Ray Dalio of Bridgewater Associates:
Fantastic interview!
Streetside Chat
The TSC Streetside Chat: Ray Dalio of Bridgewater Associates
By Brett D. Fromson
Chief Markets Writer
12/24/00 8:00 AM ET
URL: thestreet.com
In a low-slung stone-and-glass building hard by the Saugatuck River in Westport, Conn., Ray Dalio and his staff manage $31 billion for some of the largest pension funds and endowments in the world. Since starting Bridgewater Associates in 1975, Dalio has made a name for the firm among big institutions that invest globally.
In June, Pensions & Investments magazine ranked Bridgewater as the best performing global bond manager in both the past year and the past five years. Bridgewater's $3 billion hedge fund is flat this year, but since 1989, the Pure Alpha fund has earned about a 20% average annual compound rate of return, excluding fees. Over that same period, the S&P 500 returned 12.7% a year, including reinvested dividends.
Dalio has shown he is a survivor. (That may be because he got his start on Wall Street creating hedging strategies.) In these dicey times, you could do worse than to listen to a survivor. Dalio spoke this week with TSC's Brett D. Fromson. They discussed the Federal Reserve, the economy and the Nasdaq crash, as well as the outlook for stocks and the U.S. dollar. It's a sobering, but necessary, read for tough times.
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Brett D. Fromson: Ray, what is your reaction to the FOMC's decision Tuesday to change its monetary policy bias to easing, but not to lower the fed funds target rate?
Ray Dalio: I think they're still behind the curve. They didn't do anything. They are talking about a recession. I think you will get a recession. The most important thing to realize is that 25-, 50- or 75-basis-point cuts do not pull economies out of recessions. If you look at all the post-World War II recessions, the minimum rate cut has been 290 basis points [2.9%] and the average has been 550 basis points [5.5%]. They have yet to begin to cut, so the chances are that when the Fed does cut, they will be cutting hundreds of basis points.
Brett D. Fromson: How do you rate Greenspan's response to the slowing economy so far?
Ray Dalio: I think that Alan Greenspan has done a good job. But he is now viewed as a miracle worker, and that he isn't. He always does the most obviously appropriate thing, given the information he has. I think he will handle this downturn in a similar manner. He'll be cautious about cutting rates to begin with. Then events are likely to turn out worse than the conventional wisdom, and he will then have to be more aggressive.
He's very reactive. His actions tend to be very much with the consensus. He is not a man who deviates from the consensus views much. Economic questions are difficult. Is this a bubble bursting? If he eases monetary policy, might the Fed cause the bubble to grow bigger still? At these moments, it's very difficult to run monetary policy. Greenspan is not a guy who has ever surprised the market. He has always followed the market. The bond market has always forecast a Fed easing before Greenspan actually made the cuts. He is a follower.
Brett D. Fromson: Sounds like we're in for some rough sledding here.
Ray Dalio: Yes. I think there will be significant economic disappointment. Asset values themselves will be materially affected by those disappointments. The question now is: What impact will the declining financial markets have on the real economy? It is one thing for the financial markets to have disappointments. There is a real economy out there. Will the bursting of the financial bubble affect the real day-to-day economy proportionately, or can the air come out of the bubble while the economy remains OK?
I unfortunately think there will be some effects on the real economy. If you look at the correlation recently of the stock market to household consumption, you see they are connected. Retail sales have tended to move with moves in the stock market. We see this now in the Christmas season. And I think it may be worse after Christmas. Traditionally, if you have had a lot of consumption, a lot of income growth and a lot of wealth creation as we have had over the last several years, you have one last Christmas that reflects the past sense of wealth and abundance. Then you come into the New Year and the realization sinks in that things have changed for the worse. You see people switch from an environment of greed to one of fear. That is what I think we may see. But who knows? There is a saying that he who lives by the crystal ball is destined to eat ground glass.
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"The most important thing to realize is that 25-, 50- or 75-basis-point cuts do not pull economies out of recessions."
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Brett D. Fromson: Let's talk about the nature of the financial bubble that is bursting.
Ray Dalio: There are cycles, which are self-reinforcing. In bubble expansions -- particularly when they get very overdone -- we see situations in which positive economic growth raises earnings. Higher earnings raise stock prices. Higher stock prices lead to the wealth effect, which in turn leads to higher rates of consumption and higher rates of investment. Higher investment raises profitability, which causes stock prices to rise. That process is so self-reinforcing that it creates an exaggerated condition that is not sustainable.
Brett D. Fromson: Of course, that's the upside of the cycle.
Ray Dalio: That's the upside of the cycle. And when it ceases to be sustained, growth expectations become disappointing or there is a tightening of monetary policy or something pricks that bubble, then there's a reversal of that cycle. Earnings disappoint and stock prices go down. Then lower stock prices adversely affect consumption and investment rates, and profits disappoint. Consumption goes down, and credit spreads blow out.
Brett D. Fromson: Where does that downside of the cycle typically end?
Ray Dalio: That cycle is a very powerful force. There is, of course, the [FOMC's] ability to boost consumption through the lowering of interest rates. And in the business cycle sense, whenever you're lowering interest rates, effectively you're lowering the price of everything -- because anything that is purchased on debt can be purchased more inexpensively. If you cut interest rates in half, you're effectively cutting the price in half for anything that's purchased on debt.
Brett D. Fromson: How would you characterize Fed monetary policy in recent years?
Ray Dalio: Cautiously reactive. The Fed has always done the most obvious thing and has always done it in a very gradual way.
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"What we have is a situation in which I believe that earnings growth will chronically disappoint."
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Brett D. Fromson: Are you also saying that the market has tended to lead the Fed?
Ray Dalio: Yes, just as the market is leading the Fed right now. Right now the market is discounting the most aggressive easing that it has discounted going back to 1981. What we have is a situation in which I believe that earnings growth will chronically disappoint. The I/B/E/S estimates on earnings growth over the next two years is about 15% a year. That kind of an estimate is based mostly on the earnings growth this year that we've had. Whenever you have an earnings growth rate that is above the nominal GDP growth rate, there is a question about whether that is sustainable. I don't believe that's sustainable. So I think there's a lot of room for significant disappointment in earnings growth and rate cuts.
Brett D. Fromson: And where do you think those cuts might end?
Ray Dalio: Before the cycle is over we'd be in the 2 1/2% to 3% area probably.
Brett D. Fromson: And that would be in which rate?
Ray Dalio: The fed funds rate.
Brett D. Fromson: Now is there any doubt in your mind that we are staring recession in the face?
Ray Dalio: No, I don't think there's a doubt. When we think of recession, we have to keep in mind what a recession is. This is something different than a recession. All the post-WW II recessions have been recessions caused by hikes in Fed policy. We have a situation here that is a whole different dynamic having to do with business cycles or this bubble bursting. So it has a life of its own. It is not as managed by the Fed as a typical business cycle, and so when we talk about a recession, this really isn't one of those typical recessions.
Brett D. Fromson: What does that suggest to us about the ability of easing monetary policy by the Fed to counteract the down cycle here?
Ray Dalio: Well, it suggests that there is going to be a greater amount of easing than is normal. People are always concerned that the Fed can't reverse it. The only times major central banks have been unable to reverse a bursting bubble has been Japan in 1990 and the U.S. in 1930. And those problems had to do with interest rates very quickly going to essentially zero. We have 650 basis points on the Fed funds rate before we get to zero.
Brett D. Fromson: Whatever happened to the Fed's worrying about inflation?
Ray Dalio: Well, I think that the Fed doesn't yet know, and no one yet knows for sure, that this bursting of the bubble is anything that is necessarily sustainable on the down side. I believe that it is. But what they have seen really is the financial markets communicating a message that's fairly loud and clear. The economy is slowing, but it is not declining at a rate that is anywhere near in proportion to the market's rate of decline and what is implied in that. So, I think the Fed's concerns about inflation and growth or whether this economy turns up again are very cautious reactions. If anything, I think the Fed is behind the curve.
"History shows that investors who have bought growth stocks without regard to the price they pay for growth have done very poorly."
Brett D. Fromson: Might the financial markets be overreacting?
Ray Dalio: It's possible. More than likely, though, I'm a believer that the bubble has burst and there is a very strong dynamic to create disappointment. If I'm looking at the implied earnings growth rate that is still priced into many equities, there is still a lot of room for disappointment. I think economic forecasts are very unreliable. The Fed is in a position of reacting to the actual evidence, and they'll see more evidence of slowing, and that's why they will probably be behind the curve.
Brett D. Fromson: So what does your view mean for stock investors?
Ray Dalio: The earnings growth rate built into equities prices still appears to me to be very optimistic in the aggregate. But the disparity of equity prices is enormous between growth/technology sectors and the value sectors. I think the value stocks look very cheap. They are discounting very poor earnings growth rates. When interest rates come down, the present value of those income streams will rise and make those stocks quite attractive. The stock market environment looks very much like the environment in 1973. In that period, growth stocks were extremely high priced compared to value stocks, and in 1974 and 1975 that disparity was closed when the growth stocks, the so-called Nifty Fifty, declined enormously in price. Today, we are again in a bear market, and the growth stocks will feel it a lot more than the value stocks.
Brett D. Fromson: What signs will you be looking for that the tech/growth stock sector is poised to recover?
Ray Dalio: Personally, I think it's going to be a while before that happens because you are going to need to have two things happen. One, you are going to need the prices of those growth stocks to decline a lot so that the P/E multiples get down to the point where they are about 20% higher than the multiples on value stocks, which is the normal premium. That means that the P/Es on growth stocks should come down roughly to their earnings growth rates. So, stocks whose earnings per share are growing at about 20% a year should be trading at about a 20 multiple before this cycle works itself through.
Second, you'll need to reach the point where economic contraction or recession is completed and earnings growth estimates favorably surprise investors. We are still in that part of the cycle where growth estimates are going to be disappointing. You have to get to the part of the cycle when interest rate cuts are substantial enough to create upside surprises.
Brett D. Fromson: What about the notion held by many growth stock investors that they buy these stocks because their earnings will keep on growing even if the economy slows?
Ray Dalio: History shows that investors who have bought growth stocks without regard to the price they pay for growth have done very poorly. That was what the Asian crisis of 1997-98 was all about. Asia had very fast growth rates. Before the crisis, we saw P/E's on Asian stocks move from about one-half of their growth rates to about twice their growth rates. There was an overpricing of growth. That corrected itself, and I think we'll see that in growth stocks here too.
Brett D. Fromson: Which P/E's would you suggest investors focus on? The 12-month forward P/E? Or the 12-month trailing P/E?
Ray Dalio: The reality is that it depends on how much fluff is in the forward P/E's. Right now, I think the forward earnings estimates are substantially too high. So, use whatever you think is the best estimate of earnings. If that is the trailing earnings, use that. If you think you have a good forward estimate, use that to compute your P/E's.
Brett D. Fromson: What is your outlook for bonds?
Ray Dalio: We are bullish on the short end of the yield curve. We think over the next three months the short end will be attractive as the Fed rate cuts lag the economic decline. Then we will extend out into the longer maturities.
"We're setting ourselves up for a very, very bearish set of confluences for the dollar, particularly vs. the euro."
Brett D. Fromson: What is your outlook for the U.S. dollar?
Ray Dalio: Very bearish. Right now, we have a number of things working against the dollar. Two main capital flows have driven the dollar up over the last two years. First, mergers and acquisitions from Europeans, particularly large telecom deals. Forty percent of the M&A activity of the past two years has come from big telecom deals. There won't be many more of those.
Also, a lot of the capital inflows came via new equity purchases by European pension funds. Because of changes in the regulations that allowed them for the first time to buy international equities, they made a one-time asset reallocation shift to international equities, in particular to U.S. equities. That shift is completed. So, those equity flows and their upward pressure on the dollar are also past. In addition, the technology-led U.S. productivity miracle is no longer quite the positive it was in attracting capital. Now with the collapse in the Nasdaq, it's a negative.
In addition, we're looking at lower interest rates on dollar-denominated assets. So, we're setting ourselves up for a very, very bearish set of confluences for the dollar, particularly vs. the euro.
Brett D. Fromson: What does this mean for investors with most of their assets in dollar-denominated investments?
Ray Dalio: It means that the last 10-to-15-year period in which U.S. dollar-denominated assets outperformed all others around the world has come to an end. And it means that we may be entering a period in which dollar-denominated assets will underperform. |
