How to invest like John Paulson

How to invest like John Paulson

Hedge fund tycoon John Paulson is the man who made his name, and a fortune, betting against subprime mortgages when no one else even knew what they were.

And he's just made three big financial calls that you need to know about.

Speaking to the University Club in New York, he said, first, that gold could go to $2,400 an ounce based on the fundamentals–and that momentum could carry it to $4,000 an ounce. Right now it's around $1,300. Second, he said you should get out of bonds while you can: You're much better off investing in blue chip stocks with good dividend yields than bonds.

And third, he said you should buy a home. Now.

"If you don't own a home, buy one," he reportedly said. "If you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home."

(A spokesman for Mr. Paulson did not challenge the accounts of the meeting.)

Among the New York commentariat there's been a lot of head-scratching about Mr. Paulson's take–especially this contrarian stance on housing.

Is he right? If so, what does he know that everyone else doesn't?

Ignore the critics. The odds have to be on his side. The reason is simple: Inflation.

There is a debate raging on Wall Street these days between those warning about deflation and those warning about inflation. We are at, or near, deflation at the moment. It may even get worse before it gets better. But Mr. Paulson sees inflation coming by 2012 or so. Last week, several contrarian money managers I was talking to made the same prediction.

The explanation isn't hard to find.

Forget the usual technical issues economists like to talk about, such as output gaps, labor markets, money supply and the like.

Put simply: We will get inflation because we have to. It doesn't get any more straightforward than that.

We are the most indebted nation in the history of the world.

Data out from the Federal Reserve last week revealed that in the second quarter the total sum of U.S. debts (excluding the financial sector) had risen to a record $35.5 trillion. That is 243% of gross domestic product–barely a smidgen from last year's peak, and off the map by past history. Thirty years ago it was less than 150% of GDP.


The debt orgy has been everywhere. Government debt continues to skyrocket. Corporate debt–contrary to some reports–is rising too. And after two years of brutal retrenchment, defaults and pain, households have managed to slash their debts by a massive, er, 3% from the peak. Household debts are still twice what they were just a decade ago.

There is only one plausible route out of this appalling situation. The government needs inflation. The country needs inflation. That will shrink these debts in relation to the economy, asset prices and incomes.

Deflation would make debts even bigger in real terms. That would be a disaster. We're skirting it at the moment, but it can't be allowed to take hold. That's why Fed chairman Ben Bernanke has just offered more quantitative easing–and if that won't work he'll try something else. Anything else.

That's what Mr. Paulson knows–and what anybody could know if they just take a step back from the day to day details and look at the big picture.

If the government succeeds in stimulating inflation, bonds will be in big trouble. Fixed coupons become a lot less valuable when prices and interest rates rise. At 2.5%, the 10 year Treasury already offers a paltry yield: The risks surely outweigh the rewards. Take profits on your bond funds.

Housing? It isn't just that home prices have fallen a long way. It's also that, if you can get a mortgage, you are basically taking a reverse bet on the bond market. You could be a long-term borrower at fixed rates, instead of a long-term lender. Right now you can borrow for 30 years at around 4.3%. After the mortgage tax deduction, for some people the net effective interest rate is nearer to 3%. That's going to prove an awesome deal if we see inflation again.

As for gold? Mr. Paulson's prediction isn't that extreme. I've seen guesses from perfectly sane people, based on the money supply and other measures, suggesting gold might go even higher.

No one knows, of course. But the bull market seems to be very much alive. And I think there's a chance–a pretty good chance–that gold could be the next Nasdaq.

Naturally, the future is unknown. And most normal people can't afford to risk a lot of their money speculating–especially these days. But you don't want to miss out on a boom.

How should you bet if you think Mr. Paulson's right?

One idea: Instead of wagering a lot of your money on gold, try taking leveraged bets with small stakes. That way you can make plenty of profits if the boom continues, while minimizing your risks if it turns tail. Here are two suggestions.

First, try buying "out of the money call options" on the SPDR Gold Trust. These are simple, if misunderstood, products that can be bought through a regular broker. You can view them like long-odds bets on the GLD booming.

How do they work? Here's an illustration: The GLD, worth one-tenth of an ounce of gold, costs around $127 a share right now. But for just $3.90 a share you can instead buy a call option, good until Jan. 2012, that will give you the unilateral right to buy into the GLD at $180 a share.

If it booms to, say, $300, equivalent to $3,000 an ounce, you can exercise the options and make $120. But if gold plummets, as it has in the past, all you can lose per share is your $3.90 stake.

A second alternative: Take a look at speculative gold mining stocks. They should give you plenty of bang for your buck in a mania. There are funds, such as U.S. Global Investors World Precious Minerals fund, that specialize in smaller mining companies. One intriguing stock is Alaska's NovaGold Resources (NG: 9.25, +0.09, +0.98%). (For more see this MarketWatch story.) A number of rich, powerful investors are involved–including Marc Faber, George Soros, and… John Paulson.