Ray Dalio: The COLLAPSE That Will Change a Generation

Ray Dalio is one of the most highly respected names in investing, and someone you need to be paying attention to. As the founder of Bridgewater, the world's largest and arguably most prestigious hedge fund, he has unique insight into the economy and stock market. This is why his recent comments got my attention. So in this video, we're going to examine Dalio's thoughts around the collapse of major banks, and even more importantly, the economic repercussions that would be felt for generations to come.

Dalio even referred to the collapse of Silicon Valley Bank as the first domino to fall that will ultimately lead to the bubble bursting in both the stock market and real estate. So, in case you missed it, a bank named Silicon Valley Bank recently collapsed, and this was the largest bank failure since Lehman Brothers. For those who may not be familiar, the failure of Lehman Brothers was the spark that caused the great financial crisis back in 2008. So naturally, seeing SVB fail virtually overnight has a lot of people very cautious about what comes next for the economy and stock market.

Silicon Valley Bank was the 16th largest bank in the United States. The bank had assets of $209 billion in December 2022. SVB provided business banking services for companies at every stage, but it was particularly well known for serving startups and venture-backed firms. Believe it or not, 44% of venture-backed technology and healthcare IPOs in 2022 were clients of SVB. So, given the massive tech boom over the past few years, SVB saw massive growth between 2019 and 2022, which resulted in the bank having significant amounts of deposits and assets.

While a small amount of those deposits were held in cash, most of the excess was used to buy treasury bonds and other long-term debts. These assets tend to have relatively low returns but also relatively low risk. But as the Federal Reserve increased interest rates in response to high inflation, SVB's bonds became riskier investments because investors could buy bonds at higher interest rates. The bank's bonds declined in value as this was happening. Some of Silicon Valley Bank's customers, many of whom are in the technology industry, hit financial troubles, and many began to withdraw funds from their accounts.

To accommodate for these large withdrawals, SVB decided to sell some of its investments, but those sales came at a loss. SVB lost $1.8 billion, and that marked the beginning of the end for the bank. The bank was required to disclose this loss to investors and the public, which set off a panic. Depositors raced to pull their money out of the struggling lender, making the problem even worse. Eventually, the panic was widespread enough that the bank didn't have the cash to pay depositors, and the bank became insolvent.

Ray Dalio is worried that the collapse of Silicon Valley Bank is only the first domino to fall and that there will be even greater pain to follow. So here's what he had to say: "I think that it is a very classic event in the very classic bubble bursting part of the short-term debt cycle, which lasts about seven years, give or take about three, in which the type of money to curtail credit growth and inflation leads to a self-reinforcing debt credit contraction that takes place via a domino falling-like contagion process that continues until central banks create easy money that negates the debt credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem."

"Until these short-term cycles build up the debt assets and liabilities to a point that they are unsustainable, and the whole thing collapses in a debt restructuring and debt monetization, which typically happens about once every 7 to 25 years, give or take about 25 years."

Okay, do not worry if that doesn't all make sense right away; let me explain. Ray Dalio is great at breaking down something as complicated as the economy and the stock market into the few things that really matter. He has become famous for his explanations of what he calls the economic machine, which is broken down into three parts: a productivity curve, a short-term debt cycle, and a long-term debt cycle.

The economy is just the sum of all the individual transactions that occur between people, businesses, and governments. In these transactions, money is being exchanged for goods, services, and financial assets, with the most well-known financial asset being stocks. The productivity curve is the simplest of the three graphs to understand. Over time, society gets better and more efficient at making products. The perfect example of this is farming. Farming used to be extremely labor-intensive, requiring many people to produce the food necessary to feed a country. Now, farming relies less on people and more on machinery and other forms of technology, which is why roughly 40% of Americans were farmers in the year 1900. But today, that number is just a couple of percent, despite the country producing exponentially more food now than back in 1900.

This dynamic is what Dalio refers to as the productivity curve. In the long run, this productivity growth is what grows the economy. But in the short term, it is debt that drives the fluctuations we see in the economy. Productivity growth is relatively constant. However, debt drives the dramatically different states of the economy we have to deal with as investors.

This is because debt essentially allows us, as a society, to consume more than we produce when we are acquiring debt. The opposite is also true: we have to produce more than we consume when we are paying that debt back. According to Dalio, history has shown that the short-term debt cycles take place over a five to eight-year period.

The greater usage of debt means consumers and businesses both have a greater ability to spend on goods and services. When that spending exceeds the economy's production, we get inflation. Now, if that sounds familiar, that's because that has been the driving dynamic at play the last couple of years in the United States economy. That increased spending relative to production led to the highest inflation rate in 40 years.

This inflation then forces the central bank, or the U.S. Federal Reserve, to step in. The main tools central banks have to fight inflation are to raise interest rates. These higher interest rates make it more expensive to borrow, and as a result, businesses and consumers then borrow less money to spend on goods and services. This decrease in money spending causes prices to decline and ultimately leads to deflation. While inflation is now under control, there is one nasty side effect of the interest rate increases: the economy is now in a recession.

To stimulate the economy, the central bank will then decrease interest rates, starting the short-term debt cycle all over again. In addition to these short-term debt cycles, there are also what Dalio refers to as long-term debt cycles. The long-term debt cycle, as the name suggests, is much longer-term in nature, taking place every 75 to 100 years. This graph that Dalio put together demonstrates how productivity growth, the short-term debt cycle, and the long-term debt cycle interact together. This graph represents 75 to 100 years. The straight line is productivity growth, which doesn't fluctuate much.

The large curve represents the long-term debt cycle, and the smaller curves around it represent the short-term debt cycles, in which one cycle represents five to eight years. Notice here how the bottom and top of each short-term debt cycle finishes with more growth and more debt than the previous one because people are inclined to borrow more and spend more rather than paying off debt. This dynamic continues all the way to the top of the long-term debt cycle, and the top of the long-term debt cycle is what Dalio calls a bubble.

As incomes and assets rise, borrowing increases. When the debt repayment grows faster than spending, incomes begin to go down, which then makes people less creditworthy. The cycle reverses itself in this process called deleveraging. People cut back spending, income falls, the stock market crashes, credit disappears, assets drop, banks are squeezed, and social tensions rise. The central bank can't lower interest rates any further because they're at zero percent. To recover, people cut back spending, banks reduce debt through defaults, the government redistributes wealth through higher taxes on the rich and social welfare programs for the poor, and the central bank prints money.

Okay, so now that we have that background, that brings us to what is going on today in 2023. Dalio says that the failure of Silicon Valley Bank is a sign that we are at the bubble bursting part of the short-term debt cycle. This means that we are at the first red dot on this chart here of the short-term debt cycle. Until recently, we had been in the expansion part of the cycle. Here, the economy was booming and stock prices and real estate values were soaring. Events are playing out just like in our explanation of the short-term debt cycle from earlier in the video.

The U.S. Fed took interest rates down to zero percent in early 2020 to stimulate the economy, and stimulate it they sure did. The economy actually became overheated. Spending outpaced the production of goods. Remembering back to the earlier example, what happens when spending outpaces production in the economy? Inflation. And now the Fed has dramatically increased interest rates, causing the economy to move from the expansion part of the short-term credit cycle and begin the descent into the depths of a recession.

According to Dalio, we are currently right here, and there will be more dominoes to fall. Here's what he had to say: "While in different cycles, the sectors that are in bubbles are different, i.e., in 2008 it was heavily in residential real estate, and now it’s negative cash flow venture and private equity companies as well as commercial real estate companies that can take the hit of higher interest rates and tighter money. The self-reinforcing contraction dynamic is the same. Based on my understanding of this dynamic and what is now happening, which lines up, this bank failure is a canary in the coal mine—a early sign dynamic that will have knock-on effects in the venture world and well beyond it."

This last line in Dalio's essay is incredibly important: this bank failure is a canary in the coal mine—an early sign dynamic that will have knock-on effects in the venture world and beyond. One of these knock-on effects from the collapse of SVB for the economy is that credit, which is just a fancy way of saying debt, will likely become less available. Companies' ability to easily access large amounts of debt has become fundamental to the U.S. economy. Even the most stable and "quote-unquote" safe companies in the world rely on large amounts of debt to run their operations.

Coca-Cola has nearly $40 billion in debt. Boeing's is $42 billion. Walmart has $58 billion. For Microsoft, that number is $61 billion. General Motors has a whopping $115 billion in debt. The point is that these are all iconic American companies and are generally considered stable bellwethers of the U.S. economy. However, these companies still rely on large amounts of debt in order to be able to operate. These massive companies will likely not have any difficulty continuing to borrow money. The real difficulty will likely be small businesses' access to credit.

Given that small businesses account for an estimated 44 percent of economic activity in America, the results can be devastating. Many of these small businesses don't bank with the massive banks like JPMorgan Chase and Bank of America. These small businesses rely on small regional or local banks and credit unions for their financing. The small banks will likely be the ones that are most impacted from the fallout from the collapse of Silicon Valley. These small lending institutions being forced to dramatically pull back on lending will only accelerate the bubble bursting collapse from Dalio's chart of the short-term debt cycle.

Here's a tangible example to demonstrate that point: imagine a small business in your town or city. Let's say this business is in the trucking industry, meaning they move truckloads full of goods all across the country. The business has 10 trucks that they use. Currently, business has been great so far, so the owner wants to expand. He wants to buy another 10 trucks and build a warehouse to store all the equipment. Given how much money this takes, the owner has to go to a bank to get a loan for the cost of the new trucks and the construction of the building. Whether he gets the loan or not has massive ripple effects for the economy.

If the owner is able to get the loan, think about all the economic activity that creates. The manufacturer of the truck gets more revenue. The companies that supplied the various parts of the truck benefit. Even the truck dealer that acted as a middleman makes money. And then there is the construction of the new building. Think about all the people and businesses that will economically benefit: roofers, plumbers, electricians, drywall, painting—the list is massive. And then there are other companies that supply all the materials that these trades use during the construction process.

The point is that the U.S. economy is incredibly dependent on businesses having access to credit. When you think about it, using this small trucking company as an example, it's easy to see how businesses not being able to access credit can send huge ripple effects throughout the entire economy. The other big knock-on effect relates to Dalio's productivity curve as part of his explanation of how the economic machine works.

As this diagram from Dalio shows, the productivity curve is the main driver of economic growth and improvement in society's quality of life over time. Economies tend to get more productive, which means that they're able to create the same amount of goods and services but use less labor hours. Probably the biggest driver of productivity growth is technology. Thinking back to our farming example from earlier, why is the United States able to grow so much more food now than 100 years ago? Well, the main reason has to do with technological advances, the more advanced farming equipment, the better seeds, and the increased knowledge about how to maximize how much food can be grown on a given piece of land.

In America, the biggest driver of technological advancement in the business world has been venture capital, which gets to the heart of Dalio's comments around the knock-on effects from the collapse of SVB. Dalio specifically called out venture capital as an area that's going to suffer immensely from the bubble bursting. These impacts are much longer-term in nature. See, venture capital funds invest in extremely risky early-stage companies. These companies are working on technology that more than likely won't work. Over 90% of the companies that venture capital funds invest in fail and end up being worthless.

However, the small percent that do turn out to be successful can be transformative to the economy. Many of the new companies that led to major technological breakthroughs were funded by venture capital. These technological breakthroughs can help increase productivity in the economy, pushing Dalio's productivity growth curve up and to the right. However, the worry is that less money flowing into startup companies from venture capital could dramatically hinder productivity growth in the economy. Instead of up and to the right, the productivity growth curve may stagnate and flatline, resulting in a lack of progress in the economy and society.

While only time will tell how this plays out, this could very well be the biggest risk from the fallout of the bubble bursting. So there we have it. Make sure to like this video and subscribe to the channel, because our community of investors is approaching 200,000 people strong, and it would be even better with you as a part of it. Talk to you again soon.