market folly

Seth Klarman has released Baupost Group's 2018 year-end letter and it's already received some media coverage which we linked to yesterday regarding his thoughts on rising global uncertainty, rising division in America, and growing global debt.  As always, he seems to have a cautious stance.  Below are further excerpts from the letter that are more investment-focused.  For 2018, Baupost's funds finished between flat and down less than 1% for the year. 

"Today’s markets feel strange and enigmatic. We will not complain about this; indeed, we see it as an opportunity. While the indices remain historically expensive, many stocks – of growing, not cyclical or declining firms – recently hit 52-week lows and trade at single-digit P/Es. These are levels that traditionally occur closer to market bottoms than tops. The recent selloff likely presented a buying opportunity – you can go years without seeing such valuations – but not across the board and not one for the faint of heart."

Klarman also postulated that private equity might have been the most over-extended asset class last year and wondered if the trend could continue as their tailwinds of low interest rates starts and a growing economy start fading away.

The Baupost founder also expressed another area of concern:

"Moreover, we have been increasingly worried that the U.S. financial markets are very highly leveraged not only with copious direct borrowings but also in less obvious ways – psychologically, algorithmically, and structurally – with investors vulnerable to exactly the same sort of urgent pressures that actual portfolio leverage can give rise to. As with a margin call, those pressures can include an intensely short- term orientation, extreme loss resistance, and an inability to stand apart from a panicky crowd."

As it pertains to psychological leverage, he notes that complacency has risen with the reduction of volatility.  And this complacency can then violently swing the other direction once volatility picks up (as the market showed in its recent sell-off).

Regarding algorithmic trading, his point is that with as much as 85% of all trading being done by machines, it's really hard to predict how these algorithms might react to new and/or unexpected conditions.

Lastly, index funds hold the lion's share of stocks these days and liquidity and ownership have become more concentrated, he notes.  This could cause a sharp impact on small cap companies.

Klarman then finishes up by touching on balancing risk-taking with risk aversion.  Baupost's strategy is to "forgo some upside in order to truncate the downside."  

"We believe another key element in portfolio management is curtailing the duration (the weighted average life) of one’s portfolio through exposure to investments with catalysts for the realization of underlying value. Catalytic events shift the outcome of investments from a reliance on future market multiples and macroeconomic developments (which are not at all under your control) to a dependence on your assessment of the outcomes, probabilities, and implications of announced or anticipated corporate events, including mergers and acquisitions, bond maturities, debt restructurings, bankruptcies, major corporate asset sales, spinoffs, and tender offers. No strategy can avoid all risk of loss. But we believe our approach should increase the likelihood of achieving sustainable gains with limited downside risk over the long- run. To put it differently, a portfolio of near infinite duration (such as an all equity portfolio without catalysts) can trade just about anywhere. With such exposures, if stock prices plummet, the odds go up that an investor will feel pressure to do the wrong thing and sell into market weakness. A limited duration portfolio, both because of the hopefully truncated downside in a bad market as well as the beneficial cash inflows (buying power) that catalysts usually generate, is hugely advantageous in navigating through turmoil."

Baupost saw the recent sell-off as an opportunity in some equities, establishing new stakes, while also increasing and decreasing other stakes. 

That said, he is certainly concerned about growing global uncertainty, rising division in America, as well as rising global debt.