Seth Klarman: We are in a "Goldilocks stock market resulting from a tepid economy, dampened volatility, and relentlessly low interest rates"
In his quarterly letter to investors, Seth Klarman criticized the complacency that has seeped into the global markets. He said that investors have been seduced into a false feeling of calm. With stocks touching new highs, Klarman expressed his fear that the markets are marching straight in the direction of a crisis as this continued up-cycle sows the seeds for the next fall. Warning signs like consistently high inflation, strikingly low volatility and finally the revision of the U.S GDP to -2.9% in Q12014 seem to have gone unnoticed by the market. The letter said,
"Investors have clearly grown weary of worrying about risky scenarios that never seem to materialize or, when they do, don't seem to matter to anyone else.U.S. GDP, for example, was recently restated to minus 2.9% for the first quarter of 2014. Normally, this magnitude drop signals recession. Equities, nevertheless, marched relentlessly higher."
Take a look at our previous coverage of Baupost's second quarter letter here. Sign up for our daily newsletter to ensure you catch all our articles
The Goldilocks stock market
Klarman went on to note that two of the most popular types of investments these days indicate possible danger ahead. One investment is stacking up a portfolio with substandard credit, and the other is leveraging up the portfolio. He cautioned that we might be close to the point where the continued weakness in bond markets spills over into equities and breaks up the party. However, on the other hand, things could go on just as they are now:
"…Or perhaps things can go on forever exactly as they are: a "Goldilocks" stock market resulting from a tepid economy, dampened volatility, and relentlessly low interest rates. Amidst the market rally, complacent investors continue to ignore a growing array of global trouble spots. Contrary to claims from the Obama Administration, the world is not a tranquil place at present. As such, risks facing investors seem to be rising but are not yet priced into the markets."
Possibility of imminent collapse
Klarman was highly apprehensive of the way central banks are implementing the most aggressive kind of easing programs these days. The ECB is championing its unprecedented -.1% deposit rate. Even though bond yields in European countries are at multi-century lows, nobody seems to be concerned. African countries are making record bond issues, even those countries that have recently emerged from default. He said that the issuance of low-grade credit in U.S is also breaking a history in which yields have particularly bottomed out for junk and CCC-rated debt. Klarman said with the amount of risk in such portfolios; even a little instability can throw the markets in turmoil,
"Given changes in regulation, Wall Street has far less capital available to support the trading of this burgeoning junk issuance and the corresponding surge in debt ETFs. A sudden change in rates or sentiment could lead to serious market instability. When is harder to predict than if. While we are not predicting imminent collapse (market timing is not our thing), we are saying that a selloff, greater volatility, and investor losses would hardly be surprising from today's levels."
A bubble in complacency
Klarman believes that the fear of a slowdown appears to have gone out of investors' decision-making process. Klarman quoted John Mauldin to emphasize his point. He once described this scenario as "bubble in complacency." The letter talked about a few more causes for concern as well:
"Investors have become numb to risk because such policies continue, seemingly forever, and new measures (such as European and now even Chinese QE) are regularly threatened and claimed to be costless and reliably effective. We are far from convinced of this; indeed, the higher the level of valuations and the greater the level of complacency, the more there is to be concerned about. Even as reported inflation remains quite subdued, signs of incipient cost increases are increasingly evident. We are seeing them, for example, in apartment rents, construction costs, and salaries of newly minted engineering graduates and oilfield workers."
Klarman also explained how the wealth effect has lulled investors,
How would everything feel if the S&P 500 were suddenly cut by one-third or one-half? Would such a drop drive astonishing bargains, or would the U.S. economy soon falter, with festering problems such as unemployment, the federal, state and local deficits, the long-term fiscal situation, and the creditworthiness of most sovereigns suddenly seeming ominous? It's not hard to reach the conclusion that so many investors feel good not because things are good, but because investors have been seduced into feeling good—otherwise known as "the wealth effect."
Baupost, unlike other hedge funds, is not seeing as many opportunities for investment as risk-takers are, however, the fund is enjoying its fair share of disciplined buying and selling.
The post Seth Klarman Cautions Against The Complacency Bubble appeared first on ValueWalk.
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