Who’s irrationally exuberant?, asks PIMCO bond king Bill Gross in his latest commentary. Well, pretty much anybody who bought or sold high-yield bonds or exchange-traded funds this year or last and expects their recent double-digit returns to continue.
In “Rational Temperance,” his investment outlook published this Wednesday, Gross quotes former Federal Reserve Chaiman Alan Greenspan’s question—“How do we know when irrational exuberance has unduly escalated asset values?”—and answers it with some questions of his own.
“If the Fed’s so smart, why are some of us still poor?” writes Gross (left). “Why did our 401(k)s become 201(k)s in 2009 before recovering to near peak levels currently? If they’re so smart, why the roller coaster ride, the 30% decline in home prices since 2006, and our current 7.9% unemployment rate?”
‘High-Yield Bonds Are Somewhat Exuberantly and Irrationally Priced’
Gross then considers another Fed official, Jeremy Stein, who this February asked an equally pointed question: “What factors lead to overheating episodes in credit markets?” And like Stein, he warns that investors should tread cautiously as asset price “irrationality” reaches ominous levels in 2013.
On a scale of 1-10 measuring asset price “irrationality”, Gross believes, the U.S. markets are at about a 6 and moving in an upward direction.
“Corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced,” Gross concludes. “Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile.”
His advice to investors is that they needn’t entirely purge their portfolios of those products. But he does note that recent double-digit returns were “unlikely to be replicated” and that when current 5% to 6% high-yield interest rates are adjusted for future defaults and recovery values, a paltry 3% to 4% in realized returns is the likelier outcome.
Investors: Adjust Your Expectations Downward
The point, Gross says, is that investors should realistically adjust their expectations.
“PIMCO’s and Governor Stein’s ‘rational temperance,’ in contrast to excessive historical bouts of ‘irrational exuberance,’ simply counsels to lower return expectations, not to abandon ship,” he writes. “We join with Governor Stein and perhaps Alan Greenspan in encouraging not an exit but a reduced expectation.”
Placing blame where blame is due, Gross says that while individual investors may get irrational when it comes to buying high-yield ETFs or mutual funds, it is the banks, insurance companies and pension funds that influence the price of credit—whether high yield, investment grade or municipal.
As ominous as high-yield debt looks now, so too will the stock market look, says Gross, referencing historical correlations compiled by Jim Bianco of Bianco Research that find that high-yield and corporate bonds are really just low-beta equivalents of stocks.
“The conclusion would be that where high yield prices go, stock markets follow,” Gross writes. “The course of future equity returns may not resemble its recent exuberant past. Three percent to 4% high-yield returns over the next few years? Why shouldn’t that logically lead to a generalized 5% to 6% return forecast for stocks?”
Read PIMCO’s Gross, Roubini Slam Fed Over Possible Bubble at AdvisorOne.