“One day a physicist, a biologist, and an economist were sitting at a café
across from an apparently empty building. They watch two people enter and then, later, three leave.
The physicist says, “Apparently there was some error with our measurements,”
while the biologist says, “Obviously, they reproduced while in the building.” Then the economist observes,
“If another person were to enter the building, it would once again be empty.”
– Seth Klarman
Baupost’s Seth Klarman is a very concerned man.
Like all of you, I’m worried about our future. I’m 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.
Some of Klarman’s big picture thoughts:
- Despite trillions of dollars thrown at the problem and the passage of nearly five years, the crisis is in many ways still with us and great pain is still being felt, especially among some of the most vulnerable populations.
- Unemployment in the U.S. is stuck in the mid-7%s, and would be roughly twice that if you counted all of those actually out of work.
- Real median household income in 2011 fell for the fourth straight year to 1995 levels.
- The U.S. stock market, at 19 times trailing earnings, is overvalued on an historic basis, yet real improvement in the economy is far from certain
- Many suspect, accurately I believe, that ebullience in the financial markets is primarily attributable to the unprecedented interventions we have experienced, most especially quantitative easing.
- Weak fundamentals accompanied by expensive and rising financial markets is almost always a dangerous combination for investors.
What follows are his far more nuanced observations. We can only hope those in charge would read them and learn from them.
On asset bubbles:
Alan Greenspan’s mantra was that the Fed couldn’t possibly identify financial bubbles before they burst; it is better for the government to clean them up after they implode. I couldn’t disagree more strongly. Asymmetrically truncating investors’ downside risk, without an equal and opposite intervention to limit bubble-like upside, is highly pernicious. For decades, financial institutions and individual investors have come to expect limited financial market downside due to such government interventions. With downside artificially constrained and upside driven by the forces I’ve described, a purported era of “Great Moderation” prevailed through 2007 – one of low volatility and shallow downturns. Such conditions were used to justify increasingly lax lending standards (because few loans went bad amidst steadily rising asset values) and, because of the availability of credit and its low cost, a monumental expansion of leverage. All these things that propel markets higher, that limit downside volatility, that drive perceptions of risk lower, sow the seeds for periodic collapses such as the one in 2008, that are far more devastating than would happen otherwise.
With the taper approaching, and the recent Taper Tantrum all too vivid, the issue of bursting bubbles is suddenly front and center. So what happens if one assumes that 30% (or much more) of the market upside is due to the Fed – will stocks simple drop a perfect 30% and then stop. But nobody could have possibly seen it coming when it finally does come.
Implicit is that a 30% market drop might follow a full reversal of QE policies. But equity investors who have embraced a momentum strategy are ill-prepared for a policy change that could reverse the market’s artificial gains. What will happen when the Fed declares, as it someday must, that the era of artificially low interest rates is at an end? Or if another serious crisis—economic, political, international—materializes and governments have insufficient ammunition to intervene? The content, though not the timing, of the next chapter in market history is quite predictable. Few will say they saw it coming, though, in fact, everyone could have seen it if they had only chosen to take off their blinders and look.
On the free lunch and “printing our way to prosperity“
There is no free lunch in economics: if governments could print or borrow money in astronomical amounts without any major adverse consequences, why wouldn’t they always do this, forever avoiding downturns while their countries bask in the sunshine of limitless prosperity? Indeed, it seems clear that prior misplaced confidence in the Fed contributed greatly to years of complacency that turned the 2008 downturn into a full-blown crisis. Of course there will be a price to pay for today’s policy excesses—an equal and opposite reaction. We just haven’t seen it yet. Will it take the form of a collapse of the dollar and the end of dollar hegemony, high interest rates, failed auctions of U.S. government securities and runaway inflation, a wrenching and protracted downturn requiring exceptional sacrifice, or something else’? We will find out soon enough
On “perhaps trying capitalism” for a change:
Leverage is always a double-edged sword, and in 2007 excessive leverage at all levels of the economy had eroded our nation’s margin of safety. When things went wrong in 2008, we’ had nothing to fall back on. There was no room for error, little cushion to give us time to refocus and rebuild. Today, with massive deficits and even higher government debt, we have less margin for error than we did four years ago. What might we do instead of today’s unsuccessful, misguided, and dangerous programs? Jim Grant, in a CNBC interview several months ago, had one suggestion: perhaps we should try capitalism. Let’s allow markets to operate freely; let’s allow the invisible hand to work its magic; let’s once again permit failure.
On the Fed’s attempts to eradicate the business cycle.
Nassim Taleb, author of the new book, Antifragile, praises volatility and criticizes those who would artificially dampen it at great unseen cost. Taleb writes: Stifling natural fluctuations masks real problems, causing the explosions to be both delayed and more intense when they do take place. As with the flammable material accumulating on the forest floor in the absence of forest fires, problems hide in the absence of stressors and the resulting cumulative harm can take on tragic proportions. And yet our economic policy makers have often aimed for maximum stability, even attempting to eradicate the business cycle.”
On the chorus of “but not yet“:
Two problems are upon us at once: short-term stimulus that is unaffordable and unsustainable entitlements that must be reined in. But restoring fiscal sanity by reducing spending and raising receipts will be bad in the short run for the economy and financial markets. What Treasury official or politician would want the cash spigot turned off before a recovery is certain? Recipients of government handouts would grumble at the prospective termination of government policies that offer them outsized benefits. We’ve seen what that looks tike in cities across Europe. Which explains the endless chorus of “but not yet.” One sees this in editorials and commentaries, such as the ones saying it’s time to close down bankrupt Fannie Mae and Freddie Mac, but not yet, because doing so might harm the housing market. There will never be a good time to end housing support programs, reverse quantitative easing policies, or reduce massive budget deficits—because doing so will restrict growth and depress stock prices. Nor will there be a good time to cut entitlement programs or to solve Social Security or Medicare underfunding. Most will always agree the stimulus cannot go on forever, that excessive entitlements must be reined in, “but not yet”
On the Fed’s “no way out” policy:
A juiced-up stock market is seen as stability? A policy that creates such “stability” and from which there is no apparent exit is seen as wise and even successful? And the policy must be continued because it was so ill-conceived that it cannot be ended? The Greenspan-Bernanke put exists because even the hint of a minor economic downturn has for decades been viewed by government officials as a crisis so extreme that it must be warded off at all costs. Thus, we have created the twin illusions of limitless prosperity and the taming of economic volatility at the high cost of ever-expanding deficits, overleverage in the consumer and government sectors, extreme moral hazard, and episodic market meltdowns. Economist Hyman Minsky has posited the simple but brilliant notion that stability leads to instability. Low economic volatility, by enticing lenders to make low-cost loans available to historically risky borrowers and by encouraging borrowers to take on ultimately unaffordable debts, creates conditions ripe for destabilizing credit hubbies to form, expand, and eventually collapse.
A few days ago, coincidentally, we presented thoughts from GMO’s James Montier musing if there no longer is a mean reversion. To Klarman this, even hypothetically, is pure hogwash – mean reversion always, eventually, comes back.
While zero rate policy is somewhere between financial catnip and heroin to investors, one of the most powerful concepts in finance is reversion to the mean, Jeremy Grantham is perhaps the most articulate proponent of this concept. Across all markets and asset classes, valuations eventually revert to the mean. While you can never tell in advance precisely when they will end, all bubbles, which he defines as valuations more than two standard deviations above trend-line, eventually reverse. The psychology that allows bubbles to form always breaks, sometimes on a dime. This is not just theoretical; looking back over the centuries, Jeremy has the data that prove it.
As we discussed first nearly four years ago, when we predicted that the inevitable outcome of a global all-in central bank “put” would be market gyrations of ever greater amplitude and ever higher frequency, what will happen when reality eventually resurfaces will be an epic collapse, which will be offset by even more of the same failed central planning “tools” and even more bailouts, and so on, until it finally all ends.
Government effort to pump stocks higher is expensive and distortive. And if the impact will only be ephemeral, if what goes up is certain to come back down, then the consequence is bound to be increased volatility, more financial catastrophe, and possibly an endless cycle of propping up followed by collapse, perhaps with greater and greater amplitude and, looking back, ultimately without any purpose other than as a short-term palliative for psychological or political purposes.
On how the government’s manipulation leads directly to unprecedented social and class disparity – a very acute problem in a world with record youth unemployment and replete with daily protests and riots, as the fabric of society slowly but surely tears apart.
Government manipulation of stock prices to unnaturally high levels is economically destructive because the wrong market signals are sent and society’s resources are potentially massively misallocated. It also at least temporarily accentuates wealth disparities that undermine social cohesion. Indeed, they may have coaxed out additional production of assets already in excess supply, such as housing and office building which, if truly unneeded, would only exacerbate losses in the next economic downturn. Worse still—and this is one of my great fears–I’m certain that in the minds ofFed and Treasury officials, government actions since 2008 have been a great success and as such will figure prominently in the playbook they will leave on the shelf for their successors
On going bankrupt as a nation: “Gradually, and then suddenly”
There is no precise level where debt becomes excessive. It depends on the vicissitudes of investors and the vagaries of the markets. When asked how he went bankrupt, Hemingway’s character, Mike Campbell, in The Sun Also Rises, answered, “Gradually, and then suddenly.” An unknowable tipping point looms over the horizon. When we reach it outsiders and U.S. citizens alike will become increasingly suspicious of our creditworthiness causing interest rates to rise and the dollar to decline. No one knows precisely how much debt is too much, or at what moment the tipping point will be reached. It’s like driving a car with a faulty navigation system along a steep mountain road on a moonless night. Sooner or later, you’re going to plummet over the edge. By the time we reach that point, it will likely be too late.
In conclusion: we are living on a prayer.
We borrow heavily, spend a lot but invest very little, fail to address long-term problems allowing them to fester and compound, and leave ourselves at the mercy of creditors with little or no room for error. Should disaster suddenly strike—an act of God, a war, another Wall Street or financial market implosion—we would be in great trouble. No rational investor would want to rely on prayer or divine intervention for their future viability. No country should, either. I certainly don’t think we should feel good because we are less of a basket case than Europe or Japan. Getting our affairs in order to where we once again build in a margin of safety will take considerable time. We must get started right away.
Alas, we won’t.
Source: Seth Klarman remarks at a Private Meeting of Business Leaders