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John Engle
John Engle
Articles (613) 

Seth Klarman: The Federal Reserve Has Killed Price Discovery

The central bank's ongoing market interventions have lulled investors into a false sense of security

January 22, 2021

Seth Klarman (Trades, Portfolio) has always been a man with strong opinions about the stock market. He has also proven unafraid of sharing them, as even a casual review of his annual letters to the investors of the Baupost Group will attest.

Klarman's most recent installment is no exception. The Federal Reserve is the undisputed star of Klarman's latest investor letter, a reasonable choice given that the central bank has played an outsized part in the government's response to the ongoing economic crisis. It has also taken an expanded role in the effort to stabilize capital markets, committing to interventions unprecedented in both scale and scope.

In Klarman's letter, the Fed is cast as an "800-pound gorilla" that has, as a consequence of its efforts to prop up asset prices and maintain market liquidity, disrupted the normal functioning of capital markets in potentially dangerous ways. Klarman's fresh market forecast presents a warning to investors, one that deserves further consideration.

Drowning out risk signals

For the most part, market participants tend to obey the conventional pattern of economic and market cycles. Investors tend to engage in "risk on" behavior during periods of economic expansion and bullish market sentiment and generally move to a "risk off" stance during periods of contraction and retrenchment.

The potential triggers of a secular move from a "risk on" to "risk off" stance are many and varied, but a rising perception of market risk has long been amongst the most common of them. According to Klarman, the loose monetary and fiscal policy of the past year has compromised this important signal:

"With so much stimulus being deployed, trying to figure out if the economy is in recession is like trying to assess if you had a fever after you just took a large dose of aspirin. But as with frogs in water that is slowly being heated to a boil, investors are being conditioned not to recognise the danger."

Unsurprisingly, if risk signals are perpetually drowned out by wave upon wave of fiscal and monetary stimulus, investors are liable to find them harder to spot. According to Klarman, the Fed's continued market interventions appear to have caused many investors to conclude that market risk has "simply vanished." That is obviously problematic, since investors who cannot identify or quantify risk factors accurately cannot hope to price those risks accurately.

Disrupting price discovery

Among the most widely accepted benefits of an orderly public capital market is its role in facilitating efficient price discovery. When functioning properly, capital markets involve the separate actions of many thousands of market participants engaged in securities analysis and investment allocation, the net result of which is meant to (at some point) be an accurate a picture of each security's price.

Unfortunately, this process can be disrupted if critical signals and information flows are drowned out or ignored on a wide scale. According to Klarman, the Fed's intervention policies have, in erasing investors' perceptions of market risk, fundamentally warped the process of price discovery:

"[The Fed's actions] have directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated. The market's usual role in price discovery has effectively been suspended."

In compromising the market's critical role in price discovery, investors have been left largely in the dark. Unable to determine prices accurately, investors may be left making sub-optimal allocations and decisions based on the faulty assumptions that have been propagated by distorted market signals.

My verdict

Klarman's arguments are certainly worth heeding, in my opinion. Indeed, I have argued along similar lines previously in my discussion of the Fed's role in fueling the stock market's ongoing speculative frenzy.

I share Klarman's misgivings about the current state of capital markets. Economic risks have continued to compound in recent months even as stocks climb to ever new highs. Such divergences rarely end well for those investors who have allowed themselves to become overly exposed to market risk.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

Rating: 5.0/5 (3 votes)



Bruce Bohannon
Bruce Bohannon premium member - 2 months ago

Thank you John!

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