Investment

Bill
Gross
Outlook
February 2001

New Age Crossroads

New York, Feb.7 (Bloomberg) – Optimism about U.S. stocks surged to a 14-year high last week,
according to a poll by Investors Intelligence newsletter. The percentage of financial consultants
who considered themselves bullish, or optimistic, rose to 61.8 from 61.0 the week before. Optimism
hasn’t been this high since January 1987. “A lot of people are optimistic about stocks with the Fed
cutting rates,” said Michael Burke, editor of the newsletter.

I was asked by the Wall Street Journal
recently to participate in a four-person
panel discussing the topic of “The Prob-
lem With The Herd” (January 29th edition).
One of the editor’s questions asked whether
there was “any time when following the
conventional wisdom (was) the smart
thing to do?” I was taken aback, not by
my printed response (since my answers
were indubitably the “correct” ones)
but by those of my co-panelists which
included Elizabeth Bramwell, John Rogers
and John Bogle. Basically they all said
“no” – the crowd was always wrong. Well,
my fine feathered investor friends, the
crowd can’t always be wrong. It’s the
crowd that drives markets. They may be
wrong at the top and wrong at the bottom,
but in between the crowd is a momentum-
bred monster that in turn creates its own
inertia. Was the “crowd” wrong to buy
stocks in the 1990s? Hardly. Many of
them may have been late to the party, but
the American investor is still sitting on a
lot of paper profits despite the carnage in
the NASDAQ over the past nine months.
My answer then, to the same questions
was “Sure you should follow the conven-
tional wisdom – most of the time. In this
business of investing it’s best to follow,
instead of oppose – until that is – it becomes
increasingly obvious that the crowd has,
through its own momentum, carried
prices to an extreme. That is the time
to oppose, instead of conform.”
Such timing, of course, is one tricky
proposition, because no one, except for
my wife Sue’s favorite psychic, can
consistently outfox the market and the
crowd. “They don’t ring a bell,” as the
saying goes and when there’s blood in the
streets or sugarplums on the Christmas
tree, it’s oh so hard to resist being human
and joining the crowd in their fear or
ravenous greed. I’m not especially good
at short-term counter-trend investing, but
I’ve found that by analyzing markets from
a long-term secular perspective, it’s
possible to decipher changes in major
trends, despite the difficulty in calling
precise turning points. Opposing the crowd
can begin as early or as late as 1 to 2 years
around major financial market turning
points and still be successful. What’s
necessary, as I suggested in my Wall
Street Journal response, is to recognize
major extremes and future secular
economic forces that point prices in the
opposite direction, and to forget about
getting that last 1/8 of a point at the top
or the bottom.
 Investment Outlook
We are at just such a juncture in the stock
market. I write this with reservation and
trepidation and all of the concomitant
fears that legitimately follow a supposed
bond market guru swimming into foreign
equity waters. Still, the two markets
share more than a mild if somewhat
jagged correlation and many of the
economic forces that affect one, will
influence the other. So hear me out you
paper-wealthy, “stocks for the long term,”
“buy the dips” stock market investors.
There may be at least a few tidbits of
secular wisdom that follow in these next
few pages.
I begin not with talk of a recession or
discussion of a V shaped vs. a U or L shaped
recovery, because those are short-term
cyclical calls that lead to short-term
trends in market prices. With the Fed on
the move, there is justification to support
a claim that no matter what the shape of
the recovery, as long as there is one, the
stock market may have seen its worst
days and months in terms of a rate of
decline. Doesn’t mean the NASDAQ has
bottomed but it does indicate at least an
absence of carnage as long as the Fed
keeps lowering interest rates.
When I speak of a juncture in the stock
market though, this potential cyclical
bottom is not the crossroads to which
I point. I direct your attention instead to
expectations of returns for the next
10-15 years – those double-digit capital
gains you may have come to suppose
were your birthright, and that you have
already “used” to provide a comfortable
nest egg for your retirement in 2020.
Sorry about that – you better start
saving instead.
February 2001
How so? Does not the New Age Economy
with its productivity miracle more or less
guarantee those future capital gains?
That is a critical question of course but
one that could (and has) occupied numer-
ous prior pages of Investment Outlook
comment. The condensed answer is “no”
– there may be a New Age Economy but
its claims for New Age profit growth of
10-15% annually are fallacious. If any-
thing, the increased accessibility to
pricing information afforded by technol-
ogy and the Net leads to reduced profit
margins and a closer step towards perfect
competition as opposed to increasingly
monopolistic profits. A similar New Age
argument applies to the supposed ben-
efits of globalization which is another
dominant secular trend. While increased
trade should almost certainly foster
higher global economic growth rates,
the increased competition that it fosters
spells danger for future corporate profit
margins. Both of these New Age produc-
tivity-oriented trends (technology and
globalization) promise then to be more
consumer than business friendly and to
minimize future stock market gains.
There are other more easily understood
examples which point to a stock market
crossroads. One of them speaks to the
topic of valuation. It comes from recog-
nizing currently high P/E ratios – yes –
and low dividend yields – certainly, but
also from an historical analysis of how
stocks have performed given the starting
line valuation of equities themselves.
Would the potential capital gain growth
rate on your home, for instance, vary
depending on whether you paid $250,000
or $500,000 for it? Of course it would.
If you paid twice the price, it would cut
 the annual appreciation percentage in the 40+ P/E he calculated for 1/1/2000
half given an appropriately long-term and incorporated it in the graph. (The 40
time period to measure by. It was just P/E is calculated by using the average
such an analysis that was put forth in earnings for the past 10 years in the
Robert Schiller’s book Irrational Exuber- denominator.) “Off the charts!” is perhaps
ance that I now replicate below. the most appropriate description. If history
holds true to form, you can expect a
Annualized ten-year real return (%)
20 negative return from stocks over the next
19
20
49
10 years. Start saving money, indeed!
21 50
89
15 48 47 52
1882 5154 88

83 43 8645
80 84
53 55
9746 96*
My argument for a stockmarket crossroads
10 24 85 42 58 21
22 81
7879
44 26
77
97*56
91*5795*
is further enhanced by demographic
82*
89* 93*92*
59 00
41

5
75
3323
32
25 35 85*
1776
83*94*
84*88*
04 90* 60
63
36 98* 01
99* trends that appear to be in the process of
15 16 34 86* 8161 03 62 02

74 38
0739 31
1408
0 13
71
09
12 10
11
-5
-10
5 10 15
Price-earnings ratio for January of year indicated
Source: “Irrational Exuberance”, by Robert J. Shiller
This chart shows a scattergram of stock
returns over numerous overlapping 10-year
periods of time given the P/E ratio of the
market at the beginning of the 10 years.
Same example as the $250,000/500,000
house except this time in the form of
price/earnings ratios. It shows that if
your starting point begins with the
market at a high P/E, your long-term
returns will invariably be reduced when
compared to beginning at a low P/E. Sort
of commonsensical I guess, but common
sense is not what most crowds exhibit
near market peaks. Irrational exuberance
is more like it.
Now take a look at where we were when
Schiller’s book was written in January
of 2000. Although he hesitated to include
the specific point himself (probably
because it was too shocking) I have taken
87*40
05
06
28
30
culminating. Investment Outlook readers
64
67 37
29 will recognize PIMCO’s reliance for
70
73 66
72 6968
65
many years now on shifting population
00
patterns to forecast long-term trends in
interest rates. Consumption, housing,
20 25 30 40 and savings patterns all seem to rely
heavily on gradual demographic aging
patterns that alter the supply and de-
mand for investable funds. And while
corporate profit growth rates may domi-
nate stock price trends over the longer
term, favorable or unfavorable demo-
graphics can certainly accentuate the
trend, to put it mildly. Currently high
P/Es and valuations for most stock
market averages, for instance, are likely
due to the peaking of the baby boomer
generation in terms of their earning
power and necessity to save for future
retirement; they have been buying lots of
stocks. Over the next few years, however,
not only will boomers begin to contribute
less money to mutual funds and 401K
plans, but their investment vehicle of
preference should gradually shift from
risk-oriented stocks to income generating
fixed income. Tim Bond of Barclays Capital
has compiled numerous demographic
studies which point to the bloom coming
off the stock market’s rose. While I’m
 naturally suspicious of most historical,
ex-post models, demographically oriented
ones may hold the highest probabilities
of future forecasting success if only
because population trends are relatively
immutable. The chart below which
models U.S. demographic changes in
the 35-54 year old age group (high savers)
and compares it to stock market dividend
yields is startling in terms of its future
forecast.
Actual and demographically modeled dividend yield
U.S. market (regression 1958-2000)
6
5
4
3
2
1
0
58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
Source: Barclays Capital “Global Speculations”, January 2, 2001
With current dividend yields near 1% for
the S&P 500 index, the model suggests a
return to 4-5% yields prevalent in the late
1970s. While those yields can come
partially from higher payout ratios and
not necessarily drastically lower stock
prices, the real message of the chart is
that future P/Es should be lower than
they are today and if so, that stock market
returns will fail to match expectations of
investors used to better times.
I could go on and on and probably should
for at least one more paragraph. Current
stock market valuations are being sup-
ported in part by a number of dubious
accounting practices that have led to
earnings overstatements of as much as
30-40% annually. Peter Bernstein, in a
November strategy piece, reports that
over the past fifteen years, an average of
20% of reported earnings in any one year
vanish five years later due to “extraordi-
nary” write-offs. “These are not minor
league numbers,” he writes, “hence how
much confidence can we have in reported
earnings?” Undermining confidence even
further has been the use of options as a
replacement for normal compensation
among corporate management. The
Economist magazine reports that if the
cost of options were reported in American
financial statements as many astute
investors such as Warren Buffet believe
they should be, then earnings would be
reduced by an additional 20% annually.
Take those wonderful earnings per share
numbers then, that CNBC reports on
a minute-by-minute basis, and reduce
them by at least 40% to recognize future
write-offs and the cost of options. The
S&P 500, with a reported P/E of 25x
suddenly looks more like 40x when
viewed rationally or even historically.
No wonder market yields are only 1%.
It’s not that easy to pay dividends with
phantom profits.
So you like stocks do you? You’re banking
on those 10-15% annual returns to let you
retire in style a few decades from now?
Somehow I don’t think so. Not that
bonds will be any better. With Treasury
yields pressing 5%, it’s clear that double-
digit returns for fixed income over the
next decade are not in the cards either.
Instead, investors must acclimate to a
future environment of diminished
expectations. While our New Age
Economy may still exhibit near average
historical growth rates due to enhanced
productivity trends and the benefits
of globalization, our New Age Markets
promise nothing of the sort.
840 Newport Center Drive
William H. Gross P.O. Box 6430
Managing Director Newport Beach, CA
92658-6430
(949) 720-6000
Past performance is no guarantee of future results. All data as of 1/31/01 and is subject to change. The return on both individual
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