Wednesday, December 27, 2006

Bill Gross on the Alpha/Beta Challenge

Well, I have just returned from beautiful and warm Thailand. Thai must mean "snacks" in Thai, because the country is literally full of them. I have to say, it was pretty interesting having 78 degrees (Fahrenheit, that's 24 degrees Celsius) on Christmas Day. I'm now in Munich again, where it's sunny (if only for a few hours a day), but -3 (Celsius, which is 26 degrees Fahrenheit. It is an adjustment).

Any event, with my return to broadband, I am also catching up on my back reading, which has been severely curtailed by vacation travelling and sightseeing, moving countries, leaving my former employer and gearing up for a year at the University of St Gallen in Switzerland, where we compress a 22 month degree (the MBA) into 12 months.

But to the topic of this article, Gualberto Diaz has written a post about the current arguments between bulls and bears. I just read a great assessment by Bill Gross, the Managing Director at Pacific Investment Management (PIMCO) about the dilemma that we as investors are facing, which also sheds some light on the issue of what sort of markets to expect going forward. He describes it as the Alpha/Beta anemia. It's implications are far-reaching for investing strategy.

Start with a basic (and correct) assumption. Since GDP measures the overall income from domestic sources (domestic assets), over long periods, returns on assets are likely to rise in lock-step with growth in (nominal) GDP. Many investors still long for the "good old days" when double digit investing returns were common. This was due to the fact that from 1970-1985, nominal GDP increased in double digit amounts. (In the 1970s, asset price returns - which can diverge sharply from the growth of the underlying business income - lagged overall GDP growth, setting the stage for asset price growth stronger than GDP growth in later years to restore the correlation), and the period after 1993, when real GDP grew at 4-5% per year for most of a decade. While nominal GDP increased around 8%, any selectivity in investment choices meant that returns above 8% were easily obtained (and were easily magnified by using financial leverage, i.e. buying on margin).

Unfortunately, from one perspective, those days are over, at least, it would appear so. Economic growth (GDP by another name), is averaging much closer to 2.5%, with inflation matching that figure for a nominal GDP rate of 5% or so per year. Assets should return, therefore, something like that figure. Applying financial leverage (debt) might enable investors to push that up by 1 or 2%. Since asset price levels (in the very long term) reflect earning power of the underlying assets, asset prices (investor returns) are likely to be in this range. Incidentally Warren Buffett wrote an article in Fortune a few years back, and said about the same thing - he expected 6% returns going forward.

Are you still with me? In short, what Gross is saying is, asset income growth should be between five and six percent in the future, with the opportunity to use debt to improve returns on equity to six to seven percent per year. This figure, also called "beta" which describes how much of an investment's price movements can be correlated to market price movements (a basket of stocks with perfect market correlation has a beta of 1.0) is simply too anemic for most investors.

Faced with these returns, however, investors are essentially saying, "that's fine for other people, but I need at least nine or 10 percent". There are several reasons for this, Gross mentions only one, which is the fact that six or seven percent returns will not be adequate to fund future liabilities. He does not specify which liabilities he means but my sense is that he means healthcare and retirement expenses. This blog has said as much many times over (see retirment crisis).

As a result, investors are instead seeking out riskier investments, those that tend to have higher "alpha" which is the additional "reward" that riskier investments should offer. But with that effort to find higher return investments (like small-cap stocks, a favorite of "foolish" investors, particulalry right now), the ususal price discounts that these investments offer in return for their high risk (the risk premium) has diminished. In fact, small cap stocks, far from trading at a discount to large issues, trade at a substantial price premium (which, to some degree may be mitigated by the potential for faster growth, but this is what these alpha-seeking investors are all assuming).

You know what happens when people are lining up to buy something, particularly something that is sold at an auction (which is the case with stocks!), buyers overpay.

In short, what has happened is that the price of risk, the risk premium, has declined substantially. The implications are significant. First, periods of significant stability can actually create risk, because over long periods investors become accustomed to being rewarded for making ever riskier bets, until, unfortunately, they aren't. When the tide turns, many investors will find they have been "swimming naked" in the words of Buffett.

Worse, systemmic underpricing of risk means that index-weighted portfolios (which are weighted in large part based on price levels) will always over-invest in over-priced assets, and under-invest in (risk-adjusted) underpriced assets, as the overpriced assets have higher market capitalization relative to earning potential, and underpriced assets, by definition, have low capitalization relalitve to earning potential. Indexers, in other words, far from being protected by "diversification" will discover that diversification has them overinvesting in today's high priced assets. While their losses might not be as spectactular as those of an investor who was 100% invested in "optical networking" stocks in 2000-2001, losses of 30-50% in diversified porfolios will be little comfort.

Gross suggests, I believe rightly, that the only thing an investor can do is seek to concentrate his money in the single few best investments he can find. Those that offer opportunities to earn superior (and here he means 7%) returns with comparably little risk.

He does not believe that assuming addtional financial leverage is a smart move at this point. Basically, there are two options, the first is that the Fed will renew vigilance with respect to inflation and again raise interest rates. This will reduce financial leverage in the system, which _should_ make things safer, but might also lead to a collapse in certain overvalued asset prices, thereby provoking the crisis that the Fed hopes to prevent. Or, the Fed can allow higher inflation, which, while it will prevent (at least in the short term) a credit crisis, inflation also generally leads to lower asset prices as the twin effects of taxes and higher discount rates reduce present values of assets thereby leading to price declines or stagnation (like the 1970s).

Finally, unmentioned by Bill Gross, but mentioned by Gualberto, most businesses are at peak earning cycles. corporate profits' share of GDP is at all time highs (which is one way that asset prices have outstripped GDP growth over the past three years). The trend of business income increasing faster than overall income cannot continue indefinately. Tax levels linger near post-war lows as (unrecognized) government liabilities pile up on balance sheets, which foretells of greater tax burdens in the future; corporate income, already at high levels, is a natural target for revenue raising.

Finally, we have the issue of those other pesky liabilities for which assets earning six or seven percent - the ones I call the Boomer-Lifestyle Liabilities. These are the costs associated with retiring in the style the Boomers imagine themselves living. Let me make this clear, Boomers, as a group, will live a retirment lifestyle well below that which they are living now. There are various ways that they can help to reduce the gap - they can continue to work in retirement (or not retire), they can pick really great investments (but not all of them can) and they can win the lottery (again, not all can do this either), which means that Boomer consumption will begin declining.

Lower consumption (and higher savings) means more money chasing assets of declining quality (less consumption means lower business income). I don't have to tell you where that leads.

What does this all mean? Most of the bull arguments I have seen are really trader/herder mentality. It amounts to "ride the wave", with a focus on recent economic reports and stock market price level movements as a reason to invest. I will not tell anyone not to ride the wave. But I will ask, what happens when the tide turns, as it will, maybe next year, maybe 2009. Are your assets good enough to survive a major change? Even good enough to survive a tsunami? As Thais can tell you, bad things can happen even when the weather seems perfect at the beach.

1 comment:

  1. Hi!
    i'm a prospective HSG MBA from India.I've been offerred admission to the HSG MBA program starting Sept'07.
    I am keen to discuss this program with u and seek ur help in making this imp decision.

    can v discuss this over mail / skype/ messenger chat?
    my email is

    looking forward to ur mail