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My Book Reviews

Category: Investing strategy
Published: 1997
Read: 2000
Reviewed: Aug 2010

Written in 1997 by well-known bond fund manager Bill Gross of Pimco, this book is 1/4 biography, 1/4 tutorial, and 1/2 prediction. The basic premise is that the superbull trend in the stock market is over and that investment returns will be lower going forward. He refers to these post-bull markets as the "era of 6%". He claims that things won't be a good as they were, but they will still be OK.

Gross' hypothesis is based on a combination of factors, specifically: high debt levels, stagnant wages, and unfavorable demographics. These factors will result in tepid GDP growth that will lead to an era of low inflation and an investment environment where bonds will have a advantage over stocks. He recommends giving a heavier weighting to bonds in your portfolio and to keep maturities long.

He uses a very simple, but useful, model for predicting expected returns. For stocks, the formula for total return is "expected earnings growth + current dividend yield". He arrives at an 8% expected return for stocks. John Bogle also uses a model like this. For bonds, the formula for total return is "coupon + expected capital appreciation". He assumes that the bond market will be stable going forward, so the capital appreciation will be about 0%. When you add the 6% coupon, you arrive at the expected 6% total return for bonds.

Since his book is promoting bonds, he gives some quick introductory tutorials about how bonds work. He lists the types of bond risk (default risk, interest rate risk, liquidity risk) and the returns on the different types of bonds (Treasury, muni, corporate, junk, emerging market, mortgage, inflation-indexed bonds). He also educates the reader about how "bond market vigilantes" keep the bond markets in order.

Here are a few useful quotes from the book:

  • "In the last few years, market behavior has become a lot more anticipatory."
  • "It's fortuitous sometimes to be an outsider on the inside."
  • "Financial assets benefit more from the transition to lower inflation than from the actual lower inflation itself."
  • When talking about how volatility affects option valuation models, he says, "Because of market noise...the short-term volatility of price will be greater than the short-term volatility of value."... Money managers who use short-term volatility estimates for longer-term option valuation are systematically overvaluing option prices. Most of the optionable characteristics of bonds (corporate calls, mortgage prepayments, and selected futures contracts) are longer-term in nature but appear to be priced on ten-and ninetey-day volatility histories.

This book is strong in many ways. (1) It is written in a down to-earth style which makes it easy to grasp. (2) It teaches you to think for yourself. His models for predicting returns and his "plankton theory" of housing markets were very useful. (3) Gross is very progressive when it comes to his views towards markets. He doesn't believe in the efficient market hypothesis and explicitly states that is possible to time the market based on secular changes, like globalization and demographics. He cites Jesse Livermore as his hero, which is surprising considering he is a Wall Street guy - and a bond investor. (4) He is not afraid to make a tangible prediction about the market, instead of some vague outlook.

Looking back at the decade after it's publication, the book's hypothesis that bonds should be given a heavier weighting and that investors should be happy with a 6% return were proven true. By this time though, the book has become too dated to be used as a template for where to put your money. We are now in an environment where long bonds have very small yields (3.7%) and are more apt to have negative capital gains than posititve. Interestingly though, Gross hasn't necessarily backed off his promotion of bonds. This is presumably due to an expectation of a persistently bad economy which will keep rates from rising. Bond investors should definitely be more careful now though since: there are whispers about muni-bond defaults, mortgage-backed bonds don't have any transparency, and junk bond risks are high because of the still-shaky economy. With the pristine balance sheets of corporate America and a pretty wide spread between corporate bonds and Treasuries, perhaps high-grade corporate bonds are the place to be with 20-year AA-rates bonds current yielding 5.8%.

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