{"id":48431,"date":"2014-03-12T19:12:52","date_gmt":"2014-03-12T23:12:52","guid":{"rendered":"http:\/\/countingpips.com\/forex-news\/?p=48431"},"modified":"2014-03-12T19:12:52","modified_gmt":"2014-03-12T23:12:52","slug":"outside-box-seth-klarman-investors-downplaying-risk-never-turns-well","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex-news\/2014\/03\/12\/outside-box-seth-klarman-investors-downplaying-risk-never-turns-well\/","title":{"rendered":"Outside the Box: Seth Klarman: Investors Downplaying Risk \u201cNever Turns Out Well\u201d"},"content":{"rendered":"

By John Mauldin<\/span><\/h4>\n
\"\" <\/p>\n

Today\u2019s Outside the Box is unusual in that it isn\u2019t an original document but rather a summary of a client letter from one of the greatest investors of our generation, Seth Klarman, who is also one of the more reclusive \u2013 he rarely speaks in public or grants interviews. He is known for his very deep value investing style and willingness to pursue value where others get very nervous.<\/p>\n

This last year he returned $4 billion cash to his clients (from a fund in the $30 billion range). Not difficult for a hedge fund, you may say, but this is what a good value investor does when there aren\u2019t many opportunities. He won’t have any trouble raising cash if he decides he wants more at some point, as his fund is easily in the top-performing bracket by almost any measure. Some refer to him as the Warren Buffett of his generation.<\/p>\n

I think the author of the piece you\u2019re about to peruse, Mark Melin, did a pretty good job of giving us the highlights and a little color from what is really a thought-provoking letter from Seth Klarman.<\/p>\n

Tonight I find myself in Houston, where I flew down for a meeting. I am always exploring ways to serve you better and help you protect yourselves from the consequences of the Code Red policies of central banks and governments. This is not a short-term problem; it will be with us for some time. More to come as we work through a hundred logistical issues.<\/p>\n

The last few issues of Thoughts from the Frontline have sparked the most comments and letters of any column ever, including healthcare. It seems income inequality is a very sensitive subject, and I have heard from you, both pro and con. Some remarks have been merely dismissive but most have been quite thoughtful. And I was pointed to LOTS more research that I now have to cover for this week\u2019s letter.<\/p>\n

One thing I can count on is that readers will let me know when I miss something. I mentioned in passing at the end of last week\u2019s letter that I had dinner with Senator Rand Paul in DC last week and that our conversation was conducted under Chatham House rules. As it turns out that is not quite the case. I actually had a very polite letter from DeAnne Julius, a former chairman of Chatham House (and a former member and founder of the Monetary Policy Committee of the Bank of England, CIA analyst, World Bank economist, etc. \u2013 one very busy lady!). She wrote:<\/p>\n

Not to be pedantic, but there is only ONE rule. More importantly, that rule is that participants are free to use the ideas and information they gain from the discussion but NOT to identify any of the speakers or participants. In other words, the rule is nearly the opposite of what you say below. If the content of the discussion is not to be revealed, then the discussion is \u201coff the record\u201d rather than \u201cunder the Chatham House rule.\u201d<\/p>\n

Sigh. I knew that. David Kotok gives us a lecture on the Chatham House rule every summer at the beginning of our Maine \u201cShadow Fed\u201d meetings. At the end of my letters, when I write my personal notes, I sometimes write \u201con the fly\u201d and don\u2019t stop and think about what I am saying. And when I blow it, I hear from very nice people who politely correct me.<\/p>\n

DeAnne did offer to arrange for me to come to Chatham House and conduct a discussion group, after which I presume I could actually state correctly that I was in a meeting held under the Chatham House rule. I may take her up on that.<\/p>\n

It is time to hit the send button. I am making preparations to leave for Argentina and South Africa\u00a0 next week and be out for 25 days. But I will be in contact and writing and reading away. And I will have a new wifi-enabled Moto X phone that in theory will enable me to make and receive calls from even the remote Andes essentially for free. The whole thing is remarkably cheap and is a shift in the cost paradigm for cellular. And the phone looks to be cool, although I have to learn to speak something called Android as opposed to iPhone. I am told that it is easier to learn than Spanish, so maybe this old dog can figure it out.<\/p>\n

Have a great week and enjoy the spring weather, whenever it gets to you. It is perfect in Dallas and Houston.<\/p>\n

Your always looking for value analyst,<\/p>\n

John Mauldin, Editor
\nOutside the Box <\/em>subscribers@mauldineconomics.com<\/a><\/p>\n

\n

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Seth Klarman: Investors Downplaying Risk \u201cNever Turns Out Well\u201d<\/strong><\/h2>\n

By Mark Melin, March 04, 2014, 2:00 pm<\/strong><\/p>\n

ValueWalk.com<\/a><\/p>\n

Major hedge fund trader says the QE stimulus bubble will burst… at some point<\/h3>\n

In his letter to investors, Seth Klarman noted that \u201cmost\u201d investors are downplaying risk and this \u201cnever turns out well,\u201d noting that most people are not prepared for anything bad to happen. \u201cNo one can know what the future holds, but any year in which the\u00a0S&P 500 jumps 32% and the\u00a0NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance,\u201d\u00a0Seth Klarman\u2019s investor letter said. \u201cIt might not look like it now, but markets don\u2019t exist simply to enrich people.\u201d<\/p>\n

Noting that stock markets have risk and are not guaranteed investments may seem like an obvious notation, but against today\u2019s backdrop of never before witnessed manipulated markets Seth Klarman sagely notes \u201cSomeday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won\u2019t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.\u201d<\/p>\n

When will this happen? \u201cMaybe not today or tomorrow, but someday,\u201d he writes, then starts to consider what a collapse might look like. \u201cWhen the markets reverse, everything investors thought they knew will be turned upside down and inside out. \u2018Buy the dips\u2019 will be replaced with \u2018what was I thinking?\u2019 Just when investors become convinced that it can\u2019t get any worse, it will. They will be painfully reminded of why it\u2019s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain. They will be reminded that it\u2019s easier to buy than to sell, and that in bear markets, all to many investments turn into roach motels: \u2018You can get in but you can\u2019t get out.\u2019 Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill-prepared will find there\u2019s a long way to fall. Few, if any, will escape unscathed.\u201d<\/p>\n

Seth Klarman\u2019s focus on Fed<\/h3>\n

Seth Klarman then once again turned his sharp rhetorical knife to the academics that run the US Federal Reserve who seem to think that controlling free markets is a matter of communications policy.<\/p>\n

\u201cThe Fed, in its ongoing attempt to tamp down market volatility as much as possible decided in 2013 that its real problem was communication,\u201d Seth Klarman dryly wrote. \u201cIf only it could find a way to communicate to the financial markets the clarity and predictability of policy actions, it could be even more effective in its machinations. No longer would markets react abruptly to Fed pronouncements. Investors and markets would be tamed.\u201d The Fed has been harshly criticized by professional traders for its lack of understanding of real world market mechanics.<\/p>\n

This lack of understanding is a concern given that the Fed is taking the economy into uncharted territory with unprecedented stimulus. \u201cAs experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that the Fed\u2019s itinerary is bound to be exceptional, each stop more exciting than the one before,\u201d Seth Klarman wrote, sounding a common theme among professional market watchers. \u201cWeather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly.\u201d<\/p>\n

While the mainstream media is loaded with flattering articles of the Fed\u2019s brilliance in quantitative easing and its stimulus program, the real beneficiaries of such a policy are the largest banks. Here Seth Klarman notes they have\u00a0placed the economy at great risk without achieving much reward. \u201cBefore 2009, the Fed had never bought a single mortgage bond in its nearly 100-year history,\u201d\u00a0Seth Klarman writes of the key component of the Fed\u2019s policy that took risky assets off the bank\u2019s balance sheets. \u201cBy 2013, the Fed was by far the largest holder of those bonds, holding over $4 trillion and counting. For that hefty sum, GDP was apparently raised as little as 25 basis points in the aggregate. In other words, the policy has been a near-total failure. Bernanke is left arguing that some action was better than none. QE in effect, had become Wall Street\u2019s new \u2018too big to fail\u2019 policy.\u201d<\/p>\n

Seth Klarman: What do economists know?<\/h3>\n

There has been considerable discussion that the academic side of the economics profession has little clue how markets really work. Economic academics, who now make up the majority of the Fed governors, often look at the world from the standpoint of a game of chess, where one can explore different options and there is now a \u201cright\u201d or \u201cwrong\u201d approach to market manipulation.<\/p>\n

\u201cThe 2013 Nobel Memorial Prize in economics was shared by three academics: two were proponents of the efficient market hypothesis and the third was a behavioral economist, who believes in market inefficiency,\u201d Seth Klarman wrote. \u201cWe suppose that could be considered a hedged position for the awards committee, one that would never occur in the hard sciences such as physics and chemistry, where a prize shared among three with divergent views would be an embarrassing mistake or a bad joke. While a Nobel Prize might well be the culmination of a life\u2019s work, shouldn\u2019t the work accurately describe the real world?\u201d<\/p>\n

Another interesting insight on the topic was to come from David Rosenberg, Chief Economist and Strategist at GluskinSheff, who recently wondered \u201c[A]m I the only one to find some humour, if not irony, in the fact that the three U.S. economists who won the Nobel Prize for Economics did so because they \u2018laid the foundation for the current understanding of asset prices\u2019 at the same time that these asset prices are being determined less today by market-determined forces but rather by the distorting effects of the unprecedented central bank manipulation?\u201d<\/p>\n

Seth Klarman: Fed Created Truman Show Style Faux Economy<\/h3>\n

Baupost Group, among the largest hedge funds in the world, returned $4 billion in assets to clients at the end of 2013 because it didn\u2019t want to grow too quickly and dilute performance. Klarman\u2019s fund, which in 2013 had a high of 50% of his portfolio in cash, up from 36% in 2012, posted 2013 returns in the mid-teens consistent with the fund\u2019s nearly 22-year track record.<\/p>\n

Seth Klarman on Baupost\u2019s returns<\/h3>\n

Saying the fund \u201cdrew a line in the sand\u201d when it decided to return roughly $4 billion to clients at year end, Seth Klarman reflected on the decision, saying he wanted to control the fund\u2019s head count, noting \u201cwe could not allow the firm to grow without limit. We are wise enough to know a good thing when we see it, and cautious enough to want to cherish, protect and nurture it so that we might maintain its essential qualities for a very long time.\u201d A 50% cash position for a hedge fund might be construed as an indication the fund has grown to the point it was having difficulty allocating all the capital in appropriate trades.<\/p>\n

He noted the 2013 performance occurred \u201cdespite the drag of large, zero-yielding cash balances throughout the year.\u201d Klarman, author of Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, said the performance resulted from \u201cconsiderable progress in event-driven and private situations, and at least some uplift from the strong equity rally. Distressed debt, public equities, structured products, and real estate led the gains.\u201d Tail risk hedges, the only material area of loss in the portfolio, cost approximately 0.2% as the fund reduced exposure to distressed debt, structured products, and private investments while public equity exposure increased modestly.<\/p>\n

Market bifurcation {the basis for being bullish on equities}<\/h3>\n

In 2013 Seth Klarman noted the market bifurcation, which he describes as \u201ca momentum environment of market haves (which we avoid spending time on) and have-nots (which receive our undivided attention) \u2013 coupled with our energetic sourcing efforts and valued long-term relationships,\u201d and he expressed optimism for the fund in 2014 amidst what might be a stock market subject to individual interpretation. \u201cIn the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test,\u201d he wrote. \u201cWhat investors see in the inkblots says considerably more about them than it does about the market.\u201d<\/p>\n

Seth Klarman noted that those \u201cborn bullish,\u201d those who \u201cnever met a stock market they didn\u2019t like\u201d and those with \u201ca consistently short memory,\u201d might look to the positives and ignore the negatives. \u201cPrice-earnings ratios, while elevated, are not in the stratosphere,\u201d he wrote, stating the bull case. \u201cDeficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn\u2019t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December\u2019s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke\/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.<\/p>\n

Seth Klarman\u2019s market analysis<\/h3>\n

Like many of the best market analysts, Seth Klarman looks at both sides of the issue, the bull and bear case, in depth. \u201cIf you\u2019re more focused on downside than upside, if you\u2019re more interested in return of capital than return on capital, if you have any sense of market history, then there\u2019s more than enough to be concerned about,\u201d he wrote. Citing a policy of near-zero short-term interest rates that continues to distort reality and will have long term consequences, he ominously noted \u201cwe can draw no legitimate conclusions about the Fed\u2019s ability to end QE without severe consequences,\u201d a thought pervasive among many top fund managers. \u201cFiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?\u201d<\/p>\n

As he outlined the bear case, he started to divulge his own analysis that \u201con almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix, Inc. and Tesla Motors Inc.<\/p>\n

As it turns out he was just warming up. \u201cThere is a growing gap between the financial markets and the real economy,\u201d Seth Klarman wrote, noting that even as the Fed promised that interest rates would stay low, they did get out of control to some degree across the yield curve in 2013. \u201cMedium and long\u00adterm bond funds got hammered in 2013. Meanwhile, corporate earnings sputtered to a mid-single digit gain last year even as stocks drove relentlessly higher, without even a 10% correction in the last two and a half years,\u201d a concern among many professional traders.<\/p>\n

When it comes to stock market speculation and jumping on the bull market happy talk, Seth Klarman notes it\u2019s never hard to build a \u201ccoalition of willing\u201d who are willing to climb on the bandwagon. \u201cA flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities,\u201d he wrote. \u201cEven with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500 , Dow Jones Industrial Average 2 Minute, and Russell 2000 regularly posted new record highs.\u201d<\/p>\n

Seth Klarman noted that whether you see today\u2019s investment glass as half full or half empty depends on your age and personality type, as well as your \u201clifetime\u201d of experiences. \u201cOur assessment is that the Fed\u2019s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth,\u201d while citing numerous examples of overvalued internet stocks that defied value investing logic.<\/p>\n

\u201cIn an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987,\u201d he wrote. \u201cA paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people\u2019s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does. Frankly, wouldn\u2019t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?\u201d he said in a somewhat hilarious moment that bears a degree of truth.<\/p>\n

Seth Klarman on Europe<\/h3>\n

Seth Klarman still isn\u2019t much of a bull in Europe, as we noted in a previous ValueWalk. \u201cEurope isn\u2019t fixed either, but you wouldn\u2019t be able to tell that from investor sentiment,\u201d he noted. \u201cOne sell-side analyst recently declared that \u2018the recovery is here,\u2019 a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece\u2019s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008,\u201d he said, noting a growing concern among fund managers regarding the government debt crisis getting out of hand.<\/p>\n

Seth Klarman noted that Germany\u2019s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008, and said \u201cThat doesn\u2019t look fixed to us.\u201d The EU credit rating was recently reduced by S&P, he noted, while European unemployment remains stubbornly above 12%. \u201cNot fixed,\u201d he said. \u201cVarious other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world\u2019s population, 25% of its output, and 50% of its social spending.\u201d\u00a0While he notes the problems in Europe, Seth Klarman did not rule out that opportunity might be found in the region.<\/p>\n

Seth Klarman on Bitcoin<\/h3>\n

Seth Klarman also weighed in on Bitcoin, noting that \u201cOnly in a bull market could an online \u2018currency\u2019 dubbed bitcoin surge 100-fold in one year, as it did in 2013. Now most sell-side firms are rushing to provide research on this latest fad,\u201d he also noted that while \u201cbitcoin funds\u201d are being formed, the fund is \u201chappy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality. If paper currencies \u2013 dollars and yen \u2013 can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the \u201ccrypto\u201d kind of money?\u201d<\/p>\n

Comparing the economy and the Federal Reserve\u2019s management of it to the movie The Truman Show,<\/em> where the lead character lived in a false,\u00a0highly-orchestrated environment, Seth Klarman notes with insight, \u201cEvery Truman under Bernanke\u2019s dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they\u2019re sure everyone else won\u2019t stay on forever.\u201d Then he quotes Jim Grant who recently noted on CNBC, the problem is that \u201cthe Fed can change how things look, it cannot change what things are.\u201d<\/p>\n

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The article Outside the Box: Seth Klarman: Investors Downplaying Risk \u201cNever Turns Out Well\u201d<\/a> was originally published at mauldineconomics.com<\/a>.<\/div>\n
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By John Mauldin   Today\u2019s Outside the Box is unusual in that it isn\u2019t an original document but rather a summary of a client letter from one of the greatest investors of our generation, Seth Klarman, who is also one of the more reclusive \u2013 he rarely speaks in public or grants interviews. He is … <\/p>\n

Continue reading “Outside the Box: Seth Klarman: Investors Downplaying Risk \u201cNever Turns Out Well\u201d”<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[],"tags":[],"class_list":["post-48431","post","type-post","status-publish","format-standard","hentry"],"_links":{"self":[{"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/posts\/48431","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/comments?post=48431"}],"version-history":[{"count":0,"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/posts\/48431\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/media?parent=48431"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/categories?post=48431"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmacro.com\/forex-news\/wp-json\/wp\/v2\/tags?post=48431"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}