“The new normal” has become commonplace in describing the world economy recently. It is being used to imply a break from the past – a laying bare of the assumptions and beliefs that once formed our worldview, while at the same time defining a new, if not better, understanding of our economic reality. The phrase is so commonplace that it is even spawning new incarnations: Microsoft CEO Steve Ballmer wrote a letter to customers recently describing how the “new normal” necessitates a “new efficiency.”

Its rapid popularization, if not its origin, has much to do with the use of the phrase at PIMCO. First conceived in May 2009 at the company’s annual Secular Forum, Gross describes the “new normal” as “a period of time in which economies grow very slowly as opposed to growing like weeds…in which profits are relatively static; in which the government plays a significant role in terms of deficits and regulation and control of the economy; in which the consumer stops shopping until he drops and begins…to start saving to the grave.”¹

That it is now normative to refer to the “new normal” speaks to Gross’ widespread influence, even if it remains to be seen whether his projections are accurate. He is after all the “Bond King,” running one of the largest mutual funds (PIMCO’s Total Return Fund had $185.7 billion in assets under management – September 2009), with an enviable track record of outperforming the benchmarks. He is also widely recognized for having transformed active bond management: in the 1970s investments were made solely in government and high-grade corporate bonds; today bond managers embrace alternative debt vehicles such as derivatives, emerging markets debt, and asset-backed securities. Gross is never more relevant than now, and it is worth thinking about the characteristics that define his investment approach.

It’s important to have a secular outlook

Gross’ investment approach is not defined by any particular bond investment strategy, product, or style. He uses a multiplicity of approaches to make his investment decisions (yield curve or maturity structuring, duration management, sector rotation, bottom-up credit analysis), invests in a broad range of fixed income products (mortgage-backed securities, corporate bonds, treasuries, inflation protected securities), and embraces a variety of geographies.²

Rather, what defines Gross’ investment approach is a top-down secular viewpoint, or an anticipation of the trends that will define the economy and the markets over a period of three to five years. The “new normal” is the most recent secular idea; it emerged out of a week-long Forum that brought PIMCO colleagues together with a diverse range of thinkers – Fareed Zakaria from CNN and Alan Greenspan to name two – to analyze the current economic, financial, social, and political environment.³

It is this secular framework that underlies Gross’ investment decisions. We can see it at work in the third quarter report for the Total Return Fund, where Gross writes that his strategy is to “tactically reduce risk exposures” because the economy might fall back into a recession; “target above-index duration” because longer maturity yields might fall in a weaker economy; “move to an underweight in Agency mortgage-backed securities” because they will cheapen as the Fed’s mortgage purchase program comes to an end; and “take positions in emerging market currencies” because they expect a long-term decline in the U.S. dollar.

Turn yourself into Mr. Spock

Not every investor adheres to a top-down investment philosophy as a first priority. Warren Buffett focuses on the quality of companies rather than forecasting broad economic trends. It’s not that Buffett doesn’t think it’s important to have a top-down perspective, but he looks at “what’s knowable and important. Currency may be important, but it’s not knowable.”⁴

Despite this difference, both Gross and Buffett use the discipline of their respective methodologies to achieve a mastery of emotion. This is what Gross means when he says you must become a “Vulcan of the investment world” – by focusing on the three-to five-year outlook, “you stand a chance of eliminating the psychological whipsaws that are inherent in money management.”⁵

In his book Bill Gross on Investing, Gross credits his investment hero, Jesse Livermore, for the insight that “an investor has to guard against many things and most of all against himself.”⁶ Livermore was a trader who became a millionaire and went bankrupt eight times in the 1920s before committing suicide. Gross has a poster of Livermore on his office wall – a potent reminder of the necessity of removing emotions from the investment decision process.

Concentrate on making big bets

In June 2009, Gross’ Total Return Fund was allocated 54 percent to mortgage-backed securities and 24 percent to government-related securities. By September, that allocation had reversed to 22 percent and 48 percent respectively.⁷ It’s not the first time Gross has made such dramatic calls on the market. In October 2005, he bet that there would be a crisis in the subprime mortgage market and oriented his portfolio accordingly. In 2008, he shifted to mortgage debt backed by Fannie Mae and Freddie Mac because he believed that the government would be obliged to support these institutions.⁸

Gross learned this principle studying the blackjack theory of Ed Thorpe.⁹ Blackjack theory uses a system of counting cards to calculate whether the odds are in the gambler’s favour, or if they lean towards the house. On the rare occasion when the odds orient towards the gambler, “gambler’s ruin” probability argues that it’s important to make a large bet – but not one that will jeopardize your nest egg if the bet doesn’t play out. Gross applies this rule to his investment approach: “when you have a really good idea, one that you’re confident of and have done your homework on, you have to step up and make a large – though not potentially disastrous – bet”.¹⁰

Investing in the “new normal”

We can think about norms as the rules that govern a system and define the actions, beliefs, and behaviours within that system. Gross’ vision of a “new normal” is defining the investment decisions PIMCO is making now and over the next three to five years – and his power and prominence is ensuring that his ideas permeate the investment world. Of course, only time will prove this conception right or wrong. Even if investors use a bottom-up process, Gross’ approach reminds us of the importance of removing emotions when making decisions, and making sure that the investments we make with conviction are meaningful.

¹ Bill Gross, “On the ‘Course’ to a New Normal”, PIMCO Investment Outlook, September 2009. www.pimco.com
² http://www.pimco-funds.com/Overview.aspx
³ Mohamed El-Erian, “A New Normal”, PIMCO’s Secular Outlook, May 2009. www.pimco.com
⁴ Warren Buffett, Berkshire Hathaway Annual Meeting, 2000. www.berkshirehathaway.com
⁵ William H. Gross, Bill Gross on Investing (New York: John Wiley & Sons, Inc., 1997) 83.
⁶ Ibid., 82.
⁷ “PIMCO Total Return Fund: Quarterly Investment Report”. September 30, 2009.
⁸ Katie Benner, “PIMCO’s Power Play”, Fortune 30 March 2009. http://money.cnn.com/2009/02/19/news/newsmakers/benner_gross.fortune/index.htm
⁹ William H. Gross, Bill Gross on Investing, 91.
¹⁰ Ibid., 93.