Is Super-Investor John Paulson Turning Bearish?

On Wednesday, the Financial Times reported that uber-successful hedge fund manager John Paulson had reduced his exposure to stocks. This is the same person who told his investors in a conference call at the beginning of May that "there is a lot of upside in U.S. markets," citing rising corporate profits. When an investor of this caliber changes his outlook in a market that is driven by macro considerations, what are the lessons we can learn?

Who?
If you haven't heard of John Paulson, it's worth learning about him. In the lead-up to the credit crisis, he made arguably "the greatest trade ever" (the title of Greg Zuckerman's first-rate account of the trade), betting against subprime mortgages. The main vehicle for the trade, the Paulson Credit Opportunities LP fund, produced a 590% return in 2007. All told, the bet netted his funds approximately $15 billion in gains that year.

No one-trick pony
But Paulson is no one-trick pony: In the second quarter of 2009, i.e., shortly after the market bottomed, he turned bullish on U.S. financials, buying a near 2% stake in Bank of America (NYSE: BAC  ) and opening/adding to positions in Goldman Sachs (NYSE: GS  ) , JPMorgan Chase (NYSE: JPM  ) , and Capital One Financial (NYSE: COF  ) , among others. Paulson was betting that the credit cycle was close to bottoming and bank shares would lead the stock market recovery -- which has largely been borne out.

What changed since May?
The economic environment, and the market's perception of it, has worsened since early May, thanks to the eurozone crisis and increasing indications that the economic recovery is flagging. Amid rising volatility, Paulson's Recovery fund, which was created to profit from the recovery in the housing market and the economy, lost 20% between May and June (although year-to-date performance remained positive).

Still long -- significantly so
However, one shouldn't overstate Paulson's response: According to a letter to his investors, the net exposure in the Paulson Recovery fund has fallen from 140% to 107% in recent weeks. In other words, the fund continues to maintain a leveraged long position. The net long exposure in Paulson's flagship Advantage fund has also declined, from 72.4% to 67.3%.

The 'reflation' trade
Between his investments in financials, gold and gold miners -- at the end of March, Paulson & Co. had a reported $3.4 billion position in the SPDR Gold Shares ETF (NYSE: GLD  ) and a $1.7 billion position in AngloGold Ashanti (NYSE: AU  ) -- Paulson has implemented a massive "reflation trade," betting on further gains in economic activity and inflation. Lower net exposure now suggests his conviction regarding this trade has diminished somewhat.

My take for individual investors
My own view has been less sanguine than Mr. Paulson's for some time now, but he has the time and the means to monitor his stocks' positions closely and make any corresponding adjustments. However, with the S&P 500 at a cyclically adjusted price-to-earnings multiple of almost 21 -- 26% above its long-term average -- being overweight the broad U.S. market doesn't look like a sound allocation for nonprofessional investors.

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Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On August 06, 2010, at 8:46 PM, TMFMMTInvestor wrote:

    <i>My take for individual investors

    My own view has been less sanguine than Mr. Paulson's for some time now, but he has the time and the means to monitor his stocks' positions closely and make any corresponding adjustments. However, with the S&P 500 at a cyclically adjusted price-to-earnings multiple of almost 21 -- 26% above its long-term average -- being overweight the broad U.S. market doesn't look like a sound allocation for nonprofessional investors.</i>

    Completely agree, Alex! Just out of curiosity, are you familiar with John Hussman's peak-to-peak earnings valuation method and, if so, what do you think of it? And his criticism of valuing the broader market based on operating earnings and forward P/Es? See: http://www.hussmanfunds.com/weeklyMarketComment.html

    Thanks!

    Scott

  • Report this Comment On August 07, 2010, at 7:14 AM, TMFAleph1 wrote:

    @sjf2005

    Thanks for your comment! I'm not familiar with Hussman's peak-to-peak earnings valuation methodology, but I agree with his critique of forward earnings multiples.

    On this topic, I recommend one book above all others: 'Valuing Wall Street' by Andrew Smithers and Stephen Wright.

    Best,

    Alex D

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