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Jeff Saut Presents: Notes From the Pimco Investment Conference


Interestingly, all of the speakers were long-term bearish on the dollar and bullish on energy.


"She's so fine, there's no tellin' where the money went."

. . . "Simply Irresistible," by Robert Palmer

I had the privilege of attending Pimco's investment conference in Dana Point, California last week. The headline speakers were Colin Powell and Alan Greenspan, with Jay Leno providing the entertainment. To begin the conference, however, Bill Gross was the opening speaker and suggested that "Alpha" is getting harder to generate. While we have never heard a retail client talk about buying alpha or beta, these two Greek words are commonly discussed among investment professionals. For the record, alpha and beta are defined as follows:

ALPHA is the measure of risk-adjusted performance. An alpha is usually generated by regressing the security, or mutual fund's, excess return over the S&P 500's return. The BETA adjusts for the risk (the slope coefficient). While most stocks move in the same direction as the stock market, the level of the beta indicates the degree of correlation between a stock and the stock market. The market is the benchmark and has a beta of 1. Therefore, a beta of 1.50 signifies a stock that tends to be 50% more volatile than the S&P 500 Index.

Clearly the rational investor wants more alpha with less beta (aka less risk), yet Bill Gross correctly observes that alpha is becoming harder to generate (note that our Focus List has provided an excess return of some 4% year-to-date). One of the reasons for this, he averred, is the "democratization of finance," which has increased money flows around the world and in the process compressed risk-premiums as well as alpha. He further suggests that trillions of dollars are currently being held not for economic reasons, but for noneconomic reasons . . . hello
. Consequently, Bill Gross stated that as he attempts to follow the world's money flows, he often finds himself recalling the line from one of Robert Palmer's hit tunes, "She's so fine, there's no tellin' where the money went." Bill concluded his presentation by noting, "That in an alpha deficient environment, why in the world would anybody want to index and run the risk-reward 'bet' that risk premiums could expand with an attendant loss of investment capital?" His strategy, therefore, is to find nonindexed, less risky, bonds, which are on the "fringe," and overweight them in portfolios. As an example, he said he is buying euro dollar futures maturing in 2007 – 2008 ("CD-like"), while taking small anti-dollar "bets" (he's bearish on the U.S. dollar) in an attempt to generate alpha.

Colin Powell began his talk by noting that after being retired twice, and about to turn 69, he was in need of a new "toy" so he bought a Corvette. Using this as an analogy, he suggested that you have to approach "things" looking through the front window because what is in the rear window is already behind you and cannot be changed. He said that while it was not a mistake to liberate , that indeed mistakes had been made. One mistake was in not realizing that once "the regime" was overthrown we would de facto become the government. Still, the former Secretary of State declared it would be a far greater mistake to abandon now. While Mr. Powell was fairly upbeat on the world's geopolitical climate (no wars in Europe for the first time in 200 years), he did express concern with the rising tide of protectionism and the fact that fewer foreign students are coming to for education. His sense is that this will hurt the in the long-run because those students have not "lived" with Americans and learned how welcoming, compassionate, generous, caring, etc. we are and thus be able to carry that experience back to their homelands. For example, he related the story of 12 South American students he had met with in Washington D.C.

Months later he journeyed to
South America and asked to meet with those same students. Upon seeing them, he encouraged each student to share an event that had impacted them the most from their two-week stay in the US. The story that most impressed him was recounted by a 12-year old boy who stated that – while in Chicago the students had snuck away from their chaperones in search of "real" Chicago pizza. Eventually they found a pizzeria and promptly devoured the sought after treasure. When presented with the bill, however, the students did not have sufficient funds to pay the "tab." Upon hearing this, the waitress walked over to her manager who subsequently approached the table. Fearing the consequences, the students trembled as he approached, but it was all for naught. Indeed, the manager said that he was so happy to have students like them in his country that the meal was on "him." And that experience, said Colin Powell, will stick with those students for the rest of their lives.

Then there was Alan Greenspan, who said that the "new conundrum" was the collapse of "risk premiums" around the world. Now our definition of risk premium is – the excess return required for holding a more "risky" investment than a risk-free investment. For example, the excess yield spread between Treasury and non-Treasury Bonds of comparable maturity. Or, the extra return the overall stock market, or a particular stock, must provide over the interest rate on Treasury Bills to compensate for the market risk. While the esteemed ex-Chairman attributed some of this "new conundrum" to excess worldwide savings, he suggested the untold story is the extraordinary low-inflation expectations that currently exist. He proposed those low expectations have been driven by the collapse of Russia, which showed the world that "central planning" doesn't work. Many countries, therefore, eschewed communism/socialism in favor of capitalism/democracy. And that, ladies and gentlemen, caused a few hundred million educated people to be thrown into the workforce, which in turn has kept wages "flat." Mr. Greenspan observes that "flat" wage growth is not just a phenomenon . . . it is ubiquitous.

On the dollar, Greenspan is bearish, noting that "concentration risk" will, over time, curb capital flows into the greenback. To wit, eventually
will have too many dollar reserves and will have to diversify its currency exposure. He was also quite concerned about the looming Medicare/Medicaid deficits as more of the baby boomers come of age. While the social security deficits are quantifiable, he noted, Medicare/Medicaid deficits are not! He further opined that short-term deficits tend not to matter, yet long-term deficits (like Medicare/Medicaid) matter a great deal. Whenever the 30-year Treasury Bond begins discounting these deficits is unknowable, but eventually it will with an attendant rise in interest rates. Greenspan concluded his comments with a bullish stance on energy. He said that while reserves were growing somewhat in-line with demand, refining capacity, to process that crude oil, was woefully short due to 25 years of underinvestment (we are bullish on the drillers).

Interestingly, all of the speakers were long-term bearish on the dollar and bullish on energy. Obviously, those comments resonated with us given our bullish stance on "stuff stocks," as well as our bearish stance on the "buck" over the last five years. Verily, oil prices, and interest rates, are rising again, with crude oil tagging a multi-month high of $67/bbl. last week. As well, interest rates broke above the much-watched 4.8% level (10-year T'bond yields closed at 4.85% on Friday). Meanwhile, the yen "carry trade" is back in play coincident with the recent strength in the commodity markets combined with the weakness of the yen. Yet while several indices rose to new reaction-highs last week, Lowry's Buying Power continued to wane and Selling Pressure continued to rise. Manifestly, despite all of the media hype, the S&P 500 (SPX) is no higher now than where it was on
January 11, 2006 (SPX/1294.90). Moreover, the D-J Utility Average (DUX) has dropped to a new reaction low, which is troubling since the DUX has been among the best performers since the October 2002 lows (we were bullish). Note that the DUX tends to "top" three to 12 months prior to the major market indices.

As for us, we remain cautious in the short/intermediate-run thinking that end-of-the-month, end-of-the quarter, end-of-the-year (in ) machinations will have "end-of-the-rally" connotations for our equity markets. Whether we get an upside blow-off or not, we remain cautious. Therefore, we advise participants to review their portfolios and eliminate positions that have not performed since the October 2005 lows (again, we were bullish). Last Monday we also expressed the opinion that natural gas had bottomed, a view we still hold. Almost on cue, natural gas gained roughly 9% last week with an attendant "lift" in two of the natural gas stocks we recommended in last week's letter, namely Apache (APA) and Ultra Petroleum (UPL), both of which are followed by our fundamental analysts. Also worthy of note is that 3.3%-yielding Newell Rubbermaid (NWL) broke out to the upside in the charts last week.

The call for this week: A bunch of mergers, combined with a renewed yen "carry trade," has the pre-opening futures pretty perky this morning. Consequently, look for a higher opening that could build into an upside blow-off into Wednesday's synchronistic serendipity when at two minutes and three seconds after 1:00 a.m., the time and date will be 01:02: 03 04/05/06, which will not happen again in our lifetimes.


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