It’s becoming increasingly clear that the smart money is concerned about the level of bullishness in the US, including, Paul Singer, David Einhorn and Seth Klarman among others. That’s not to say that fund managers are calling the market a bubble, but more and more think that assets are overpriced and that fundamentals are being ignored. In a recent letter to investors, David Capital Partners LLC managing partner Adam J. Patinkin took a break from his normal explanation of new investments to explain at length why he thinks that investors need to be more cautious.

David Capital

David Capital: Every crisis has some hallmark warning signs

“History doesn’t repeat, it rhymes,” writes Patinkin. “The next crisis will likely not involve the US housing market. But certain warning signs are timeless, they are hallmarks of every crisis. Leverage. Deteriorating lending standards. Unbounded investor optimism. Asset prices untethered from a prudent view of risk vs. reward.”

As an absolute return fund, David Capital doesn’t have to measure itself against an index. And as an investor who literally started his career a few weeks after Bear Stearns went under, Patinkin isn’t one to chase returns when he sees serious problems all around. He argues that it doesn’t make sense to lend at 0.1% annual interest to anyone, no company or government, especially when entity already has $17 trillion in debt and an annual deficit of around $500 billion. Moving up from there, he says that investment grade debt at 3% and junk bonds that offer less than 6% are just more proof that there is a disconnect between risk and reward in today’s debt market.

David Capital: Fed pushing investors further out the risk curve

If the poor risk-adjusted returns were confined to debt markets, Patinkin would just look elsewhere, but he argues that this has spilled into equities by pushing entire portfolios (not just individual securities) further and further out on the risk curve. If pension funds that used to be content to take the returns on short-term government and investment grade corporate debt are now looking at risky assets that forces other investors to take even bigger risks to meet their own benchmarks.

“The Fed-induced step-out of capital on the risk curve – can last years, and this one may have a while yet to run, but we are cautious,” writes Patinkin. And this isn’t coming from some bear who would rather sit on cash while the market soars. David Capital beat the market by 1200bps in 2011, 1900 bps in 2012, and 900 bps in 2013, mostly because of successful stock-picking, and the fund has 231% gross exposure to the market.

“Investors are misreading low yields as an indicator of low risk, when we believe the opposite is true. In such a climate, we think it a time not for greed but for prudence.”