Why Dalio and Bridgewater see investment falling much more

If you've been wondering when stock investing might return to its most recent high, we can sit back and wait. Ray Dalio and his research team They think we still have to wait a little longer. Investment in stocks must still fall further, and will do so as the US economy enters recession in 1-2 years. Let's see how this story could unfold...

What is your opinion then?

Researchers at Ray Dalio's Bridgewater Associates, the world's largest hedge fund, say stocks tend to fall in two stages when interest rates rise. And it is possible that the first stage has not yet finished developing…

1st Stage: stock valuations fall

The more interest rates rise, the more attractive cash becomes relative to investing in stocks. With so much uncertainty in our future, we will only stay invested in stocks if we expect it to provide us with a return that more than offsets its higher risks and the higher opportunity cost of holding cash. That is, we recommend holding them if they are trading at a discount, meaning their valuations fall to a level that makes them attractive again.

That's exactly what has happened, with falling stock valuations responsible for most of the price correction so far. But even though stocks are less expensive than they were a few months ago, they are nowhere near discount levels. And the more interest rates rise, the more valuations will have to fall to remain competitive relative to cash. As the Federal Reserve continues to aggressively raise rates, Stage 1 is likely to continue to play out, and a further decline in equity valuations is a very real risk.

2nd Stage: company profits weaken

While the valuation dynamics we explained above have been the main driver of recent stock investing returns, there is another that could play an even bigger role in the future. Bridgewater research shows that a slowdown in earnings growth can be the deciding factor in whether stocks experience a small correction or worse. If the economy and profits decline slightly in the coming months, stock investing likely won't fall much further. But if profits take a big hit, a catastrophic decline like the one in 2008 becomes a clear possibility.

At this point, investors are speculating a modest decline in earnings. Considering that the economy is “down, but not bankrupt,” they are optimistic and believe that companies will be able to keep their margins and profits high. Bridgewater warns us that this may be a mistake. This is because the effects of rising interest rates take time to spread through the economy and affect company profits. That is, the rise in rates usually hits profits hard, but it does not occur immediately.

How much lower can stocks go?

Based on these stages that we have analyzed, the prospects for stocks now depend on two things: how much interest rates rise and how companies' profits cope with these increases. Right now, neither of those things seem particularly positive. With inflation still high, the Federal Reserve just approved its third consecutive interest rate hike saying more are on the way. As we have explained before, this is negative for stock valuations. The main indicators of economic activity continue to show signs of weakness, which tells us that company profits could be about to fall. That would be tough on investing in stocks, which historically have seen their biggest losses when rates rose and profits fell.

Ray Dalio estimated that interest rates hitting 4,5% would likely lead to stocks falling another 30%. Given investors' optimism about future earnings, we think Dalio is right...

So how do we take advantage of this opportunity?

The positive side of rising interest rates is that it is becoming easier (and more profitable) for investors to stay on the sidelines. By keeping a good portion of our portfolio in dollar cash or short-term bonds, we not only maintain our financial and emotional capital, but we also get paid (up to 4,5%) for doing so. If stock investing takes an epic plunge, we can take advantage of a once-in-a-decade entry point. At the same time, we can consider gradually building our stock investment portfolio by averaging our purchases to take advantage of opportunities that arise. Timing is the most difficult point in investing, and there is a good chance that even a great investor like Dalio will get it wrong...