Exceprted from Seth Klarman's Baupost letter to investors,
We donât know now (nor do we ever know) what the overall market will do. As weâve discussed in recent letters, there are reasons for investors to be frightened but also numerous individual opportunities worth seizing. Todayâs limited opportunity set means that we are still holding sizable cash balances, about 35% of the portfolio at June 30. This dry powder will become more valuable if the markets become more turbulent.
Equity markets continue to hit successive record highs, volatility remains strikingly low in equity and most other markets, and inflation is ticking higher. Investors have clearly grown weary of worrying about risky scenarios that never seem to materialize or, when they do, donât seem to matter to anyone else. U.S. GDP, for example, was recently restated to minus 2.9% for the first quarter of 2014. Normally, this magnitude drop signals recession. Equities, nevertheless, marched relentlessly higher.
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In todayâs ebullient markets, we see many investors ratcheting up their own risk levels--buying substandard credits and piling up leverage are two favorite methods--in an attempt to generate near-term performance.
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The financial markets could be getting closer to an inflection point, where the economic weakness that the bond market seems to be reflecting derails the more optimistic equity market. Or perhaps things can go on forever exactly as they are: a âGoldilocksâ stock market resulting from a tepid economy, dampened volatility, and relentlessly low interest rates. Amidst the market rally, complacent investors continue to ignore a growing array of global trouble spots. Contrary to claims from the Obama Administration, the world is not a tranquil place at present. As such, risks facing investors seem to be rising but are not yet priced into the markets.
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Late in a market cycle--when bargains are increasingly hard to find, valuations are lofty, and most investors have been scoring handsome gains for a number of years--we can say from experience that history tends to rhyme. Money becomes more freely available to pursue even the most marginal of opportunities. Dollars pour into venture capital, and the largest buy-side firms take strategic stakes in hot, late-stage private investments just prior to an expected big money IPO. Specialized funds are raised, regularly and easily, to invest in things like Greek private investments, Spanish real estate, or European non-performing loan pools. Willing investors abound for these. It doesnât matter that market prices have mostly rebounded, prospective returns are thereby limited, and the capital in those funds is likely to be put to work whether or not prices warrant and even if conditions on the ground deteriorate. With investment bankers and hedge fund executives canvassing Europe today to bet on recovery, you have the increasingly common circumstance of proliferating âopportunity funds,â absent only the investment opportunity. Some clients of hedge funds today are, in a sense, disintermediating themselves, funding new entities to bid higher for the same sort of assets their other, more disciplined managers are already bidding more judiciously for. The discipline problem in this case is not that of the legacy managers; it may just be that of the clients.
The pressure to reach for return virtually ensures that many investors will take greater and greater risk for less and less potential reward at market peaks. If you canât find bonds that yield 8%, better grab those offering 6%. Or 4%. If you need 8% to meet your bogey (assumed pension fund returns, for example, or promised returns to investors), then you will be prone to own increasingly risky assets or leverage up the safer ones. These pressures, as much as any indicator, are today signaling danger. Investors today are bidding ever higher amidst frenzied competition to buy pools of non-performing loans, and then leveraging them up to get double-digit returns. Mortgage securities backed by questionable loans issued to dicey borrowers now trade close to par and yield a downright stingy 3-5% where they once yielded a generous 15-20%. A recent brokerage report excitedly touted the new HoldCo PIK Toggle notes of a Croatian consumer goods retailer. Nearly every word of that description is a flashing red light to seasoned investors.
To put it a bit differently, writer and investor John Mauldin is right when he says that there is âa bubble in complacency.â Fear has effectively been banished. The members of the Fed know it. Stock traders who chase the market to new highs almost daily know it. Implied volatilities (and realized volatilities) are historically low (the VIX Index recently hit a seven-year low), and falling. The Bank for International Settlements recently cautioned that financial markets are euphoric and in the grip of an aggressive search for yield. The S&P has gone over 1,000 days without a 10% decline, according to Birinyi Associates. Dutch and French 10-year government bond yields are at 500 and 250 year lows, respectively; Spain, 225 years. Spanish debt yields were recently inside of U.S. levels.
Increasingly, hopes and dreams are being capitalized as if the future is certain and nothing can go wrong, as if up cycles such as the present one donât inevitably sow the seeds of the next decline. The European Central Bank recently cut its deposit rate to an unprecedented minus 0.1%, and Mario Draghi assured that he isnât finished. Can this be done without consequence? Investors have become numb to risk because such policies continue, seemingly forever, and new measures (such as European and now even Chinese QE) are regularly threatened and claimed to be costless and reliably effective. We are far from convinced of this; indeed, the higher the level of valuations and the greater the level of complacency, the more there is to be concerned about. Even as reported inflation remains quite subdued, signs of incipient cost increases are increasingly evident. We are seeing them, for example, in apartment rents, construction costs, and salaries of newly minted engineering graduates and oilfield workers.
Like global equity markets, credit markets have been surprisingly resilient, and our worry meter is high here, too. Ecuador recently issued $2 billion of ten-year bonds, as the market shrugged off its 2008 default. Kenya also completed a $2 billion offering, the largest ever debt sale by an African country, according to The Wall Street Journal. That offering attracted $8 billion worth of bids. In the U.S., issuance of low-grade credit is at record levels, as is covenant-lite issuance. Yields are at or near historic lows, which is especially nutty for junk credits, including the hideously risky CCC-rated issues. June CLO issuance set a record. Given changes in regulation, Wall Street has far less capital available to support the trading of this burgeoning junk issuance and the corresponding surge in debt ETFs. A sudden change in rates or sentiment could lead to serious market instability. When is harder to predict than if. While we are not predicting imminent collapse (market timing is not our thing), we are saying that a selloff, greater volatility, and investor losses would hardly be surprising from todayâs levels.
In markets, itâs always hard to tell, in the words of the old commercial starring Ella Fitzgerald, Is it real or is it Memorex? Is the market nearly triple its spring 2009 level because things are better, or do things feel better because the market has nearly tripled? Indeed, we can do a simple thought experiment that might be revealing: How would everything feel if the S&P 500 were suddenly cut by one-third or one-half? Would such a drop drive astonishing bargains, or would the U.S. economy soon falter, with festering problems such as unemployment, the federal, state and local deficits, the long-term fiscal situation, and the creditworthiness of most sovereigns suddenly seeming ominous?
Itâs not hard to reach the conclusion that so many investors feel good not because things are good but because investors have been seduced into feeling goodâotherwise known as âthe wealth effect.â We really are far along in re-creating the markets of 2007, which felt great but were deeply unstable when shocks started to pile up. Even Janet Yellen sees âpockets of increasing risk-takingâ in the markets, yet she has made clear that she wonât raise rates to fight incipient bubbles. For all of our sakes, we really wish she would.
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