For Seth Klarman, founder and president of the Boston-based Baupost Group, last fall was a period that offered many of those opportunities. He delivered the keynote lecture at the annual meeting of the Boston Security Analysts Society last week.
Klarman called the market rally that began in March “increasingly speculative” and driven by investors who “looked for and saw green shoots – or thought they did.” He questioned whether we can know if things are “stabilizing or pausing before they get worse.”
Recently, Klarman has spent a lot of time thinking about what a bear market rally would look like. He concluded that it would closely resemble the current rally – a bold move, fueled by speculation based on green shoots or similar wishful thinking, led by more speculative securities.
The rally has led some investors – who six months ago would have “cut a deal with the devil to stabilize their portfolios” – to resume speculating on shares that have risen two- or three-fold in the current rally.
“The pressure not to lose has been replaced by the pressure not to miss out,” he said, and that fear leads to speculation, not investing. Indeed, such speculation combines the two motivations that are anathema to rational, long-term investors like Klarman: “The fear of missing out on a rally is greed, not fear,” he said.
Klarman did not offer any forecasts for the economy or the market. Such forecasting would belie his investment style, which focuses on individual security valuation and purchasing undervalued assets, not on betting that the economy or the market is headed in a particular direction.
“Value investors don’t know what will come next,” he said. “They must focus on the issue of price versus value and owning things because they are cheap.” The problem, he noted, is that undervalued stocks can remain cheap for a long time.
Inflation, however, is one outcome that Klarman clearly fears, and he has taken out “massive” portfolio protection through interest rate caps and swaptions, he said. He prefers these two hedging techniques because he pays a one-time premium and can tailor them to the maturities he wants to protect. If rates do go up, he can take the protection off.
Klarman does not like TIPS because he doesn’t trust the government’s calculations of the inflation index, and he isn’t inclined to make a meaningful bet on his portfolio with gold at current price levels because of the high opportunity cost.
Klarman said to ignore the noise and the “idiots on cable TV” and instead to form an opinion and act on it, divorcing one’s decisions from short-term price movements. Investing requires the right temperament and the right business model – one that focuses on long-term value creation.
Markets will pay a price for government actions, but he is not sure whether that price will be inflation, a loss of faith in the dollar, or both.
Another dilemma is whether Americans would be willing to accept the pain of slower growth, if that turns out to be the only way out of the crisis.
The biggest question in Klarman’s mind concerns moral hazard, and whether the government has created “the mother of all moral hazards” by instilling a belief in investors’ minds that all crises can and will be solved by government actions. Such a belief, he fears, would skew every investment decision toward unnecessary risk taking.