I have long believed that real returns should be – and are – the reward for taking real risk, notably the risk that you lose hard cold dollars relative to parking your wealth in a money market account. The sources of risk on the investment buffet are many and varied: duration risk, equity risk, credit risk, volatility risk, yield curve risk, liquidity risk and yes, even fraud risk. The longer the period for which you underwrite these risks, the greater is the uncertainty associated with underwriting them. Accordingly, basic logic says that the longer the time horizon for underwriting investment risk, the greater should be the expected real return.

Conceptually, there should not be any controversy about what I just wrote. It’s just common sense, similar to a car manufacturer demanding that you pay up at an increasing rate for extra years or miles on his warranty – the longer the horizon, the greater is the uncertainty associated with bad stuff happening. In the financial markets, such extra return for taking risks is frequently called “excess return.”

Now truth be told, I’ve never liked the adjective “excess,” as it implies that the returns to risk taking are consistently positive. They aren’t! Unless, perhaps, in the very, very long run, in which we are all also dead. The horizon that is relevant to the modern day investment manager varies, depending upon many factors, including the type of investment vehicle and the track record. For an established investment manager like PIMCO, let’s say 3-5 years. Or, as Bill Gross is fond of saying, that’s about as long as clients will tolerate persistent negative “excess” returns from risk taking.

Not that it’s not okay to sometimes lose money. Indeed, it is impossible to make money without risking losing money. This holds for both managers running against benchmarks of market risk – such as equity managers against the S&P 500 and bond managers against the Lehman Brothers Aggregate – and hedge fund managers, who are de facto benchmarked against the rate of return on cash. In the end, what clients ultimately want from their investment managers is a high information ratio: high excess returns per unit of volatility generated by the strategies employed to generate those excess returns.

Conventional Basis of Valuation
This is not a new game. Indeed, none other than John Maynard Keynes described the game beautifully in Chapter 12 of the General Theory:

“It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investors, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing change in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps,’ but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behavior is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organized along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.”

Yes: “Foreseeing change in the conventional basis of valuation” is the cat’s meow of professional investment management. I joke with my good buddy Bill Miller of equity management fame that doing this is easier in his arena than in the fixed income arena. And he doesn’t altogether disagree with me: swings in the “conventional basis of valuation” are more extreme within the equity market than in the bond market, notably swings in both the overall P/E of the market and the relative P/Es of small caps versus large caps and growth versus value.

But then Bill reminds me that such changes in relative valuation, while certainly influenced by changes in mass psychology, as Keynes intoned, are more fundamentally linked to the changing ability of various types of companies to generate free cash flow. In fact, Bill is actually a proven exception to Keynes’ description of “most” professional investors. Miller really does have the mind set of a man who buys “for keeps!” One of his favorite one-liners is that stocks are bonds without a maturity date or any coupons printed on them. What he does is try to forecast the coupons.

In contrast, since bonds do have maturity dates and coupons, it is much more difficult to ignore changes in “conventional basis of valuation.” While equity holders get to keep “for keeps” positive surprises with respect to free cash flow, bond holders’ upside is capped by a bond’s par value at maturity. To be sure, a bond investor can do what Miller does in the distressed debt market, also known as equity in drag. And, a few years ago (but not necessarily now), she could do it in the emerging debt market, too.

But in the investment grade market, and particularly in the developed-country sovereign debt markets, the nature of the game inevitably must be about “foreseeing change in the conventional basis of valuation.” Put simply, it’s all about foreseeing changes in:

• Central bank policies, which determine the real rate of return on the cash, which is the floor for required expected returns on all other more risky investments, and
• Investors’ risk appetite, which determines market-clearing risk premiums above the expected real rate of return on cash.

It really is that simple; and that difficult! And at the global level, the difficulty is compounded by the interaction of capital flows and fiat currency regimes: changes in central bank policies and investors’ risk appetites not only have domestic impacts, but reverberate literally ‘round the world, with the most profound implications being on currency values, which definitionally are relative prices (you can’t love one without hating another!).

But no complaining. Professional investment management, and particularly fixed income management, is about the coolest job there can be for macro mavens. Over the last year, we have had to grapple intensely with competing changes in the “conventional basis of valuation” for the U.S. yield curve: soaring real short-term interest rates and a collapse in the risk premium for duration extension. This dual outcome is known, of course, as Mr. Greenspan’s conundrum.

A Curve Should Curve
He will be retiring at the end of this month with his conundrum still intact. For us mortals who will continue to toil in the fixed income vineyard after the Maestro retires, however, nothing is more important than figuring out how the conundrum will resolve itself. Nothing! Unless, of course, one wants to assume that the current flat yield curve is now the new “conventional basis of valuation,” set to remain in place for the foreseeable future.

I don’t. Which brings me back to where I started: common sense – which is Bill Gross’ PhD in economics – tells us that the yield curve should be positively sloped, that long rates should be meaningful above short rates, to reflect a positive risk premium for the inherent price risk of longer-dated instruments. In turn, that common sense axiom says that a year from now, either long-term rates are going to be higher than today or short-term rates are going to be lower than today. Or maybe both!

We here at PIMCO have a viewpoint: short rates will be lower, as the Fed closes the on-going tightening cycle at the end of this month and commences an easing cycle by the end of this year. Long rates? Call us card-carrying agnostics. Therefore, we are not nearly as enthusiastic about running long of duration versus our benchmarks as we are running long of yield curve risk versus our benchmarks. Borrowing from the great movie The Graduate , the one thing you need to know is that today’s yield curve ain’t normal, but rather, borrowing from the great movie Young Frankenstein, Abby Normal.

Other Risk Premiums?
And what does normalization of the term risk premium in the yield curve imply for other risk premiums? Regrettably, it depends on how the yield curve normalizes. If it happens as we anticipate, with short rates falling and long-rates going sideways, stocks are going to go up, shrinking the equity risk premium a lot, with large-cap growth shares providing the leadership. In contrast, if the curve were to normalize with short rates going sideways (the Fed ain’t going be tightening a year from now, even if it ain ’t easing!) and long rates rising, the equity risk premium is likely to remain stuck where it is, with upside for stocks limited to earning growth.

And whichever the case turns out to be for stocks, credit risk premiums are likely to widen, for the simple reason that Corporate America has too much cash on its collective balance sheet. It’s been great for corporate bonds while the cash has been building, but it’s important to remember that corporate leaders work for shareholders, while only having a contractual obligation with bond holders. Shareholders are now demanding that CEOs watch reruns of that great film, Jerry Maguire: Show Me the Money!

Indeed, it is stunning to recall that a little over three years ago, in the summer and fall of 2002, the investment grade corporate market was not functional, in what was known as a “crisis of confidence” in capitalism. It was a great time to buy. Now, with capitalism and capitalists presumed to do no wrong, it is a great time to let others take that risk at skinny premiums. Remember, CEO’s don’t work for bondholders, unless they have no choice. Now, they have choices.

Volatility risk? I must admit that it is worrisome that it is priced so low, in equities, bonds and currencies. Somehow, my gut says, actual volatility – which drives implied volatility, or the risk premium, in options – is not going to stay low in all three markets. Put differently, you don’t have a major turning point in the Fed cycle without some gritting and gnashing of teeth somewhere.

Logic says, however, that a nasty rise in volatility is far more likely to visit stocks and currencies than bonds. The prospect of never-ending Fed tightening has held stocks back, with the P/E multiple shrinking, lifting the equity risk premium. The prospect of never-ending Fed tightening has also supported the dollar, particularly in the context of little-to-no expectation of tightening by other developed country central banks.

With the Fed ending the present tightening process (and with the markets romancing easing thereafter, even if the Fed will be reluctant to ease), it seems to me that it is time for a change in the “conventional basis of valuation” between U.S. equities and the dollar: time for stocks to go up and the dollar to go down, bringing rising volatility in those markets, even as we in the bond market hum Pink Floyd’s Comfortably Numb.

Bottom Line
Risk taking is a risky business. But logic says you gotta take risk to make real returns. As the Lotto jingle goes, you gotta be in it to win it. What the Lotto folks don’t tell you is at what odds to be in it, because the odds are definitionally in favor of them, not the buyers of their tickets.

In the investment arena, you don’t have to be in it to win it. Rather, you have to be in it or out of it at the right price . It’s called active investment management, taking positions on both the overweight (long) and underweight (short) sides of risks embodied in benchmarks. And determining the right price inevitably is about evaluating risk premiums: are they too wide or too skinny?

Yes, in the long run, risk premiums tend to be mean reverting, an axiom embedded in many long-term portfolio optimization exercises. But cyclically, risk premiums behave cyclically, as the great economist Forrest Gump might say. Accordingly, the game of active investment management is, as the great economist Maynard Keynes described, one of “foreseeing change in the conventional basis of valuation a short time ahead of the general public.”

And that cyclical game is fundamentally about anticipating changes in central bank policies and investors’ risk appetites. With the Fed near the end of its tightening cycle and the term risk premium embedded in the yield near zero, cyclical logic screams that the most important looming change in the “conventional basis of valuation” will be the yield curve: PIMCO firmly believes that over the next 1-2 years, the curve will once again become a curve.

We are positioned accordingly.

Paul McCulley
Managing Director
January 5, 2006

mcculley@pimco.com