As the founder and CEO of Bridgewater, the world’s largest hedge fund company by assets under management, Ray Dalio (Trades, Portfolio) knows a thing or two about capital markets. And, as a macro strategist, he is well versed in the ebbs and flows of broader economic action. Thus, it usually pays to listen when Dalio speaks.
Lately, Dalio has been ratcheting up his warnings about broadening market and economic risks. Indeed, as we discussed in February, he apparently fears that a recession could be on the horizon. Dalio’s gloomy forecast has continued to the present. Apparently, the risk of economic turmoil has actually become sufficiently high as to make the hedge fund billionaire a gold bug.
Leveraged long
In a recent discussion with Goldman Sachs (GS, Financial) Managing Director Allison Nathan, Dalio discussed the current economic outlook and the problems facing investors. Specifically, he sees investors’ current risk exposure as a major red flag:
“I think investors today are mostly leveraged long, meaning they own risky assets and have substantially leveraged those assets through company buybacks, private equity, and so on. In order to diversify against this—i.e. reduce exposure to leveraged long portfolios—investors should look to other stores of wealth and areas that have intrinsic diversification.”
There is a lot of truth to this insight. Investors clearly are still leveraged heavily to the long side, while companies have been engaging in behavior that is effectively doing the same. As a consequence, investors have been exposed to highly levered position. That is a very risky place to be when the world seems to be spinning out of control.
But, if stocks are not the answer, where should investors be putting their capital to protect their assets?
Cash is not king
Many investors turn to cash as a hedge when things go south in capital markets. Dalio does not think this is a good idea, as he told Goldman’s Nathan:
“People seem to think that going to cash reduces risk. But that's only the case from a standard deviation perspective. When interest rates are negligible—below the inflation rate/nominal GDP growth—and you pay taxes on that, you're not getting any return. Cash over the long run is the worst performing asset class and therefore the riskiest asset class.”
This is a point Dalio has made many times in the past. Cash is, generally speaking, a poor hedge compared to other stores of value insofar as cash is not free of market forces, and is susceptible to the long-term predation of inflation. Inflation risk may even accelerate in a downturn if monetary policy is deployed with gusto, as has been the case in recent years.
Gold is golden
With cash out of the equation, Dalio suggests turning to a classic alternative: gold. That may sound a bit odd coming from a sophisticated macro strategist, a point Dalio freely admits in fact, but he makes a solid case:
“I know gold sounds like a kooky investment. But gold is just an alternative currency to fiat paper currencies. If your portfolio is likely to perform poorly in the adverse environment I’ve been describing—less effective monetary policy, the need to run larger fiscal deficits and monetize them, and challenging politics—the behavior of gold as alternative cash has some diversifying merit.”
Dalio is no full-blown gold lover by any stretch of the imagination, and rightly so. But, if the economic turmoil he foresees in the relative near-term does come to pass, the idea of having exposure to a physical currency alternative with decent long-term value storage is probably a solid idea.
Verdict
Gold is an odd asset. Many people turn to it in bad times, which is why it is not terribly surprising that Dalio would be talking about its merits. However, it is certainly no panacea. On the surface, gold’s record during market downturns appears strong; it was up in eight of the 10 worst months for stocks in the past 30 years. But its average return during these periods was not terribly impressive.
During the two most recent downturns, however, gold did very well, as we discussed in a previous research note:
“Gold’s record during the past two bear markets was quite impressive, however. In the bear market of 2000 to 2003, gold rose 27.6% while stocks fell 42.5%. That looks like a real hedge after all. During the bear market following the 2008 financial crisis, stocks fell 51% while gold rose 18.6%.”
Clearly, gold has merit as a means of reducing portfolio risk and, if the past two bear markets are anything to go by, it should hold up very well in any forthcoming market shock. Investors worried about market turmoil in the near-term might do well to consider adding a bit of gold to their portfolios.
Disclosure: No positions.
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