How John Paulson's Former Wiz Is Playing The Market: Short Equities, Short The Dollar, Long Commodities

(This guest post originally appeared at the author's blog)

This week’s Guru Outlook brings you Paolo Pellegrini. Although he is not the most well known of investment gurus Pellegrini has built quite a name for himself in recent years. Before founding his own hedge fund PSQR (a play on PP Squared) Pellegrini was John Paulson’s right hand man at Paulson and Co (see Paulson’s guru outlook here & most recent strategy comments here). Of course, Paulson and Co. made waves during the sub-prime crisis when they made billions shorting the market during the crisis. Pellegrini was instrumental in devising the strategy. Like Paulson, however, Pellegrini wasn’t a one trick, short the market, pony. In 2009 he crushed the market with a 61.6% return in his fund after he made big bets on a rising oil market and a tanking treasury market.

So where does Pellegrini see the market going now? In a recent letter to shareholders he said:

“the structural problems that precipitated the Great Recession around the globe remain unresolved”

He says we are essentially papering over the problems with more debt. We are simply adding more debt to a debt-laden world while China adds more exports to a saturated market. He says the problems in Europe are a harbinger of these continuing issues. Thus far the massive stimulus has been successful in jumpstarting the global economy, but is nothing more than a temporary respite from the longer-term structural problems that remain.

Pellegrini’s favorite trades in 2010 are the following four:

• Short US fixed income
• Short US equities
• Short US dollar
• Long commodities

The short trade on fixed income is a reflection of the likelihood for higher yields as investors grow increasingly fearful of the U.S. as a steward of its debt. Pellegrini believes demand for treasuries will decrease in the coming years.

In terms of equities Pellegrini says valuations are becoming stretched as organic growth fails to match expectations. He also believes higher taxes could ultimately be a net negative for equities.

Pellegrini is short the dollar based on the expectation of more stimulus. He predicts that policymakers will come back to the taxpayer asking for another handout as they explain their first stimulus plan was not a failure, but simply too small. He says the dollar will “plunge” if this occurs.

The one sector of the market Pellegrini likes is commodities. He says they remain attractive long-term as China exports inflation and demand for hard assets remains high.

One of Pellegrini’s primary concerns is the stimulus based growth occurring in China. He says China is one of the greatest risks to the recovery. He says:

“I was in China late last year. One particularly enlightening meeting was with the top official of a major bank, who pointed to all the empty office buildings surrounding his own, observing that his country’s stimulus money would have been better spent paying people to stay home”

Pellegrini expects China’s CPI to exceed 5% in H1 2010 due to excessive demand from the stimulus programs. He says China will respond aggressively with policy measures throughout 2010. He expects the equity market to respond negatively. One of this favorite China investments is the Yuan. He is long the Yuan based on his “impossible trinity” trade:

“a country can control its interest rate, its exchange rate or its capital account – but not all three. If the US keeps interest rates low, the only way China can raise rates is by first addressing the currency undervaluation. Otherwise, it would just attract hot money inflows, as it did in 2006-2008. Indeed, it is our expectation the the experience of that period – when gradual CNY appreciation was chosen – will lead China’s policymakers to prefer a more aggressive, upfront, one-off revaluation this time around.”

In the US, Pellegrini says we are coming face-to-face with the critical structural problems. The end of the stimulus and the Fed’s programs will mark an economic top in Q1 2010 and set the stage for economic weakness in the latter half of 2010. He says the headwinds we face are likely to occur sooner rather than later:

“Eventually, there must be a reckoning. In our judgment, that day may be much sooner than the markets suggest.”