Bill Gross, “King of the Bond
Market”, was recently quoted in the FT as he gave a presentation to an audience
of financial advisers in Chicago:
I’ll be handing you the keys to the Pimco Mercedes.
I am sure that at this point the
audience members leaned just a little farther up in their seats in order to
make sure that they heard every word uttered by the biggest bond owner in the
world (outside of the voracious central bank owners, of course).
Mr. Gross then went on to
explain that he was selling insurance to other bond buyers against market
volatility. He is, for a small fee, willing to insure others against falling
bond prices.
Now, this might be a
reasonable thing to do, or it might be quite foolish. As the FT points out, it
doesn’t really pay to write flood insurance right before a big flood. Over time
though, it can be quite a reasonable business if priced correctly.
Mr. Gross says about the
strategy that:
….over time it has been a very respectable structural
template alpha generator.
In short, it has generally
paid to write this type of insurance.
My response to this is, of
course it has paid to write insurance in the bond market over the past several
decades. After all, the market has seen almost nothing but interest rate
declines (price appreciation) for most of the past thirty years. The last 15 years of interest rate declines
were in fact turbocharged by central banks printing copious amounts of new
scrip and using it to buy bonds. Selling insurance against losses in this type
of environment was a good idea for several decades. The premiums rolled in and
you rarely had to pay out on losses.
The question is, is it a good
idea today to sell such insurance? I suspect not.
The reason, quite simply,
that this is so is that interest rates are nearly zero today and even the Fed
realizes that they must stop their infinite dollar creation soon. Logic,
therefore, might require a little caution with regard to the financial
insurance business. When the biggest bond buyer steps away and stops creating infinite
amounts of liquidity I would think that an accident in the bond market might
become a more likely scenario. Hence, we should expect the price for insurance
to start to rise.
Alas, the market is acting in
the opposite fashion. According to this, admittedly month old, FT article there
are now so many players desperate to sell insurance here that insurance prices
in the market are actually falling. Why would this be?
Now, I doubt that many
financial advisors would be willing to lean forward in their seats to hear what
I am going to say, but I am going to let you in on a major secret of the money
management business:
If you are a fund manager,
clients don’t care if you lose most of their money if everyone else is losing
money too. Lose their shirts for them in a bear market and you are probably OK.
If, however, you fail to participate fully in a bull market your clients will
fire you. Failure to perform in a bull market is the cardinal sin of money
management.
The pressure to participate
in what has been a 33 year bull market in bonds must be enormous. Of course, I
am certain that Mr. Gross truly believes that his strategy will be a profitable
one for his clients, but I am also certain that with interest rates near zero
it has become enormously difficult to produce outsized returns for clients and
the pressure to do so in this environment is substantial. It is this pressure
that is leading so many to want to sell insurance in order to pick up a little
added yield even after a 33 year bull market in bonds that has resulted in
interest rates near zero.
In my opinion, this is the
type of behavior that is exhibited at major bull market tops. Of course, I have
been thinking this way for several years and financial asset prices just jet
ever higher.
There is an axiom to major
bull markets that I would like to add right here; major players in bull markets,
no matter how irrational their investment calculus, see their reputations becoming
ever more lustrous while dissonant voices are dismissed (or worse, exiled to
the writing of blogs that no one reads).
This, of course, is nothing
new. It is part of human nature and it has always been so. Today, the world is
desperate to believe that central bank printing can create wealth from thin
air, a constantly growing economy, jobs for everyone, stock, bond and real
estate prices that will never again be allowed to fall and all of this can be
done without any inflation in the price of goods and services.
In that world, selling
insurance against financial loss seems to be the wise choice. Buying insurance,
on the other hand, amounts to flushing money down the toilet. Your performance
will suffer and you, as a fund manager, run the risk of being fired. Again, dissonant
voices in bull markets are silenced.
All of this brings me to the
subject of today’s scribbling, the original dissonant voice, the Earl of Stair.
Now, I am unsure as to how
many Earl’s there have been, but I am referring to the gentleman who was
Britain’s ambassador to France in the early 18th century.
As a bit of background, the
information that I am going to relay comes from the book Millionaire written by Janet Gleason in 1999. The book’s title
comes from the fact that the word millionaire was coined at this time in France
thanks to the efforts of one John Law. At this time, money was so ubiquitous that it seemed as if
everyone could become rich on the back of rising prices in the greatest share
scheme of its day.
Before Bernanke and Greenspan
ran amok by artificially forcing down interest rates via the printing press
leading to a series of financial market bubbles, there was John Law.
Gleason in her book details
how Law, in the early 18th century, wound up as the central banker
of France, took control of the Mississippi Company, moved France from using
gold as money to a paper standard that then unleashed an incredible bubble in
the Mississippi Company shares that enveloped all of Europe before crashing.
While the scheme was running
full tilt it appeared that paper money and Mississippi shares were allowing
France and her people to amass incredible fortunes. Everyone was desperate to
participate. Every word uttered by Law was dissected and analyzed for a key as
to how far Mississippi shares could rise, and the power of France appeared to
be on the upswing as its apparent wealth skyrocketed.
Not everyone fell for the
scheme, however. Britain’s ambassador to France, the aforementioned Earl of
Stair, was quite skeptical of it all. Though he was a good friend of Law’s, Gleason
says:
Stair was distrustful of Mississippi speculation and
scoffed at every price rise. In August, as share prices zoomed upward he had
commented venomously that the frenzied market was ‘more extravagant and more
ridiculous than anything that ever happened in any other country.’ Law had then
offered him a large number of shares and was offended when he refused them with
the pompous rejoinder that he did not think it became the king’s ambassador to
give countenance to such a thing.
As Law’s power grew, Stair
did notice that this power was going to Law’s head:
He….pretends he will set France much higher than ever
she was before and put her in a condition to give law to all Europe; that she
can ruin the trade and credit of England and Holland whenever he pleases; that
he can break our bank whenever he has a mind and our East India Company.
As France’s power was on the
rise and Law’s influence was strengthening, Law’s overt jingoism frightened
those back in London and the wisdom of antagonizing Law, as Stair was apt to
do, was questioned. As Gleason points out:
The career of Stair, the weakling who had picked an
argument with a prizefighter, was doomed. When Lord Stanhope visited Paris in
early 1720, his predictable conclusion that Law should not be provoked heralded
the end of a brilliant diplomatic career for Ambassador Stair. The following
spring he was recalled.
Stair, of course, was right
about Law, paper money and the Mississippi Bubble. It was all completely
ridiculous and doomed to failure. Stair, as the dissonant voice in the bubble,
had to be silenced, however.
Today, Bill Gross is
implementing a strategy that was a great idea three decades ago while I contend
that it is nothing but folly today. Gross remains the “King of Bonds” while
those of us with dissonant voices scribble our musings for just a few other
like-minded individuals. I am confident that, like Stair, we will be proven
correct about today’s bubble. Unfortunately, also like Stair, we will
apparently have to run a gauntlet of abuse from bubble believers before it all
ends.
Things rarely ever change.
I would also like to make one
other concluding point; just how threatening to other powers Law was willing to
become as the Mississippi Bubble expanded. This too sounds suspiciously
familiar to modern day bubble chroniclers, though this is a topic for another
day.
Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.
