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What’s Jeff Gundlach Thinking?

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Our interview took place prior to the announcement in mid-September that Gundlach’s home had been burglarized of 13 pieces of valuable art, in addition to wine, wrist watches and cash. Thieves also took Gundlach’s red 2010 Porsche Carrera 4S. In a dramatic and chaotic press conference in downtown Los Angeles two weeks later, the star fund manager increased the reward offered for the return of his stolen property from an initial $200,000 to $1.7 million. We’ll continue to report new information as it becomes available.

Sure, Jeff Gundlach is given to loud suits, fast cars and quoting Shakespeare. He also has assets under management and a performance record that are the envy of the money management industry. Call him eccentric if you like, but you’d have to follow it with another accompanying superlative (Hint: It rhymes with “zenius”).

The CEO and CIO of DoubleLine Capital is the “it” manager of the mutual fund space, a title he’s enjoyed since being named 2006 Fixed Income Manager of the Year by Morningstar. At the time he was CIO and head of fixed income activities for TCW. Barely three years later he was named as a finalist for Fixed Income Manager of the Decade—a title that eventually went to Bill Gross—when, in a move that shocked the industry, he was summarily fired from TCW (makes you wonder about those stewardship grades). His acrimonious exit led to lawsuits and counter lawsuits, the salacious details of which won’t be repeated here. But Gundlach’s winning ways meant he somehow “lost” the case by being awarded $66.7 million.

If living well is the best revenge then Gundlach is the fund industry’s Juvenal. Since starting DoubleLine in 2010, when the ashes of the TCW debacle were still hot, he’s amassed $43 billion in assets under management ($45 billion by the time this interview is published, he confidently told us). As we said, the envy of the industry.

The star manager status he’s attracted is something we’ve witnessed firsthand. Following his presentation at a conference in early April, Gundlach held forth in the lobby as advisor after advisor—oblivious to or uninterested in the subsequent presenters on stage—asked for his insight for the better part of an hour. It was only after his PR assistant deftly informed him of his next appointment that he was able to extricate himself. As we headed off for our scheduled interview, one lone advisor followed to thank Gundlach for all he does and inform him of the millions the advisor’s firm had just invested with DoubleLine.

Funny thing about Gundlach; he’ll make you his Passepartout for a trip around the investing world in 80 minutes. A person can’t be an expert on everything, but in Gundlach’s case, the truism is wrong, or so it seems. We posited one question and got an earful of master’s level information. In the process, he answered four or five other questions we’d prepared without ever being asked.

We began with his criticism of model-driven investing, our raison d’être for the latest interview, before getting off track. But with a not-insignificant percentage of money managers making a very good living from the strategy, it seemed as good a place as any to start.

“It extrapolates the past into the future,” Gundlach said. “Models by their very nature use statistical regression at their center. The thesis underneath it is that the way things behaved in the past will be predictive of how they will act in the future. What’s wrong with it is that the future doesn’t resemble the past, particularly when there is technological change or innovation.”

The example he cited was the modeling of homeowner behavior. An important question in the world of fixed income and mortgage-related securities is, “When and to what degree will these people refinance?”

“When I started in the business, there was a general rule almost set in stone on Wall Street,” he said. “You would never see higher than a 20% annualized rate of refinancing. Then comes 2003, and that rule no longer works. In that year, 70% of all homeowners in America refinanced their mortgages.

“Obviously, 70% is way higher than 20%,” he wryly added.

Despite surrounding himself with world-class research and the industry’s best and brightest, it was nonetheless his own intuition that alerted him to the danger.

“I got home from work one evening, and there was junk mail from a mortgage originator that described the interest-only loan,” he recalled. “The models that had been developed in those days to predict homeowner behavior, not surprisingly, did not have this type of loan factored into their forward-looking projections for 2004 and 2005. They were operating under the false assumption that the variables and coefficients from the past would stay the same.”

It got so bad, he recounted, that one month’s refinancing results were 250% higher than the highest forecast from the month prior, something he found “very telling.”

“If there’s one thing you would have to believe in if you’re going to believe in model-based investing, it’s that you should be able to predict next month’s prepayment behavior,” he explained. “You know where interest rates are, you know where the refinancing index is, you know what housing starts are, you know what existing home sales have been and you have lots and lots of data, and yet the error was 250%. Model-based investing takes that type of embedded assumption error and multiplies it.”

Easy to criticize, but what does DoubleLine do that’s better?

“We’re selling water in the desert,” Gundlach quipped. “And we have some uniqueness to what we do. We have a product that’s in demand and cash-flow-based. It generates more than competitive returns.”

Color us skeptical, but from the headlines he’s generated and the enthusiasm we’ve witnessed, his “star manager” image has to be a factor. Whether it’s false modesty or he truly believes it’s inconsequential, he wasn’t buying that.

“Our clientele really is independent-minded; they think for themselves and really understand the way in which we think about risk, which is carefully,” he diplomatically answered. “We have a huge following in the very high-net-worth category, and that’s where all the money is. We have the luxury of having our maximum appeal in the demographic that has all the money.”

That’s all well and good, but he still hadn’t told us, specifically, what he does better than model-based managers (or anyone else, for that matter). In a case of “be careful what we wish for,” when we repeated the question, he was more than happy to oblige.

“It has to do with exploring how your performance is going to be affected under a plausible range of scenarios, rather than focusing on one that has a very high likelihood,” Gundlach countered. “Model-based investing also tends to give very little mind to what’s perceived to be very low probability outcomes. There are some outcomes in which one might say, ‘That’s out of synch with my macro thinking’ or ‘It’s never happened before.’ If it’s a disaster case, it’s weighted at such a low probability that it doesn’t really matter. On average, one could think they’ll be OK. But ‘on average’ is very dangerous. A six-foot-tall man can drown in two feet of water on average. You have to watch out for what I call ‘fatal risks’.”

He referred to Fed Chairman Ben Bernanke’s pledge to keep interest rates low for an extended period. Because investors needn’t worry about rising interest rates, they feel justified in taking on more risk to combat low yields. The problem, Gundlach explained, was that if circumstances changed “even modestly,” a fairly sharp market correction could occur as a result. 

“One of these days we will exit this strange set of circumstances. When we do, you’re going to see very substantial ramifications, especially if you were invested simply for a frozen set of variables. My viewpoint has been that the officials would take on this credit crisis and then fight it with everything in their arsenal. It continues to be cobbled together, but eventually you run out of the wherewithal to do these bond buying programs. When the economy rolls over, it’s probably going to roll over fairly sharply.”

We approached the next question with trepidation, after his reaction to a similar question we asked in April; is he at all worried about being tagged as a perma-bear?

“It’s not pessimism; it’s reality. The numbers take you to the answer,” Gundlach answered, with umbrage, last time around (See “The Endangered Perma-Bear,” Investment Advisor, June 2012).

Thankfully, this time he wasn’t quite so affected and clued us in to where he is finding alpha.

“I’m not a perma-bear because I’m actually a little bit more positive on certain things than I’ve traditionally been. For example agriculture, oil, natural gas—energy in general—even gold. I was a serial buyer of gold, frankly, below $1,600. I haven’t made much money on it, but it’s a very interesting looking setup. Boy, if you want to take a look at what was a moribund trading chart for quite a few months, it was gold.”

Now, gold is starting to show signs of life, Gundlach said. “We were not convinced just which way it was going to go. We thought it was going to break out to the upside for sure, and we’re right at the money now on our call. This is exciting because once you get a multi-month call at the money, it starts to have huge, huge gain potential. If gold [goes] up another $100, we’ll make 100% on the call. And we’ve got a couple of months left. I mean, $100 on gold from these levels strikes me as being pretty sensible.”

We also asked him about some surprising trades he’s recently made, beginning with the Spanish stock market. Maybe the fact that we found it surprising is the reason he’s so good at what he does, given what’s happened (and is happening) in Iberia these days.

“I closed that one out a couple of days ago, and it was up,” Gundlach said. “It was actually a para-trade against the S&P 500, and I made 8.3% non-leveraged. It went against me at first. But if you want to do a para-trade, I like the idea of long the Shanghai stock market.”

He switched from the Spanish stock index (IBEX) to the Shanghai because “the Shanghai has just been a debacle,” he said, somewhat disconcertingly.

“The IBEX has had such a decent rally that now the one that’s kind of on the cheap, that would go up the most due to the so-called inflationary fix, would probably at this point be the Shanghai. It’s just a study in contrast. You’ve got the S&P 500 at basically a five-year high, or very near it, and then the Shanghai is at a multi-year low. There are all kinds of problems, and China continues to disappoint, hence the drop in the Shanghai. But if the Shanghai is really going to take a big haircut, I’ve got a feeling that you’re looking at some serious problems in the global economy. It’s going to be hard for other markets to hold up.”

What he’s most looking for, unsurprisingly, are anomalies in pricing during this “frozen period.”

“I’m looking for things that have a lot of downside and minimal upside for a certain scenario and pairing them with something that for that same scenario has a lot of upside and minimal downside. That was kind of like my short-Apple, long-natural gas trade, which worked by 50%. That’s probably still a good trade. I mean, if Apple’s really going to go up 100% from here, I have a feeling that gas is going to go up 200%.”

And, of course, there are commodities.

“I like commodities more than anything else for this base-case world,” he concluded. “Commodity price increases just seem like one of the ways in which the middle class in the United States and developed Europe will lose its standard of living relative to the emerging world, which is an inevitability I think. You have this vise grip that’s going with median household incomes falling, and yet commodity prices are rising.”

Given his penchant for quoting the Bard, we asked him how Shakespeare would have described conditions to come.

Quoting Mark Antony in Act Three, Scene Two of “The Life and Death of Julius Caesar,” Gundlach left us with, “If you have tears, prepare to shed them now.”

Not exactly optimistic, given what he described prior to the quote. But we’ll take him at his word; he’s no perma-bear, he’s just looking at the numbers.


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