The Bond Market’s Raging Bear

Why stock investors should ignore bond guru Bill Gross.

Bill Gross—no relation to Moneybox—startled the markets last week when he proclaimed that the Dow Jones Industrial Average should fall 40 percent more. “Stocks stink and will continue to do so until they’re priced appropriately, probably somewhere around Dow 5,000, S&P 650, or NASDAQ God knows where,” he wrote.

The proclamation was a little like a teetotaler proclaiming this year’s Beaujolais Nouveau undrinkable. Someone who never touches the stuff shouldn’t have much credibility as a critic. After all, Gross manages the PIMCO Total Return Fund, a huge mutual fund that invests only in bonds. His job is to think that stocks are damaged goods.

Gross’ admittedly derivative argument is not terribly sophisticated. “The primary element in determining how a stock market is priced—whether it’s cheap or expensive—is its yield,” he contends. Yield is represented by dividend payment. Currently, the broad Wilshire 5000 index pays a collective dividend of about 1.7 percent. That’s less than the yield paid by the safest long-term investments—30-year government bonds. Since people need the promise of a higher return to own stocks for the long-term, the market “needs to yield close to 3.5 percent before it approaches fair value,” he argues. For the current dividend yield of the Dow to be 3.5 percent, it would have to fall to 5,000. He concludes that unless the market crashes, and soon, “future real equity returns will be lower than 5 percent, and a diversified portfolio of government, mortgage, and corporate bonds will be the best performing asset class for years to come.”

The play this thinly veiled marketing ploy received is both a sign of just how far stocks have fallen—literally and figuratively—and an indicator of the new hierarchy on Wall Street. As many fund managers have struggled in the past two years, Gross and his colleagues have prospered so much that he now runs the largest actively managed mutual fund in the country.

For much of the 1990s, bond fund managers were like tourists standing outside a Tribeca nightclub, inching up on their tippytoes to catch a glimpse of A-listers heading inside. Bonds, with their single-digit returns, were boring, Old Economy. Nobody swapped tales on the 18th green about how they made a killing on General Electric’s 10-year notes.

PIMCO, which manages $274 billion, mostly in bond funds, grew in the 1990s as well. Large institutional investors like pensions and insurance companies continued to buy bonds. And as interest rates fell, companies refinanced debt and sold new bonds. But bonds were never explosive and never glamorous. While Gross did occasionally appear on CNBC as a token fixed-income pundit, he was not really part of the New Economy scene.

The explosion of the dot-com bubble and the cascade of stock-killing corporate scandals have made bonds trendy and bond fund managers like Gross the preferred gurus of the post-Enron-WorldCom-Tyco-Global Crossing-Arthur Andersen era.

Bond investors are by nature more suspicious, more risk-averse, and less gregarious than stock investors. Stock mutual fund managers buy into stories and hold on until they stop believing. They put up their money with no guaranteed return. By contrast, bondholders require a regular interest payment and security. (Bonds are backed by the assets of the company in some form. If the company fails, they still end up with something.)

Bonds are less compromised by the conflicts of interest in the stock business. Stocks are rated, or recommended, by analysts at investment banking houses, many of whom have turned out to be little more than shills. Bonds, by contrast, are rated by more-or-less independent agencies like Standard & Poor’s and Moody’s. Many analysts maintained buy ratings on stocks that were plunging down to $1 per share. By contrast, bond ratings agencies don’t hesitate to change their grades if a company falters.

For much of the 1980s and 1990s, Fidelity’s mammoth Magellan Fund was the largest U.S. mutual fund. Consequently, the manager of Magellan—whether it was Peter Lynch, Jeffrey Vinik, or Robert Stansky—was paid special deference. Whatever he said was amplified, and the positions he took had the power to make individual stocks and influence the overall market. Now Gross has inherited that first position. In the late 1990s, as indexing grew in popularity–and as the indexes rose–Vanguard’s passively managed Vanguard 500 Index Fund challenged Magellan for the top spot. But since 2000, both have lost value—and lost investors—while PIMCO has gained. At the end of July 2002, PIMCO Total Return managed $61.2 billion, compared to Magellan’s $59.9 billion, making it the largest actively managed U.S. mutual fund.

This puts Gross in a tough and unfamiliar position.

Bonds have already experienced a tremendous bull market. And unlike stocks, there’s a limit to how high bonds can go. The value of bonds rises when interest rates fall. And interest rates have plummeted in recent years, reinforced by the economic slowdown, the Fed’s 11 rate cuts in 2001, and the flight of investor cash out of stocks and into bonds.

But with rates at historical lows—the Fed Funds rate stands at 1.75 percent—and future significant interest rate reductions unlikely, a bond mutual fund manager will find it difficult to make excellent returns on new cash invested in bonds.

There are two ways that Gross’ mammoth portfolio can continue rise—and hence attract new investors. The first is if interest rates fall further, which is unlikely. The second is for lots of new money to flow into bonds. If a flood of new buyers seeks to take positions in existing bonds, prices will rise. The prediction that the Dow will crater to 5,000 can be seen as an effort to encourage more people to abandon stocks and join his bond squad.

Hmm. Individual investors rushing into a new and unfamiliar asset class? A market guru with a product to sell setting seemingly outlandish price targets on the Dow? Prices of securities determined more by demand than by their yield? Giant pools of money sloshing around in search of new ways to beat the indexes? Evidently, I’m not the only one who thinks this sounds familiar. The cover of the current issue of Business Week asks: “Bonds: Is There a Bubble in the Market?”