Seth Klarman (Trades, Portfolio) has always been a skeptic when it comes to exuberant bull markets. The latest strong gains in the benchmark stock indices have not escaped his notice either.
In his most recent letters to investors in his Baupost Group, Klarman gave his views on recent economic developments and what he sees as the disconnect between the stock market and underlying economic reality.
The dangers of chasing yields
Klarman noted the well documented fact that the recent stock market rally has been primarily driven by the biggest names in the indices (a point that real estate investor Sam Zell also discussed in a recent interview).
In Klarman’s opinion, the rally has been almost entirely driven by central bank policy, rather than by a radical improvement in the cash generative abilities of companies. He said that the U.S. Federal Reserve has not only artificially stabilized asset prices, it has altered investor behaviour:
“Fed policy has been magnificently successful in achieving its objectives not only of lifting security prices, but also of altering investor behaviour. The Fed wanted to influence buyers of securities to be bolder in their pursuit of return. The head of a major pension fund recently authored a piece describing how the fund had responded to lofty markets and low yields on safe debt instruments. Their reaction was not to lower the fund’s currently aggressive 7% risk-adjusted return objective to a more realistic threshold, but instead to direct more assets into “lower volatility” private investments while leveraging the portfolio.”
In other words, this fund was so wedded to a specific return that they failed to take into account the additional risk that they were taking on. Private equity is sometimes considered to be lower volatility, but that is only because there are no second by second price updates for private investments like there are for public equities. The volatility is there - you just can’t see it.
Klarman added that targeting a specific return is especially dangerous in an environment where asset prices are rising across the board, and in which it is difficult to see which businesses are genuinely doing well vs. which are just being raised by the general tide.
He pointed to the example of car rental company Hertz (HTZ), which saw its share price increase fivefold off the back of its bankruptcy announcement. In markets like these, it definitely pays to be as skeptical as Klarman.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Real Estate Investor Sam Zell Weighs In on REITs
- Paul Tudor Jones: We Are Living Through a Great Monetary Inflation
- 2 Important Investing Insights From Charlie Munger
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
