Ray Dalio on the Future of Monetary Policy

[moore_capital54]

An insightful post from Dalio who has been both prescient and correct in most of his predictions post 2008.

 

A period I distinctively recall from this board was the summer through fall of 2011. There were several EU related headwinds (PIIGS, Cyprus, Greece) and this was before the announcement of the EURO-TARP (Draghi "whatever it takes" speech). Equity valuations in the US were dropping and the board collectively sought and identified several incredible long ideas. The most obvious was BAC but there were also others.

 

Since then, much has changed in macroeconomics, central Bank experimentation ("policy"), and even geopolitical/social momentum. We are seeing upheaval in virtually every key pillar of our investment methodology as value investors. The risk-free interest rate is gone, we are on the precipice of an asinine concept known as negative interest rates, the balance of economic causality appears to have shifted to the other side of the planet (lets not forget that China started this global selloff in commodities and now equities), and socially there is an increasing reliance on centrally planned top down stratified policies in economics, politics, and even academia.

 

The point I am making is, we have to be realistic about our goals in such a changed environment. The margin of safety as calculated by our traditional methodology appears to be wider than at any time since 2011, we should probably spend more time trying to identify and flush out some great ideas (I am buying ESV, CG, POT, and GLRE here). However, we should also come to terms and plan for what seems like a 1970's era hyperinflation/stagflation which I believe is inevitable at this stage.

 

The majority of academics (Larry Summers and his cabal) and thought leaders are so focused on deflation and stimulating aggregate demand. The majority of market participants are fearing a systemic event such as 2008 and sell everything at any sign of stress. I am highly confident now 8 years since 2008, we won't see either of those events materialize.

 

The academics and central planners at the helm of the global financial system have shown to be relentless in their willingness to devalue their fiat currencies for the purpose of saving the system. Any worthless loans will be reversed repo'd ad infinitum while a simultaneous QE or its simulacra stabilizes the system. So an end of the world systemic event emanating from the financial system won't happen again. Remember, the reason 2008 happened was none of us believed the Fed had the authority or moral gumption to devalue 20-30% of the monetary base for the purpose of bailing out the AIG swaps. I, and most market participants thought the sensible thing to do was allow the equity holders of the SIFY's to lose 100% of their equity while protecting the depositors, government sponsored securities, and senior or Triple AAA rated debt obligations of those SIFY's. That was why any intelligent investor was selling or shorting (before they implemented rules disallowing us to do so) those SIFY's. But that's not what was concocted by Kashkari/Paulson. They decided to have the central bank bail the equity of the SIFY's under a solipsistic view that this was the only way to save the system.  That model has since been replicated by every central bank. So again, the point here is stop worrying about systemic, it won't happen. Even in China, that won't happen.

 

Deflation - The world is short on aggregate demand and the reasons have not been fully understood. My opinion is that a lot of this cause/effect has to do with cultural/non economic reasons relating to the deferral of household formation and overall decline in fertility rates among the GenX and Millenial generations. Nevertheless, the academics and central planners continue to fear deflation and do all that they can to stimulate notional fiat currency denominated growth. This brings us back to MP3 as Dalio puts it, It will eventually succeed. There will not be a deflation, not if denominated in fiat currency. What we will however have is a 1970's style commodity cycle where we get inflation in the things we need and deflation in the things we already own. Not all equities will fare well in such a cycle. More importantly, I am unsure how the central planners will end such a cycle as they do not have the flexibility that Volcker had in the late 1970's.

 

 

 

 

[petec]

I am unsure how the central planners will end such a cycle as they do not have the flexibility that Volcker had in the late 1970's.

 

 

Why's that?

[moore_capital54]

I am unsure how the central planners will end such a cycle as they do not have the flexibility that Volcker had in the late 1970's.

 

 

Why's that?

 

Well, the only way to slow inflation in the supply chain of commodities as I describe is by increasing the cost of capital (raising interest rates) or implementing price controls. I assume they will try the latter first (bringing us ever closer to the socialism/communism we all despised) but that won't be enough, they will need to stop the capital from capitalizing on the steep contango in the markets (at that point) and the only way to do that is raising rates aggressively.

 

But they cannot raise rates because of the $19T in gov owed debt. Each 1% interest rate hike widens the deficits and brings the US closer to notional insolvency.

 

It's going to be very interesting to see how they deal with this.

[vinod1]

 

On profit margins, I got lucky because the financial crisis caused market to go down. It did not go down due to mean reversion of profit margins. So I was right for the wrong reasons. So it was a mistake on my part and if not for luck, it would have been a major mistake that could have cost be very dearly. That again happened in 2011. If not for the banking crisis, I would have very low allocation to stocks. So again a major mistake. In investing, doing the same thing again and again, we can get different results. :)

 

 

I would argue that falling profits (and therefore falling margins) had a LOT to do with the sell-off in stocks in 2008/9.  That was, in fact, mean reversion.  The fact that it didn't *last* was down to huge stimulus.  And if people had correctly diagnosed the original high margins (as being caused by too-low interest rates) then they would also have predicted that, with huge stimulus, margins would bounce back to new highs after the crisis.  Point being, there's macro and there's the policy response to macro and you have to look at both together.  But I believe you were right to worry about aggregate margins and that they will eventually mean revert.  I try to stick with market sectors where margins are not above long run norms.

 

Mean reversion of profit margins is a core cherished belief of mine for 10 years from 2004 to 2014, when I finally let go of that notion. I wasted much effort reading arcane economic and other papers related to this, so I can say with some conviction I was wrong.

 

Stimulus can mean fiscal or monetary. So l will take one at a time.

 

Fiscal Stimulus: If profit margins are due to say fiscal deficit as GMO and others have made a case. It was debunked both in theory and in actual results. Fiscal deficit has dramatically been cut down from around $1.4 trillion range during the crisis years to less than $500 billion now. Profit margins have increased even as the fiscal deficit has come down. Last 15 years there is a sort of negative correlation instead of positive correlation between these two measures.

 

Monetary Stimulus: There is this notion going around that the federal reserve pumped money into the system with QE and that money is causing financial assets to be bubbly or you seem to be pointing it to increase in profit margins. Both of these notions are false.

 

Fed has essentially engaged in a massive security swap. Banks have swapped their mortgage and long term treasury bonds to Fed and in turn Fed has credited them with reserves on which it pays 0.25%. So the Fed is essentially acting as a massive commercial bank to the tune of $4 trillion in assets on which it earns around 3.5% and it pays 0.25% to fund those assets. It is generating $100 billion annually from this. So all it did was reduce interest rates at the long end of the treasury bonds and in mortgage bonds. No money has really leaked into other assets nor did it cause profit margins to rise.

 

Any effect it has is indirect via lowering of interest rates and causing people to choose to hold more risky assets and thereby increasing their valuations.

 

So I do not think profit margins are impacted by stimulus in a material way.

 

One more way to look at this is to look at distribution of profit margins across all the companies. 80% of the companies did not see any profit margins at all. Many have declined in fact. The profit margin expansion is concentrated in 20% of companies, many in technology and some in financials (obviously not the banks). The suspicion is that this might be due to winner take all economics in these fields. If this is true it can persist for a very long time and may or may not ever revert.

 

Ok. Let us say even now you are not convinced about the fallacy of mean reversion of profit margins.

 

What has happened the last time profit margins got cut down it half? The last time there was a long term shift down in profit margins over a 20 year period, coming down from 12% to 6%, what do you think happened to earnings?

 

They increased 10% annually over this 20 year period, when profit margins got cut in half.

 

So there are multiple ways in which worries about profit margins can be be resolved without earnings getting wacked.

 

Vinod

[Graham Osborn]

@vinod: When you agree with what William White says we are much more in agreement than you think. It's just that I draw some very different conclusions from what he says. I also think that Pete and I have similar frameworks or at least think about a lot of the same things.

 

Basically, what brought me to macro was what Druckenmiller has been saying for two or three years now: that corporate America is levering up its balance sheet and that you should look at sales growth and not EPS. I had been following Dalio for quite some time at that point and what Druckenmiller said made perfect sense in Dalio's framework.

 

I thought – and I still think – that if Dalio is right value investors are in great danger. That is because in the next slowdown (happening about now) they are going to confuse a secular downturn in the long-term credit cycle (happening since at least 2007) with a short-term downturn in the business cycle. They are going to buy "cheap" stocks without paying attention to the big picture and this is going to be very painful for a lot of them. This is why I'm posting this stuff here. I'm honestly surprised to find quite a few people here more or less agreeing with me or at least considering this.

 

I think value investors are going to look at Buffett go shopping in the downturn like he successfully did in 2008 and so many times before that. But when you think – like I do – that we are talking about a downturn that happenes every 80 years or so nearly everything Buffett has done in his investing career has to be rethought in this light. He has never experienced such a downturn and I don't think he fully gets it; otherwise he'd certainly sell his bank holdings and insurance businesses.

 

To be clear, I think there may be great opportunities to buy great companies, too (like KO, DIS, health and cable cos etc) but you really have to think about how their business models react to long periods of first deflation and then inflation. There is also the risk that they might be state owned by then (which is what's happening in Japan right now). I also think that there are going to be ample opportunities to buy the surviving companies much cheaper than they are now and with a much improved understanding of how their future might look like.

 

At this point there are some real macro guys on the thread and I feel like a blithering idiot.  That said I'll suggest this on Buffett - he's not in it for the capital gains anymore.  Buffett is a more an industrialist than an investor, and an industrialist will pay a hefty premium for assets with strategic importance to the empire.  Maybe there is a logic to coattailing Buffett in a rising market in businesses with great fundamentals, but the fact that Berkshire has a position in various media and energy companies isn't going to keep these assets from declining in market value.  Secondly, I think Buffett's powers are waning based on hearing some recent interviews he has given and some recent investments he's made/ signed off on like CBI.  I'll be the first to admit that Buffett in his prime was one of the best industrial/ financial/ creative minds in American history, but at this point he's "a landmark, not a beacon" as Oppenheimer would say.

[vinod1]

@vinod: When you agree with what William White says we are much more in agreement than you think. It's just that I draw some very different conclusions from what he says. I also think that Pete and I have similar frameworks or at least think about a lot of the same things.

 

Basically, what brought me to macro was what Druckenmiller has been saying for two or three years now: that corporate America is levering up its balance sheet and that you should look at sales growth and not EPS. I had been following Dalio for quite some time at that point and what Druckenmiller said made perfect sense in Dalio's framework.

 

I thought – and I still think – that if Dalio is right value investors are in great danger. That is because in the next slowdown (happening about now) they are going to confuse a secular downturn in the long-term credit cycle (happening since at least 2007) with a short-term downturn in the business cycle. They are going to buy "cheap" stocks without paying attention to the big picture and this is going to be very painful for a lot of them. This is why I'm posting this stuff here. I'm honestly surprised to find quite a few people here more or less agreeing with me or at least considering this.

 

I think value investors are going to look at Buffett go shopping in the downturn like he successfully did in 2008 and so many times before that. But when you think – like I do – that we are talking about a downturn that happenes every 80 years or so nearly everything Buffett has done in his investing career has to be rethought in this light. He has never experienced such a downturn and I don't think he fully gets it; otherwise he'd certainly sell his bank holdings and insurance businesses.

 

To be clear, I think there may be great opportunities to buy great companies, too (like KO, DIS, health and cable cos etc) but you really have to think about how their business models react to long periods of first deflation and then inflation. There is also the risk that they might be state owned by then (which is what's happening in Japan right now). I also think that there are going to be ample opportunities to buy the surviving companies much cheaper than they are now and with a much improved understanding of how their future might look like.

 

I think overall Dalio's framework makes sense in describing the past. It is I think a good framework for thinking about the future with two exceptions:

 

1. The long term debt cycle (the 50 year to 80  year cycle). As I have mentioned earlier, how many cycles did we really have, especially where we have reliable data? At most it is 1.5 cycles in US. It is a stretch to expect it to repeat based on such limited data.

 

Here is how Dalio refers to as cycle:

A cycle is nothing more than a logical sequence of events leading to a repetitious pattern. In a market-based economy, cycles of expansions in credit and contractions in credit drive economic cycles and they occur for perfectly logical reasons. Each sequence is not pre-destined to repeat in exactly the same way nor to take exactly the same amount of time, though the patterns are similar, for logical reasons.

 

It is to the expectation of repetitious pattern that I object to. There is a sense of near inevitability to this which I do not agree with. I believe that we (including central bankers and politicians) have learned from the Great Depression and Japanese experience, so that in itself might invalidate a "pattern".

 

I, for one, am very impressed with the way Bernanke and Paulson responded to the credit crisis. This is in no small measure due to experience gained from Great Depression and Japan. So future might play out quite differently from the past.

 

Even if the pattern holds true, can we really say for example, how the next 10 years or 20 years are going to play out? It could just be that cycle needs another 10 or 20 years to turn. If that is the case, our bet would be right eventually but it might take 10-20 years to play out. How can we be really confident in any such estimate.

 

This is a general problem with macro. You get to make a bet and you would have to wait many many years for it to play out to know if you are right or wrong. How long should one wait to say they are wrong? The entire portion of the portfolio dedicated to this approach would be either a huge win or a loss. So over an entire lifetime you get to make 3 or 4 macro bets at a maximum.

 

If we follow someone who had success in macro, it could be from 2 or 3 successful macro calls. How can we separate out luck from skill in this case?

 

2. No attention is given to the distribution of debt within a society. Debt in general would not be a problem regardless of the absolute level under one condition. This is the case because one man's debt is another man's asset.

 

The problem really occurs because of uneven distribution of debt in society.

 

Denmark had one of the highest household debt ratios in the world in 2007 at 267% of income. US was 125% at its peak. But default rates peaked at 0.6% in Denmark where as they were 12% in US. This is because the debt is concentrated mostly in high income households in Denmark and mortgages were limited to 80% of value of property.

 

So just because debt has increased does not tell us a whole lot were we are in the cycle and how it is going to play out.

 

Are you not making a bet that you know (a) that there is such a thing as an 50 or 80 year cycle (b) you know how it is going to play out © you also know the timing of it, and (d) the market has not priced this in.

 

If you are wrong about anyone point either (a) or (b) or ©,  or (d)  portfolio returns would be unsatisfactory.

 

Vinod

 

[vinod1]

Here is my general approach as far as risk management is concerned

 

1. We cannot really protect ourselves from risks of much greater severity than the Great Depression. Really guns and ammo and that kind of survivalist stuff. So I just leave this alone.

 

2. Risk of similar magnitude to GD are possible but very unlikely. So I keep a portion of my portfolio in cash (I-Bonds bought at 3% real yields and above) in nearly all circumstances. This should help me carry me through a similar occurrence. Sure this is suboptimal if GD scenario does not play out. A lot of stuff has to go wrong for this scenario to play out. Since this is very unlikely I only tie up the absolute minimum that I would need in such a scenario.

 

3. The rest of my portfolio, I just ignore GD type scenarios. I invest in simple Graham and Buffett manner. I try to bake in pretty negative scenarios in my baseline case and I end up with IV estimates lower than most others. I buy when they are at a discount and sell when they reach close to 90% of IV - except for a few "exceptionals" that I hold even if they are a bit richly valued.

 

Vinod

[JBTC]

I think overall Dalio's framework makes sense in describing the past. It is I think a good framework for thinking about the future with two exceptions:

 

1. The long term debt cycle (the 50 year to 80  year cycle). As I have mentioned earlier, how many cycles did we really have, especially where we have reliable data? At most it is 1.5 cycles in US. It is a stretch to expect it to repeat based on such limited data.

 

Here is how Dalio refers to as cycle:

A cycle is nothing more than a logical sequence of events leading to a repetitious pattern. In a market-based economy, cycles of expansions in credit and contractions in credit drive economic cycles and they occur for perfectly logical reasons. Each sequence is not pre-destined to repeat in exactly the same way nor to take exactly the same amount of time, though the patterns are similar, for logical reasons.

 

It is to the expectation of repetitious pattern that I object to. There is a sense of near inevitability to this which I do not agree with. I believe that we (including central bankers and politicians) have learned from the Great Depression and Japanese experience, so that in itself might invalidate a "pattern".

 

I, for one, am very impressed with the way Bernanke and Paulson responded to the credit crisis. This is in no small measure due to experience gained from Great Depression and Japan. So future might play out quite differently from the past.

 

Even if the pattern holds true, can we really say for example, how the next 10 years or 20 years are going to play out? It could just be that cycle needs another 10 or 20 years to turn. If that is the case, our bet would be right eventually but it might take 10-20 years to play out. How can we be really confident in any such estimate.

 

This is a general problem with macro. You get to make a bet and you would have to wait many many years for it to play out to know if you are right or wrong. How long should one wait to say they are wrong? The entire portion of the portfolio dedicated to this approach would be either a huge win or a loss. So over an entire lifetime you get to make 3 or 4 macro bets at a maximum.

 

If we follow someone who had success in macro, it could be from 2 or 3 successful macro calls. How can we separate out luck from skill in this case?

 

2. No attention is given to the distribution of debt within a society. Debt in general would not be a problem regardless of the absolute level under one condition. This is the case because one man's debt is another man's asset.

 

The problem really occurs because of uneven distribution of debt in society.

 

Denmark had one of the highest household debt ratios in the world in 2007 at 267% of income. US was 125% at its peak. But default rates peaked at 0.6% in Denmark where as they were 12% in US. This is because the debt is concentrated mostly in high income households in Denmark and mortgages were limited to 80% of value of property.

 

So just because debt has increased does not tell us a whole lot were we are in the cycle and how it is going to play out.

 

Are you not making a bet that you know (a) that there is such a thing as an 50 or 80 year cycle (b) you know how it is going to play out © you also know the timing of it, and (d) the market has not priced this in.

 

If you are wrong about anyone point either (a) or (b) or ©,  or (d)  portfolio returns would be unsatisfactory.

 

Vinod

 

Agree completely.

 

If we are truly rational, we have to admit such a small sample size has no predictive value.

 

Extreme claims require extreme proof. Considering what held true about value investing for decades is being questioned, the proof is thin.

 

Somehow, I have a suspicion that Dalio may not be doing what some of his followers on this board are doing at all. I have no proof of that, given it appears no one (on this board) knows what he is doing.

 

This fact alone is fascinating.

 

Most of us ignore the sellside strategists because they only talk and have no skin in the game. We pay attention to fund managers because we can study what they say and what they do, to make sense of their strategy and execution. In investing, execution is as important as strategy, if not more.

 

We know what Buffett and Watsa do. Even for the super private fund managers such as Klarman, we know what he does. During Soros' heyday, what he did was tracked and reported by media. Today, Dalio is as prominent as anyone. He is on TV and in Davos. But we don't know what Dalio is doing to execute his views.

 

My feeling is there is a possibility (again no proof whatsoever), Dalio operates a bit like Grantham. Grantham is a lead thinker of his firm, but GMO runs many strategies that are not necessarily reflecting his view. While he was spot on in recognizing the peril in 2007 and recommended stepping up in 2009, his firm's funds didn't do nearly as well.

 

Maybe Dalio is now mostly a thinker, a brand for his firm, becoming in a sense like a sellside strategist. He has very high freedom to express his very broad views, because precisely his funds don't have to follow those views precisely.

 

Just on the issue of precision, his views are anything but. GMO sets and updates 7-year return targets, and Grantham mentions his S&P 500 target.

 

Dalio is a 50-to-80-year debt cycle prophet. How helpful.

 

 

[Cardboard]

Hi Moore, glad to see you back!

 

If I recall properly, you have been absent from this board since shortly after the March 2013 Cyprus crisis and were moving heavily to cash because you felt most assets were levitating or being inflated by the large money printing or QE. What did you do since then? Sounds like you are now picking bargains in the wreckage that many are now ignoring because they are busy fighting the last war.

 

At least, I can attest that your macro call of moving to cash at that time was near perfect.

 

Cardboard

[JBTC]

 

The point I am making is, we have to be realistic about our goals in such a changed environment. The margin of safety as calculated by our traditional methodology appears to be wider than at any time since 2011, we should probably spend more time trying to identify and flush out some great ideas (I am buying ESV, CG, POT, and GLRE here). However, we should also come to terms and plan for what seems like a 1970's era hyperinflation/stagflation which I believe is inevitable at this stage.

 

 

Would you mind elaborating on why owning CG? Is it beaten up or is it for your anticipated inflationary environment?

 

Thanks.

 

 

[HJ]

One thing about these very long cycle statistics that make me wonder is how consistent is the data set collected throughout history.  Take the commonly referenced overall debt number, I don't know how much of the rise is just counting something that wasn't counted before.  Credit card lending, for example, barely exists 50 years ago, today it's widely quoted at something like $900 billion, because it's quoted from the Federal Reserve G19 report.  50 years ago, it may well just be store /restaurant credit that never went through a financial intermediary, and therefore never counted in the data set.   

 

Take it to the extreme, slave ownership, likely not counted in this overall debt number for that period of time, but if one had to make a consistent set of calculation, should it be quantified as the life long earnings of a productive person, and be tabulated in this data set accordingly?

 

Cycle exists, history rhymes, and today, we have arguably the most elaborate and sophisticated form of social organization the world has ever known.  So it's not surprising certain data set, tabulated certain way, would look extreme by historical comparison.  But to infer that this therefore has to mean revert, and we are doomed to war and can only start building a new social scheme from ground zero seems a suspicious idea.

[ni-co]

Vinod, one quick question about profit margins. I don't have read any arcane papers or similar stuff. What I took from the Napier speech, though, is that the profit margins are a social function – meaning when margins are high people let get companies away with lower tax rates or pay for workers and vice versa. Napier is saying that the high margins are mostly a result of a (historically) very low tax share/GDP ratio and that companies are "severely undertaxed" if you take historical averages as a measure (not as a political statement – to be clear about that). Would you agree with that notion?

 

If that's the case I don't see any chance that they'll stay where they are. At the very least demographics (health care costs, social benefits etc) will take care for that.

[ni-co]

However, we should also come to terms and plan for what seems like a 1970's era hyperinflation/stagflation which I believe is inevitable at this stage.

 

Deflation - The world is short on aggregate demand and the reasons have not been fully understood. My opinion is that a lot of this cause/effect has to do with cultural/non economic reasons relating to the deferral of household formation and overall decline in fertility rates among the GenX and Millenial generations. Nevertheless, the academics and central planners continue to fear deflation and do all that they can to stimulate notional fiat currency denominated growth. This brings us back to MP3 as Dalio puts it, It will eventually succeed. There will not be a deflation, not if denominated in fiat currency. What we will however have is a 1970's style commodity cycle where we get inflation in the things we need and deflation in the things we already own. Not all equities will fare well in such a cycle. More importantly, I am unsure how the central planners will end such a cycle as they do not have the flexibility that Volcker had in the late 1970's.

 

I agree with you on this in so far as this is at least one part of the explanation for the deflationary forces (debt being the other important one, I'm a bit more skeptical when it comes to technology). I don't know whether hyperinflation/stagflation is an inevitable result of all this but it's a great risk. I think Dalio may agree on this, too. He hinted at that in the Davos CNBC interview ("In a couple of years from now we are going to come to a point where we're going to be thinking hard: What is a good reserve currency? What is safe in investing? Is 'safe' cash? In what currency?").

 

It's certainly good to keep that in mind and watch for any signs of QE eventually working but the deflationary problem has yet to grow larger before the government would implement something like MP3. This is a matter of years. This is why I think that, as an investor, you have to be careful not to jump on the hyperinflation train before it has arrived at the station (a mistake many gold bugs make). Otherwise you might get overrun by the deflation train which arrives there first. It has to get worse with regard to deflation before governments really take the drastic measures that may lead into hyperinflation.

 

I am highly confident now 8 years since 2008, we won't see either of those events materialize.

 

...

 

I, and most market participants thought the sensible thing to do was allow the equity holders of the SIFY's to lose 100% of their equity while protecting the depositors, government sponsored securities, and senior or Triple AAA rated debt obligations of those SIFY's. That was why any intelligent investor was selling or shorting (before they implemented rules disallowing us to do so) those SIFY's. But that's not what was concocted by Kashkari/Paulson. They decided to have the central bank bail the equity of the SIFY's under a solipsistic view that this was the only way to save the system.  That model has since been replicated by every central bank. So again, the point here is stop worrying about systemic, it won't happen. Even in China, that won't happen.

 

Where do you gain your confidence from? Not only do I think you will be proven absolutely wrong on this one because you can't be right on it in the long-term and you didn't specify a time frame. But moreover, saying that bank/insurance equity holders got bailed out in 2007/2008 is flat-out ridiculous. Have you ever looked at this chart (logarithmic scale)? How do you think did this bail-out feel as an equity holder?

[petec]

@ Vinod on margins:

 

Fascinating post.  I disagree on monetary stimulus: falling rates a) reduces interest costs for companies with debt, b) increases discretionary spending power (after interest) for indebted consumers, and c) encourages consumers to spend using debt.  All of these boost margins directly or indirectly (via operating leverage inherent in most businesses).  This is extremely clear to me having watched Brazil go through a leverage-boom and deleverage-bust over the last 7 years.  I believe US margins are on a much longer cycle but with similar underlying drivers.  My view is that corporate margins will go below the long run average at some point in the future.  I have no view on the timing of that and I don't really use it to guide my investing although it is a reason I am cautious about overall market valuations.

 

I'm also sceptical of the winner-takes-all economics argument simply because for it to be true we'd have to prove that prior periods did not have temporarily monopolistic winner-takes-all companies - and for it to last you'd have to believe that the current winners are permanent winners, which I don't.

 

*However* the point of my post is really this: could you point me to the sources for your stats about 80% of companies having flat or falling margins, and about earnings growth compounding at 10% when margins last fell structurally?  (I am not at all surprised by either stat although I'm interested to know if the 10% earnings growth was nominal or real?)

 

Many thanks.

 

Pete

 

 

[JBTC]

So Dalio says 1937-38 is the most analogous period to look at.

 

In case anyone is curious (I was), here's some data (source: Anatomy of the bear)

 

1937 unemployment 14.3%, half of the peak during 1900-30

Fed raised reserve requirements in Aug 1936

Fed raised margin on security purchase from 25% to 50%

Federal deficit to GDP fell from 4.2% in 1936 to 2.8% in 1937

Corporate profitability fell due to rising labor costs

Industrial production fell by a third from the 1937 peak to the 1938 low

S&P earnings dropped 50%

DJIA fell 49% in the 12-months from March 1937

Recession troughed in Jun 1938

S&P earnings then doubled from 1938 to 1941, but DJIA was unchanged

WWII began in 1939

 

A lot to look forward to, guys  :(

 

[SharperDingaan]

Just finished re-reading “The New Paradigm for Financial Markets” (Soros G, 2008).

This entire thread is an example of the reflexivity he described.

 

Central bankers pushing in one direction *in the absence of facts* (‘cognitive’ function) against market participants bettering themselves by pushing in the other direction *in the absence of facts* (‘manipulative’ function). The resultant ‘angst’ is reflexivity. The level of ‘angst’ reflects the state of information in the market; the *less facts* the higher the reflexivity.

 

View the cognitive function as a long call, and the manipulative function as a long put; the result is a long straddle on the current market ‘equilibrium’ state. You are anti-fragile, in the words of Taleb.

 

Both the reflexivity of Soros, and the anti-fragility of Taleb, are new additions to theory; they didn’t really exist prior to 2000. More recent practical additions to finance are P2P networking, block chain & smart contracts. * Absence of facts* also means predicting off of out-of-date theory.

 

Take this to the extreme, & it really means a 100% T-Bill portfolio + a 100% portfolio of puts/calls. Arguably, an investor would favour long T-Bills and use the Basel liquidity requirements to drive yields down (all GSIB’s & DSIB’s must hold a risk weighted portion of their capital in unencumbered treasury bills; the more risky they are, or the bigger they get, the more total $ in T-Bills).

 

The risk is that the next round of QE gets funded with a flood of long maturities; excess supply driving down price, raising yield, & restoring the yield curve to normality. The reflexivity we see in the thread.

 

SD

 

[vinod1]

Vinod, one quick question about profit margins. I don't have read any arcane papers or similar stuff. What I took from the Napier speech, though, is that the profit margins are a social function – meaning when margins are high people let get companies away with lower tax rates or pay for workers and vice versa. Napier is saying that the high margins are mostly a result of a (historically) very low tax share/GDP ratio and that companies are "severely undertaxed" if you take historical averages as a measure (not as a political statement – to be clear about that). Would you agree with that notion?

 

If that's the case I don't see any chance that they'll stay where they are. At the very least demographics (health care costs, social benefits etc) will take care for that.

 

Tax rates had an impact but not in the way one would generally think. Profits from foreign operations of US companies has increased as a percentage of total profits. Further foreign tax rates are lower than US. 

 

US Corporates profits from foreign operations have increased roughly by about 2.5% of US GDP compared to historical averages. Take GM for example, it gets $2 billion in equity income from Chinese JV's. Most of these sales dont show up in revenues, just adds to overall profits. This is extreme case to show the impact on net margins/sales, but think of all the tech companies profits from abroad. In these tech companies case, it shows up in net margins, but when you look at profits/(US GDP), it adds to the numerator but not the denominator.

 

If you look only at domestic US corporate operations and foreign companies US operations, profits have not nearly been as high as when you look at overall profits. They are roughly only around 30% or so higher rather than the 70% levels when you look at overall profits.

 

Tax rates have declined domestically as well. So if you look at domestic operations (of US and foreign companies), pre-tax levels are only about 20% higher than historical average.

 

So we are now down to explaining the 20% gap over historical average.

 

Interest rates had a bigger impact as well that accounts for more than half of the 20% gap.

 

So if you put it all together

1. Profits from foreign operations have increased in importance compared to past.

2. Profits abroad are taxed at a lower rate.

3. Lower interest rates had an impact around 3/4 the size of 1&2

 

This is evident from the distribution of profit margin gains from a sector and size perspective as I already mentioned in earlier post. This is the most damming piece of evidence.

 

Now as Krugman would say, I do not have the courage of my complacency.

 

There is no doubt there are structural headwinds (emerging market governments and companies are not likely to sit still forever while US and other developed market companies make out like bandits, increased taxes, etc) to profit margins. But these would take decades to play out.

 

I think we have enough data to show that we need to be cautious (like Buffett) but there is no need to panic (like Hussmann).

 

Vinod

 

 

[vinod1]

@ Vinod on margins:

 

Fascinating post.  I disagree on monetary stimulus: falling rates a) reduces interest costs for companies with debt, b) increases discretionary spending power (after interest) for indebted consumers, and c) encourages consumers to spend using debt.  All of these boost margins directly or indirectly (via operating leverage inherent in most businesses).  This is extremely clear to me having watched Brazil go through a leverage-boom and deleverage-bust over the last 7 years.  I believe US margins are on a much longer cycle but with similar underlying drivers.  My view is that corporate margins will go below the long run average at some point in the future.  I have no view on the timing of that and I don't really use it to guide my investing although it is a reason I am cautious about overall market valuations.

 

I'm also sceptical of the winner-takes-all economics argument simply because for it to be true we'd have to prove that prior periods did not have temporarily monopolistic winner-takes-all companies - and for it to last you'd have to believe that the current winners are permanent winners, which I don't.

 

*However* the point of my post is really this: could you point me to the sources for your stats about 80% of companies having flat or falling margins, and about earnings growth compounding at 10% when margins last fell structurally?  (I am not at all surprised by either stat although I'm interested to know if the 10% earnings growth was nominal or real?)

 

Many thanks.

 

Pete

 

Regarding monetary stimulus: Pushing on a string and all that from Dalio, et all. Is this not his central point about deleveragings and 80 year cycles, that monetary policy is ineffective in a such a case? That it does not do much to growth?

 

Do not want to argue too much about this, let us agree to disagree.

 

I am quoting everything from memory but data is from the philosophical economics blog. I would urge you to read it. There is a ton more of detail and data that make a rather strong case to support my view.

 

The earnings growth in nominal earnings (the start date is 1967  :) I just do not want to give you a point to argue about inflation helping out in this case. :) ).

 

Vinod

 

 

 

 

[petec]

Thanks Vinod, I'll read it.  Re Dalio, I would agree that monetary policy in the US and Europe has reached an ineffective point now; but the long fall in rates from 1980 to (say) 2006 was very effective in boosting all the things I talked about - clear example being HELOCs boosting household spending before the last crisis.  But as you say, we may have to agree to differ.

 

 

The earnings growth in nominal earnings (the start date is 1967  :) I just do not want to give you a point to argue about inflation helping out in this case. :) ).

 

 

;)

[vinod1]

 

I'm also sceptical of the winner-takes-all economics argument simply because for it to be true we'd have to prove that prior periods did not have temporarily monopolistic winner-takes-all companies - and for it to last you'd have to believe that the current winners are permanent winners, which I don't.

 

Pete

 

They might not last forever, but they might last long enough that betting on reversion to mean in profit margins might be an expensive mistake.

 

Vinod

[vinod1]

William White probably wrote it best about Macro and specifically NOT to think of economy as a machine like Dalio:

 

The fundamental problem is that modern macroeconomics is based upon a false belief: namely, that the workings of the economy can be understood and therefore closely controlled, as though a machine in the competent hands of its operator. A philosopher would say that we have made a profound ontological error. We have failed to realise that what one can know about a system depends upon its very nature. And the nature of our economies is simply too complex to be understood, much less controlled.

 

Consider that the analytical frameworks generally accepted by central banks totally failed to see the crisis coming or, despite concerted and persistent action, the weakness of the subsequent recovery. That alone should have been sufficient to raise some fundamental analytical questions. Moreover, support for scepticism is provided by reviewing the actual practice of monetary policy over the last 50 years. Every aspect of it–including its objectives, instruments and indicators–¬has been subject to repeated change. Generally these changes have been in response to previous policies failing to deliver the intended results, or producing unintended and unwarranted side effects. In short, monetary policy has systematically got it wrong. There would then be nothing unwarranted about another fundamental rethink in response to recent events. One approach with promise is to think of the economy not as a machine, but as “a complex adaptive system” with millions of interactive and adaptive agents following simple behavioural rules. Such systems characterise car traffic, movements of crowds, the spread of crime and disease, social networks, etc. These kinds of systems are everywhere in both nature and society, and exhibit recurrent instability and highly nonlinear outcomes. Does it make sense to assume that the economy, with all its flows and myriad interactions, should almost uniquely fail to exhibit these traits?

 

Vinod

 

[TwoCitiesCapital]

William White probably wrote it best about Macro and specifically NOT to think of economy as a machine like Dalio:

 

The fundamental problem is that modern macroeconomics is based upon a false belief: namely, that the workings of the economy can be understood and therefore closely controlled, as though a machine in the competent hands of its operator. A philosopher would say that we have made a profound ontological error. We have failed to realise that what one can know about a system depends upon its very nature. And the nature of our economies is simply too complex to be understood, much less controlled.

 

Consider that the analytical frameworks generally accepted by central banks totally failed to see the crisis coming or, despite concerted and persistent action, the weakness of the subsequent recovery.

 

Actually, given Bridgewater's Pure Alpha performance in 2008 was near +10% while global equities were significantly negative (S&P at -38.5%), I think it's fair to say Dalio's model did predict the crisis and profited from it...

 

 

[ni-co]

William White probably wrote it best about Macro and specifically NOT to think of economy as a machine like Dalio:

 

The fundamental problem is that modern macroeconomics is based upon a false belief: namely, that the workings of the economy can be understood and therefore closely controlled, as though a machine in the competent hands of its operator. A philosopher would say that we have made a profound ontological error. We have failed to realise that what one can know about a system depends upon its very nature. And the nature of our economies is simply too complex to be understood, much less controlled.

 

Consider that the analytical frameworks generally accepted by central banks totally failed to see the crisis coming or, despite concerted and persistent action, the weakness of the subsequent recovery.

 

Actually, given Bridgewater's Pure Alpha performance in 2008 was near +10% while global equities were significantly negative (S&P at -38.5%), I think it's fair to say Dalio's model did predict the crisis and profited from it...

 

I'm also not sure whether White and Dalio are using the same analogy here. Does Dalio really say that the machine "can be closely controlled"? – I always pictured this more as an autonomous machine, though he definitely does say that it can be understood.

[TwoCitiesCapital]

William White probably wrote it best about Macro and specifically NOT to think of economy as a machine like Dalio:

 

The fundamental problem is that modern macroeconomics is based upon a false belief: namely, that the workings of the economy can be understood and therefore closely controlled, as though a machine in the competent hands of its operator. A philosopher would say that we have made a profound ontological error. We have failed to realise that what one can know about a system depends upon its very nature. And the nature of our economies is simply too complex to be understood, much less controlled.

 

Consider that the analytical frameworks generally accepted by central banks totally failed to see the crisis coming or, despite concerted and persistent action, the weakness of the subsequent recovery.

 

Actually, given Bridgewater's Pure Alpha performance in 2008 was near +10% while global equities were significantly negative (S&P at -38.5%), I think it's fair to say Dalio's model did predict the crisis and profited from it...

 

I'm also not sure whether White and Dalio are using the same analogy here. Does Dalio really say that the machine "can be closely controlled"? – I always pictured this more as an autonomous machine, though he definitely does say that it can be understood.

 

I think Dalio definitely ascribes to a belief that a certain action that occurs with an economy will have certain predictable outcomes. That doesn't mean he gets those outcomes correct 100% of the time, but what that does mean is that simple higher level truths can be found based on history and logical reasoning.

 

Things like if a country is devaluing their currency, exporters should benefit. Bridgewater's analysis is obviously much deeper than that, BUT that's what he means when he says the economy is like a machine. A general framework would be something like: when some action occurs it has led to some outcome because of a, b, c, and d. Further, a, b, c, and d all still hold true today, therefore we expect a similar outcome. Then Bridgewater bets a small amount on that outcome, either directly or indirectly, in the securities markets.

 

Now, he obviously allows for the option to be wrong because he is very, very heavily diversified in the Pure Alpha funds. If he thought he could predict with 100% accuracy, he'd have the heaviest concentrations in the highest payoff ideas, but that's not really how the fund operates. But he has to be right far more than he is wrong to achieve the results he's achieved.

[vinod1]

William White probably wrote it best about Macro and specifically NOT to think of economy as a machine like Dalio:

 

The fundamental problem is that modern macroeconomics is based upon a false belief: namely, that the workings of the economy can be understood and therefore closely controlled, as though a machine in the competent hands of its operator. A philosopher would say that we have made a profound ontological error. We have failed to realise that what one can know about a system depends upon its very nature. And the nature of our economies is simply too complex to be understood, much less controlled.

 

Consider that the analytical frameworks generally accepted by central banks totally failed to see the crisis coming or, despite concerted and persistent action, the weakness of the subsequent recovery.

 

Actually, given Bridgewater's Pure Alpha performance in 2008 was near +10% while global equities were significantly negative (S&P at -38.5%), I think it's fair to say Dalio's model did predict the crisis and profited from it...

 

I'm also not sure whether White and Dalio are using the same analogy here. Does Dalio really say that the machine "can be closely controlled"? – I always pictured this more as an autonomous machine, though he definitely does say that it can be understood.

 

I understood White's general drift is that economy is too complex to be understood in terms of a machine as in "If A then B" (for example, reduce interest rate and "X" happens) and hence his reference to complex adaptive system. Dalio repeatedly uses this logic throughout his 300+ page document. I really do not know if he believes that or if he does it to make it more understandable for others.

 

Vinod