Baupost Sees Financial Risk When Monetary Support EndsKelly Bit and Inyoung Hwang
Seth Klarman, the hedge-fund manager who runs Boston-based Baupost Group LLC, said risks to financial markets today are in some ways greater than they were before the 2008 crisis once governments around the world halt their aggressive stimulus.
“The real downside scenario -- which concerns us greatly - - involves the end of the ‘free lunch’ of large deficits, zero interest rates, and relentless quantitative easing,” Klarman wrote in a 19-page year-end letter to Baupost investors obtained by Bloomberg News. “This story line would take the form of a currency, sovereign, or economic crisis inciting panic throughout the financial markets.”
Klarman, a bargain hunter and author of the 1991 book “The Margin of Safety,” is at odds with investors such as Ray Dalio, founder of hedge fund Bridgewater Associates LP, whose firm is betting that stock markets will rise this year as people start to spend and invest again. David Tepper, who runs the $15 billion hedge fund Appaloosa Management LP, and Carlyle Group LP co-founder David Rubenstein have said they’re positive on the U.S. economy.
Elaine Mann, a spokeswoman for Baupost, declined to comment on the letter.
Global stocks have rallied 10 percent in the past six months as investors have grown confident about the U.S. housing market recovery, European leaders’ steps to contain their debt crisis, and reports in China suggesting economic growth is accelerating. Fed Chairman Ben S. Bernanke signaled Jan. 31 he isn’t close to easing up on $85 billion in monthly bond purchases to spur the economy and bring down unemployment, which climbed last month to 7.9 percent from 7.8 percent in November and December.
Once central banks around the world end stimulative policies, investors who “bore excessive risk will encounter substantial market value declines,” Klarman wrote. “The underpinnings of our economy and financial system are so precarious that the unabating risks of collapse dwarf all other factors.”
The European sovereign debt crisis remains a threat to the global economy, Klarman wrote, in contrast to Bridgewater’s co-chief investment officer Bob Prince, who said on a client conference call on Jan. 23 that risk in the region “dropped substantially” following European Central Bank President Mario Draghi’s comments in July that the ECB was committed to preserving the euro.
Bridgewater expects cash to move to riskier holdings, which would support an increase in the value of assets and improve balance sheets, credit and economic growth until the Federal Reserve moves toward tighter policy.
“The sovereign debt crisis and Eurozone fiscal imbalances remain grievous threats to the global economy,” Klarman wrote. Draghi’s actions “are keeping market forces temporarily at bay, but when they re-emerge another day of reckoning will be at hand.”
Klarman said investing may be harder than any time in the last 30 years and called 2012 “profitable but frustrating” as low interest rates pressured investors to pile into risky assets, which made finding bargain investments difficult. Baupost’s year-end return was “not scintillating,” he said, without specifying. The firm held about 30 percent cash throughout the year, he said.
“For much of the year, it felt as if we were all dressed up with no place to go,” Klarman wrote in the letter. “Investing today may well be harder than it has been at any time in our three decades of existence.”
Klarman expects 2013 to be a reprise of 2012, as low interest rates will push yield-starved investors into the market, and opportunities for bargain-seekers will shrink.
Low levels of volatility, or the swings in asset prices, in combination with the Fed’s three rounds of unprecedented asset purchases and interest rates near zero have made it difficult to identify attractive investments, Klarman said. The Chicago Board Options Exchange Volatility Index, the gauge of S&P 500 options prices known as the VIX, fell to 12.46 on Feb. 15, near a 5 1/2-year low.
“Dampened volatility, accompanied by higher securities prices, is a challenge for Baupost,” Klarman said. “The Federal Reserve’s relentless interventions and manipulations (the ‘Bernanke put’) have truncated market declines, leaving relatively little worth acquiring -- at least for now.”
An eventual market or economic collapse may cause a decline in the U.S. dollar and increase in the price of gold, Klarman said.
“An unknowable tipping point looms over the horizon,” he wrote. “When we reach it, outsiders and U.S. citizens alike will become suspicious of our creditworthiness, causing interest rates to rise and the dollar to plummet. Holders of greenbacks will rush to spend their money while it still has some value, causing the prices of goods and stores of value (like gold) to surge.”
Klarman wrote the preface to the sixth edition of “Security Analysis,” a 1934 book by Benjamin Graham and David Dodd that is considered the bible of value investing. Baupost, which opened in 1983, employs an investment team of 43 analysts and six traders, Klarman said in the letter.