Warren Buffett and Bill Gross are two of the most prolific investors of our time. And it just so happens both made recent headlines. The Oracle of Omaha was first with his Berkshire Hathaway Annual Letter to Shareholders. Then PIMCO’s Bill Gross issued his monthly investment outlook titled Defense. Both have made names for themselves through consistent and successful market calls. Yet, based on their latest work, they seem at odds about the future direction of markets and where to be invested. So who is right?
In Buffett’s high-level overview of investing and future expectations, he divides investments into three categories: those denominated in a given currency, like money market funds and bonds; those assets that do not produce anything, like gold; and productive assets, like businesses, farms, and real estate. Referring to the first type of investments (e.g. bonds), Buffett states: “in truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.” This is because with interest rates at historical lows, these assets actually erode purchasing power when factoring in taxes and inflation. Not to mention the substantial downside risk should interest rates rise. So their perception as “safe” is dead wrong. As an equity investor (predominately), it’s probably no surprise Buffett’s favorite area is productive assets. He views businesses, farms, and real estate as the most attractive investments in the current environment.
Gross: Staying ‘Defensive’
The primary theme of Gross’ recent post is defense. What it means exactly is up for debate, as Gross is extremely vague on portfolio positioning and lacks Buffett’s ability to clearly and succinctly state his points. Or maybe he does this on purpose, who knows? Gross is a fixed income manager, so it’s also not surprising he recommends income producing assets. Specifically, he emphasizes relatively reliable and safe income, while at the same time seeking alpha. He dubs this a combination of defense and offense. Again, vague. It appears his biggest assumption is that low interest rates and de-leveraging are here to stay. He also believes lower yields will reduce the interest component of personal income, which in turn will impact consumer spending, act as a drag on economic growth, and reduce investment returns in general.
Who Should You Believe?
In some ways, Buffett and Gross have similar positions. They both recognize the massive bond rally over the last 30 years is likely at an end, given historically low interest rates. As such, the ability for bond investors to generate outsized returns has become much more difficult. But this is where the similarities end. Buffett prefers productive assets like equities, which historically perform best during economic recoveries. In fact, he recommends staying completely away from bonds unless they’re for liquidity purposes. The downside risks are simply too great. And he makes no claim that investors should seek income over growth. He appears to view the current environment more as a typical recovery, which is the primary area he and Gross differ.
Gross believes the current interest rate environment will persist, and the use of leverage to generate profits will not—an environment he dubs “The New Normal.” In other words, he expects lower overall returns for the foreseeable future, and not just for bonds, but for the economy as a whole, including equities and GDP. To me, his “New Normal” seems eerily close to one of the most dangerous phrases in finance: it’s different this time. Gross coined this concept in mid-2009. At the time, his partner Muhammad El-Erian even suggested a V-shaped market recovery was unlikely. But that’s exactly what happened, isn’t it? The S&P 500 (using SPY as a proxy) returned 26.4% in 2009, 14.6% in 2010, and 1.9% in 2011. So far it is up 9.2% year-to-date (through February 29th). Outside of 2011, when Greece sparked a market correction, those are solid returns – representative of a V-shaped recovery. And despite the market’s run, the S&P 500 is still trading cheaper than historical levels.
Rather than say it’s different this time, I side with Buffett and say it’s not. Of course, every economic expansion is unique in some ways. This recovery has been slower than normal, especially when it comes to employment. Also, risk aversion and the Fed have kept interest rates very low. But it’s a recovery nonetheless. Employment is improving and the business environment is sound – corporations continue to post solid earnings. And stocks are climbing the wall of worry, in typical bull market fashion.
I disagree with Gross that investors should primarily seek income producing assets. There are still plenty of growth opportunities out there.