DEEP THOUGHTS FROM SETH KLARMAN

Seth Klarman, the legendary hedge fund manager at Baupost is increasingly concerned about the macro investing environment.  With the retirements of several prominent hedge fund managers in recent months he’s clearly not alone in his thinking.  In a recent interview (see here for the entire interview) Klarman provides some excellent macro insights and explains why he is more worried about the world than he has been in his entire career.  Klarman echos comments I have often made here.  In effect, the recovery has been almost entirely artificial and will result in unquantifiable future threats.  Klarman calls the current market a “Hostess Twinkie”:

“A Hostess Twinkie is a confection that has made many childhoods slightly happier, but it is composed of totally artificial ingredients.  My context, of about 6–12 months ago, was that virtually everything was being manipulated by the government. Nothing was natural in the markets. Interest rates were held at zero, the government was buying all kinds of securities—notably, mortgage securities—and who knows what else has ended up on the Fed’s balance sheet.

We have had lending programs—Troubled Asset Relief Program (TARP), Cash for Clunkers, and even Cash for Caulkers. We just don’t know the full extent to which investors have been manipulated. But certainly, the government wants people to buy equities, to invest so that the market will move higher, creating a wealth effect or at least eliminating the negative wealth effect in order to make people feel better about their situation, to restore a degree of optimism so that the economy might recover.

I am worried to this day about what would happen to the markets, to the economy if, in the midst of all these manipulations, we realized that they are, in fact, a Twinkie. I think the answer is that no one knows, including those in Washington. Will the economy continue to recover and grow at a healthy rate or will we sink into a double-dip recession? As we can all see, the high degree of government involvement continues.”

Of course, the USA isn’t the only country kicking the can.  Klarman cites the European bailout as another game of government kick the can:

“The European bailout is gargantuan. I doubt it will work because it kicks the can further down the road and is yet one more manipulation that encourages people to own securities. It is almost as if our government is in the business of giving people bad advice: “We are going to hold rates at zero. Please buy stocks or junk bonds that will yield [an inadequate] 5 or 6 percent.” In effect, it forces unsophisticated investors to speculate wildly on securities that are too overvalued.”

All of this has Klarman more concerned than he has ever been.  That’s a mouthful from a legend like Klarman who has seen more than his fair share of cycles:

“I am more worried about the world, more broadly, than I have ever been in my career.”

Like myself, Klarman believes there are unquantifiable repercussions from the bailouts:

“I am also troubled that we didn’t get the value out of this crisis that we should have. The Great Depression led us to a generation—or even two generations—of changed behavior. I grew up hearing about how our grandparents had a “depression mentality.” It’s awful to have a depression, but it’s a great thing to have a depression mentality because it means that we are not speculating, we are not living beyond our means, we don’t quit our job to take a big risk because we know we might not get another job. There is something stable about a country, a society built on those values.

In some sense, from the recent crisis we have developed a “really bad couple of weeks” mentality, and that’s not enough to tide us through, teach us to avoid future bubbles, and ensure a strong recovery.”

Klarman isn’t a macro expert (he’s a bottom up investor), but something just doesn’t pass the sniff test with all these bailouts.  How can the global economy continually bailout the losers without ever allowing these excesses to truly pass from the system?  Klarman says we will eventually reach a tipping point:

“A tipping point is invisible, as we just saw in Greece. In most situations, everything appears fine until it’s not fine, until, for example, no one shows up at a Treasury auction. In the meantime, we can be lulled into thinking all is well, that the United States will always be rated triple-A. Treasury Secretary Timothy Geithner speaks as if—at least in his public statements—he has been lulled into thinking that the United States will always be triple-A. That kind of thinking guarantees that someday the United States will no longer be triple-A. A sovereign deserves to be rated triple-A only if it has valuable assets, a good education system, a great infrastructure, and the rule of law, all of which are called into question by an eroding infrastructure, a government that changes the law or violates it whenever there is a crisis, and a legislature that shows no fiscal responsibility. There is an old saying, “How did you go bankrupt?” And the answer is, “Gradually, and then suddenly.” The impending fiscal crisis in the United States will make its appearance in the same way.”

Klarman finds the current environment particularly difficult because many of the hedges that have been working are more speculative in nature.  He finds little value in most commodities (with the exception of land) because commodities offer no real cash flow and instead rely almost entirely on some future “greater fool” buying the asset from you.  Klarman makes an exception with gold, however:

“Gold is unique because it has the age-old aspect of being viewed as a store of value. Nevertheless, it’s still a commodity and has no tangible value, and so I would say that gold is a speculation. But because of my fear about the potential debasing of paper money and about paper money not being a store of value, I want some exposure to gold.”

Klarman sees all of this government intervention resulting in higher rates of inflation:

“I think the odds are low that such high inflation will happen in the near future, but looking ahead five years, it becomes more likely, although certainly not a 50/50 chance. With a very limited initial outlay, I think a hedge like ours is a reasonable protection.”

Ultimately, the downside of the current bailout fever comes in the form of an intangible risk.  Capitalism without losers is like Catholocism without hell.  Klarman sees no way of avoiding future collapses given that we’ve never actually been forced to learn from our past collapses:

“Essentially, the problem is that government intervention interfered with the lessons investors needed to learn. Those who stared into the metaphorical abyss are right back at it, with the possible exception of college endowments, for whom the pain has been long lasting because of their spend rate. Almost everybody else is drinking the Kool Aid again, and it is very troubling. We could have another serious collapse, and people would again not be prepared for it.”