Seth Klarman, round two

Yesterday I wrote about the concerns voiced by veteran hedge fund manager Seth Klarman about the current state of global securities markets.  He appears to have three main worries:

1.  he can’t find ultra-cheap things to buy.  As far as the stock market goes, there are no more deeply undervalued, asset-rich companies.  In the way he operates, this means he goes to cash, awaiting the next big market decline before reinvesting.

2.  he sees rampant speculation, particularly in the bond market.  This will not end well when the Fed begins a long period of money policy tightening.

3.  Stocks won’t escape unscathed.  They went up by 30% least year;  issues like TSLA, NFLX, AMZN are at crazy-high prices.

My thoughts:

1.  Bonds are at much greater risk than stocks:

–the speculative stretch for yield in fixed income is much more widespread than the speculative stretch for growth in company earnings.  The latter is a relatively recent phenomenon, I think, and is centered on a relatively small number of issues.

–stocks have had two sharp and very painful declines over the past 15 years.  Bonds, in contrast, have had smooth sailing for a generation.  To me, this means that veteran bond managers have been trained by long experience that being very aggressive–even to the point of buying ostensibly overvalued securities–always pays off.  This is like the (loony) momentum players who ran Janus in the late 1990s, only on a larger scale.  Having been burned twice in recent memory, the stock portfolio managers who have survived both downturns will be more conservative.

–in past periods of Fed tightening, stocks have gone sideways while bonds declined.  That’s because rising corporate earnings resulting from an improving economy have offset for stocks the negative effect of higher rates.

2.  No one really knows what will happen as the Fed tightens this time.  The Fed freely admits this.  During past tightening periods, short rates have risen by ~200 basis points.  This time the Fed is officially saying that “normal” for the Fed Funds rate is ~400 basis points higher than the current zero (personally, I think this is too high).  Arguably, part of the associated adjustment in long rates has already occurred, when Mr. Bernanke raised the possibility of tapering last year.  Still, the road back to normal is much longer than anything I’ve seen before.

Also, it’s not clear to me how much the Fed is motivated by wanting to quash the speculation Mr. Klarman points to, rather than by seeing rude economic strength.  If it’s more the former than the latter, corporate earnings may not be strong enough to keep stocks from declining.

3.  How far could securities fall?

For bonds, I have no clue.  I suspect most of the damage will be in things like the recently issued TSLA convertibles and in similar low coupon, long-dated corporate bonds.  No-covenant junk bonds won’t win any prizes, either.

For stocks, we’re not talking about the destruction of the world financial system and the complete cessation of industrial activity.  We know that that scenario led to a 50% decline from a speculative high in 2007.  A garden-variety bear market, meaning down 20%-30%?  I don’t see that either, since I don’t think recession is imminent.  Down 10%?  It’s possible.

4.  What to do now?

Better said, what I’m doing now.

I’m becoming mildly more defensive, and then waiting to see how the stock market develops.  This means three things:

–I’ve already accelerated sale of the clunkers I’ve identified in my portfoiio.  I’m also eyeing smaller, more speculative ideas, like SPLK, to do the same

–I’m looking at my largest positions and deciding how far to cut them back

–I’m focusing on low current PE as a criterion for stocks to add.

To sum things up, I think we’re leaving a TSLA market and entering a MSFT one, where the here and now is much more important than possible earnings a half-decade away.


One more point:  price action over the past week or so may provide valuable clues about how the stock market is reorienting itself.

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