Last week, I shared a chapter from my 2021 book Principles for Dealing with the Changing World Order that details the classic signs to watch for as the world geopolitical order breaks down in a classic progression of events that I call the "Big Cycle." By knowing what this classic process looks like and then comparing it with what is happening, one can better understand what is happening and what might happen. The article was very popular, getting more than 75 million views, and a number of people asked what it all meant for investing.
Because so many people asked, I am now passing along to you the book's next chapter, "Investing in Light of the Big Cycle." I think that it gives a good perspective on investing at this time. You can read the full chapter below.
Also, since there is a lot of interest in my investment principles, I am going to be passing them along over the coming weeks. If you want to be notified when I publish them, please subscribe to my newsletter Principled Perspectives here or you can also sign up for email notifications here.
The game I play for handling both my life and my career is to try to figure out how the world works, develop principles for dealing with it well, and then place my bets. The research that I’m sharing with you in this book was done for that purpose.
Naturally, when I look at all that we’ve covered up to this point, I think about how it applies to my investing. For me to be comfortable that I am doing that well, I need to know how my approach would have worked through time. If I can’t confidently explain what happened in the past, or at least have a strategy for dealing with it in light of what I don’t know, I consider myself dangerously negligent.
As you saw from my study of the last 500 years up to now, there were Big Cycles of great accumulations and great losses of wealth and power, and of these, the greatest contributing factor was the debt and capital markets cycle. From an investor’s perspective, this could be called the Big Investing Cycle. I felt that I needed to understand these cycles well enough to tactically move or diversify my portfolio to be protected against them and/or to profit from them. By understanding them, and ideally realizing where countries are in their cycles, I can do that.
Over my roughly 50 years as a global macro investor, I discovered many timeless and universal truths that form my principles for investing. While I won’t get deeply into all of them here, but will discuss most of them in my next book, Principles: Economics and Investing, I will convey one important principle.
All markets are primarily driven by just four determinants: growth, inflation, risk premiums, and discount rates.
That is because all investments are exchanges of lump-sum payments today for future payments. What these future cash payments will be is determined by growth and inflation, what risk investors are willing to take in investing in them as compared to having cash in hand is the risk premium, and what they are worth today, which is called their “present value,” is determined by the discount rate. [1]
How these four determinants change drives how investment returns change. Tell me what each of these determinants is going to do and I can tell you what the investments are going to do. Knowing this tells me how to connect what is happening in the world to what is happening in the markets and vice versa. It also shows me how to balance my investments so that my portfolio doesn’t have any bias to any environment, which is what produces good diversification.
Governments influence these factors through their fiscal and monetary policies. As a result, interactions between what governments want to happen and what is actually happening are what drive the cycles. [2] For example, when growth and inflation are too low, central banks create more money and credit growth, which creates buying power, which causes economic growth to pick up at first and then, with a lag, inflation to pick up as well. When central banks constrain money and credit growth, the opposite happens: economic growth and inflation both slow down.
There is a difference between what central governments and central banks do in order to drive market returns and economic conditions. Central governments determine where the money they use comes from and goes to because they can tax and spend, but they can’t create money and credit. Central banks on the other hand can create money and credit but can’t determine what the money and credit go into in the real economy. These actions from central governments and central banks influence the purchases and sales of goods, services, and investment assets, driving their prices up or down.
To me each investment asset reflects these drivers in its own way that is logical in light of the effects on its future cash flows. Each investment asset is a building block for a portfolio, and the challenge is to put together a portfolio well in light of these things. For example, when growth is stronger than expected, all else being equal, stock prices will likely rise, and when growth and inflation are higher than expected, bond prices will likely fall. My goal is to put these building blocks together in a portfolio that is well-diversified and tactically tilted based on what is happening or is going to happen in the world that is affecting these four drivers. These building blocks can be broken out by country, by environmental bias, and all the way down to the level of individual sectors and companies. When this concept is put into a well-balanced portfolio, it looks like the following graphic. It is through this lens that I look at the history of events, the history of the markets, and the behavior of portfolios.
I understand that my approach is different from that of most investors for two reasons. First, most investors don’t look for historically analogous periods because they think history and old investment re- turns are largely irrelevant to them. Second, they don’t look at investment returns through the lens I just described. I believe that these perspectives give me and Bridgewater a competitive advantage, but it’s up to you to take or leave them as you like.
Most investors base their expectations on what they have experienced in their lifetimes and a few more diligent ones look back in history to see how their decision-making rules would have worked back to the 1950s or 1960s. There are no investors I know and no senior economic policy makers I know—and I know many and I know the best—who have any excellent understandings of what happened in the past and why. Most investors who look at longer-term returns look at those in the US and the UK (the countries that won World War I and World War II) as being representative. That is because there are not many stock and bond markets that survived World War II. But these countries and time periods are not representative because of their survivorship bias. In looking at the returns of the US and the UK, one is looking at uniquely blessed countries in the uniquely peaceful and productive time that is the best part of the Big Cycle. Not looking at what happened in other countries and in previous times yields a distorted perspective.
Reasoning logically from what we know about Big Cycles, when we extend our perspective just a few decades further back and look at what happened in different places, we get a shockingly different perspective. I’m going to show you this because I think you should have it.
In the 35 years before 1945, virtually all wealth was destroyed or confiscated in most countries, and in some countries many capitalists were killed or imprisoned because of anger at them when the capital markets and capitalism failed along with other aspects of the old order. If we look at what happened over the past few centuries, we see that such extreme boom/bust cycles happened regularly—there were regular cycles of capital and capitalist boom periods (such as the Second Industrial Revolution and the Gilded Age that happened in the late 19th and early 20th centuries) that were followed by transition periods (like the 1900–10 period of rising internal conflict and rising international conflict over wealth and power) that led to great conflict and economic bust periods (similar to those that happened between 1910 and 1945). We can also see that the cause/effect relationships that were behind the movements of those boom and bust periods are now more aligned with the late-cycle bust and restructuring periods than the early-cycle boom and building periods.
My goal was simply to see and try to understand what happened in the past and do a good job of showing it to you. That is what I will now try to do. I will start in 1350, though the story begins long before.
The Big Cycle of Capitalism And Markets
Up until around 1350, lending with an interest rate was prohibited by both Christianity and Islam—and in Judaism it was banned within the Jewish community—because of the terrible problems it caused, with human nature leading people to borrow more than they could pay back, which created tensions and often violence between borrowers and lenders. As a result of this lack of lending, currency was “hard” (gold and silver). A century or so later, in the Age of Exploration, explorers went around the world collecting gold and silver and other hard assets to make more money. That’s how the greatest fortunes were built at the time. The explorers and those who backed them split the profits. It was an effective incentive-based system for getting rich.
The alchemy of lending as we know it today was first created in Italy around 1350. Rules for lending changed and new types of money were made: cash deposits, bonds, and stocks that looked pretty much like we know them today. Wealth became promises to deliver money—what I call “financial wealth.”
Think about what a huge impact the inventions and developments of bond and stock markets had. Before then, all wealth was tangible. Think about how much more “financial wealth” was created by creating these markets. To imagine the difference, consider how much “wealth” you would now have if your cash deposits and stock and bond promises to pay you in the future didn’t exist. You wouldn’t have much at all. You’d feel broke, and you’d behave differently—for example, you’d build up more savings in tangible wealth. That is pretty much what it was like before cash deposits, bonds, and stocks were created.
With the invention and growth of financial wealth, money was not constrained by a link to gold and silver. Because money and credit, and with them spending power, were less constrained, it was common practice for entrepreneurs who came up with good ideas to create companies and borrow money and/or sell a piece of those companies by selling stock to get money to buy what they needed. They could do this because promises to pay became money that took the form of journal entries. Around 1350 those who could do this, most famously the Medici family in Florence, could create money. If you can create credit—let’s say five times as much as there is actual money (which banks can do)—you can produce a lot of buying power so you don’t need as much of the other type of money (gold and silver) anymore. The creation of new forms of money was and still is a kind of alchemy. Those who could create it and use it—bankers, entrepreneurs, and capitalists—became very rich and powerful. [3]
This process of expanding financial wealth has continued up to today, with financial wealth becoming so large that the hard money (gold and silver) and other tangible wealth (e.g., property) have become relatively unimportant. But of course the more promises there are in the form of financial wealth the greater the risk there is that these promises can’t be kept. That’s what makes the classic big debt/money/economic cycle. Think about how much financial wealth there is now relative to real wealth and imagine if you and others who are holding it actually tried to convert it into real wealth—that is, sell it and buy stuff. It would be like a run on a bank. It couldn’t happen. The bonds and stocks are too sizable in value relative to what they could buy. But remember that with fiat money the central banks can print and provide the money needed to meet the demand. That is a timeless and universal truth.
Also remember that paper money and financial assets (e.g., stocks and bonds) that are essentially promises to pay aren’t of much use; it is only what they buy that is of use.
As discussed in detail in Chapter 3, when credit is created, buying power is created in exchange for a promise to pay back, so it is near-term stimulating and longer-term depressing. That creates cycles. Throughout history the desire to obtain money (by borrowing or selling stock) and the desire to save it (by investing through lending or buying stock) have been in a symbiotic relationship. This has led to growth in the form of buying power and eventually to many more promises to pay than can be delivered and broken-promises crises in the form of debt-default depressions and stock market crashes.
That is when the bankers and capitalists are hanged both figuratively and literally, vast amounts of wealth and lives are wiped out, and vast amounts of fiat money (money that can be printed and has no intrinsic value) are printed to try to relieve the crisis.
The More Complete Picture Of The Big Cycle From An Investor's Perspective
While it would be too burdensome for me and you to go through all the relevant history between 1350 and now, I will show you what the picture would have looked like if you had started investing in 1900. But before I do so I want to explain how I think about risk because I’m going to highlight these risks in what I show you.
As I see it, investment risk is failing to earn enough money to meet your needs. It’s not volatility measured by standard deviation, which is the almost exclusively used measure of risk.
To me, the three biggest risks most investors face are that their portfolios won’t provide the returns needed to meet their spending needs, that their portfolios will face ruin, and that a large share of their wealth will be taken away (e.g., through high taxes).
While the first two risks sound analogous, they are in fact different because it is possible to have average returns that are higher than required but also experience one or more periods of devastatingly high losses.
To gain perspective, I imagined that I was dropped into 1900 to see how my investments would have done in every decade since. I chose to look at the 10 greatest powers as of 1900 and skip less-established countries, which were more prone to bad outcomes. Virtually any one of these countries was or could have become a great, wealthy empire, and they were all reasonable places for one to invest, especially if one wanted to have a diversified portfolio.
Seven of these 10 countries saw wealth virtually wiped out at least once, and even the countries that didn’t see wealth wiped out had a handful of terrible decades for asset returns that virtually destroyed them financially. Two of the great developed countries— Germany and Japan, which at times one easily could have bet on as being winners—had virtually all their wealth and many lives destroyed in the World Wars. I saw that many other countries had similar results. The US and the UK (and a few others) were the uniquely successful cases, but even they experienced periods of great wealth destruction.
If I hadn’t looked at these returns in the period before the new world order began in 1945, I wouldn’t have seen these periods of destruction. And had I not looked back 500 years around the world, I wouldn’t have seen that this has happened repeatedly almost everywhere.
The numbers shown in this table are annualized real returns for each decade, which means that for the decade as a whole the losses are about eight times greater than shown and the gains are about 15 times greater. [4]
Perhaps this next chart paints a clearer picture, as it shows what percentage of countries saw losses of a 60/40 stock/bond portfolio over five-year periods.
The following table shows the worst cases of investing in major countries in detail. You will note that the US doesn’t appear on this table because it wasn’t among the worst cases. The US, Canada, and Australia were the only countries that didn’t experience sustained periods of losses.
Naturally I think about how I would have approached these periods if I had been living through them. I’m certain that even if I had seen the signs of things coming that I’m passing along in this book I never would have confidently predicted such bad outcomes—as noted earlier, seven of 10 countries saw their wealth wiped out. In the early 1900s, even those looking back over the past few decades would never have seen it coming because there were plenty of reasons to be optimistic based on what had happened during the second half of the 19th century.
People today often assume that World War I must have been easy to foresee in the years leading up to it, but that wasn’t the case. Before the war, there had been about 50 years of almost no conflict between the world’s major powers. During those 50 years the world experienced the greatest innovation and productivity growth rates it had ever seen, which led to enormous wealth and prosperity. Globalization was at new highs, with global exports up several multiples in the 50 years prior to World War I. Countries were more interconnected than ever. The US, France, Germany, Japan, and Austria-Hungary were rapidly rising empires, experiencing dizzying technological advancement. The UK was still the dominant global power. Russia was rapidly industrializing. Of those countries shown in the table of worst investor experiences, only China was obviously in decline. Strong alliances among European powers were seen at the time as a means of keeping the peace and maintaining the balance of power. Going into 1900 things looked great, except for the fact that wealth gaps and resentments were increasing and debts had become large. Between 1900 and 1914 these conditions worsened and international tensions increased. Then came the periods of terrible returns I just described.
But it was worse than just terrible returns.
In addition, the impacts on wealth of wealth confiscations, confiscatory taxes, capital controls, and markets being closed were enormous. Most investors today don’t know of such things and consider them im- plausible because they wouldn’t have seen them by looking back on the past few decades. The following table shows in which decades these events occurred. Naturally the most severe cases of wealth confiscation came during periods in which there were large wealth gaps and internal conflict over wealth when economic conditions got bad and/or there was a war.
The next chart shows the share of major countries that shut their stock markets through time. Wartime stock market closures were common, and of course communist countries shut their stock markets over a generation.
The bad parts of all the cycles that took place prior to 1900 were similarly bad. To make matters even worse, these periods of internal and external fighting over wealth and power led to many deaths.
Even for the lucky investors who were in countries that won the wars (such as the US, which was twice the biggest winner), there were two further headwinds: market timing and taxes.
Most investors sell near the lows when things are bad because they need money and because they tend to panic; they tend to buy near the highs because they have plenty of money and they are drawn into the euphoria. This means that their actual returns are worse than the market returns I showed. A recent study showed that US investors underperformed US stocks by around 1.5 percent a year between 2000 and 2020.
As for taxes, this table estimates the average impact of taxes for investors in the S&P 500 over all 20-year periods (using average tax rates for the top quintile today throughout the analysis period). The different columns represent different ways of investing in the US stock market, including a tax-deferred retirement account (where tax is paid only at the end of the investment) and holding physical equities and reinvesting dividends annually like if stocks were held in a brokerage account. While these different implementations have different tax im- plications (with retirement accounts least impacted), all of them show a significant impact, especially in real returns, where taxes can erode a significant portion of returns. US investors lost about a quarter of their real equity returns on average to taxes in any given 20-year period.
Reviewing The Big Capital Markets Cycle
Earlier, I explained how the classic big debt and capital markets cycle works. To reiterate, in the upwave, debt is increased and financial wealth and obligations rise relative to tangible wealth to the point that these promises to pay in the future (i.e., the values of cash, bonds, and stocks) can’t be met. This causes “run on the bank”-type debt problems to emerge, which leads to the printing of money to try to relieve the problems of debt defaults and falling stock market prices, which leads to the devaluation of money and in turn to financial wealth going down relative to real wealth, until the real (inflation-adjusted) value of financial assets returns to being low relative to tangible wealth. Then the cycle begins again. That is a very simplified description, but you get the idea—during the downwave in this cycle there are negative real returns of financial as- sets relative to real assets and there are bad times. It is the anti-capital, anti-capitalist part of the cycle that continues until the opposite extreme is reached.
This cycle is reflected in the following two charts. The first shows the value of total financial assets relative to the total value of real assets. The second shows the real return of money (i.e., cash). I use US numbers rather than global numbers because they are the ones that are most continuous since 1900. As you can see, when there is a lot of financial wealth relative to real wealth it reverses and real returns of financial wealth, especially cash and debt as- sets (like bonds), are bad. That is because interest rates and returns for debt holders have to be low and bad in order to provide the relief to the debtors who have too much debt and in order to try to stimulate more debt growth as a way of stimulating the economy. This is the classic late-cycle part of the long-term debt cycle. It occurs when printing more money is used to reduce debt burdens and new debts are created to increase purchasing power. This devalues the currency relative to other storeholds of wealth and relative to goods and services. Eventually as the value of financial assets declines until they become cheap relative to real assets, the opposite extreme is reached and reverses, which is when peace and prosperity return, the cycle goes into its up phase, and financial assets have excellent real returns.
As explained earlier, during periods of the devaluation of money, hard money and hard assets rise in value relative to cash. For example, the next chart shows that periods when the value of the classic 60/40 stock/bond portfolio declined were periods when gold prices rose. I am not saying anything about gold being a good or bad investment. I am simply describing economic and market mechanics and how they have been manifest in past market movements and investment returns for the purpose of sharing my perspective on what happened and what could happen and why.
One of the most important questions investors need to regularly ask themselves is whether the amount of interest that is being paid more than makes up for the devaluation risk they face.
The classic big debt/money/capital markets cycle, which has re- peated through time and in all places and is reflected in the charts I just showed you, is seen in the relative values of 1) real/tangible money and real/tangible wealth and 2) financial money and financial wealth. Financial money and financial wealth are valuable only to the extent that they get you the real money and real wealth that have real (i.e., intrinsic) value. The ways these cycles have always worked is that, in their rising phases, the amounts of financial money and financial wealth (i.e., created debt and equity assets) are increased relative to the amounts of real money and real wealth that they are claims on. They are increased because a) it is profitable for those capitalists who are in the business of creating and selling financial assets to produce and sell them, b) increasing money, credit, and other capital market assets is an effective way for policy makers to create prosperity because it funds demand, and c) it creates the illusion that people are wealthier because the stated values of financial investments go up when the value of the money and debt assets goes down. In this way central governments and central bankers have always created many more claims on real money and real wealth than could ever be turned in for real wealth and real money.
In the rising parts of the cycle, stocks, bonds, and other investment assets go up as interest rates go down because falling interest rates make asset prices rise, all else being equal. Also putting more money in the system raises the demand for financial assets, which lowers risk premiums. When these investments go up because of lower interest rates and more money in the system, that makes them seem more attractive at the same time as interest rates and the future expected re- turns of financial assets are going down. The more outstanding claims there are relative to what there are claims on, the more risk there is. This should be compensated for by a higher interest rate, but it typically isn’t because at that moment conditions seem good and memories of debt and capital market crises have faded.
The charts that I showed you before to convey the cycles would not be complete in painting the picture without some interest rate charts. Interest rates are shown in the next four charts that go back to 1900. (Note: This chapter was originally published in 2021 and the following charts only contain data up to that year.) They show real (i.e., inflation-adjusted) bond yields, nominal (i.e., not inflation-adjusted) bond yields, and nominal and real cash rates for the US, Europe, and Japan at the time of my writing. As you can see they were much higher and now they are very low. Real yields of reserve currency sovereign bonds, at the time of my writing this, are near the lowest ever, and nominal bond yields are around 0 percent, also near the lowest ever. As shown real yields of cash are even lower, though not as negative as they were in the 1930–45 and 1915–20 great monetization periods. Nominal cash yields are near the lowest ever
What does this mean for investing? The purpose of investing is to have money in a storehold of wealth that one can convert into buying power at a later date. When one invests, one gives a lump-sum payment for payments in the future. Let’s look at what that deal, as of this writing, looks like. If you give $100 today, how many years do you have to wait to get your $100 back and then start collecting the reward on top of what you gave? In US, Japanese, Chinese, and European bonds you could have to wait roughly 45 years, 150 years, and 30 years [9] respectively to get your money back (likely getting low or nil nominal returns) and in Europe at the time of this writing you would likely never get your money back given negative nominal interest rates. However, because you are trying to store buying power you have to take into consideration inflation. At the time of this writing, in the US and Europe, you may never get your buying power back (and in Japan it will take over 250 years). In fact, in these countries with negative real interest rates, you are almost guaranteed to have a lot less buying power in the future. Rather than get paid less than inflation, why not instead buy stuff—any stuff—that will equal inflation or better? I see a lot of investments that I expect to do significantly better than inflation. The following charts show these payback periods for holding cash and bonds in the US, in both nominal and real terms. As shown, it is the longest ever and obviously a ridiculous amount of time.
Conclusion
What I showed you here was the Big Cycle from an investor’s perspective since 1900. In looking around the world going back 500 years and in China going back 1,400 years I saw basically the same cycles occur repeatedly for basically the same reasons.
As discussed earlier in the book, the terrible periods in the years prior to the 1945 establishment of the new world order are typical of the late Big Cycle transition stage when revolutionary changes and restructurings occur. While they were terrible, they were more than matched by terrific upswings that came after the painful transition from the old order to the new order. Because these things have happened many times before, and because I can’t say for sure what will happen in the future, I can’t invest without having protections against these sorts of things happening and my being wrong.
Footnotes
[1] The discount rate is the interest rate that one uses to assess what an amount of money in the future is worth today. To calculate it, one compares what amount of money today, invested at that interest rate (i.e., the discount rate), would be worth a certain amount at a specific time in the future.
[2] If governments and their systems break down, non-government-directed forces take over, which is a whole other story that I won’t get into now.
[3] You can see this kind of alchemy at work today in the form of digital currency.
[4] When compounded over a decade, gains are greater than losses because you keep building off of gains; whereas as you experience losses and approach zero, future percent losses matter less in dollar terms. The comparison of annualizing gains versus losses represents compounding from 10 percent annualized gains and -5 percent annualized losses on average. At more extreme changes the multipliers change from there.
[5] For China and Russia, bond data pre-1950 is modeled using hard currency bond returns held as though hedged back to local currency by a domestic investor; stocks and bonds modeled as full default at time of revolution. Annualized returns assume a full 10-year period even if markets closed during the decade.
[6] Cases of poor asset returns in smaller countries such as Belgium, Greece, New Zealand, Norway, Sweden, Switzerland, and across the emerging world are excluded from this table. Note that for conciseness the worst 20-year window is shown for each country/time period (i.e., including Germany in 1903–23 precludes including Germany from 1915–35). For our 60/40 portfolios, we assumed monthly rebalancing across the 20-year window.
[7] While this diagram is not exhaustive, I include instances where I could find clear evidence of each occurring in the 20-year period. For this analysis, wealth confiscation was defined as extensive seizure of private assets, including large-scale forced, non-economic sales by a government (or revolutionaries in the case of revolution). Relevant capital controls were defined as meaningful restrictions on investors moving their money to and from other countries and assets (although this does not include targeted measures directed only at single countries, such as sanctions).
[8] Tax impact for 401(k) method applies a 26 percent income tax rate (effective average federal tax rate for top quintile from the Congressional Budget Office as of 2017) at the conclusion of each 20-year investment period (i.e., tax-free investment growth). Tax impact for brokerage method separately taxes dividends (at the same 26 percent income tax rate) and capital gains, paying taxes on all capital gains (at a 20 percent rate) from both principal and dividend reinvestment at the conclusion of each 20-year investment period and netting losses against any gains.
[9] Based on August 2021 levels of 30-year nominal bond yields (treated as a perpetuity).
