ffirs.qxd 5/17/07 3:53 PM Page i Your Financial Edge ffirs.qxd 5/17/07 3:53 PM Page ii ffirs.qxd 5/17/07 3:53 PM Page iii Your Financial Edge HOW TO TAKE THE CURVES IN SHIFTING FINANCIAL MARKETS AND KEEP YOUR PORTFOLIO ON TRACK Paul McCulley Jonathan Fuerbringer John Wiley & Sons, Inc. ffirs.qxd 5/17/07 3:53 PM Page iv Copyright © 2007 by Paul McCulley and Jonathan Fuerbringer. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Wiley Bicentennial Logo: Richard J. Pacifico. 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HG4529.5.M384 2007 322.6—dc22 2007003310 Printed in the United States of America. 10987654321 ffirs.qxd 5/17/07 3:53 PM Page v For Everett and Susie McCulley For Johanna McGeary and the three granddaughters, Leila Stark, Charlie Fuerbringer, and Siena Stark ffirs.qxd 5/17/07 3:53 PM Page vi ftoc.qxd 5/17/07 3:53 PM Page vii Contents Acknowledgments ix Introduction 1 1 New Steps 11 2 More Than Stocks, More Than Bonds 33 3 What Can Go Wrong 53 4 Reading the Federal Reserve 97 5 Prices and the Fed 125 6 McCulley 137 7 Speaking Of . 157 8 Driving Your Portfolio 185 Notes 223 Index 237 About the Authors 243 vii ftoc.qxd 5/17/07 3:53 PM Page viii flast.qxd 5/17/07 3:53 PM Page ix Acknowledgments ooks don’t just happen, even when you’ve been writing all your Bcareer, with a huge body of essays over a long period of time in the hopper. A book requires both inspiration and perspiration. Many have inspired me, but none more than Mohamed El- Erian, Bill Gross, Peter Bernstein, and Bill Miller. Thank you, gentlemen, for believing in me professionally and supporting me personally. Your wise counsel and caring words mean the world to me. The perspiration for this endeavor came from many sources, with the largest quotient from my co-author, Jonathan Fuer- bringer. I had known and respected Jonathan professionally for many years before we took up this project. As it has unfolded, my admiration for Jonathan has been in a powerful bull market. I’m now proud to call him not just my professional partner in crime, but also my dear friend. Thank you, Jonathan, for never letting me quit, when the pain of other exigencies in my life tempted me. Let me also offer huge thanks to Jim Pankovich, the best ex- ecutive assistant in the world, who can finish my sentences, even when I cannot. Kudos, too, for yeo-person statistical work by Vineer Bhansali, Lisa Kim, Steve Schulist, and Craig Bourne. Special thanks, and love, to my ex-wife, Karen, who tolerated my idiosyncrasies for 17 years, with grace and dignity, while be- ing an awesome mom to our son, Jonathan. And finally, hugs of appreciation to Saumil Parikh, one of the special ones, of whom only a few grace our lives, both profession- ally and personally, who is as a second son to me. —Paul McCulley ix flast.qxd 5/17/07 3:53 PM Page x x ACKNOWLEDGMENTS his book started with a phone call from Paul McCulley. I was at Tmy desk at The New York Times on a calm day in the markets, or both of us would have been too busy to talk. Paul had an idea. He wanted to do a book based on the “Fed Focus” columns he had written since 1999 at PIMCO, the fixed- income powerhouse headquartered in Newport Beach, Califor- nia. I did not bite. But Paul persisted, sending me every column he had written. And I began to think he had a good idea as I worked out what kind of book we could do. I also realized that this was a special opportunity—a chance to make good use of all I had learned over a long journalistic career about financial markets and, at the same time, take me away from them for a while. So I thank Paul for asking me to be his co-author, for giving me a pretty free hand, and for the challenge of doing something new. Without his persistence and enthusiasm, this book would not have happened. Also at PIMCO, thanks to Jim Pankovich, who was the traffic cop between the co-authors. Vineer Bhansali, Lisa Kim, Steve Schulist, and Craig Bourne all helped enormously with their re- search, numbers crunching, graphic design, and willingness to ex- plain. At The New York Times, thanks to all the good friends who have taught me so much over the years—and whom I missed dur- ing my year writing this book. And thanks to Ray Bonner and Jane Perlez, old friends and colleagues, who allowed Johanna and me to make their apartment in Notting Hill our temporary Lon- don home. In the world of finance, there are many who answered my questions, helped me with information, checked my thinking, and gave me some quotes. You all know who you are and I thank you. Thanks also to the data people who fielded my many in- quiries, including Robert Adler, Alexa Auerbach, Dorsey Horowitz, Gloria Kim, and Howard Silverblatt. Also thanks to Gary Kleiman, a longtime voice in my ear on emerging markets, who reviewed parts of this book. flast.qxd 5/17/07 3:53 PM Page xi ACKNOWLEDGMENTS xi At John Wiley & Sons, thanks to Debra Englander, who helped turn an original idea into a publishable one, and Greg Friedman, who put up with every question I threw at him. I could not have written this book without the counsel of Di- ana Henriques, another colleague from The New York Times, who worked with me from beginning to end on this project, read- ing, supporting, and guiding all the way. Finally, and always, I thank Johanna McGeary, my wife. I would not have attempted this book without her behind me. Her love and support—and her ability to make such a wonderful home in London so quickly—all made this book better and life while doing it enjoyable. Thanks and thanks, again. —Jonathan Fuerbringer flast.qxd 5/17/07 3:53 PM Page xii ccc_mcculley_001-010_intro.qxd 4/27/07 8:58 AM Page 1 Introduction he investing environment has changed dramatically in the past T10 years: from taken-for-granted, double-digit annual returns in stocks to double-digit losses and, now, gains that are not even half of what they used to be; from a bubble-fueled mania that led to a complete disregard for fundamental values to the painful af- termath of the bursting of the stock bubble and, maybe, the painful aftermath of the bursting of a second bubble, in housing; from the expectation that you can retire early—and rich—to the fear that you cannot retire at all—and certainly not rich. On the positive side, the battle against inflation, which began in 1979, has been won, bringing with it all the benefits that come with price stability. But there is even a downside for investors to that victory. With very low inflation the threat to the economy becomes deflation. And with stable prices, speculators are hap- pier and market bubbles are more likely.