John Paulson Needs To Go Austrian

By Jeff Harding of The Daily Capitalist.

John Paulson, the hedge-funder who made a personal fortune of $5 billion in 2010, is now seen as a goat rather than as the “top kid” on the hedge fund block because of recent big losses.

Paulson suffered a huge loss on his firm’s investment in Sino-Forest Corp, a Chinese tree plantation grower. Reports of balance sheet fraud caused the stock to tank. It is difficult to assess the loss, but estimates from the press range from $750 million to $150 million. In a Forbes.com article:

“Paulson initially said it had lost around $750 million as a result of pulling out its 30 million shares from Sino-Forest. That loss may be smaller, maybe closer to $150 million, Paulson said in a conference with investors in Paris this month, based on Sino-Forest’s stock price in 2007, when the firm began buying the shares, according to The New York Times.”

I like Paulson a lot, mainly because he makes big contrarian bets that have performed very well for himself and his investors in the past. He called the bust correctly with bets in subprime securities. He’s also a major investor in gold. But these kinds of comments make you wonder what he’s doing at his $37[?] billion fund. The fact that he got suckered by an accounting scam at Sino-Forest was bad enough, but when he can’t pin down his losses, it raises serious questions about his firm. Here is what they said about it:

“Paulson reviewed both sides’ written materials, asked questions and engaged in further independent research, including conversations with the chairman of the special committee about the scope and process of their investigations. Although Sino-Forest steadfastly denies the Muddy Waters allegations … and maintains that there is no fraud, we believe significant uncertainties exist and we made the determination to sell our full position and await the results of the independent investigation. Even if Sino-Forest’s special committee investigation clears management and supports the public disclosures and financial statement, the stock may remain depressed for an extended period of time.”

The next thing that makes me wonder about him are his big bets on Citigroup (C) and Bank of America (BAC). Last year he wagered on a “V”-shaped economic recovery and loaded up on bank stocks. It was reported Friday that he dumped a large portion of his 124 million shares (1.2% of the float) of BAC, during the past two months, prior to the announced settlement between Bank of America and the customers of Countrywide’s RMBS.

Paulson made it big in 2007 and 2008 on correct bets on subprime securities. Then he had another big year in 2010. This gives him a lot of credibility. In the financial world success is the only measure of credibility. Lose money, and what do you know?

He’s a poster boy for Nassim Taleb’s ideas on randomness in the investment world. The way Mr. Black Swan sees the world is that successful investors are probably lucky. Looking on a scale of probabilities, if you plot the performance of the world of investment advisers on a scatter graph a very few investors are going to be at the upper end of the investment performance scale, but most are right around the middle. The funny thing about the performance scale is that it looks just like any other random pattern of behavior. That is, the performance results of all of the managers in the world on a scatter graph looks like any random event similarly plotted.

What does that mean for Mr. Paulson? It raises the question: is he smart or just lucky?

The answer is that I don’t really know and neither does Mr. Paulson. I’d like to think he’s smart and lucky.

Here is an obvious question with a seemingly obvious answer: if he’s so smart how come he loses money? Well, nobody is always right. If that is the case, then how do you determine whether or not his results were based on luck or brilliance? Please refer to the sidebar.

If he were an adherent of Austrian theory then I would say he is brilliant. Why? Almost all of his investment moves have been based on decisions that an Austrian theory economist/investor would make. For example, in 2007 and in 2008 he correctly shorted subprime securities, foreseeing the bust which many Austrian theory investors/economists saw coming. Others (not Austrian) made this same bet and won and then lost it again (three months later for Peloton Partners; they had luck, and then bad luck)

The acquisition of large positions of gold by Mr. Paulson would also be something an Austrian theory investor would make. He started accumulating gold in 2009, a dead-on call in terms of the gains he made. In the Fall of 2010 he turned negative on the economy and started to pull back on equities. But then, curiously, he turned around and called a V-shaped recovery, and that’s when he bet on the banks... and lost again.

As an Austrian theory investor/economist, I and others like me have been forecasting stagnation and inflation since last year and my forecast has been holding up to this point. It seems logical based on Austrian theory and the actions the Fed and the Administration have taken. I’m not claiming prescience, but rather what a close look at the data tells me in light of Austrian theory. Yes, it works.

I am saying that Mr. Paulson has been mostly lucky in the Mandelbrotian-Talebian sense. He should start reading Mises.

This article originally appeared in The Daily Capitalist.