Storm Clouds Coming

One of the world’s most successful investors sees the market changing. Here’s what to do

An average 15% gain for U.S. stocks over the next 12 months …

That’s the takeaway from an historical market study we’ve referenced a few times here in the Digest.

The study tracked market performance following an interest rate cut when the S&P was within 2% of all-time highs … which is what happened one week ago today. The results of the study pointed toward an average gain for stocks of 15% over the ensuing 12 months.

So, despite the trade-war-based volatility we’re seeing this week, all good, right?

Perhaps … but …

Wise investors are always looking at the horizon — not just the next 6-12 months out, but beyond. After all, you don’t plan on liquidating your portfolio in 6-12 months, do you? If not, then there’s value in looking further, and beginning to prepare for whatever market conditions that might bring.

With that in mind, today, we’re going to look at a recent research piece written by one of the most successful investors in the world. It’s sobering, pointing toward storm clouds in the distance.

It won’t happen today or tomorrow. But if this paper is correct, over the coming quarters/years, we’re going to see a radical shift in the markets that’s going to do a great deal of damage to the portfolio of those investors who aren’t prepared.

Today, let’s begin to prepare.

The research report comes from Ray Dalio, the billionaire founder of the investment group, Bridgewater. You may recognize Dalio’s name, as he famously predicted the Global Financial Crisis in 2017. Beyond that, Dalio has a history of nailing market calls, which, in part, is why he now has $150 billion of assets under management.

As his piece explains, we’re nearing a paradigm shift in the markets. Investors who see this shift coming can position themselves to protect their wealth — even grow it. Yet the investors who believe things will continue as-usual are likely in for vast portfolio losses.

Let’s make sure you’re not one of them.


***The common investing flaw of extrapolating into the future

Dalio introduces his research by making a summarizing point …

In over 50 years of being a global macro investor, he’s observed that there are relatively long of periods — about 10 years or so — in which the markets operate in a certain way. He calls this a “paradigm.”

Investors adapt to paradigms and then extrapolate them out into the future. Eventually, any given paradigm-extrapolation is adopted by a majority of investors, to the point where it becomes the consensus view. Usually, this consensus is more heavily influenced by what’s happened in the markets over the last few years, than what conditions are suggesting is going to happen in the ensuing years.

Eventually, when the consensus view is embraced to an extreme level, the market is pushed out of whack, forcing it to recalibrate. This recalibration leads to a new paradigm — which usually means the market operates in a way that’s more opposite than similar to the last paradigm. This is the market’s way of squeezing out the excesses of what came before.

Now, these shifts often divide investors into two camps. From Dalio:

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.

We need to see what’s coming so we’re prepared and not left “overextended.”

***So, where are we today in light of these paradigms?

Before delving into specifics of today, Dalio makes a few interesting points — two I’d like to highlight.

First, at the end of these paradigms (which, remember, loosely run about one decade), most investors expect the coming decade to be similar to the last one.

But due to the excesses that have been built up in the market — and because most investors think it’s just “business as usual” going forward — the paradigm shift is often unexpected and causes a major transfer of wealth.

Second, theories about why paradigm-shifts happen are almost always backward-looking. And more importantly, they prove to be terrible guides for how to invest during the next decade.

Here’s Dalio on the takeaway:

The worst thing one can do, especially late in a paradigm, is to build one’s portfolio based on what would have worked well over the prior 10 years, yet that’s typical.

Dalio believes we’re in the late stage of our current paradigm, approaching a key shift. So, let’s talk about what that means.

***The paradigm we’ve been enjoying, and what might be coming next

Dalio begins by summarizing the nature of the paradigm we’re still in today … though at the tail end of it.

Beginning around 2010, markets were at a bottom. Investors took the money they got from selling assets to central banks and bought up other assets (like stocks). Prices rose, which benefitted people with financial assets, relative to those people who didn’t own them. This widened the wealth gap.

Today, asset prices are relatively high, and growth is priced into the market with the expectation it will remain moderately strong, while the expectation is inflation will remain low.

But here’s the thing …

The forces that have created our current paradigm aren’t sustainable.

For example, central banks around the world have been lowering interest rates and performing quantitative easing. But interest rates around the globe can’t be lowered much more. Plus, quantitative easing is offering diminishing benefits since the money that is being pumped in is increasingly going to investors who are buying other investments with it, which drives up the prices of those assets (which pushes down their expected future returns).

As another example of this paradigm being unsustainable, Dalio points toward expanding profit margins due to advances in automation, and corporate tax cuts. He suggests neither is likely to continue indefinitely; meanwhile, both increased the wealth gap, which adds to instability.


***So, what’s coming next then?

From Dalio:

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.

As to “when” this will happen, he believes it will be when interest rate returns are pushed so low that investors holding debt will no longer want to hold it, so they’ll transfer their wealth.

Meanwhile, the massive need for money to fund liabilities (again, think pensions and health care), will lead to a “big squeeze” of sorts.

Dalio says that our current paradigm will end when interest rates reach their lower limits (slightly below 0%), which will mean that returns for risky assets are pushed down to near the expected return for cash. This will coincide with the demand for money to pay for debt, pension, and healthcare liabilities increasing.

While there is still a bit of room remaining for central banks to stave this off, there’s not much.

Back to Dalio:

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.

Below are two charts illustrating the monsoon of unsustainable debt coming our way.

Source: Bridgewater & Associates

So, we’re left with a question, which Dalio presents this way:

… 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.

***Your portfolio and the coming paradigm

According to Dalio, on the horizon is a period in which our current paradigm — which, frankly, has been characterized by just about all stocks rising — will end.

So, while we should enjoy this rising market while it lasts, it’s time to begin thinking about the required portfolio-repositioning of tomorrow.

I see this as requiring two things: an altered “offensive” strategy, combined with a new “defensive” strategy.

As to the offensive aspect, expectations are that we can’t bank on big gains from the broad market (the S&P) in the coming paradigm. So, for long positions, making sure you have exposure to specific sectors and trends that will outperform is key.

Here, I’m envisioning portfolio-exposure to trends highlighted by Matt McCall and Louis Navallier, such as 5G, cybersecurity, AI, autonomous vehicles, the Internet of Things, and marijuana, among others. If the broad market is going to be languishing, having a portion of your stock portfolio earning above-average returns from these trends will be critical.

As to defense, that’s where Eric Fry comes in. Eric actually wrote a book on this topic — Bear Market 2020: The Survival Blueprint. Part “diary” and part “owner’s manual,” this book takes you by the hand and walk you, step-by-step, through the simple strategies that will help you and your family navigate America’s next bear market.

One of these defensive strategies is allocating a greater portion of your wealth to gold. Here’s Eric on why this can be critical:

Many investors may not realize that the S&P 500 produced a loss during the 11-year span from August 2000 to August 2011. Based on price, this blue-chip index slumped more than 25% during that decade-plus. Even after adding in dividends, the S&P 500 produced a loss of 8% during those fruitless years.

But gold shined brightly. Its priced soared nearly 600%.

Eric isn’t the only smart investor who believes in gold as an effective defensive strategy. It just so happens that Dalio himself likes gold for the coming paradigm shift.

Back to Dalio:

… (the investments) 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 … 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.

As I write Wednesday morning, gold is up 2% on the day — just the latest in an explosive move that started in late May, as you can see below …

Now, gold is just one part of a comprehensive defensive strategy. There’s plenty more you can do to protect your wealth. To read more on this as part of Eric’s bear market blueprint, click here.

As we wrap up today’s Digest, let’s make sure we’re on the same page — despite the market upheaval as I write on Wednesday, I’m not suggesting we’re standing on the edge of a bear market.

But one of the smartest investors in the world sees storm clouds in the distance. Beyond that, it’s common sense that markets are cyclical, and there’s a good deal of evidence suggesting we’re toward the tail end of our current cycle.

Given this, it’s not too early to begin thinking about wise portfolio modifications that reflect the market conditions of tomorrow, not yesterday. Getting into position now could make all the difference later. After all, would you rather buy flood insurance when the skies are sunny, or during a downpour that’s already dumped three feet of rising water in your basement?

We’ll continue to bring you offensive and defensive strategies for the next paradigm here in the Digest.

Have a good evening,

Jeff Remsburg

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