I think of myself as a pretty smart guy, but not that smart, if you know what I mean; no Mensa candidate but intelligent enough to earn a few paper degrees that helped get me a job where the real education began. My mother used to tell me that I had the highest IQ of all the first graders in Butler County, Ohio, which sounded impressive until I figured out that there were just a handful of kids that had taken the test. Youre smart but not a genius if you graduated non cum laude from both Duke and UCLA graduate school. Thats me. Still, Ill take it because Ive come to the conclusion that success – at least in a career – requires more than an IQ. It requires a CQ.
A CQ is what I think of as a Common Sense Quotient. It refers to an ability to not just absorb information and recycle it upon demand, but to analyze it and apply it within a uniquely different environment or context. A CQ Mensa candidate is able to view the world in a state of apparent equilibrium and wonder – does this make sense? And if not, what might change it, and when? The problem with measuring CQ, however, is that you never can be quite sure that you or anyone else has it. Its elusive and perhaps even ephemeral. Its also uniquely personal: the world always makes sense when viewed from your own eyes – its those other people who cant seem to understand. Still – in the business and investment worlds – time has a habit of unmasking one-dimensional pretenders who have the obvious IQ, but score below 100 with an experience-tested CQ. Warren Buffett, a bona fide Mensa in both categories, said it best many years ago in his usual folksy way: You dont know whos swimming naked until the tide goes out.
CQs, then, in Buffetts metaphor, know that protective cover-ups – call them swimming-suit insurance policies – should be worn even when the waters high and the whole world seems to be enjoying an endless summer at the beach. That is an apt description of the global investment environment up until Bear Stearns 2007. The world seemed so caught up in the long-term unfolding of the Great Moderation that almost everyone assumed that nothing could go wrong. I heard a brilliant, high-IQ portfolio manager describe himself on the radio a few days ago as a child of the 25-year secular bull market – trained to buy on dips. In fact, we all are bull market children. But those that define it by dip buying, or a secular time frame encompassing only the past quarter century, are certainly self-limiting and perhaps lacking in common sense. The era now coming to an end is not a one-generational bull market that was born out of the ashes of double-digit inflation, and the end of governmental strangulation of private initiative in the early 1980s. It was much more, and much longer in duration.
The past era can best be described as a more than half-century build up in credit extension and levered finance. While home mortgages or buying a washing machine on time began in the early decades of the 20th century, the use and innovative application of credit really began when – well, when I was born. 1944 is as good a year as any to chronicle the beginning of our levered economy. I was a child of war, but also a child of a new global leadership confirmed at Bretton Woods and founded on faith in the U.S. dollar and the healing power that its printing could bring to the global community. That Richard Nixon amended the bargain in the early 1970s did no immediate damage save for the inflationary decade that followed. Credit continued to be the mighty lubricant of capitalisms engine, allowing its pistons to accelerate at an increasing pace as financial innovation mixed with our own animal spirits produced more and more profits, more and more jobs, more and more everything. Mortgage-backed GNMAs in the 1970s, financial futures a bit later, swaps, then credit default swaps (CDS) – the litany is too long to list.
What is important, though, is that at some point early in the 21st century, things began to go terribly wrong with this miracle of modern finance. It was spreading substantial benefits via diversification and indeed the productive powers of lending upon which capitalism depends. But it had assumed an arrogance – if a secular phenomenon can be personified – that nothing could go wrong. It was promoting not just smooth sailing – a moderation – but a great moderation. Unstoppable. Except, of course, for that homeowner in Modesto, California, who bought a marked-up home for $500,000 with no money down and a 2% teaser interest rate. Even the pinnacle of levered finance could not support that fantasy and so, as yields inevitably rose and the defaults began in 2006, our great moderation was exposed for what it was – a naked swimmer at high tide.
And so – bravo, brava, a metaphorical history of the human comedy as experienced by Bill Gross since 1944. How prescient, how personal, how CQish, how self-serving. I suppose. But PIMCOs still standing, and that in this month of October 2008 is as strong a testament to a collective CQ as any I know. Weve got some Mensans to be sure, but a bunch of high CQs as well, including my partner on the investment desk, Mohamed El-Erian, who like Buffett, is probably a dual Mensa but would be the last to admit it.
For those of you who are reading these Outlooks for more than just a history lesson and a commercial, however, let me point you to our latest commonsensical thought piece, one that can be explained with a simple diagram that resembles an atom of uranium – one of natures more unstable elements.