| Seth Klarman (Bloomberg) |
Seth Klarman is bearish. Frighteningly bearish.
While several reports have already highlighted that his Boston-based Baupost Group posted a decline in the mid-single digits last year — its first loss since 2008 and only the third since the firm’s 1982 inception — seemingly overlooked is the anxiety exhibited by Klarman over some key markets in his year-end letter sent to investors.
It is enough to make you want to rush out and buy a new mattress to stuff full of dollars.
Klarman’s cautionary remarks are significant. He is not a macro specialist or a quick trader. His firm, which currently manages about $27 billion, is known for its patient, eclectic, value-driven, bottom-up investing approach.
In the letter, Klarman reminds investors that he and his team are long-term investors who have moved beyond Baupost’s initial strategies of investing in U.S. distressed debt and equities to international investments, opportunistic private equity, direct real estate, mortgage securities and other structured products.
Baupost also likes to sit on a huge pile of cash — it averaged about 43 percent of the portfolio last year and was at 41 percent at year-end.
So, while Klarman tells investors he put some of this cash to work after the stock market fell more than 8 percent over the first two weeks of the year, he also paints a gloomy picture for many of the major global markets.
“When this relentless, policy-driven bull market comes to an end, one would expect not a mild retreat but shock, dismay and tumult,” he warns. “No matter the precautions, hedges, or cash position held, there is risk in being long anything at the top, and further risk to investing cash too soon on the way down. All investors must wrestle regularly with the bull market challenges of rising valuations and a dwindling opportunity set, always absent insight into the magnitude or timeline of any potential reversal. Striking the right balance between action and inaction, between making new investments and holding cash, is extremely challenging.”
Klarman then picks apart a number of markets.
Take the equity markets. “The stock market’s ongoing gains in the face of disappointing economic fundamentals and growing market stresses has us quite nervous,” Klarman writes. He warns not to expect a small number of “beloved stocks” to lead the market higher indefinitely, as it did last year, referring to Internet and media stocks, such as Facebook and Amazon.com, that posted double-digit and triple-digit gains.
Klarman says U.S. equities are not at record valuations, but at the same time they “are hardly bargain-priced” after nearly tripling since the bull market began in the spring of 2009. “The major indices hover close to all-time highs,” he warns. “Corporate profit margins remain at record levels in many industries, and, historically, those revert to the mean.”
So, he is bracing for lower multiples being applied to lower earnings, which obviously “would lead to significantly lower equity prices.”
Klarman then moves to debt markets, reminding investors that the U.S. economic recovery since the financial crisis has been built on what he calls “a shaky foundation of epic on- and off-balance sheet federal debt.
“We wouldn’t be surprised if the sovereign debt markets in general, and euro-zone sovereigns in particular, were ground zero for the next financial crisis,” he says. Yikes!
Klarman stresses that when this period ends, interest rates will be much higher and yield chasers will suffer big losses. “And issuers of this debt will be scrambling to meet looming maturities in the face of considerably more expensive (or non-existent) refinancing options,” he adds.
Klarman is also worried about a possible bubble in venture capital, which has fueled the huge growth in private companies such as car service Uber Technologies. “A voracious appetite for tech startups has driven prices sky-high,” resulting in so-called unicorns, privately held firms worth $1 billion or more. He points out that there were 143 unicorns at year-end, up from 45 two years ago.
However, these companies have not been monetized by, for instance, the public markets. And Klarman stresses these companies will continue to need capital to invest and grow.
“A change in investor psychology could impair people’s willingness to continue to pour in capital at high and growing valuations,” he warns, adding that a few unicorns have already seen their valuations revised downward by major mutual funds. This could be an ominous sign “that excesses in that sector are in the process of being corrected, that the herd is about to be thinned.”
Klarman also raises concerns about commodities, which have been reeling for 18 months now. He reminds investors that currencies of energy- and commodity-exporting countries have plummeted against the dollar, Swiss franc and euro. “Most companies in the space have seen their bonds and share prices collapse,” he says.
Klarman also wonders whether China’s economic weakness and slowdown could grow worse, warning that an unexpected downturn “would be highly consequential.” He points to the stock market’s early-year volatility and China’s looming bad-debt problem. “Were China’s economic tide to go out, the entire world could find itself swimming naked,” he adds, alluding to a favorite Warren Buffett metaphor.
Then there are the multitude of geopolitical concerns. These include political dysfunction and gerrymandering at home, which he says has led to a preponderance of safe electoral districts and to the election of extremist candidates within both parties, creating a growing void in the middle that in turn diminishes the ability “to reach compromises and get things done.”
And while Klarman ticks off positives such as rising living standards, creativity in Silicon Valley and improving global health, he stresses that optimism is not an investment strategy.
“While we may all be better off decades from now, it’s reasonable, in light of the numerous concerns discussed earlier, to expect a bumpy ride,” Klarman says.
That sounds like an understatement.
