Bill Gross, PIMCO’s founder and managing director, latest letter to his firms’ client provides an in-depth discussion regarding the existing condition of overvalued assets. He started his letter with a question that was delivered by former Federal Reserve Chairman, Alan Greenspan in 1996, “But how do we know when irrational exuberance has unduly escalated asset values?”

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In his letter, Gross pointed out that the economy experienced two or three bouts of significant market irrationality since Greenspan delivered his speech in 1996 including the 1998 Asian crisis, 2000 dotcom bubble, and 2007 subprime euphoria. According to him, investors these days are closely watching any signed of renewed irrationality in the market.

Gross pointed out that the concerns raised by Fed Governor Jeremy Stein in his speech last February were similar to inquiry posed by Greenspan in 1996. In his speech, Stein asked regarding the factors that lead to overheating episodes in credit markets.

According to Gross, “Well to answer for the absent Chairman and the necessarily silent Governor Stein, the Fed incorrectly assumed that as long as inflation was benign, and future productivity prospects were near historical proportions, then asset price exuberance was an indirect and much less significant influence on economic growth.” In addition, he also cited the fact that people make mistakes.

Bill Gross pointed out that Governor Stein advised caution and PIMCO is stating the same.  “On a scale of 1-10 measuring asset price “irrationality,” we are probably at a 6 and moving in an upward direction,” Gross said.

On the other hand, Gov. Stein concluded that there are evidences of a “fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.”  He cited that financial innovation, easier regulatory changes, institutional buyers including  banks, insurance companies, and pension funds tend to match the mountains of issuance with an exuberance that eventually can be labeled irrational.

Gross described Gov. Stein’s speech “a little uni-dimensional and a little too supply and model driven” as opposed to behaviorally influenced, but according he liked and agreed to his conclusion.

Gross emphasized, “Corporate credit and high yield bonds are somewhat exuberantly and irrationally priced. Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile. Still that doesn’t mean you should vacate your portfolio of them. It just implies that recent double-digit returns are unlikely to be replicated and that when today’s 5-6% high yield interest rates are adjusted for future defaults and recovery values, that 3-4% realized returns are the likely outcome.”

He explained that the returns for high yield and equity markets have been duly influenced by quantitative easing; he added the writing of trillions of dollars of Federal Reserve checks and the exuberant migration of institutions and households alike to the grassier plains of risk assets are dependent on favorable economic outcomes.  According to him, if those supports stop and if the economic growth remain slow, investors should be cautious and temper their enthusiasm. In other words, Bill Gross advised investors to lower their return expectations.