Dalio Says Buy Gold before Paradigm Shift

A must read today.  But before we get into today’s news… how about silver!? After hitting that 30 year high Gold Silver Ratio of nearly 94, this week has seen what looks like the reversion we’ve been waiting for commence.  Whilst one swallow doesn’t make a summer….

Dalio Says Buy Gold before Paradigm Shift

Last night silver surged another 2.6% compared to gold’s 1.6%.  That GSR tends to revert when gold rallies, which it has commenced with earnest since April.  So where to for gold from here?  Let’s hear from arguably the most respected financial mind on Wall Street and head of the largest hedge fund, Ray Dalio.  Dalio lives on principles (the title of his books even) and yesterday he provided insight into another one, Paradigm Shifts.  

In his own words:

“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.”

It’s a long piece so let us extract some key points and then provide the full extract below for those with more time.  This is still lengthy compared to most of our articles but well worth your time.  Remember this is authored not by a gold bug commentator but arguably one of the most successful on Wall St, and one of the world’s richest and most influential people who used this methodology to position Bridgewater ahead of the GFC that caught most out.

Firstly his explanation summary:

“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 explaining how Paradigm Shifts occur:

“There are always big unsustainable forces that drive the paradigm. They go on long enough for people to believe that they will never end even though they obviously must end. A classic one of those is an unsustainable rate of debt growth that supports the buying of investment assets; it drives asset prices up, which leads people to believe that borrowing and buying those investment assets is a good thing to do. But it can’t go on forever because the entities borrowing and buying those assets will run out of borrowing capacity while the debt service costs rise relative to their incomes by amounts that squeeze their cash flows. When these things happen, there is a paradigm shift. Debtors get squeezed and credit problems emerge, so there is a retrenchment of lending and spending on goods, services, and investment assets so they go down in a self-reinforcing dynamic that looks more opposite than similar to the prior paradigm.

In paradigm shifts, most people get caught overextended doing something overly popular and get really hurt. On the other hand, if you’re astute enough to understand these shifts, you can navigate them well or at least protect yourself against them. The 2008-09 financial crisis, which was the last major paradigm shift, was one such period. It happened because debt growth rates were unsustainable in the same way they were when the 1929-32 paradigm shift happened. Because we studied such periods, we saw that we were headed for another “one of those” because what was happening was unsustainable, so we navigated the crisis well when most investors struggled.”

The paradigm since the GFC has been driven by:

1. Central banks have been lowering interest rates and doing quantitative easing (i.e., printing money and buying financial assets) in ways that are unsustainable.
2. There has been a wave of stock buybacks, mergers, acquisitions, and private equity and venture capital investing that has been funded by both cheap money and credit and the enormous amount of cash that was pushed into the system.
3. Profit margins grew rapidly due to advances in automation and globalization that reduced the costs of labour.
4. Corporate tax cuts made stocks worth more because they give more returns.

So what does the next paradigm shift look like to Dalio?

“There’s a saying in the markets that “he who lives by the crystal ball is destined to eat ground glass.” While I’m not sure exactly when or how the paradigm shift will occur, I will share my thoughts about it. 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.” 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.”

Dalio sees the large debt monetisation similar to the post 1940 war years – reflation.  He concludes:

“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. 

Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash). 

I think these are unlikely to be good real returning investments and that 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, I believe 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.”

To read his full article which includes spelling out each paradigm since 1920 click here.