Numerous individuals have requested me to elucidate what’s now happening within the markets and financial system. As you in all probability know by now, I consider that every little thing (i.e., all actuality) works like a machine with cause-effect relationships that drive what occurs, and that to be efficient it’s important to have an excellent psychological mannequin of how these machines/realities work and to have good rules for coping with them properly. So, I consider that economies and markets work like machines with primary cause-effect relationships (together with human nature) interacting to trigger their actions. Since economies are the aggregates of the markets that make them up, to know how economies work one has to know how markets work. My psychological mannequin of how markets and economies work is described in short under and is conveyed extra merely in my 30-minute animated video “How the Economic Machine Works” (situated right here). In order that will help you perceive what’s occurring now, and extra importantly to provide the template I exploit so to use it to determine what’s occurring with out me, I’d such as you to see it inside the context of how the market and financial machines work as a result of when you perceive that, you possibly can perceive this stuff by yourself.
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How the Market and Economic Machines Work
On the largest image degree, there are three massive forces that work together to drive market and financial circumstances over time. They’re 1) productiveness progress, 2) the short-term debt cycle (which usually takes about 5-10 years), and three) the long-term debt cycle (which usually takes about 50-75 years). These elements additionally have an effect on geopolitics each inside and between nations, which additionally impacts the market and financial circumstances.
Productiveness progress is crucial affect over the long run, although over the brief time period it doesn’t appear so essential as a result of it’s not extremely risky. Productiveness tendencies larger over time as individuals study and turn into extra environment friendly so they’re able to increase the output per hour labored. As defined in larger depth in “Productivity and Structural Reform: Why Countries Succeed & Fail, and What Should Be Done So Failing Countries Succeed” (situated right here), a rustic’s productiveness progress is pushed by its competitiveness in addition to cultural elements. Competitiveness is usually a perform of the relative worth a rustic provides, most significantly the worth of individuals (as measured by the price of comparably educated individuals in different nations). Tradition (i.e., values and methods of working) is essential as a result of it influences the choices individuals make about work, financial savings charges, corruption, reliability, and quite a lot of different elements which might be determinant of, and extremely correlated with, subsequent years’ progress charges. These influences come collectively to affect the standard of a) the individuals (via the schooling system and thru the standard of household steerage), b) infrastructure, c) rule of regulation, and d) market methods—all of that are proven to find out and be extremely correlated with subsequent years’ progress charges. As for what’s occurring these days, productiveness progress in developed nations has been comparatively sluggish (although according to what we projected based mostly on these determinants), and is extra concentrated in a shrinking proportion of the inhabitants and within the space of automation that reduces the necessity for staff. These modifications have considerably modified the labor markets, widened the gaps between the “haves” and the “have nots,” and raised firm revenue margins. (See “Our Biggest Economic, Social, and Political Issue—The Two Economies: The Top 40% and the Bottom 60%,” situated right here.)
Credit score/debt cycles trigger swings round that productiveness uptrend. The best way it really works is that offering credit score offers shopping for energy that fuels spending on items, providers, and funding belongings (first), which causes stronger financial exercise and better costs of this stuff (subsequent). Offering credit score additionally creates debt, which creates the necessity to pay again within the type of debt-service funds (that comes later) which in flip lessens the spending on items, providers, and funding belongings (later) which results in weaker financial exercise and weaker costs of this stuff (after). So, credit score/debt boosts progress at first and depresses it later. Central banks present it to placed on the fuel when the financial system has numerous slack and is rising slowly, and prohibit it to placed on the brakes when there isn’t a lot slack and the financial system is rising quick. For these causes, the consequences of credit score/debt on the demand, manufacturing, and costs of products, providers, and funding belongings are inherently cyclical, which is why we’ve got credit score/debt cyclical strikes across the earlier-described productiveness uptrend.
Principally, these cycles are available two varieties: the short-term debt cycle and the long-term debt cycle.
The Brief-Time period Debt Cycle
The short-term debt cycle lasts about 5-10 years, relying on how lengthy it takes the financial system to go from having plenty of slack to not having a lot, which depends upon how a lot slack it begins off with and how briskly demand grows. In the cycle that we at the moment are in, the enlargement has been lengthy as a result of it began from a really depressed degree (as a result of the 2008 downturn was so deep) and since progress in demand has been comparatively sluggish (due to the debt disaster hangover, due to the rising wealth hole and spending of these with loads of wealth having a decrease propensity to spend than these with little wealth, and due to different structural causes). When slack is lowered and credit-financed spending progress is quicker than capability progress early within the cycle, that results in worth will increase till the speed of progress in spending is curtailed by central banks tightening credit score, which occurs late within the “late-cycle” part of the short-term debt cycle (the place we at the moment are). At the moment, demand is robust, capability is restricted, and revenue progress is robust. Additionally at the moment, the robust demand for credit score, rising costs/inflation, and ultimately central banks’ tightenings of financial coverage to place the brakes on progress and inflation, causes inventory and different asset costs to fall. They fall as a result of all funding belongings are priced as the current worth of their future money flows and rates of interest are the low cost price used to calculate current values, so greater rates of interest decrease these belongings’ current values. Additionally, tighter financial coverage slows potential earnings progress, which makes most funding belongings value much less. For these causes, it’s common to see robust economies being accompanied by falling inventory and different asset costs, which is curious to individuals who marvel why shares go down when the financial and revenue progress is robust (as a result of they don’t perceive how this dynamic works). That’s the place we now are on this short-term debt cycle.
Extra notably, in the course of the enlargement part of the cycle that we’re in, central banks created exceptionally low rates of interest, which made it engaging for corporations to borrow cash to purchase their very own and different corporations’ shares, which boosted inventory costs and has left company stability sheets far more indebted. Moreover, the US company tax cuts boosted fairness costs much more and elevated the price range deficit, which would require the Treasury to borrow rather more. In addition to creating exceptionally low rates of interest, central banks printed some huge cash and purchased loads of debt, which supported the markets. These one-time boosts to the markets and economies—at first by way of the low rates of interest and the central financial institution buying of debt and extra lately within the type of company tax cuts (within the US financial system)—coming within the late stage of this short-term debt cycle when the capability to supply was constrained—led the Fed to boost rates of interest. Additionally contributing to the speed rise has been a) the Fed promoting off a few of the debt that it acquired by way of QE and b) massive company borrowings. Consequently, we at the moment are seeing this basic late-cycle robust revenue progress and powerful financial progress that’s accompanied by falling inventory costs because of the monetary squeeze. That’s when the cracks within the system start to seem and what most individuals by no means anticipated to occur begins occurring.
Sometimes at this part of the short-term debt cycle (which is the place we at the moment are), the costs of the most well liked shares and different equity-like belongings that do properly when progress is robust (e.g., personal fairness and actual property) decline and company credit score spreads and credit score dangers begin to rise. Sometimes, that occurs within the areas which have had the most important debt progress, particularly if that occurs within the largely unregulated shadow banking system (i.e., the non-bank lending system). In the final cycle, it was within the mortgage debt market. In this cycle, it has been in company and authorities debt markets.
When the cracks begin to seem, each these issues that one can anticipate and people who one can’t begin to seem, so it’s particularly necessary to determine them shortly and keep one step forward of them.
In fact psychology—most significantly worry and greed—performs an essential position in driving the markets. Most individuals greedily change from shopping for when issues are going as much as fearfully promoting when they’re going down. In the late-cycle stage of the short-term debt cycle, as soon as the beforehand described tightening prime is made, the cracks seem. The market actions are like a punch within the face to buyers, who by no means imagined the punch coming, and it modifications psychology, which results in a pulling again and better danger premiums (i.e., cheaper costs). Sometimes, the contraction in credit score results in a contraction in demand that’s self-reinforcing till the pricing of asset courses and central banks’ insurance policies change to reverse it. That usually occurs when demand progress falls to lower than capability progress and there’s higher slack within the financial system. After central banks ease by a number of % (sometimes about 5%), that modifications the anticipated returns of shares and bonds to make shares low cost and it offers stimulation to the financial system, which causes inventory and different asset costs to rise. For these causes, it’s classically greatest to purchase shares when the financial system could be very weak, there’s a number of extra capability, and rates of interest are falling, and to promote shares when the reverse is the case. As a result of these cycles occur comparatively incessantly (each 5-10 years or so), these individuals who have been round awhile have sometimes skilled a couple of of them, so this short-term debt cycle is fairly nicely acknowledged.
The Lengthy-Time period Debt Cycle
The long-term debt cycle comes round roughly as soon as each 50-75 years and occurs as a result of a number of short-term cycles add as much as steadily greater debt and debt-service burdens, which the central banks attempt to greater than neutralize by decreasing rates of interest and, once they can’t do this anymore, they struggle to take action by printing cash and shopping for debt. As a result of most everybody needs to get markets and economies to go up and since one of the simplest ways to try this is to decrease rates of interest and make credit score available, there’s a bias amongst coverage makers to do what’s stimulative till they will’t do this anymore. When the risk-free rate of interest that they management hits zero% in an enormous debt disaster, central banks decreasing rates of interest doesn’t work. That drives them to print cash and purchase monetary belongings. That occurred in 1929-33 and 2008-09. That causes monetary asset costs and financial exercise to select up as they did in 1933-37 and 2009-now. In each the 1930s case and our most up-to-date case, that led to a short-term debt cycle rebound, which ultimately led to a tightening (in 1937 and during the last couple of years) for the explanations I beforehand described in explaining the short-term debt cycle. This time round, the tightening is coming by way of each rate of interest will increase and the Federal Reserve decreasing its holdings of the debt it had acquired.
For all the beforehand described causes, the interval that we at the moment are in appears lots like 1937.
Tightenings by no means work completely, so downturns comply with. They’re harder to reverse within the late stage of the long-term debt cycle as a result of the skills of central banks to decrease rates of interest and purchase and push up monetary belongings are then restricted. Once they can’t do this anymore, there’s the top of the long-term debt cycle. The proximity to the top may be measured by a) the proximity of rates of interest to zero and b) the quantity of remaining capability of central banks to print cash and purchase belongings and the capability of those belongings to rise in worth.
The limitation within the potential to print cash and make purchases sometimes comes about when a) asset costs rise to ranges that decrease the anticipated returns of those belongings relative to the anticipated return of money, b) central banks have purchased such a big proportion of what there was to promote that purchasing extra is troublesome, or c) political obstacles stand in the best way of shopping for extra. We name the facility of central banks to stimulate cash and credit score progress in these methods “the amount of fuel in the tank.” Proper now, the world’s main central banks have the least gasoline of their tanks because the late 1930s so at the moment are within the later levels of the long-term debt cycle. As a result of the important thing turning factors within the long-term debt cycle come alongside so occasionally (as soon as in a lifetime), they’re sometimes not properly understood and take individuals unexpectedly. For a extra full rationalization of the archetypical long-term debt cycle, see Half 1 of “Principles for Navigating Big Debt Crises” (hyperlink).
So, it seems to me that we’re within the late levels of each the short-term and long-term debt cycles. In different phrases, a) we’re within the late-cycle part of the short-term debt cycle when revenue and earnings progress are nonetheless robust and the tightening of credit score is inflicting asset costs to say no, and b) we’re within the late-cycle part of the long-term debt cycle when asset costs and economies are delicate to tightenings and when central banks don’t have a lot energy to ease credit score.
Politics is affected by economics and impacts economics in basic methods. I gained’t go into all of them now, however I’ll contact on what I consider is most related for us to now think about. As beforehand talked about, when rates of interest hit zero%, central banks print cash and purchase monetary belongings, which causes these belongings to rise. That advantages those that personal monetary belongings (e.g., the rich) relative to those that don’t, which widens the wealth hole. Different elements reminiscent of know-how and globalization (which take away the obstacles between lower-cost and higher-cost populations) additionally contribute to the widening wealth hole inside nations whereas narrowing the wealth gaps between counties. This causes the rise of populism and larger conflicts each inside nations and between nations. Populism might be of the appropriate or of the left. The conflicts can turn into dangerous to the efficient operations of presidency, the financial system, and day by day life (e.g., by way of strikes and demonstrations). This dynamic can develop into self-reinforcing as a result of when populist conflicts undermine effectivity it could result in extra battle and extra excessive populism, which is extra disruptive, and so forth. Such occasions at their worst can threaten democracies and favor autocracies as most individuals consider that a robust chief is required to get management of the chaos “to make the trains run on time.” For a extra in-depth examination of this dynamic, see “Populism: The Phenomenon” (situated right here). As a result of populists are extra confrontational and nationalistic by nature, and since home circumstances are extra irritating, the dangers of confrontations between nations additionally rise throughout such durations. Over the previous few years, we now have seen this develop around the globe. The emergence of populism in developed nations classically occurs most forcefully late in long-term debt cycles when the short-term debt cycle turns down, which occurred within the late 1930s and has a great probability of occurring over the subsequent couple of years, maybe earlier than the subsequent US presidential election. The result of that election could have a huge impact on nearly the whole lot.
There’s one other geopolitical precept that’s related at the moment and was related within the 1930s (and lots of different occasions earlier than) that was highlighted by the good American political scientist Graham Allison (who was additionally dean of the Kennedy Faculty of Authorities at Harvard and is now a professor there), which he calls the Thucydides Lure. In brief, when a rising energy features comparable power to compete with an present energy, there’ll inevitably be higher battle between these nations. That battle sometimes begins off being financial and turns into geopolitical in most methods. It sometimes impacts commerce and capital flows, what’s produced the place, and army encounters. “Wars” of varied varieties occur as a result of there’s a battle between nations to determine which nation is dominant in a variety of areas and a lot of places (which turn into scorching spots). During the last 500 years, there have been 16 occasions when an rising energy developed to turn out to be similar to an present energy, and in 12 of these occasions there have been capturing wars, which determines which nation is dominant and which one needs to be submissive. Wars are naturally adopted by durations of peace as a result of when a rustic wins a conflict nobody needs to go to struggle with that dominant nation. That continues till there’s a new rising energy to problem the main energy, at which era there’s a struggle once more to determine which energy is dominant. Therefore, there’s a war-peace cycle that has proven up all through historical past and tracks the long-term debt cycle fairly intently. China is definitely a rising energy that’s gaining comparable power to problem the US in a lot the identical approach as Germany and Japan rose to problem the weakening “British Empire” and different nations that gained World Warfare I. This type of battle has related financial implications as a result of anticipations of such circumstances set off behaviors on each side that may adversely have an effect on commerce flows, capital flows, and provide strains. This problem is now enjoying a big position within the markets and can be with us for the subsequent a number of years.
In different phrases, as I see it there are a selection of analogous timeless and common cause-effect relationships which might be driving issues now that drove issues within the 1935-40 interval and in a variety of occasions in historical past, which we must be aware of. That doesn’t imply that the longer term is destined to play out the best way it did within the 1940s. There are definitely levers that may be moved to supply good outcomes. What issues most is whether or not there are expert and sensible individuals who have their palms on these levers.
The Markets’ Connections with the Financial system
In order to know what’s occurring and what’s more likely to occur within the markets and the financial system, it’s important to know the connection between the monetary markets and the financial system. The monetary system and the financial system are inextricably linked as a result of it’s the monetary system that gives the cash and credit score that’s behind spending. Consider cash and credit score as being the gasoline that modifications demand.
Economic actions are pushed by all markets interacting and looking for their equilibrium ranges, in a lot the identical method because the elements of nature work together in a endless strategy of looking for their equilibria. They’re continuously shifting to regulate the provides and calls for of products, providers, and monetary belongings in such a means that nothing can keep both very worthwhile or very unprofitable for lengthy. If a very good, service, or monetary asset could be very worthwhile for lengthy, the portions produced and the competitors to supply it is going to improve, eliminating that extreme profitability, and if making it’s unprofitable, the reverse will occur.
On the massive image degree, there are three necessary equilibria that have to be achieved or huge modifications will ultimately happen to cause them to regulate towards this stuff being in equilibrium. Governments have two levers to make use of so as to push them towards equilibrium—financial and monetary coverage. By understanding these three equilibria and these two levers, and by understanding how they affect one another, one can fairly nicely see what is going to come subsequent.
The three most necessary equilibria are:
1) Debt progress is in keeping with the revenue and cash progress that’s required to service money owed. Debt progress itself isn’t an issue. Extra particularly, a) if the debt is used for functions that produce additional cash influx than the money outflow because of the elevated debt service then there can be a internet profit, and if the reverse is true there will probably be an issue, however b) if debt progress is at charges that finance spending charges that don’t produce the money flows to pay for debt service, it is going to be unsustainable and large modifications have to happen.
To be sustainable, debt progress should occur in a balanced approach. Borrowing and lending needs to be good for each debtors and collectors. When debt progress is just too sluggish, investing and spending won’t be sufficient for the financial system to succeed in its potential, but when debt progress is persistently larger than the expansion fee of the revenue that’s required to service the money owed, demand shall be unsustainable and debt issues will comply with. For these causes, the equilibrium price of debt progress is that which is according to the expansion within the revenue that’s required to service the debt. As a result of incomes are risky, this can’t be exactly calibrated, which is why having financial savings (e.g., for a rustic, overseas change reserves) is necessary.
2) Utilization of the financial system’s capability is neither too excessive nor too low. An excessive amount of spare capability (plenty of unemployed staff, idle factories, and so on.) is a painful set of financial circumstances. Over time, it is going to spur unrest and coverage makers to behave to enhance circumstances (by way of the levers described under), and it’ll result in pricing changes till utilizing up the spare capability is worthwhile once more. Too little spare capability creates undesirable inflation pressures, which spurs central banks to attempt to restrict demand progress by tightening credit score.
three) The projected return of money is under the projected return of bonds, which is under the projected return of equities by applicable danger premia. These spreads in anticipated returns are essential for the wholesome functioning of capital markets and the financial system as a result of they create the incentives to lend, borrow, and produce. Keep in mind that economies work as a result of individuals are buying and selling issues that they’ve for issues that they need extra, based mostly on the relative attraction of these issues. That is no totally different in terms of monetary belongings. Buyers will demand greater returns for riskier belongings, because the additional danger makes the belongings much less interesting in any other case. The dimensions of the spreads between the anticipated return of money and the anticipated returns of dangerous belongings will decide how a lot capital will transfer the place and drive the motion of cash and credit score by way of the system. In reality, most monetary selections are made by monetary intermediaries making an attempt to seize this unfold, and it’s subsequently an enormous driver of credit score progress, asset class returns, and financial progress.
Applicable spreads are required for the capitalist system to work. In essence, one individual’s return is one other individual’s value of financing. The financial machine works by central banks making money obtainable to those that can borrow it and generate larger returns than they should pay again in curiosity. These spreads can’t be too giant or too small as a result of if they’re too giant they may encourage an excessive amount of borrowing and lending and if they’re too small they may result in too little. As a result of short-term rates of interest are usually under the charges of return of longer-term belongings, individuals borrow on the short-term rate of interest and purchase long-term belongings to revenue from the unfold. These long-term belongings is perhaps companies, the belongings that make these companies work properly (e.g., capital investments corresponding to factories or gear), equities, and so on. Due to the borrowing and shopping for, the belongings purchased are likely to go up, which rewards the leveraged borrower. That fuels asset worth appreciation and most financial exercise, and results in the constructing of leveraged lengthy positions. Against this, if the anticipated returns of money rise above the anticipated returns of bonds and/or above the anticipated returns of equities, buyers are rewarded for holding on to money and financial contractions will happen as a result of the lending that may have been achieved as an alternative is slowed.
Whereas there’s usually a constructive unfold between the anticipated returns of equities and bonds and bonds and money, that may’t all the time be the case. If short-term rates of interest have been all the time decrease than the returns of different asset courses (i.e., the spreads have been all the time constructive), everybody would run out and borrow money and personal higher-returning belongings to the utmost diploma potential, which might be unsustainable. So there are occasional ”dangerous“ durations when that isn’t the case, at which era each individuals with leveraged lengthy positions and the financial system do badly. As I’ll describe under, central banks sometimes decide when these dangerous durations happen, simply as they decide when the great durations happen, by affecting the spreads by way of their use of financial coverage. They’ve just lately made such a nasty interval in an effort to put the brakes on the financial system and markets.
These three issues—i.e., 1) debt service obligations in relation to money flows wanted to satisfy them, 2) demand relative to the capability to satisfy it, and three) the relative attractiveness of every of the totally different capital markets for each those that search to take a position their cash properly and people who search to get funding properly—fluctuate round their equilibrium ranges in an interactive means, with the pushing for equilibrium in a single shoving the opposite out of equilibrium. If these circumstances stay out of equilibrium for lengthy, insupportable circumstances will ensue, which can drive modifications towards these equilibria. For instance, if the financial system’s utilization of capability (e.g., labor and capital) stays low for an prolonged time period, that may result in social and political issues, in addition to enterprise losses, which can produce change till the equilibria are reached. The US within the Nice Melancholy is a basic instance of this course of: at first the US offered too little stimulation, till the ensuing deep melancholy introduced concerning the election of President Franklin Roosevelt, who subsequently printed cash and devalued the greenback to stimulate the financial system.
The 2 levers that governments have to assist result in these equilibria are:
- Financial coverage: Central banks change the portions and pricing of cash and credit score to have an effect on financial exercise, the worth of belongings, and the worth of its foreign money. They do that primarily by shopping for debt belongings, thus placing extra money into the system and affecting the spreads in anticipated returns of funding belongings in the best way beforehand described. When debt progress is sluggish and capability utilization is low, central banks sometimes add cash to the system, which pushes short-term rates of interest down in relation to bond yields, that are made low in relation to anticipated fairness returns (i.e., “risk premia” are excessive). Those that purchase this liquidity purchase belongings which have larger anticipated returns, pushing their costs up and growing lending. Greater asset values make individuals wealthier, which inspires lending and spending. Conversely, when debt progress is just too quick and capability is just too tight (so inflation is rising), central banks do the reverse—i.e., they take “money” out of the system, making money extra engaging relative to bonds, which makes bonds extra engaging relative to equities, which causes asset costs to fall (or rise much less shortly) and lending and spending to sluggish. There are three forms of financial coverage that central banks progressively flip to: rate of interest coverage (which I’ll name Financial Coverage 1), quantitative easing (Financial Coverage 2), and eventually financial stimulus focused extra instantly at spenders (Financial Coverage three). Rate of interest coverage is the simplest sort as a result of it has a broad impact on the financial system. By decreasing rates of interest, central banks can stimulate by a) decreasing debt-service burdens, b) making it simpler to purchase gadgets purchased on credit score, and c) producing a constructive wealth impact. As defined earlier, when short-term rates of interest hit zero%, central banks go to quantitative easing (Financial Coverage 2), during which they purchase bonds by “printing money.” This type of financial coverage works by each injecting liquidity into the system (which may scale back precise dangers), in addition to by pushing down the spreads on bonds relative to money, which may drive buyers/savers into riskier belongings and produce a wealth impact. Financial Coverage 2 is only when danger and liquidity premia are giant, however its effectiveness is diminished when spreads between belongings are low, as a result of at that time they can’t be pushed down a lot additional in order to supply a wealth impact and induce individuals to spend. At that time, central banks can goal stimulation at spenders immediately as an alternative of buyers/savers (Financial Coverage three), by offering cash to spenders with incentives for them to spend it. For a extra full rationalization of this, see “Principles for Navigating Big Debt Crises.”
- Fiscal coverage: Governments can impression the financial system via their spending on items and providers, taxation, and authorized structural reforms (by affecting laws). Whereas central banks decide the entire sum of money and credit score within the system, central and native governments affect how it’s distributed. They get their cash by taxing and borrowing, they usually spend and redistribute it by means of their packages. How a lot they tax, borrow, and spend, and the way they do it (e.g., what will get taxed how a lot and the way they spend their cash) additionally impacts the financial system. Once they spend extra and/or tax much less, that’s stimulative to the financial system, and once they do the reverse, that subdues the financial system. For instance, the Trump administration’s massive company tax cuts had an enormous impact on market costs and thru it financial exercise. Governments additionally make legal guidelines that have an effect on conduct (e.g., create laws that have an effect on security and effectivity, create guidelines that govern labor markets). When structural reforms take away impediments and enhance a rustic’s competitiveness, it helps enhance long-term productiveness progress. Fiscal insurance policies can both assist or harm financial exercise.
In the brief time period, coverage makers’ use of those levers can both hold economies away from these equilibria (in the event that they act too slowly or inappropriately) or might help velocity up the changes (if their actions are well timed and applicable). Understanding these equilibria and levers is necessary to understanding the market and financial cycles. By seeing which equilibria are out of whack, one can anticipate what financial and monetary coverage shifts will happen, and by watching these shifts one can anticipate what the modifications in these circumstances might be.
I hope this rationalization of my template and what’s occurring now in mild of it has helped you to place issues in perspective and, extra importantly, will aid you independently put issues in perspective sooner or later.
Article by Ray Dalio, LinkedIn