PIMCO’s Bill Gross is still one of the top bond fund managers in the U.S., if not the world.  But his tome of words that comes out each month is starting to become a reactionary market retort, and since PIMCO brought on Alan Greenspan as an advisory agent you can tell that the vocabulary out of PIMCO is changing with their crystal ball projections.  Having one of the largest bond portfolios in the world and having the ‘former’ most powerful man in the world markets on your team is starting to sound like even that does not yield omnipotence.

Here are some comments from his December investment outlook:

The woven tangled web of subprimes has claimed more than its share of victims in recent months. Homeowners by the hundreds of thousands, to be sure, but also those that created, packaged, insured, distributed, and ultimately bought what should have been labeled "junk mortgages," but which by a masterstroke of marketing genius were given a more respectable imprimatur. (that sounds like Greenspanian if ever) "Skim milk masquerades as cream," warned Gilbert & Sullivan a century ago and sure enough, modern day subprimes packaged into financial conduits with noms de plume such as "SIVs" and "CDOs" pretended to be AAA rated cubes of butter (again, this soujnds Greenspanian). Financial institutions fell for the charade hook, line, and sinker and now we all suffer the consequences. Defaults are rising, the dollar’s sinking, and good Lord—even Google’s stock price is going down. Something must really be wrong here.

So Gross can comment on Google (NASDAQ:GOOG), but if you read the wording it isn’t clear if he is referencing that Google shares have dropped or if he’s predicting a further drop.

It is. What we are witnessing is essentially the breakdown of our modern day banking system, a complex of levered lending so hard to understand that Fed Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August. My PIMCO colleague, Paul McCulley, has labeled it the "Shadow Banking System" because it has lain hidden for years—untouched by regulation—yet free to magically and mystically create and then package subprime mortgages into a host of three-letter conduits that only Wall Street wizards could explain……  Now, as the subprimes undermine these structures and the confidence in them, it is a stretch of the imagination to suggest that 75 basis points of interest rate cuts by the Fed will bring back the love.

Home prices have been the obvious first hit—down 5% nationwide already, with perhaps another 10% to go over the next several years.

Those that claim that the current cycle of Fed ease will inevitably—andshortly—lead to vigorous economic growth do not really have their earsto the ground or their eyes on their Bloomberg screens. The Fed needsto bring Fed Funds levels down steadily and significantly more in orderto counteract the contraction of the shadow banking system which hasimposed, and will continue to require, higher risk premiums fornon-Treasury securities in an increasingly risky financialenvironment…………..  Nonetheless, there are theoreticalguidelines which may help to validate or invalidate current assumptionsreflected in Fed Funds futures contracts which currently forecast anultimate floor of 3 1/4% sometime late in 2008…..  there is noone number that a computer can spit out, but nonetheless, usingreasonable assumptions, neutral Fed Funds levels somewhere in the 4% "+or –" range are produced. Assuming the Fed would have to drop belowneutral to stimulate a faltering economy, the 3 1/4% Fed Funds futuresforecast does not seem unreasonable.

….2% core inflation and 1.5% real Fed Funds require a drop to at least 3.5% just to maintain current momentum. To restart a near recessionary economy we may need to eventually go down to 3% or lower.…… Forward-looking bond investors should understand….. a return to Fed Funds levels closer to those of 2003 may be required. While the Fed is not likely to repeat its 1% "deflation insurance" levels of that year, currentFed Funds futures which predict a 3 1/4% bottom are not likely to becorrect either. Standby for a tumultuous 2008 as the market strugglesto move from the shadows back into the sunlight of sounder banking andfinancial management, accompanied by Fed Funds levels at 3% or lower.

If you would like to read the full commentary you can access that here, and that of course doesn’t include our meager and humble opinions.  But if you review his most recent notes, you’ll see how his drum beat changes quite rapidly.  It also sounds like Greenspan taught him what the word "cupidity" really means.

• This is a slightly different drum beat than in late October. 
• It also is quite different than his higher rates commentary just in June.

Jon C. Ogg
December 5, 2007

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