Baupost’s Seth Klarman compares investors to ‘frogs in boiling water’

// Seth Klarman, the founder of hedge fund Baupost Group, has told clients central bank policies and government stimulus have convinced investors that risk “has simply vanished”, leaving the market unable to fulfil its role as a price discovery mechanism.

The private letter to investors in his fund, which was seen by the Financial Times, amounts to a damning critique of recent market behaviour by one of the world’s foremost value investors.

Mr Klarman criticised the Federal Reserve for slashing rates and flooding the financial system with money since the onset of the coronavirus pandemic, arguing that the central bank’s moves have made it difficult to gauge the health of the US economy.

“With so much stimulus being deployed, trying to figure out if the economy is in recession is like trying to assess if you had a fever after you just took a large dose of aspirin,” he wrote. “But as with frogs in water that is slowly being heated to a boil, investors are being conditioned not to recognise the danger.”

The biggest problem with these unprecedented and sustained government and central bank interventions is that risks to capital become masked even as they mount

US stocks are up more than 75 per cent since their low in March, while spreads on corporate debt — a measure of how much extra interest corporate borrowers have to pay compared to the US government — returned to pre-Covid levels this month.

Mr Klarman — who founded Boston-based Baupost almost four decades ago and has grown it to $30bn in assets under management — underperformed the market in 2020.

He has been intensifying his criticisms of US central bank interventions for the past several months. In the latest quarterly letter, Mr Klarmen referred to the Fed as an “800-pound gorilla” that has priced out investors who typically provide liquidity in moments of distress.

“The biggest problem with these unprecedented and sustained government and central bank interventions is that risks to capital become masked even as they mount,” he said.

Mr Klarmen also said the Fed policies had exacerbated economic inequality, referring to a “K” shaped recovery that has seen “the fortunes of those already at the top bounding swiftly upward, while those at the bottom remain on a downslope without end”.

Using Tesla as an example, Mr Klarman said shares in the “barely profitable” electric carmaker had soared “seemingly beyond all reason”, briefly making the company’s founder Elon Musk the richest person in the world. Low interest rates have made projected cash flows more valuable, he said, a point many investors have unwisely used to justify valuations on companies that sit far above historic norms.

“The more distant the eventual pay-off, the more the present value rises,” he wrote. “When it comes to the value of cash flows, the vast and limitless future, yet to unfold, has gained considerable ground on the more firmly anchored present.”

The Fed’s policies and programmes “have directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated”, he added. “The market’s usual role in price discovery has effectively been suspended.”

Mr Klarman said investors were now in a constant hunt for yield that was driving them to riskier corners of the markets, including investment grade corporate debt, private credit or junk bonds.

The Fed’s drastic measures had helped to boost economic activity and rescue ailing businesses, Mr Klarmen said. “But they have also kindled two dangerous ideas: that fiscal deficits don’t matter, and that no matter how much debt is outstanding, we can effortlessly, safely, and reliably pile on more.” //