Seth Klarman is undoubtedly one of world's top money managers. Klarman is one of the most successful exponents of the philosophy known as value investing, fathered by Benjamin Graham and popularized by Warren Buffett. His fund, The Baupost Group, has grown into a $30b beast, despite generally eschewing leverage, and has racked up mid-teen returns over its lifetime, which is a truly impressive feat. Klarman's book, Margin of Safety, sells for an absurdly high price on Amazon, because it's out of print, and his insights are understandably sought after (you can, however, find free copies on the Internet - that's arbitrage for you!).
But even the rich and brilliant should be challenged. In late 2010, Klarman and a host of other investors, economists and commentators penned an open letter to Ben Bernanke, asking him to reconsider and refrain from further monetary easing. In his latest investor letter, Klarman is full of disdain for the Fed. Here are some choice excerpts:
- "Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won't be free. Someday, corporate failure will be permitted."
- "As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that Fed's itinerary is bound to be exceptional, each stop more exciting than before. Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly."
- Comparing the US economy to The Truman Show, where the lead character lives in a totally fabricated, made-for-TV environment: "Every Truman under Bernanke's dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no-one wants it to end, and no-one want to exit the dome until they're sure everyone else won't stay on forever."
All investors are entitled to their own views of where the economy is headed. As I discussed in a previous post, that call can sometimes make or break an investment. It's worth pointing out that Klarman is no bull - he is, after all, returning $4b in capital to his investors due to concerns about market valuations. But he's not alone among value investors in chiding the Fed. Fellow successful value disciple David Einhorn garnered a lot of attention for comparing Fed policy to a steady diet of jelly donuts. Value junkie and financial writer Jim Grant continually bashes Fed policy, and even gets quoted by Klarman in the letter: "the Fed can change how things look, it cannot change what things are."
Please don't misunderstand me here - I'm neither wildly bullish on the prospects for equities in the near-term, nor a devout supporter of all Fed policy. I don't even mean to disparage the value philosophy. Applied correctly, it is a powerful foil to human tendencies to over-optimism and faddishness. (However, I'm critical of dogmatic value investing, which Aswath Damodaran demolishes quite effectively here and here.) And ironically, the decision to return investor capital could look very bright in retrospect for exactly the wrong reason, i.e. a concerted tightening by the Fed and the PBoC while the ECB dithers. But part of the challenge of investing, or analyzing its success, is trying to be right for the right reasons. It would be equally disappointing if value investors resorted to what I've called "the Zhou Enlai theory of monetary policy." It's often reported that Zhou, when asked in 1972 what he thought of the French Revolution, responded that it was too early to tell. Ignoring the fact that this story is almost certainly apocryphal, it's disingenuous to say "we don't know yet what the results of Fed policy have been" unless you set up an explicit counterfactual, or provide a prediction of what you think will happen and in what timeframe. At some point, no doubt, the economy will turn down and financial crisis will ensue... but sorry, you don't get any prizes for stating the obvious.
My question is, why do value investors hate the Fed? One answer that I'll reject out of hand is that Klarman and his friends are rich hedge fund types who are indifferent to the suffering of the unemployed and luckless. Klarman, for example, is renowned for his philanthropy,as is Elliott Associates' Paul Singer. I believe Klarman, Singer, Chanos et al when they say they are genuinely concerned that Fed policy will harm the economy. Perhaps the question I mean to ask is "why are value investors more predisposed to look unfavourably upon Fed action?" Here are some possible answers:
1) The correlation is not between value investors and Fed-haters, but between conservatives and Fed-haters. Despite the best efforts of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis (among others) , conservatives still seem more likely to view Fed policy as pernicious. It just so happens that many value investors are conservatives (although we should then ask why...) - Jonathan Haidt and Miles Kimball would probably suggest that value investors/conservatives have strong leanings towards karmic retribution.
2) It's a subconscious response to stocks becoming fairly valued. Buffett once said he was like "an oversexed guy in a harem" when stocks became cheap in the 1970s. I assume that means that when equities are fairly valued, he feels like, well, every guy of average libido. Perhaps this is a variation of Benjamin Cole's criticism that Richard Fisher gets upset when a strong economy raises rare book prices.
3) Value investors are broadly mean reversionists, and are trained to look for cycles & bubbles (unlike growth investors, who are more interested in secular stories). The Fed is an obvious contributor to the business cycle, and is therefore particularly odious to value investors. The existence of investor favourites like Tesla and Netflix is merely anecdotal, but reinforces value guys' belief that the cycle is turning.
Frankly, none of these seem like particularly strong theories to me. I'd appreciate comments with other theories - please, no comments saying "if you're so smart, why aren't you rich?". But let me end by saying that whether they like it or not, successful value investors owe the Fed. Those who have made their names buying at "cheap valuations" have profited from the fact that the Fed didn't pull a 1929 or a Japan. I can only assume Japanese value investing was a fool's errand for 20 years. And some of those who made their names shorting overvalued securities from 2006-2009 (whether it was the homebuilders, the bond insurers or banks) profited from the Fed's failure to stabilize nominal GDP. Not all of them, mind you - lots of these securities were over-valued given the industry conditions. But bearish bets were made to look much better by the economy's unimpeded march downwards. Sadly, the investors just don't seem to know it.