Ray Dalio (Trades, Portfolio) is the founder and chairman of Bridgewater Associates, one of, if not the premier hedge fund in the world. He's well known for his all-weather strategy as well as his recent book, "Principles,"Â which ascends the realm of finance.
Bridgewater releases daily research to its clients, but Dalio also shares his views publicly through LinkedIn. I think he has purposefully chosen LinkedIn, while most investors don't get beyond Twitter, as it allows for more long-form content and he wants to share his knowledge. I really enjoy his work. Currently, he's quite bearish. The basic message of this latest note: buy gold. Here are a few key excerpts along with my commentary:
"Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops."
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Dalio thinks we have been so long in this low-interest rate environment without inflation that investors got used to it. He calls a certain market environment a paradigm:
"Over my roughly 50 years of being a global macro investor, I have observed there to be relatively long of periods (about 10 years) in which the markets and market relationships operate in a certain way (which I call 'paradigms') that most people adapt to and eventually extrapolate so they become overdone, which leads to shifts to new paradigms in which the markets operate more opposite than similar to how they operated during the prior paradigm. Identifying and tactically navigating these paradigm shifts well (which we try to do via our Pure Alpha moves) and/or structuring one’s portfolio so that one is largely immune to them (which we try to do via our All Weather portfolios) is critical to one’s success as an investor."
In his note, he expands on why and how he did the research. In this overview, I'll stick to the key points. Dalio doesn't merely identify the low-interest rate environment as a paradigm investors got complacent about, but also believes the shift is near:
"I think now is a good time 1) to look at past paradigms and paradigm shifts and 2) to focus on the paradigm that we are in and how it might shift because we are late in the current one and likely approaching a shift. "
The low-interest rate post-2008 crisis paradigm is characterized as follows:
"Central banks have been lowering interest rates and doing quantitative easing (i.e., printing money and buying financial assets) in ways that are unsustainable. Easing in these ways has been a strong stimulative force since 2009, with just minor tightenings that caused 'taper tantrums.' That bolstered asset prices both directly (from the actual buying of the assets) and indirectly (because the lowering of interest rates both raised P/Es and led to debt-financed stock buybacks and acquisitions, and levered up the buying of private equity and real estate). That form of easing is approaching its limits because interest rates can’t be lowered much more and quantitative easing is having diminishing effects on the economy and the markets as the money that is being pumped in is increasingly being stuck in the hands of investors who buy other investments with it, which drives up asset prices and drives down their future nominal and real returns and their returns relative to cash (i.e., their risk premiums). Expected returns and risk premiums of non-cash assets are being driven down toward the cash return, so there is less incentive to buy them, so it will become progressively more difficult to push their prices up. At the same time, central banks doing more of this printing and buying of assets will produce more negative real and nominal returns that will lead investors to increasingly prefer alternative forms of money (e.g., gold) or other storeholds of wealth."
Dalio believes equities have enjoyed significant tailwinds not just because of asset price inflation through monetary policy, but also because of forces like globalization and technology that are more or less exhausted. He basically likes neither equities or bonds and describes the paradigm shift he expects as follows(with the usual caveats about predictions being very hard to make):
"I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly be coming due and won’t be able to be funded with assets.
Said differently, I think that the paradigm that we are in will most likely end when a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better and b) simultaneously, the large need for money to fund liabilities will contribute to the 'big squeeze.'Â At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax."
This is basically a paragraph explaining that Dalio really doesn't like U.S. Treasuries. He does a deeper dive into the problems with Medicare and such off balance sheet liabilities. Probably, he doesn't like treasuries around the developed world because Europe and Japan suffer from similar problems. Both are in a tougher spot demographically as well.
The entire essay leads up to one giant relevant question of where to invest right now:
"So, the big question worth pondering at this time is which investments will perform well in a reflationary environment accompanied by large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. It is also a good time to ask what will be the next-best currency or storehold of wealth to have when most reserve currency central bankers want to devalue their currencies in a fiat currency system."
Dalio's answer is actually slightly disappointing because he doesn't lay out a specific framework that may work under such an environment. The only specific recommendation he makes is to include gold in one's portfolio.
"... those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, Ibelieve that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio. I will soon send out an explanation of why I believe that gold is an effective portfolio diversifier."
Because I'm worried about many of the same things as Dalio, who isn't really, I have some idea of other assets that could perform well. A diversified set of commodity interests could work. Shorting especially vulnerable companies could work, like those with too much debt. I prefer commodity equities, especially royalty companies, but, ultimately, straight up commodities may be less risky. Land companies are another set I continue to consider. Think of the likes of Joe (JOE, Financial), Consolidated-Tomoka (CTO, Financial), Howard Hughes (HHC, Financial) and Tejon Ranch (TRC, Financial). I'm invested in Keweenaw Land Corp. (KEWL, Financial), which is a forestry operation over 100 years old that owns a forest located in Michigan. I'm not sure Dalio would agree with any of this, but these are some of the ideas I'm thinking about when considering how to navigate the treacherous decade to come. I would love to hear how you protect yourself from paradigm shifts. Read Dalio's full note here.
Disclosure: Long Keweenaw Land.
Read more here:
- Portfolio Strategy: Diversification Versus Concentration
- Richard Pzena Interviews Joel Greenblatt at Benjamin Graham Conference
- Bill Nygren on the Changes in Value Investing and Why Alphabet Is Undervalued
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