Bill Gross’ Warning: Pot, Pigs and P/E Ratios

Bond manager explains how credit contraction will force down P/E ratios, boost high-quality bonds

Bill Gross (far left) and Liz Ann Sonders speaking to Tyler Mathisen of CNBC at Schwab Impact. Bill Gross (far left) and Liz Ann Sonders speaking to Tyler Mathisen of CNBC at Schwab Impact.

PIMCO bond manager Bill Gross is warning investors that the Treasury’s retreat from credit creation will slow down GDP and limit price/earnings ratios, depressing stocks and helping bonds.

Writing in his February monthly investment outlook, Gross said that a declining budget deficit and the beginning of the Federal Reserve’s tapering of bond purchases are gradually withdrawing a significant source of growth in the economy — which could only be ameliorated through an increase in private sector activity.

But because such private sector activity has not been forthcoming, the PIMCO manager sees narrower economic horizons ahead, saying “the days of getting rich quickly are over, and the days of getting rich slowly may be as well.”

The latest commentary from the manager of the world’s largest bond fund reads like an edutaining lesson in basic finance, explaining through colorful examples the role credit plays in a modern economy.

Gross’ thesis is that all the things people look at as measures of valuing stocks, bonds, home prices and the like — be they P/E ratios or interest rates — depend ultimately on the availability of credit.

In an island-based economy where crops could be traded for livestock, a hot commodity like marijuana might see its P/E ratio accelerate from 1 pig to 3 pigs, he humorously illustrates.

"In order to keep this system going," he writes, "you need more pigs or more credit in order to continue. But you’re out of pigs. A funny thing now happens in this capitalistic South Sea island and mainly to the price of marijuana. It traded last year at 3 pigs to 1, but since you’re out of pigs and credit, the price collapses. Grass goes to zero because there is no more credit; you have no more pigs to pay for it."

That dynamic of available credit and consumer demand plays out thusly in the money market:

“If there was only one dollar to lend and someone was desperate to have it, the interest rate would be usurious. If there was one trillion dollars of credit and no one was eager to borrow for some reason or another, then the rate would be .01% like it is today and for the past five years in my personal money market account.”

And so it is in today’s financial economy, where Federal Reserve credit expansion and government deficit spending have inflated U.S. credit to, officially, $57 trillion. Gross says that this credit expansion has fueled P/E ratios and GDP growth.

But, “with the deficit now down to $600 billion or so, the Treasury is fading as a source of credit growth,” Gross writes.

And the Federal Reserve taper together with interest and mortgage rates some 150 basis points higher than they were in July 2012 have compounded the problem by slowing down the “velocity” of money.

The result he says is that “the U.S. and other similarly credit-based economies may find that future growth is not as robust as the IMF and other model-driven forecasters might assume.”

This poses risks, possibly including what he describes as “the whisper word of ‘deflation’ at Davos.” In this environment, “high-quality bonds will continue to be well bid and risk assets may lose some luster.”

The bond manager, whose firm was battered in 2013 by more than $30 billion in outflows, sought to reassure investors that their investments would be well tended were they to remain with the Newport Beach-based asset manager:

“Stick with PIMCO. Believe me when I say, we are a better team at this moment than we were before,” he writes, in a reference to a management shake-up that included the loss of co-CIO Mohamed El-Erian and elevation of former COO Douglas Hodge to CEO and other staff changes.

In an interview with Bloomberg TV, Gross elaborated on his views of a slowing down of financial markets, specifying he was buying 4- to 5-year Treasuries yielding a paltry 1.25% to 1.5%.

Page 1 of 2
Single page view Reprints Discuss this story
This is where the comments go.

Related

PIMCO’s Gross: ‘Era of Getting Rich Quickly Is Over’

Bill Gross talks to Bloomberg TV about bond-market tumult, why China is like "mystery meat" and what could be next...