John Paulson Lecture: "Bonds Are Wrong, Stocks Are Right"

John Paulson is now 'all in' that for the first time in history bonds are wrong and stocks are right... We'll take the other side of that bet. Of course, this also means that David Tepper is across the table as well. Oh well, we do like to live dangerously. Full notes from Paulson's lecture at the University Club, to a standing audience. Then again, if anyone suspected that JP was actually on the same side of the bet as us, it wouldn't really work now, would it...

Here is today's permabullish elixir from the man who has a $30 billion reflation bet on.

1.    What Happened – We all know what happened in 2006, 2007, and 2008. By end of 2008 they had completely covered their mortgage CDS and had started to buy high-yield Corporates into 2009.  They averaged in at under 55c on the dollar for most of those bonds and sold most over par. There is not much opportunity in high-yield at this point.

2.    Equities – They are now think one of the best places to be is equities, with a strong focus on distressed equities.  Paulson’s case for equities in general focused on the discrepancy between equity earnings yields of about 7% to 8% now compared to the 10-year yield at 3.6%.  This is one of the highest dislocations since they started tracking these numbers.  As such, some equities he owns offer superior returns to long-dated bonds: JNJ: 3.8% yield, 7% earnings growth; KO: 3% yield, 8% growth, PFE: 4% yield, 3% growth.  On distressed equities, they look at bankruptcies and major restructurings.  The most well known examples are his holdings in financials like C and BAC.  They also own STI and RF.  They follow every bankruptcy and will buy the debt in interested.  As the companies come out of bankruptcy, they’ll convert the debt to common stock.  He gave the example of K-Mart, which went into bankruptcy with billions in debt, emerged at $10 a share and debt-free, then eventually went to $190.  Paulson thinks he’ll find more of these over the next few years.

3.    Bonds – The purchase of long-dated bonds, either treasuries or Corporates, should turn out to be a horrible trade.  Rates are at record lows and the economy is turning should continue to churn higher.  Paulson expects roughly 2% GDP growth for both 2011 and 2012.  Quantitative easing should contribute to significant inflation over the next few years, with inflation possibly hitting low-double digits by 2012.  This is bad for the 10-  and 30-year and bad for the USD.  The USD should fall and the yields on long-dated US Treasuries should rise.  Paulson has been buying 5 and 7 year calls on the 30-year bond yield.

4.    Homes – This is the best time 50 years to buy a home.  This thesis is the exact opposite of his thoughts on bonds.  You don’t want to own long-dated debt, you want to issue it.  Buying a home (an asset) with a 30-year mortgage (issuing debt) is exactly that.  Home prices will rise with a better economy and with inflation.  Your debt and interest payments get locked in at record lows.  The price of your home will rise.

5.    Gold – The price of gold has moved in correlation to the monetary base for as long as they have tracked the two data items.  As the Fed prints more money, gold should rise.  If the Fed were to increase the monetary base by 100% over the next 3 years, Gold should increase by that same amount. Additionally, as inflation accelerates, investors tend to push gold higher than its correlation, like in 1980 when it increased an additional 100% above the correlation.  So if gold is at $1,200 now, it should hit $2,400 on the monetary expansion alone, then $4,000 as investors flee inflation. Additionally, he has offered his investors the ability to hold their investment in his fund in either US Dollars denominated or in gold denominated.  Paulson himself has 80% of his assets gold denominated.

Let the debate begin

h/t Mike