Recent Comments from Seth Klarman

                                            Elihu Vedder, The Pleiades, 1885

Seth Klarman, the founder and president of Baupost Group, is a highly successful and very conservative investor who formerly worked with Max Heine and Michael Price at Mutual Shares. Klarman's own funds have continued in the value tradition and are known for holding high levels of cash, investing in distressed situations, and using a variety of hedging methods.

It is unfortunate that Klarman makes few public statements, because his portfolios have averaged an annual return of around 20% since the founding of Baupost in 1982 and 17% over the past decade, a period when equity index returns have been flat. Fortunately, some of his remarks at the recent annual meeting of the CFA Institute have appeared in the press, and Jason Zweig published additional comments in the Wall Street Journal.

Currency Devaluation Threat

The world seems to be in deflationary mode right now, but Klarman is looking at the future. "Will money be worth anything if governments keep intervening anytime there's a crisis to prop things up?" The point is that it doesn't matter if you make wise investment allocations, because you will lose money anyway if that money is in a depreciating currency. If all currencies suffer relative to real things, you can lose out in any currency. For that reason, Klarman said, "I am more worried about the world, more broadly, than I ever have been in my career."

Cheap Inflation Hedges

If the government is borrowing every-increasing amounts, what to do? Klarman's Baupost funds are focusing on the "tail risk" that bond prices will increase not modestly, but to levels unheard of in the US since the inflation of the 1970s. Baupost's response is to purchase "way out-of-the money puts on bonds" because "It's cheap disaster insurance for five years out." Focusing on tail risk means that Baupost holds options that will expire worthless if long-term interest rates rise to the 6 percent to 7 percent level, but will appreciate considerably if long-term rates rise to the 10 percent range, and 50 to 100 times if long rates pass 20 percent.

Traditional Hedges Are Expensive

Klarman has a very specific reason for using options on bonds to protect against future inflation and currency devaluation, rather than some other vehicle: "All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive." This applies also to gold: "Near its all-time high, it's a very hard moment to recommend gold."

What to Think of This?

Not everyone would agree that expanding government debts will lead to inflation and a declining currency. As many people like to point out, the US is not Greece. Our debt is denominated in our own currency, and the government can simply rearrange accounting entries to control the amounts in various accounts. In this view, higher bond rates (and associated troubles managing debt) are not as inevitable as Klarman asserts. Because the whole issue is subject to credible contending opinions, it is interesting that someone with Klarman's investing record does view bond rates as a substantial risk. He is not alone.

Patient Value Strategy

If traditional hedges are expensive, what is the individual investor to do when faced by hyperinflation and declining purchasing power? Not surprisingly, a value investor like Klarman advises buying things that are "out of favor, loathed, and despised". So, all that is needed, according to him, is to have patience and fortitude -- wait until things are hated that they are cheap, and then buy them. For example, Klarman is looking into private commercial real estate, although he cautions that publicly-traded REITs are "quite unattractive" because they have "rallied enormously."

Investing When Government Determines the Winners and the Losers

This blog has previously complained of the difficulty of investing when traditional valuation measures have lost their meaning, and government policies determine the winners and losers. Klarman has the same complaint: "There is nothing natural in the markets. Everything is being manipulated by the government." Zweig's article mentions that Klarman compared the financial markets to a Hostess Twinkie in a recent newsletter.

"The government is now in the business of giving bad advice." He explained this comment as follows: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

You may have noticed that, despite these complaints about government interference, Klarman is still plugging his value approach to investing.

Recent Comments from David Rosenberg

                           Henri Matisse, Harmony in Red

Over the past few months this blog has summarized the views of several market observers, mainly those with bearish, deflationary views. It's time for an update, this time from David Rosenberg, the Chief Economist at Gluskin-Sheff, whose "Breakfast with Dave" letters you may have seen quoted from time to time in the financial news.  He continued to lay out a cautious, deflationary line in the May 24 letter and a recent interview on Bloomberg Radio.

Regarding the markets at present, Rosenberg advises investors "to be patient and disciplined" and avoid the often-heard advice to buy at the lower prices offered by the recent market selloff.  In his view, another decline in the financial markets is coming due to economic risks, in contrast to the financial risks (European debt concerns among them) that triggered the latest nosedive in stocks.

In support of this view, he cites an impressive list of leading economic indicators suggesting that the two-quarter long V-shaped recovery will turn south. Just a few of the indicators that have already peaked include the leading economic indicators of the Economic Cycle Research Institute and the Conference Board, the orders/inventory ratio of the Institute for Supply Management, and mortgage purchase applications.

"One of our primary themes has been deflation," at least in part because of price trends, extreme low interest rates, and declining real income excluding government transfers. This fits into Rosenberg's view that current economic problems are more structural than cyclical in nature.

Given the structural problems with the economy, the next recession is coming soon, rather than years away, and it will lead to "pernicious deflation", in Rosenberg's view. With so few policy options left, healso  thinks that to counter these pernicious effects the Fed will be forced to engage in quantitative easing again and expand its balance sheet even more.

As Rosenberg said in the interview "that's why gold is going to be making new all time highs." Despite this long term view, in the near term he advised caution because gold has become "a very crowded trade; better pricing points likely lie ahead."  It is no wonder that he is bullish on gold in the longer term, given that he says (not surprisingly) that "critical issues at the sovereign level" and "a crisis in confidence" are the root of the troubles in the financial markets.

This Is Fiscal Austerity: California Sacrifices the Old, the Disabled, the Children of the Poor

To solve its budget crisis, California has decided to dismantle programs that preserve the lives and health of its most helpless citizens.

Faced with a fiscal deficit that totals 20% of its annual budget, Governor Schwarzenegger decided that the best path to austerity was to cut support for those who cannot defend themselves. The trouble is that, because the Federal government also contributes money, court judgments have prevented California from going through with attempts to scale back these programs. So, the Terminator proposed a budget that will do away with the programs entirely.

The programs eliminated include home healthcare for the elderly and disabled, a nearly $2-billion program that serves 440,000 Californians, and the Healthy Families program, which uses federal money to help provide health insurance for about 900,000 low-income children.

As the San Jose Mercury noted last week, more single mothers and their children will be homeless and hungry, more mentally ill people will be in jail, more old people will be forced into nursing homes. In California, no one will look after poor children while their parents work, look after shut-ins, buy food for low-income seniors, of take in the homeless.

These are the kinds of actions and consequences that reveal where the values of our country's supercilious voters and politicians really lie. These are the kinds of values that put to the lie to the self-righteous rhetoric of "value" obsessed electorates.

Rather than bear the consequences of their own past foolishness, the politicians and the vast bulk of the electorate will simply shift the punishment onto the helpless. Presumably, the electorate and their leaders will have no trouble ignoring the suffering that they cause now, any more than they were troubled by their past foolishness.

Maybe citizens should be more concerned about how fiscal austerity is implemented.

Do they think that today's poor are the only losers? Think again, because there are more jobs to be lost, and more homes to be foreclosed.

Do they think that fiscal austerity is only for other states or other countries? Think again, because California isn't the only state in budget trouble, and Greece isn't the only Western country in budget trouble.

Painful fiscal austerity should soon be coming to more states. Just hope that it is not coming to your home.

We Will Defend the Euro Whatever It Takes

Last weekend, European Commission President Jose Manuel Barroso said: "We will defend the euro whatever it takes."

This was after French President Nicolas Sarkozy and German Chancellor Angela Merkel announced that Europe will set up an intervention mechanism to calm markets rattled by the Greek debt crisis, and stave off any attack against weakened nations whose financial systems are at risk.  Sarkozy and Merkel also said laid out a plan to defend the euro against "speculators", which led to Barroso's statement.

This is just a stopgap, and it does nothing to eliminate the underlying problems -- low productivity of southern European nations, high debt loads all over Europe, unrealistic social commitments, higher growth in the rest of the world.  If it takes $1T at this initial stage of the crisis, what will it take later?  What will they do when the next southern European country reaches crisis stage?  If the ECB has to buy government bonds, they are just monetizing debt (while holding toxic assets).  The underlying problems will remain, which raises the risk that eventually debts will be defaulted or inflated away, and that the EU will face some kind of political rearrangement in the future.

"Whatever it takes"?   The real problems are just being postponed.

The China Real Estate Bubble

Jim Chanos Interview

You probably know that Kynikos Associates Ltd and its founder, Jim Chanos, are shorting property developers and building suppliers in China. In an interview that will soon air on the Charlie Rose Show, Chanos provided some information on the Chinese property bubble, as well as a contrarian opinion on the Renminbi.

According to Chanos, China needs to keep up the pace of property investment because up to 60 percent of its gross domestic product relies on construction. "They can’t afford to get off this heroin of property development. It is the only thing keeping the economic growth numbers growing." Chinese state and local governments are among the most leveraged to property-related borrowings among all government entities around the world. Chanos also said that the bubble may start to burst perhaps later this year or in 2011.

How the Property Collapse May Play Out

Most observers probably expect the property bubble to collapse and result in a banking crisis, although others remain optimistic that China can mop up the effects of any financial bubble without ill effects. Chanos said that China will "ultimately" have to nationalize a lot of the bad loans from the property bubble, and that its foreign currency reserves will be "one asset" available to clean up the banking system. It would be useful to know more about how the collapse will play out, however.

Several Years of Sub-Par Growth

A good source is a recent article by Michael Pettis, Who Will Pay for China's Bad Loans, which argues that China will have a heavy price to pay for its excessive investment in the property sector, but not in the form of a banking collapse. Pettis is worth listening to as an expert on Chinese financial matters, in view of his position as a professor at Peking University’s Guanghua School of Management, and a Senior Associate at the Carnegie Endowment for International Peace.

Pettis says that we can learn a lot from the situation a decade ago when China had a huge surge in non-performing loans, the cleaning up of which was to cost China 40% of GDP. Although China paid a very high price for this earlier banking crisis, that price came not in the form of a banking collapse but rather in the form of a collapse in consumption growth. GDP growth was trimmed by several percentage points as households cut back consumption and raised savings in response to government policies. Money transferred from the household sector to the banks served to fund very low lending rates and to guarantee sufficient bank profitability to rebuild capital, avoiding a banking crisis.

Because at that time US leverage was rising and the world growing quickly, the cost of the collapse in consumption was easily masked by China’s surging trade surplus. Today, however, the US and the rest of the developed world are deleveraging rather than leveraging up. If China cannot rely on growing exports, the only acceptable alternative will be to increase household consumption. The problem is, as Pettis says: "But since growth in household consumption has always been constrained by the growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharp increase in non-performing loans."

Pettis's conclusion is that the price China pays for the present bubble may be several years of below-average growth.

Implications for the Renminbi

Despite recent widespread anticipation of an upward revaluation of the Renminbi, it is possible that a collapsing property bubble could lead to a decline in the value of the Chinese People's currency in dollar terms. In another report of the interview Chanos was quoted as saying: "Chinese exports aren't the problem here. And what if it turns out that by having to nationalize lots and lots of real estate bad debts, the RMB is devalued." It is interesting that the latest month's data from China did show that the trade balance has deteriorated sharply, although this announcement was, just incidentally, immediately prior to talks with Treasury Secretary Timothy Geithner about exchange rate and trade issues.

Property Debt Continues to Increase

In an online article for China International Business, former Morgan Stanley analyst Andy Xie described the massive size of the property bubble and how destabilizing it is socially for land to continue be so unaffordable as to slow the growth of the middle class. An interesting takeaway is that the bubble may continue to build, and that it will be very difficult to predict the timing of the collapse.  "The bubble can still continue because China's banking system has plenty of liquidity – thanks partly to hot money and because local governments have many levers to channel bank liquidity into the market. But the longer the bubble lasts, the more damage it will do to the economy."

Collateral Damage

It is hard to imagine how a country can avoid financial collapse when it has incurred so much debt for so many unproductive assets.  In fact, China has been over-investing in fixed assets of all kinds, including industrial capacity, for some time and not just housing property.  The problem is that many firms in the US and other developed countries are involved in sectors throughout the Chinese economy, which makes one wonder:  Which firms will suffer the most, and how far will the damage go?

Cyclical Upturn within a Structural Decline

There is an interesting presentation from the Economic Cycle Research Institute (ECRI) indicating that the US economy has been recovering from the Great Recession and suggesting that the recovery may continue for a while.

They suggest that, from a cyclical perspective, we are about to see higher inflation, more employment, and higher levels of economic activity.  This does not sound good for bonds in the near future.

There is an interesting divergence between this good news about the immediate future of the economy and implications for the longer term.  The presentation includes several decades of economic data series indicating that the magnitude of US economic recoveries has been declining for a number of decades, and that economic volatility is declining (less difference between peaks and troughs).  This means that the US economy is spending a greater proportion of the time in a state of economic contraction or at very low levels of economic activity.

ECRI suggests that unemployment may have peaked for this cycle, but the news on employment is not totally happy.  The shortening of the expansion phase of the cycle has some sobering implications, including: Job growth during this expansion, if it continues, is unlikely to compensate for the jobs lost during the recession.  ECRI's indicators also suggest that inflation is increasing, which would  not bode well for bonds.

Changing topics to the stock market,  the stock market looks expensive now, and the prospects for very mild growth do not bode well for improved valuations.  For a good source of information on that topic, John Hussman's weekly commentaries contain useful perspectives, as well as references to other sources of information on stock market valuation.