Recent Comments from Ray Dalio

                       El Greco, The Vision of Saint John

There is an interesting interview with Ray Dalio of Bridgewater Associates in this week's Barrons. As you probably know already from earlier Barrons interviews of Dalio, Bridgewater is a very large hedge fund that specializes in global credit.  Here are some of the highlights that I found particularly interesting:

The Recovery and the Next Recession

"But it is a fragile recovery ... and it goes back to the fact we still have too much debt ... between now and 2012, the economy will probably go down again."

Contagion from Europe

“The European situation is a particularly risky one for a number of reasons. ... the size of the debt dwarfs that of any other debt crisis."

The Deflationary Environment

"My point is, in developed countries there is too much of most things at the moment, and that’s creating a deflationary environment.  There is too much manufacturing capacity. There is too much labor. There is too much housing stock."

Currencies of Developed Countries

"I want to minimize my exposure to the major developed countries’ currencies — the U.S. dollar, the euro, the British pound and the yen — because those countries have a lot of debt, and they are going to need to print more and more money and will have more sluggish growth rates. I prefer the yen to the others.”

Bonds of Developed Countries

Apparently Dalio intends to hedge the currency risk:  "As Europe’s economy weakens and its debt crisis worsens, the printing of money does not mean that it will produce an accelerating inflation because simultaneously there is also less being purchased, and the surpluses are already causing deflationary pressures. That is why, contrary to almost everybody’s belief, I believe the bonds in countries that can print money will be good investments.”

No Inflation Anytime Soon

“The depreciation of the major currencies and the printing of money will not cause a significant general level of inflation anytime soon. The printing of money will offset the deflation that is coming from the weak demand for goods and services due to weak credit growth."

As I read this, he does not expect aggregate inflation "anytime soon" but leaves open the question of the timeline by which inflation may enter the equation later.

Bridgewater's Portfolio

“Our portfolio is mostly skewed to Treasury bonds, gold and emerging-market currencies, especially Asian currencies. We also hold commodity assets that are limited in supply and that high-growth emerging countries need."

This looks like a response to the present deflationary environment and anticipation of future currency deflations. Hard to say, but perhaps it also reflects an anticipation of inflation beyond the time horizon of "anytime soon".

Recent Comments from Seth Klarman

                                            Elihu Vedder, The Pleiades, 1885

Seth Klarman, the founder and president of Baupost Group, is a highly successful and very conservative investor who formerly worked with Max Heine and Michael Price at Mutual Shares. Klarman's own funds have continued in the value tradition and are known for holding high levels of cash, investing in distressed situations, and using a variety of hedging methods.

It is unfortunate that Klarman makes few public statements, because his portfolios have averaged an annual return of around 20% since the founding of Baupost in 1982 and 17% over the past decade, a period when equity index returns have been flat. Fortunately, some of his remarks at the recent annual meeting of the CFA Institute have appeared in the press, and Jason Zweig published additional comments in the Wall Street Journal.

Currency Devaluation Threat

The world seems to be in deflationary mode right now, but Klarman is looking at the future. "Will money be worth anything if governments keep intervening anytime there's a crisis to prop things up?" The point is that it doesn't matter if you make wise investment allocations, because you will lose money anyway if that money is in a depreciating currency. If all currencies suffer relative to real things, you can lose out in any currency. For that reason, Klarman said, "I am more worried about the world, more broadly, than I ever have been in my career."

Cheap Inflation Hedges

If the government is borrowing every-increasing amounts, what to do? Klarman's Baupost funds are focusing on the "tail risk" that bond prices will increase not modestly, but to levels unheard of in the US since the inflation of the 1970s. Baupost's response is to purchase "way out-of-the money puts on bonds" because "It's cheap disaster insurance for five years out." Focusing on tail risk means that Baupost holds options that will expire worthless if long-term interest rates rise to the 6 percent to 7 percent level, but will appreciate considerably if long-term rates rise to the 10 percent range, and 50 to 100 times if long rates pass 20 percent.

Traditional Hedges Are Expensive

Klarman has a very specific reason for using options on bonds to protect against future inflation and currency devaluation, rather than some other vehicle: "All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive." This applies also to gold: "Near its all-time high, it's a very hard moment to recommend gold."

What to Think of This?

Not everyone would agree that expanding government debts will lead to inflation and a declining currency. As many people like to point out, the US is not Greece. Our debt is denominated in our own currency, and the government can simply rearrange accounting entries to control the amounts in various accounts. In this view, higher bond rates (and associated troubles managing debt) are not as inevitable as Klarman asserts. Because the whole issue is subject to credible contending opinions, it is interesting that someone with Klarman's investing record does view bond rates as a substantial risk. He is not alone.

Patient Value Strategy

If traditional hedges are expensive, what is the individual investor to do when faced by hyperinflation and declining purchasing power? Not surprisingly, a value investor like Klarman advises buying things that are "out of favor, loathed, and despised". So, all that is needed, according to him, is to have patience and fortitude -- wait until things are hated that they are cheap, and then buy them. For example, Klarman is looking into private commercial real estate, although he cautions that publicly-traded REITs are "quite unattractive" because they have "rallied enormously."

Investing When Government Determines the Winners and the Losers

This blog has previously complained of the difficulty of investing when traditional valuation measures have lost their meaning, and government policies determine the winners and losers. Klarman has the same complaint: "There is nothing natural in the markets. Everything is being manipulated by the government." Zweig's article mentions that Klarman compared the financial markets to a Hostess Twinkie in a recent newsletter.

"The government is now in the business of giving bad advice." He explained this comment as follows: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

You may have noticed that, despite these complaints about government interference, Klarman is still plugging his value approach to investing.

Recent Comments from David Rosenberg

                           Henri Matisse, Harmony in Red

Over the past few months this blog has summarized the views of several market observers, mainly those with bearish, deflationary views. It's time for an update, this time from David Rosenberg, the Chief Economist at Gluskin-Sheff, whose "Breakfast with Dave" letters you may have seen quoted from time to time in the financial news.  He continued to lay out a cautious, deflationary line in the May 24 letter and a recent interview on Bloomberg Radio.

Regarding the markets at present, Rosenberg advises investors "to be patient and disciplined" and avoid the often-heard advice to buy at the lower prices offered by the recent market selloff.  In his view, another decline in the financial markets is coming due to economic risks, in contrast to the financial risks (European debt concerns among them) that triggered the latest nosedive in stocks.

In support of this view, he cites an impressive list of leading economic indicators suggesting that the two-quarter long V-shaped recovery will turn south. Just a few of the indicators that have already peaked include the leading economic indicators of the Economic Cycle Research Institute and the Conference Board, the orders/inventory ratio of the Institute for Supply Management, and mortgage purchase applications.

"One of our primary themes has been deflation," at least in part because of price trends, extreme low interest rates, and declining real income excluding government transfers. This fits into Rosenberg's view that current economic problems are more structural than cyclical in nature.

Given the structural problems with the economy, the next recession is coming soon, rather than years away, and it will lead to "pernicious deflation", in Rosenberg's view. With so few policy options left, healso  thinks that to counter these pernicious effects the Fed will be forced to engage in quantitative easing again and expand its balance sheet even more.

As Rosenberg said in the interview "that's why gold is going to be making new all time highs." Despite this long term view, in the near term he advised caution because gold has become "a very crowded trade; better pricing points likely lie ahead."  It is no wonder that he is bullish on gold in the longer term, given that he says (not surprisingly) that "critical issues at the sovereign level" and "a crisis in confidence" are the root of the troubles in the financial markets.

This Is Fiscal Austerity: California Sacrifices the Old, the Disabled, the Children of the Poor

To solve its budget crisis, California has decided to dismantle programs that preserve the lives and health of its most helpless citizens.

Faced with a fiscal deficit that totals 20% of its annual budget, Governor Schwarzenegger decided that the best path to austerity was to cut support for those who cannot defend themselves. The trouble is that, because the Federal government also contributes money, court judgments have prevented California from going through with attempts to scale back these programs. So, the Terminator proposed a budget that will do away with the programs entirely.

The programs eliminated include home healthcare for the elderly and disabled, a nearly $2-billion program that serves 440,000 Californians, and the Healthy Families program, which uses federal money to help provide health insurance for about 900,000 low-income children.

As the San Jose Mercury noted last week, more single mothers and their children will be homeless and hungry, more mentally ill people will be in jail, more old people will be forced into nursing homes. In California, no one will look after poor children while their parents work, look after shut-ins, buy food for low-income seniors, of take in the homeless.

These are the kinds of actions and consequences that reveal where the values of our country's supercilious voters and politicians really lie. These are the kinds of values that put to the lie to the self-righteous rhetoric of "value" obsessed electorates.

Rather than bear the consequences of their own past foolishness, the politicians and the vast bulk of the electorate will simply shift the punishment onto the helpless. Presumably, the electorate and their leaders will have no trouble ignoring the suffering that they cause now, any more than they were troubled by their past foolishness.

Maybe citizens should be more concerned about how fiscal austerity is implemented.

Do they think that today's poor are the only losers? Think again, because there are more jobs to be lost, and more homes to be foreclosed.

Do they think that fiscal austerity is only for other states or other countries? Think again, because California isn't the only state in budget trouble, and Greece isn't the only Western country in budget trouble.

Painful fiscal austerity should soon be coming to more states. Just hope that it is not coming to your home.

We Will Defend the Euro Whatever It Takes

Last weekend, European Commission President Jose Manuel Barroso said: "We will defend the euro whatever it takes."

This was after French President Nicolas Sarkozy and German Chancellor Angela Merkel announced that Europe will set up an intervention mechanism to calm markets rattled by the Greek debt crisis, and stave off any attack against weakened nations whose financial systems are at risk.  Sarkozy and Merkel also said laid out a plan to defend the euro against "speculators", which led to Barroso's statement.

This is just a stopgap, and it does nothing to eliminate the underlying problems -- low productivity of southern European nations, high debt loads all over Europe, unrealistic social commitments, higher growth in the rest of the world.  If it takes $1T at this initial stage of the crisis, what will it take later?  What will they do when the next southern European country reaches crisis stage?  If the ECB has to buy government bonds, they are just monetizing debt (while holding toxic assets).  The underlying problems will remain, which raises the risk that eventually debts will be defaulted or inflated away, and that the EU will face some kind of political rearrangement in the future.

"Whatever it takes"?   The real problems are just being postponed.