he thinks that over time - not tomorrow but one day - the only way the Japanese can ever deal with their debt level is more debasement so a Yen at 200 over the USD is conceivable.

Japan, most importantly, illustrates to investors that bond yields can stay low for as long as they want to.

Odds and Ends

When we got to the Q&A the first thing people wanted to hear was a comment on Jeff's now legendary pairs trade from last summer. I was in the room when he mentioned he liked "Short Apple versus 100X long Natural Gas futures" - he was demonstrating the ridiculousness of the consensus at the time, which was that Apple could never go down and natural gas was headed to zero. Obviously, he nailed it and the opposite happened. Nat gas almost doubled from there and Apple was just about cut in half from its high. World-renowned for his modesty, Jeff mentions that the trade was actually even better than we all think it was because "it was never down even or a single day."  My table - all wealth management guys with big egos (i'd presume) - got a kick out of that.

Here's the chart of his pairs trade's performance:

When asked for a new miracle trade, the manager demurred a bit but then mentioned that he would short Chipotle - which promptly knocked the stock down 8 points oncethe media reported my tweet from the event, what a world we live in! Jeff's point - much the same as David Einhorn's from last fall - is that the multiple is quite high for what is essentially an "oxymoron" product, the "gourmet burrito". He'll be at the Ira Sohn Value Investing Conference in May (as will I) and so maybe we'll get more detail on this idea then.

He was asked about preferred stock as a way to cope with the low rate environment and admitted he had no opinion (first time I've ever heard him punt on a question). Like Socrates, he admits to knowing what he doesn't know.

Nobody asked Jeffrey about gold for the first time - he was very surprised by this so he brought it up himself. He thinks that as fear of systemic collapse rolls away in the short term, gold should continue to slide. He mentioned $1200 an ounce as a possible target but didn't seem emphatic one way or the other.

There was a question about assets under management and getting too big to be an effective total return investor.  DoubleLine currently manages $56 billion - $40 billion of which is in Jeff's Total Return flagship (full disclosure - we own this fund in client accounts at our shop and have since inception). Jeff thinks anything over $100 billion would hurt the strategy and $75 billion may even be too much. He takes a dig at "trillion dollar bond funds" in that they're forced to use derivatives and swaps and as such they have counterparty risk, the single worst thing in Gundlach's eyes (he refers to it as "rewardless risk").  DoubleLine is actively rolling out funds in new categories (there's even a hedge fund in the works) and may soft-close Total Return at some point soon should the inflows continue at the current pace.

I asked the last question of the day. At the 2011 lunch he mentioned that high net worth investors ought to keep a portion of their wealth outside of banks and the traditional financial system so I brought up Bitcoin in that context. He said he really prefers to own things like fine art (he is an avid collector - I was awed by I saw in the lobby and hallways of DoubleLine's L.A. office when I visited this past fall) as well as precious gemstones. "People scoff when I mention gems as an investment - then I tell them that I possess some of the most flawless, perfectly formed emeralds in the world and they beg to see them."  Jeffrey thinks Bitcoin is a "mega mania" and a gimmick, not a currency. "I'd rather own diamonds and Picassos."

Spoken like a true boss.

***

Jeffrey Gundlach's complete slides are PDF embedded in the link below if you're left wanting more...

Why Own Bonds - DoubleLine April 2013

The Cool Kids Aren't Starting Hedge Funds Anymore

 

For the past few decades, hedge funds have been the sexiest way to make money on Wall Street — you can go long or short, fill them with "exotic" products, and lever up as you wish.
But it looks like they're losing their edginess to (are you ready?) mutual funds.
Just stay with us here.
These aren't your father's average long-only mutual funds. These are "alternative mutual funds."
These are mutual funds that act like hedge funds but they're not. They diversify and hedge with shorts, derivatives, ETFs, you name it. The reason they're not hedge funds is because investors don't have to be accredited and can invest less money, there are limits on leverage, and most importantly, alternative mutual funds do not charge that infamous hedge fund 2% and 20%.
According to data compiled by Morningstar, there were 112 alternative mutual funds in 2007. In 2012 there were 357.
Part of this is happening because the hedge fund world is a dismal place these days.
First off, it's hard to raise the money necessary to start a fund. Each investor has to be an accredited investor, which for individuals means they have to make at least $200,000 a year (or $300,000 with a spouse).
And if you don't want to get laughed off the Street, you better have a nice chunk of money to start — something like $50-100 million, and a significant portion of that should be from you (the hedge fund manager).
There are a lot of people starting (and, more often than not, failing at starting) these funds, but industry-wide hedge fund returns since 2008 have been lackluster, most underperforming the S&P. Investors are getting skittish.
That's why even hedge funds are starting mutual funds right now.
Last November legendary hedge fund manager Cliff Asness started two of them.
"You tell them, 'Hey we're a rock star hedge fund at a mutual fund price ...' It's what's working right now," one fund manager told Business Insider, adding "People just won't pay the fees, and they shouldn't have to."
Those fees, says the manager, are the reason why hedge funds, which are truly compensation schemes and not a specific asset class, has persisted.
But they keep many investors away, and if fund managers can get more assets under management by making it cheaper for people to participate, they may want to say goodbye to 2% and 20%.
It's what Jack Bogle did when he started Vanguard. He set the bar lower, he welcomed retail investors, and his fund got massive.
"We are a harbinger of things to come," said the manager.
Sorry hedge funds

The supply and demand of alpha is not static

Alpha is promised to no one. – Tadas Viskanta

I wrote that in regards to the underperformance of some high profile managers. Today another story in the WSJ about the performance problems of Jeff Vinik, former Magellan Fund manager (and owner of the Tampa Bay Lighting). The point being that managers cannot rely on any manager generating alpha over time.
In part these stories are puzzling, because in a world of ever more investors indexing it would seem that there should be more opportunities for managers to successfully pick stocks. A recent research paper from Nan Qin and Vijay Singal makes this very point. They show that greater indexing has led to less efficient stock prices. Inefficiency of course being the raw material for managers.
A couple of points that help offset this story of a greater supply of alpha. First is that at least in the US the absolute number of stocks traded on US exchanges has dropped dramatically over the past decade or so. From a USA Today article we see that from the year 2000 to 2012 the number of US listed companies has gone from 6,639 all the way down to 3,687. This drop has any number of implications one of which being a smaller pool in which managers can fish.
The second point is that over this time period the number of hedge funds, and the amount of money they manage, has increased dramatically over roughly this same time period. This means that managers are now stepping on each others toes to try and generate alpha. So even if the raw amount of potential alpha increased over this time period it is being spread over a much larger pool of managers. As Josh Brown at the Reformed Broker writes:

And now, all of this sameness and the mass-pursuit of market inefficiencies has led to an industry filled with intelligent players stifling each others abilities. Of course it did. If the world’s top fifty surfers all had to ride the same wave at the same time, how well could any of them do it? Jostling and elbowing each other for space and clear blue, whatever edge they originally paddled out with would be negated by simple physics.

The net result of all of this is that generating alpha is still a tricky business. Some ETF providers are trying to fudge the distinction between low cost, plain vanilla indexed ETFs which are now available at nearly zero cost and the many flavors of quasi-active index funds which have higher fees and track more narrow indices. Now matter how you slice the data the benefits of index-style investing are still visible in the data and increase with the amount of time you hold those funds.
That is not say there isn’t a free-rider problem with indexing. Index funds do nothing to help promote security pricing. However for the moment there seems to be no shortage of investors who are willing to step up with their dollars, and pay higher fees in the process, to try and capture some of this alpha. As the data shows alpha is an elusive beast for even the highest profile managers and is indeed promised to no one.

Caveat Depositor

by Eric Sprott & Shree Kargutkar, Sprott Asset Management

“If there is a risk in a bank, our first question should be: ‘Ok, what are you the bank going to do about that? What can you do to recapitalise yourself?’ If the bank can’t do it, then we’ll talk to the shareholders and the bondholders. We’ll ask them to contribute in recapitalising the bank. And if necessary the uninsured deposit holders: ‘What can you do in order to save your own banks?’” – Jeroen Dijsselbloem, March 26, 2013 1

A deal has just been struck with Cyprus. However, it was not the deal that Cyprus saw other countries receive. This was not the deal received by Greece, Italy and Spain. There were no bailed out banks in the aftermath. There was no transfer of risk from over-levered banks to the taxpayers. The risk was pushed back onto the banks. Their equity was wiped out. Their bondholders were wiped out. Their uninsured depositors saw their accounts raided for additional liquidity. It wasn’t just that the rules of the game had changed, the game itself changed. By raiding the depositors’ accounts, a major central bank has gone where they would not previously have dared. The Rubicon has been crossed. Going forward, this is expected to be the “template” for dealing with risky, over-levered banks and the countries which support them.

For the first time since the crisis began, we are faced with a new paradigm, or a “template”, for how a major central bank will address weakness in the financial sector. While the old template involved “bailing out” through transfer of risk from the corporate sector to the taxpayer, the new template calls for “bailing in”, whereby the risk is contained within the affected institution at the expense of equity holders, bond holders and finally the depositor.

How does the new template affect you?

This “template” is already being applied to the “too big to bail” banks in other developed countries around the world. A statement in the joint paper published by the FDIC and the Bank of England in December 2012 reads:
“An efficient path for returning the sound operations of the G-SIFI to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailedin creditors would become the owners of the resolved firm…. Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers”.2

Note the lack of the phrase “uninsured depositors” in this context, which opens the doors for both insured and uninsured depositors to be affected. In a similar vein, Canada’s recently released budget addresses the same problem. Page 144 of Canada’s Economic Action Plan 2013 reads:

“The Government proposes to implement a – bail-in regime for systemically important banks. This regime will be designed to ensure that, in the unlikely event that a systemically important bank depletes its capital, the bank can be recapitalized and returned to viability through the very rapid conversion of certain bank liabilities into regulatory capital. This will reduce risks for taxpayers.”3

Likewise, New Zealand’s Open Bank Resolution policy allows for a “bail in” of afflicted banks by wiping out the equity holders first, the bond holders second and finally forcing a haircut on the depositors.4

Over-levered banks are not a recent development. We are faced with a banking crisis, seemingly once every generation. In a majority of cases, the bad banks were allowed to fail and newer, stronger banks took their place. However, the recent modus operandi of the central banks and policy makers allowed over-levered banks to get even bigger, rewarded risk taking with bailouts and let the inherent problem of unsustainability fester.

We carried out the exercise of taking the largest banks, or in other words, the “too big to fail” banks in the G7 countries and added up their assets in relation to the host country GDP. For the layperson, a typical bank’s assets are primarily composed of the loans they have originated while the liabilities are primarily composed of deposits they have accepted. With the exception of the US, all G7 countries have banking systems that have become larger and in some cases dwarfed their respective economies.
Governments around the world are finally beginning to realize the gravity of the risk that exists in their banking sectors. The EU has decided to build upon the new template of the “bail-in” regime. The US, UK and Canada have all followed suit. This puts the onus squarely upon the depositor. The depositor is a lender to the financial institution that he banks with. However, most depositors naively assume that their deposits are 100% safe in their banks and trust them to safeguard their savings. Under the new “template” all lenders (including depositors) to the bank can be forced to “bail in” their respective banks. Several G7 countries already have provisions that allow troubled banks to be bailed in using depositor accounts. We have been vocal about our concerns over the state of the global financial system for the better part of the decade. The Greek tragedy is now being played out in Cyprus with a new twist as depositors have been unwillingly turned into sacrificial lambs. Given the size of the banking sector in most G7 countries and the burgeoning government debts, the ability of the governments to bail out their banks is severely constrained, especially considering the political headwinds that exist today. For this reason, we strongly believe that real assets trump a fiat currency in a “savings” account. It is not our intention to be alarmist here, merely to say, “caveat depositor”. "

Footnotes:
1 Import Export Stats – US Census Foreign trade: http://blogs.ft.com/brusselsblog/2013/03/the-ftreuters-dijsselbloem- interviewtranscript/
2 http://www.bankofengland.co.uk/publications/Documents/news/2012/nr156.pdf
3 http://www.budget.gc.ca/2013/doc/plan/budget2013-eng.pdf
4 http://www.centralbanking.com/

Bill Bernstein: Make Peace With T-Bills

Bill Bernstein, the former neurologist, and now the author of several books about passive investing, gets that investors looking for yield have a problem these days. Who wants to be heading into retirement at a time when the real return on risk-free Treasurys is literally negative? Well, no one.
But Bernstein, whose recent book “The Ages of the Investor” addresses the challenges of getting the final phase of an investment life right, is adamant that looking to longer-dated debt or taking on bigger risks in places like the junk market is really an accident waiting to happen for people who want nothing more than to quietly clip coupons.
So grin and bear it, Bernstein told IndexUniverse.com Managing Editor Olly Ludwig, because this too shall pass, and the last thing any senior or investor with limited appetite for risk wants is to be holding something like emerging market credits when the inevitable reversion to the historical mean starts taking shape.

IU.com: You often talk about blood in the streets, and that’s all about expected returns, right?
Bernstein: Yes.
IU.com: Now, it’s not outrageous to say the expected returns in fixed income are a little compromised these days, is it?
Bernstein: I would go a step further. I would say the expected return of the average balanced portfolio with a prudent investment policy—half stocks, half bonds—is as low as it’s ever been. It’s pretty darn close to zero in a real sense, because you take a -1 percent return for safe bonds and you combine that with a 3 percent return for stocks, you get a return of 1 inflation-adjusted percent. Even at 10 years, the expected return is still a negative number, and with a 10-year T-note, you’re taking real risk. I want to take my risk with stocks, not bonds.
IU.com: Does this mean the orthodoxy of the previous generation that said you should gravitate increasingly to fixed income late in your life might be—if not turned on its head—tweaked in a significant way?
Bernstein: My philosophy about that, which I put in the book is: Get over it; you don’t have a choice.
IU.com: Get over what, exactly?
Bernstein: Get over the low expected returns of fixed-income instruments, because you don’t have a choice. If you’ve saved up enough assets to retire on, you still want to put it into relatively riskless assets—T-bills, CDs, things like that that have relatively short maturities. If things mean-revert, you’ll be fine; you’ll be back up to the normal historical yields. The yields we’re looking at are obviously artificially low, and will inevitably reverse.
It’s very unfortunate that bonds have a negative expected real return right now. Unfortunately, the best thing to do is just to grin and bear it, because the alternatives—mainly extending durations or buying lower credit quality—are probably going to bite you at some point in the not-too-distant future.



IU.com: Burton Malkiel says--and he's certainly not saying to bet the farm--but he’s saying, why not integrate some pretty dependable large-cap stocks with dividend streams that have proven the test of time: the ATTs of the world. And there are certainly diversified equity vehicles organized around that principle. Do you buy it, or do you think that’s an accident waiting to happen?
Bernstein: Well of course it is. It’s a question of return and risks. The real return of ATT is fairly reasonable: You’ve got a nice healthy dividend; you may even have some capital appreciation, although that’s dubious. But you have to be willing—even with an ATT—to watch 30 or 40 percent of your capital disappear temporarily, and perhaps permanently.
IU.com: You’re talking about a market correction taking your beloved dividend stock down with it?
Bernstein: Right. But the dividend probably won’t decrease that much. What happened top to bottom from ’07 to ’09 was the S&P fell in price by more than 50 percent, but the dividend yield only went down by 23 percent, and in the Great Depression, prices fell by 90 percent and dividends only fell by half. The point is, who is doing this in your example? The kind of person who is doing this is someone who is used to safe assets, and who is prepared for the vicissitudes of the stock market.
IU.com: So grin and bear it, is what you’re counseling?
Bernstein: Yes; the person who’s used to T-bills and CDs is not going to be prepared for what happens to junk bonds and high-dividend-yielding stocks.
IU.com: In one of our early conversations about this topic of fixed-income investing, you talked about Pascal’s Wager—that you’re better off parking your assets in very short, safe maturities even if the return is disappointing, even negative, as you were saying a moment ago, rather than going out on the curve looking for a little bit of extra yield because the potential for “unpleasantness” is all too real.
Bernstein: Yes, and one of these years I’ll be right about that!
IU.com: That’s the catch, right? But you’re entirely comfortable with being tarred and feathered on that basis, because in your mind, there is no choice, right?
Bernstein: That’s right. There is no choice. And I still own a lot of risky assets, which have done really well the past three years. So it’s not like I’m crying in my beer. Would I have been better off owning lots of 30-year bonds? Sure I would have. But that’s not where I choose to take my risk.
To me, there are risky assets and there are riskless assets. To me, a junk bond or an emerging markets bonds or any T-note longer than 10 years is a very risky asset.
IU.com: So looking at the world of investment management at this time of low expected returns in fixed income, is the challenge not to blow it in terms of reaching for yield? Do you see things in such stark terms?
Bernstein: Yes, I do.

When Bill Gross looks in the mirror, what does he see?

In his latest monthly "Investment Outlook" commentary, the Pimco chief waxes philosophical. He questions whether he and other legendary investors are really all they're cracked up to be. Maybe guys like Warren Buffett, George Soros, and Ray Dalio were just lucky guys in the right place at the right time.

In questioning initially whether I am a great investor, I open the door to question whether other similarly esteemed public icons like Bill Miller are as well. It seems, perhaps, that the longer and longer you keep at it in this business the more and more time you have to expose your Achilles heel—wherever and whatever that might be. Ex-Fidelity mutual fund manager Peter Lynch was certainly brilliant in one respect: he knew to get out when the gettin' was good. How his "buy what you know best" philosophy would have survived the dot-coms or the Lehman/subprime bust is another question.

So time and longevity must be a critical consideration in any objective confirmation of "greatness" in this business. 10 years, 20 years, 30 years? How many coins do you have to flip before a string of heads begins to suggest that it must be a two-headed coin, loaded with some philosophical/commonsensical bias that places the long-term odds clearly in a firm's or an individual's favor? I must tell you, after 40 rather successful years, I still don't know if I or PIMCO qualifies. I don't know if anyone, including investing's most esteemed "oracle" Warren Buffett, does, and here's why.

Investing and the success at it are predominately viewed on a cyclical or even a secular basis, yet even that longer term time frame may be too short. Whether a tops-down or bottoms-up investor in bonds, stocks, or private equity, the standard analysis tends to judge an investor or his firm on the basis of how the bullish or bearish aspects of the cycle were managed. Go to cash at the right time? Buy growth stocks at the bottom? Extend duration when yields were peaking? Buy value stocks at the right price? Whatever. If the numbers exhibit rather consistent alpha with lower than average risk and attractive information ratios then the Investing Hall of Fame may be just around the corner. Clearly the ability of the investor to adapt to the market's "four seasons" should be proof enough that there was something more than luck involved? And if those four seasons span a number of bull/ bear cycles or even several decades, then a confirmation or coronation should take place shortly thereafter! First a market maven, then a wizard, and finally a King. Oh, to be a King.

But let me admit something. There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to a throne. All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Since the early 1970s when the dollar was released from gold and credit began its incredible, liquefying, total return journey to the present day, an investor that took marginal risk, levered it wisely and was conveniently sheltered from periodic bouts of deleveraging or asset withdrawals could, and in some cases, was rewarded with the crown of "greatness." Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.

The epoch that drove the returns of our investment kings, Gross says, has been an era of credit expansion. The real test for greatness will come as a new epoch dawns.
If the epoch of credit expansion is permanently over, will these guys be able to continue to perform?

PIMCO's epoch, Berkshire Hathaway's epoch, Peter Lynch's epoch, all occurred or have occurred within an epoch of credit expansion—a period where those that reached for carry, that sold volatility, that tilted towards yield and more credit risk, or that were sheltered either structurally or reputationally from withdrawals and delevering (Buffett) that clipped competitors at just the wrong time—succeeded. Yet all of these epochs were perhaps just that—epochs. What if an epoch changes? What if perpetual credit expansion and its fertilization of asset prices and returns are substantially altered? What if zero-bound interest rates define the end of a total return epoch that began in the 1970s, accelerated in 1981 and has come to a mathematical dead-end for bonds in 2012/2013 and commonsensically for other conjoined asset classes as well? What if a future epoch favors lower than index carry or continual bouts of 2008 Lehmanesque volatility, or encompasses a period of global geopolitical confrontation with a quest for scarce and scarcer resources such as oil, water, or simply food as suggested by Jeremy Grantham? What if the effects of global "climate change or perhaps aging demographics," substantially alter the rather fertile petri dish of capitalistic expansion and endorsement? What if quantitative easing policies eventually collapse instead of elevate asset prices? What if there is a future that demands that an investor—a seemingly great investor—change course, or at least learn new tricks? Ah, now, that would be a test of greatness: the ability to adapt to a new epoch.

In short, the time for testing is now