The More Things Change...

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 18^th 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 18^th 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.