Gundlach: Back Side of the Hurricane Coming

Lawrence Jones: Can you talk a little bit about some of your fears for the credit risk sectors that are outside the mortgage sphere?

Jeffrey Gundlach: Back in March, I turned very positive on all manner of risky financial assets, because of the setup of such tremendous declines and what seemed to be tremendous pessimism. I said at the time that a very large rally was coming, one that would be big enough that you wouldn't really have the ability to see past.

You needed to participate in it or else you'll find yourself in a difficult place. Certainly those that have sat out this rally don't know what to do at this point because prices are so much higher yet fundamentals remain challenging.

I think that credit risk as a general theme is overpriced at this point. We look at default trends that still remain problematic and it's hard to believe that against still challenging fundamentals and default trends, that prices have recovered essentially all the way back to where they were prior to the big break in the stock market, to the Lehman collapse, the AIG collapse, and the like.

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Its really kind of astonishing in my view that investors are willing to have the same attitude today because their eyes were open to the fragility of the system and to the potential--what high defaults could really happen, and what volatility could enter the market.

And yet, they've shut their eyes again. I prefer to remain eyes open and realize that 50% higher prices for many asset classes against large and unchanged fundamentals, that the risk on the downside seems to be building.

I kind of think of it as the hurricane metaphor. We had the front side of the hurricane in '07 and particularly in the second half of '08, now we're in the eye of the hurricane and I think the back side of the hurricane is coming and we're going to see downward movements in prices of risk assets coming, probably before the end of this year, in corporate credit and the equity markets.

I think investors should not be chasing rally at this point, rather doing what I'm doing, which is selling down credit across the board, but particularly corporate credit. And to a certain extent, also mortgage credit.

I've been selling down in my mutual funds. I still have a positive outlook relativistically. I think it's an attractive risk just as I said, but it's obvious that it's not as attractive as it was. Overall, though, I think the credit market is vulnerable.

Jones: Are there other catalysts that you are looking for or do you suspect that some large catalysts will precipitate this decline or might it be more gradual over time?

Gundlach: I think something probably changes an investor's psyche that could be driven by catalyst. One of the things I got on my radar screen is there has been this fight going on between the Treasury Department government officials and Bloomberg News about disclosure of what's going on and what went on in September of last year.

There was an injunction that was put out. Bloomberg actually won the preliminary hearing to get the information out. I have a feeling that some of the facts of what went on in the second half of 2008 will be unsettling if they come to light. That could happen between now and the end of the year, and that could be a catalyst.

Also, I think the Case-Shiller Index, which has for technical reasons, mixed shift reasons, and seasonal reasons, shown a little bit of improvement or actually has gone up, not just gone down more slowly but has actually gone up in recent months--I think that's going to change to the down side again as the seasonals wear off. That could be a catalyst as well.