“I’m more worried about the world broadly than I’ve ever been in my whole career,” Seth Klarman via Reuters.
When Seth Klarman speaks people listen. The hedge fund manager and author of Margin of Safety rarely speaks publicly, but when he does people listen. Earlier this week Klarman made some decidedly bearish comments talking about the risk of another lost decade for stocks. From a piece by Brett Arends at WSJ.com:
Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. “Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns,” he said. His firm is holding a remarkable 30% of its assets in cash.
Tariq Ali at Street Capitalist and Jay at market folly both note that holding cash is consistent with Klarman’s philosophy of going to cash when valuations are seemingly out of whack. Klarman undoubtedly is holding that cash in anticipation of investment opportunities down the road.
This view of the world is echoed somewhat today by Paul Krugman who compares the situation in the US to that of Japan. Economic stagnation of the sort contemplated by Krugman would surely feedback into poor performance for the equity market.
This line of thinking has been echoed in the discussions surrounding the stock market and what kind of equity risk premium investors should expect going forward. Stephen Gandel at the Curious Capitalist thinks this sort of debate is healthy . What is interesting not that the equity risk premium is under debate. That debate is long standing. What is interesting is that it is generally based on the notion of little (or no) equity risk premium.
Some like Allison Schrager at Free exchange contend that this notion is dominated by the past decade of data which has seen little incentive to hold stocks over bonds (or cash). While the past few years have highlighted the risks of stocks it is hard to believe that we should expect no extra compensation going forward for that risk.
Allen Matich at The Source notes that while volatility is unlikely to stay at these elevated levels for long it still behooves investors ought to be “plugging higher risk premiums into their equations.” Due in large part to above trend valuations. Felix Salmon at Reuters thinks this debate is useful for the following reason:
In any case, it’s pretty clear that the number of people with large stock-market investments is much greater than the number of people who really understand the full range of possible outcomes and are comfortable with how much they could lose in the markets if things go badly.
To which we would agree. Not too long ago we invoked the concept of uncertainty vs. risk in regards to the stock market. Some argue that academic finance’s focus on risk (as measured by volatility) is wrongheaded. Mebane Faber at World Beta pulled a quote from the new Andrew Redleaf book which argues just the opposite. That the “reduction of risk is the key to prosperity” not its embrace.
Nor is the equity risk premium (and risk itself) the only concept in academic finance under debate. The entire concept of portfolio theory is also being examined more closely. While the math of portfolio theory continues to hold, its practical use and implementation are now coming into question. It is beyond the scope of this post to discuss modern portfolio theory, but we noted in earlier linkfests pieces at Institutional Investor an Invest With An Edge.
Read incorrectly one could take all the above as a reason to stick one’s risk capital in T-bills for the next decade. However the next decade is unlikely to play out according to this “lost decade” script. In all likelihood we will see some other outcome (better or worse) than that contemplated as of late.
However even in a “lost decade for stocks” scenario there are going to be opportunities along the way. As we have discussed previously stock picking skills will be of great value in a period of increased volatility. Opportunities might come in other parts of the corporate credit structure or in markets not even recognized as such today.
What will be key going forward as we have previously written is operating with a margin of safety. That sounds a lot like what Seth Klarman is doing. By all accounts this approach isn’t easy. While Klarman may be holding 30% cash at the moment he is still looking far and wide for opportunities. When he sees them he will undoubtedly be willing to put that capital at risk. In short, don’t let a lost decade for stocks turn into a lost opportunity as well.