Dalio letter: We messed up on China bubble

Ray Dalio, Bridgewater Associates
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Ray Dalio, whose Bridgewater Associates manages $169 billion in assets, told clients this week he did not anticipate the Chinese stock market bubble accelerating and then bursting so quickly.

The letter to clients began simply with "our views about China have changed."

This reversal of opinion by the largest hedge fund in the world could add more pressure on a Chinese stock market already down 20 percent in five weeks, as measured by the Shanghai composite.

Dalio also wrote in the letter that Chinese investors now face an environment where "there are now no safe places to invest."

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Here are some other highlights from the letter.

Bubble mea culpa:

"The bubble expanded and burst much faster and more dramatically than we expected ... rising prices drew in unsophisticated speculators, and the number of new brokerage accounts exploded so that a bubble bursting seemed likely because unsophisticated speculators were gambling with borrowed money. Consider that 67 percent of those opening new accounts had less than a high school education, and that an extraordinarily high amount of buying was done on margin. Anyone who has been in the markets awhile knows how that goes. Besides buyers becoming overextended, these moves created a huge IPO pipeline of supply ... We did not properly anticipate the rate of acceleration in the bubble and the rate of unraveling, or realize that the speculation in the markets was so big by established corporate entities as well as the naive speculators. We should have. Because we are not active in this market we did not give it the type of meticulous attention that is required for us to have that knowledge."

Why they changed their mind:

"We previously conveyed our thinking about the debt and economic restructurings being negative for growth over the near term and positive for growth over the long term — i.e., that it is a necessary and delicate operation that can be well managed. While we had previously considered developments in the stock market to be supportive to growth, recent developments have led us to expect them to be negative for growth. While we would ordinarily consider the impact of the stock market bubble bursting to be a rather small net negative because the percentage of the population that is invested in the stock market and the percentage of household savings invested in stocks are both small, it appears that the repercussions of the stock market's declines will probably be greater. Because the forces on growth are coming from debt restructurings, economic restructurings, and real estate and stock market bubbles bursting all at the same time, we are now seeing mutually reinforcing negative forces on growth."

History shows bubble burst to hit economy:

"The stock market bubble bursting at the same time as the debt and economic adjustments are being made has raised our concerns. To gain perspective, we looked at analogous cases where there was a debt and equity bubble. Warning signs for us include a) whether debts are rising faster than incomes, b) whether the pace of stock market appreciation is very fast,averaged over the prior three years, c) the amount of margin debt that is financing stock purchases, d) housing price changes, and e) monetary and fiscal policy changes. Based on these factors we identified 28 analogous cases across major countries over the last century. In cases in which there were both debt bubbles and stock market bubbles that burst, the subsequent growth rate was on average 1.8 percent per year lower over the subsequent three years relative to what growth would have been without these events."

Government risking "embarrassment":

"While China's moves to support the stock market are interesting, in that they convey the importance that they are giving to the stock market bubble bursting, and their inclinations to affect prices by being active in directing purchases and sales, rather than to be less active and more trusting in the free market's ways of working things out, we do not believe that the moves will be a major factor affecting the economy. History has shown in other countries that the central banks' and other governments' purchases of stocks, while sometimes supportive to prices over the short term, are usually not effective. They are typically too small to be effective, or, to be effective, must be undesirably large. When these purchases are not large enough to have the desired effects, they undermine the government's credibility and can be politically controversial; failed interventions are embarrassments as well as expensive costs. On the other hand, large enough interventions to support prices are typically uneconomic."

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June was Bridgewater's worst month in almost a year, according to The Wall Street Journal. The fund is up 10 percent this year, according to the paper.

Bridgewater on Thursday sought to clarify the letter's contents to CNBC.

"Ray Dalio and Bridgewater believe that too much has been made of the shift in their thinking," a spokesman for the fund told CNBC. "Bridgewater's view that China faces debt and economic restructuring challenges, and that it has the resources and the capable leaders to manage these challenges, remains the same."

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—With reporting by CNBC's Kate Kelly