Wednesday, January 15, 2014

Ray Dalio

Warren Buffett once said, "It's never paid to bet against America." The same could have been said for the United Kingdom before World War I or Rome before Commodus' reign. While extrapolating the historical trend line is actually a pretty good prediction strategy, it's not the way to make money. Fortunes are made (or preserved) anticipating big economic shifts, and successful prediction requires good theory. Buffett admits his expertise is not in timing macroeconomic shifts. Ray Dalio's is. And he thinks the United States is an empire in relative decline.

Dalio is probably the best macro investor alive. He has made a fortune anticipating once-in-a-generation shifts, such as the financial crisis, the subsequent bull market in bonds, and the eurozone crisis. His hedge fund Bridgewater Associates is now the world's biggest, and its Daily Observations newsletter is devoured by policymakers and investors alike (your faithful editor included, when he can get his hands on a copy).

Dalio's model is generational. Each stage lasts about 30 years, progressing when the older generation either dies off or retires, allowing the younger generation to set the country's direction. To understand the U.S.' place in the arc of Dalio's model, let's look at each stage in turn.

Countries in the first stage, called early-stage emerging countries, "are poor and think that they are poor." For most people, staying alive is a struggle. Investment usually comes from abroad. Investors demand high returns on their capital as compensation for the big perceived risks. Foreign investors don't trust these countries to maintain the value of their currencies, so the countries peg them to gold or a reserve currency, or even adopt another country's currency wholesale. Much of Africa and parts of Asia and Latin America are in this stage and have been stuck there for decades.

Countries in the second stage, called emerging countries, "are getting rich quickly but still think they are poor." Productivity and income soar, but savings remain high and work hours long because people remember what it was like to be poor. They export more goods than they import and they undervalue their currencies to keep exports cheap. However, the currency peg keeps interest rates too low. As a consequence, debt/income and inflation rise. A country in this stage must eventually break the peg. When a big country goes through this stage, it typically becomes a world power. China is undergoing this transition.

Countries in the third stage, called early-state developed countries, "are rich and think of themselves as rich." Their per-capita incomes are among the highest in the world, and their priorities change to "savoring the fruits of life." They are seen as safe-haven investments. This describes the British Empire during the 19th century and the U.S. after World War II. These countries tend to have big armies to expand and defend their global empires.

Countries in the fourth stage, called late-stage developed countries, are becoming "poorer and still think of themselves as rich." In this stage, debt/income rises in a self-reinforcing cycle. Debt stimulates income and asset price growth, which in turn stimulates even more debt. However, research and development and capital spending decrease; budget and trade deficits increase. Infrastructure is old and less well-maintained. In other words, late-stage developed countries eat the seed corn, setting themselves up for slower growth. In the last few years of this stage, bubbles are frequent because investors extrapolate from recent trends. This stage ends when debt/income can no longer rise; incomes can no longer support bigger debt service.

In the final stage, "countries go through deleveraging and relative decline, which they are slow to accept." The self-reinforcing debt cycle now kicks in reverse: Private actors begin paying down or defaulting on their debts, leading to falling income and asset prices, encouraging more defaults and faster debt repayments. The first phase is dominated by defaults, what Bridgewater calls an "ugly deleveraging." Stocks do terribly; safe-haven bonds soar. Depending on how much monetary and fiscal stimulus is applied, the deleveraging can transition to a "beautiful" phase, where debt monetization, austerity, defaults and wealth transfers from the haves to have-nots are well-balanced. Typically, governments run deficits to make up the slack; central banks slash interest rates to both stimulate the economy and ease the burden of debt service.

It's clear the U.S. from at least 1980 to 2007 was in stage four. Look at our total debt/GDP over time. Since 1980, it rose in two steep jags: first, in the mid-1980s, when the government deregulated financial markets and ran massive deficits and the Federal Reserve began lowering interest rates to bring us out of the Volcker recession; and second, in the 2000s, when the Fed once again aggressively lowered interest rates to prop up the post-dot-com-bubble economy, and the government once again ran massive deficits.

The massive amount of debt the U.S. economy is laboring under will likely take decades to pay off. With more resources going back to paying off creditors, growth will be slower than it otherwise would have been. PIMCO calls it the "New Normal." Dalio calls it a "deleveraging process." Economists call it a "balance-sheet recession."

Dalio's model predicts a decades-long period of relative decline for the U.S. as it deleverages and the eventual graduation of China and other emerging markets from stage three to stage four. Because the U.S. is so rich and China is so big, chances are China will not catch up to the U.S.' average income during this process. The U.S. is not going to turn into a banana republic, either.

The deleveraging phase can be quite graceful, in fact. The U.K. was even more indebted after World War II than the U.S. is today. The British borrowed massively to fund nonproductive (but necessary) goods: guns, boats, tanks, and airplanes to fight the Nazis with. Its total debt/income ratio reached over 400%. How did they pay everything back? They didn't. The U.K. devalued its currency, suppressed real interest rates, and let inflation run a bit. It didn't liquidate its debt with a hyperinflationary bang, but rather let economic growth outpace debt growth over several decades.

I expect the same from the U.S. Not a big bang, but a long slog of low real interest rates and slow debt growth. Investors scared of the debt worry too much about the wrong things: vivid, hyperinflationary scenarios, in which the government's machinations ruin the economy. We have to account for the incentives and the knowledge of our policymakers. Our central bankers do not benefit by driving the economy into the ground. They also know that the debt problem can be slowly defaulted on without throwing the economy into turmoil, so that's likely the policy they'll continue to pursue.

Investment Implications
Intriguingly, it turns out that a deleveraging country's stocks can do quite well. Bridgewater notes British equities returned 13.3% annualized from 1947 to 1959, a period of "beautiful" deleveraging.[1] On the other hand, Japan's equity markets struggled for over two decades since their bubble popped and they entered an "ugly" deleveraging, which they haven't exited yet (though this may be changing with Shinzo Abe's shock-and-awe campaign of fiscal and monetary stimulus coupled with structural reform).

And even with low yields, bonds can do well. If you can leverage up bonds to match the volatility of stocks, you would have received midteens returns in both ugly and beautiful deleveragings because of capital gains from rolling down the yield curve and deflationary surprises[1]. This analysis was why Bridgewater was bullish on Treasuries after the financial crisis, a time when everyone else thought yields would rise. However, if you can't leverage up bonds, they don't offer much return.

Finally, regardless of the type of deleveraging, gold did well against the deleveraging country's currency. Unsurprisingly, Dalio is a big fan of gold. He argues it's a form of money. Many rich-world central bankers don't agree, but, according to data from the World Gold Council, Russia has been a net buyer of gold every quarter since 2007, and both China and India dramatically increased their gold reserves in 2009.

*** [2/16/14]

In many respects, Dalio is the anti-Warren Buffett. Buffett makes big bets on a handful of companies. Dalio makes many small bets on currency pairs, commodities, bonds, and, to a much lesser extent, equities. Buffett grants his subordinates plenty of autonomy and lets them figure out their own way. Dalio imposes a set of principles that his subordinates are to live by and heavily monitors them. Buffett doesn't give much thought to economic cycles. Dalio's investing style is based on identifying and navigating them. Buffett doesn't like gold. Dalio thinks everyone should own a little bit of it.

*** [8/13/14]

Some  billionaires hold onto the secrets to their money-making success with a tight fist. But Ray Dalio is worth $14 billion and is more than happy to share.

Although he isn't a household name, he should be, as he's revealed the secrets to his success in a 123 page paper simply entitled Principles, that is chalked full of great investment advice. And there are five things we should remember when making our own investment decisions.

*** [9/24/14 Grahamites]

One of my all-time favorite readings is “Principles” by Ray Dalio (Trades, Portfolio). I think everyone should read it, whether or not you are an investor. Mr. Dalio stated in the forward that he wanted us to think for ourselves – to decide 1) what you want, 2) what is true and 3) what to do about it.

Among all the principles Dalio generously shared, the principle truth – “more precisely, an accurate understanding of reality” is the one that has the most impact on me. In this article, I’d like to share with the readers a few quotes I jogged down while reading this principle.

Among all the principles Dalio generously shared, the principle truth – “more precisely, an accurate understanding of reality” is the one that has the most impact on me. In this article, I’d like to share with the readers a few quotes I jogged down while reading this principle.
  • Truth is the essential foundation for producing good outcomes.
  • I have found that observing how nature works offers innumerable lessons that can help us understand the realities that affect us. For example, I have found that by looking at what is rewarded and punished and why, universally – i.e., in nature as well as in humanity – I have been able to learn more about what is “good” and “bad” than by listening to most people’s views about good and bad.
  • I believe that we all get rewarded and punished according to whether we operate in harmony or in conflict with nature’s laws, and that all societies will succeed or fail in the degrees that they operate consistently with these laws.
  • Understanding what is good is obtained by looking at the way the world works and figuring out how to operate in harmony with it to help it (and yourself) evolve. What is bad and most punished are those things that don’t work because they are at odds with the laws of the universe and they impede evolution.
  • I believe that the desire to evolve, i.e., to get better, is probably humanity’s most pervasive driving force. Enjoying your job, a craft, or your favorite sport comes from the innate satisfaction of getting better. Though most people typically think they are striving to get things (e.g., toys, better houses, money, status, etc.) that will make them happy, that is usually not the case. Instead, when we get the things we are striving for, we rarely remain satisfied. It is natural for us to seek other things to seek to make the things we have better. In the process of seeking, we continue to evolve and we contribute to be evolution of all that we have contact with. The things we are striving for are just the bait to get us to chase after them in order to make us evolve, and it is the evolution and not the reward itself that matters to us and those around us.
  • Self-interest and society’s interests are generally symbiotic: more than anything else, it is pursuit of self-interest that motivates people to push themselves to do the difficult things that benefit them and that contribute to society. In return, society rewards those who give it what it wants. That is why how much money have earned is a rough measure of how much they gave society what it wanted – NOT how much they desired to make money. Look at what caused people to make a lot of money and you will see that usually it is in proportion to their production of what the society wanted and largely unrelated to their desire to make money. There are many people who have made a lot of money who never made making a lot of money their primary goal. Instead, they simply engage in the work that they were doing, produced what society wanted, and got rich into it. And there are many people who really wanted to make a lot of money but never produced what the society wanted and they didn’t make a lot of money. In other words, there is an excellent correlation between giving society what it wants and making money, and almost no correlation between the desire to make a lot of money and how much money one makes. I know this is true for me – I never worked to make a lot of money, and if I had I would have stopped ages ago because of the law of diminishing returns. I know that the same is true for all the successful, healthy people I know.
  • Some of the most successful people are typically those who see the changing landscape and identify how to best adapt to it.
  • It is extremely important to one’s happiness and success to know oneself – most importantly to understand one’s own values and abilities – and then to find the right fits. We all have things that we value that we want and we all have strengths and weaknesses that affect our paths for getting them. The most important quality that differentiates successful people from unsuccessful people is our capacity to learn and adapt to these things.
  • However, typically defensive, emotional reactions – i.e., ego barriers – stand in the way of this progress. These reactions take place in the part of the brain called the amygdala. As a result of them, most people don’t like reflecting on their weaknesses even though recognizing them is an essential step toward preventing them from causing them problems. Most people especially dislike others exploring their weaknesses because it makes them feel attacked, which produces fight for flight reactions; however, having others help one find one’s weaknesses is essential because it’s very difficult to identify one’s own. Most people don’t like helping others explore their weaknesses, even though they are willing to talk about them behind their backs. For these reasons most people don’t do a good job of understanding themselves and adapting in order to get what they want most out of life. In my opinion, that is the biggest single problem of mankind because it, more than anything else, impedes people’s abilities to address all other problems and it is probably the greatest source of pain for most people.
  • Aristotle defined tragedy as a bad outcome for a person because of a fatal flaw that he can’t get around. So it is tragic when people let ego barriers lead them to experience bad outcomes.

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