The legendary Seth Klarman spoke at a private meeting with business leaders in June in which he criticized not just the Federal Reserve, but all the ‘silly’ investors and the even sillier rating agencies. Klarman has been an outspoken critic of the Fed’s interventions and the consequent ebullience of the markets.
His latest speech also includes a distinct tone of regret over where the current state of affairs is taking the U.S. He sounds positively saddened by how things are run in his country. In Klarman’s words:
“Like all of you, I am worried about our future, I am concerned about the prospect for upcoming generations to have the same opportunities that ours did, and I’m saddened that our generation was handed something unique, the stewardship of the greatest country in the history of the world– and we are far down the path of making it less great.”
Klarman Slams Myth Of Efficient Markets
Klarman said that the idea that financial markets are efficient is foolish, and he goes on to describe how that will always remain the case. Markets are governed by human emotions and they do not follow laws of physics—prices will unpredictably overshoot, therefore the academic concept of market efficiency is highly incorrect.
“Academics are deliberately blind to the fifty plus year track record of Warren Buffett as well as those of other accomplished investors, for if markets are efficient, how can Warren Buffett’s astonishing success possibly explained?”
In his speech Klarman mentioned value-investor Ben Graham’s explanation of markets, where he says that Mr. Market is to be perceived as an eccentric counter-party which should be taken advantage of, but one should not follow its emotional advice. He also agrees with Ben Graham’s idea that assets should be bought at a significant discount to keep your margin of safety.
“As when you build a bridge that can hold 30 trucks but only drive 10 trucks across it, you would never want your investment fortunes to be dependent upon everything going perfectly, every assumption proving accurate, every break going your way.”
Klarman said that the current economy is being built like a house of cards that will implode. Huge deficits, empty government promises, pretty pictures painted to ease voters and reliance on external markets to keep your currency afloat, have all disrupted the margin of safety in U.S. economy.
Klarman Encourages Going Against The Grain
He says that investors have become increasingly speculative and subject themselves to frenetic trading, even the holding period of 30-yr treasuries has fallen down to a mere couple of months. Investors increasingly rely on technology to judge their performance not merely on a monthly or quarterly basis—it has now become an hourly practice.
“The performance pressure drives investors to into an absurdly short-term orientation…. If your track record is going to be considered by investment committees every quarter, if you are going to lose clients and possibly your job because of poor short term performance, then the long term becomes almost completely irrelevant.”
Klarman adds that such judgements push investors to sell things that underperform, buy more of what outperforms and all this adds to short term thinking and trading, but if one wants to take advantage of Mr. Market, it can only be in the long term. “You must ignore the market and go against the grain in the short term to win [in] the long term,” Klarman said.
He said that the urge to keep up with a rising market leads to the formation of market bubbles and when prices are rising, everybody is drawn to the asset simply because the price is rising and more will buy the same thing, thus taking the price to an absurd level. He says that constant scrutiny of markets over media adds to the already exhaustive short-term thinking,
“The daily cheerleading pundits exult at rallies and record highs and commiserate over market reversals ; viewers get the impression that up is the only rational market direction and that selling or sitting on the sidelines is almost unpatriotic…. in a world where differences between investing and speculation are frequently blurred, the nonsense on the financial cable channels only compound the problem.”
Klarman Warns About ‘Frothy Markets’
Klarman was critical of the way “relative performance” with respect to benchmarks has become so crucial in investment funds just like short term investment has. He says that the definition of being risk-averse is that you don’t bet your net worth on the toss of a coin. He jokes a little by saying that none of his investors would be thrilled if he sent a letter based on relative performance which says:
“Dear Client, we are pleased to report that we beat the market this year by 300 basis points; the market declined 43% for the year but we only lost 40% of your net worth.”
He says that these days almost everyone is bullish on stocks, thanks to the Bernanke put and repeated QE interventions. And each of these bullish investors thinks that if the market falls they will get out in time, when in actuality the exit is a revolving door and everyone cannot get out at the same time. Klarman is also regretful that despite of the very recent collapse of markets in 2008, the worst crisis since the Great Depression, people have forgotten so soon what frothy markets mean and how they can crumble so many institutions. He says that the situation reminds him of what Jeremy Grantham, the founder of GMO, said towards the end of 2008, “We will learn an enormous in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent. ”
Klarman: “The Best Of Nations Can Be Destroyed By Arrogance”
Klarman also appreciates Grantham’s view on market reversions. Grantham has proven through his research that across all markets and asset classes, valuation reverts to mean sooner or later. If that is indeed true, Klarman agrees that the Fed’s habit of issuing debt and then buying it back is not just foolish, it is very dangerous. He predicts that if this is the way the Fed will keep its hand in markets and then will eventually lift it, we would be stuck in a never ending maze of low to high volatility, support and then collapse which would contribute nothing to growth and just forward political agendas and boost short term returns.
U.S. debt is piling up and the government sees that increasing leverage as the only way to recovery when there are other ways to handle the problem. Instead of cutting back, the Fed chose to raise debt by multiple times and then spread the idea that increasing debt is not a problem. Klarman thinks that the best of nations can be destroyed by arrogance. Some parts of Klarman’s speech are taken from Baupost Group’s Q1 letter, where he says that if economy is indeed so fragile that the government cannot allow failure then we are indeed close to collapse.
He admits that there is no