Bill Gross opens his latest monthly letter to PIMCO clients with a classic 1996 quote from then Federal Reserve Chairman Alan Greenspan: “But how do we know when irrational exuberance has unduly escalated asset values?”Yale economist Robert Shiller later wrote a book titled “Irrational Exuberance” to describe the run-up in tech stocks right before the dotcom bubble burst.
So, with asset prices at multi-year highs, Gross tackles the issue of overpriced assets.
He references the recent work of economist Jeremy Stein who used “irrational exuberance” to question the run-up in the high yield, aka junk bond, market. Without getting into details, Stein ultimate concludes that he sees a “fairly significant pattern of reaching-for-yield behaviour emerging in corporate credit.” In other words, the valuations may be a bit stretched.
Now, Gross doesn’t declare that the junk bond market is in a bubble. After all, the title of his letter is “Rational Temperance.” From his letter:
On a scale of 1-10 measuring asset price “irrationality”, we are probably at a 6 and moving in an upward direction.
…Corporate credit and high yield bonds are somewhat exuberantly and irrationally priced. Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile. Still that doesn’t mean you should vacate your portfolio of them.
But having said that, he warns the returns are going to be low. On stocks, Gross notes that junk bond spreads tend to correlate well with stock prices. He offers this chart:
His conclusion is that we’re not in a bubble. But as his headline would suggest, we as investors should employ “rational temperance.” From his letter (emphasis ours):
The conclusion would be that where high yield prices go, stock markets follow, or vice versa. Narrow yield spreads in high yield credit markets appear to be accompanied by “narrow” equity risk premiums in the market for stocks, which is another way of saying that the course of future equity returns may not resemble its recent exuberant past. 3-4% high yield returns over the next few years? Why shouldn’t that logically lead to a generalized 5-6% return forecast for stocks? Admittedly, returns for both high yield and equity markets have been unduly influenced in the past few years by Quantitative Easing, the writing of trillions of dollars of Federal Reserve checks and the exuberant migration of institutions and households alike to the grassier plains of risk assets dependent on favourable economic outcomes. It is what central banks encourage and to date it has been successful. If and when that support dissipates or if the economy remains anemic, investors should be cautious and temper their enthusiasm.
Read the whole letter at PIMCO.com.
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