Seth Klarman - Notes from a recent private meeting

    Nassim Taleb, author of the new book, Antifragile, praises volatility and criticizes those who would artificially dampen it at great unseen cost. Taleb writes: "Stifling natural fluctuations masks real problems, causing the explosions to be both delayed and more intense when they do take place. As with the flammable material accumulating on the forest floor in the absence of forest fires, problems hide in the absence of stressors and the resulting cumulative harm can take on tragic proportions. And yet our economic policy makers have often aimed for maximum stability, even attempting to eradicate the business cycle."

    There is no free lunch in economics: if governments could print or borrow money in astronomical amounts without any major adverse consequences, why wouldn't they always do this, forever avoiding downturns while their countries bask in the sunshine of limitless prosperity? Indeed, it seems clear that prior misplaced confidence in the Fed contributed greatly to years of complacency that turned the 2008 downturn into a full-blown crisis. Of course there will be a price to pay for today's policy excesses—an equal and opposite reaction. We just haven't seen it yet. Will it take the form of a collapse of the dollar and the end of dollar hegemony, high interest rates, failed auctions of U.S. government securities and runaway inflation, a wrenching and protracted downturn requiring exceptional sacrifice, or something else'? We will find out soon enough.

    Implicit is that a 30% market drop might follow a full reversal of QE policies. But equity investors who have embraced a momentum strategy are ill-prepared for a policy change that could reverse the market's artificial gains. What will happen when the Fed declares, as it someday must, that the era of artificially low interest rates is at an end? Or if another serious crisis—economic, political, international—materializes and governments have insufficient ammunition to intervene? The content, though not the timing, of the next chapter in market history is quite predictable. Few will say they saw it coming, though, in fact, everyone could have seen it if they had only chosen to take off their blinders and look.

    Leverage is always a double-edged sword, and in 2007 excessive leverage at all levels of the economy had eroded our nation's margin of safety. When things went wrong in 2008, we' had nothing to fall back on. There was no room for error, little cushion to give us time to refocus and rebuild. Today, with massive deficits and even higher government debt, we have less margin for error than we did four years ago. What might we do instead of today's unsuccessful, misguided, and dangerous programs? Jim Grant, in a CNBC interview several months ago, had one suggestion: perhaps we should try capitalism. Let's allow markets to operate freely; let's allow the invisible hand to work its magic; let's once again permit failure.

    A juiced-up stock market is seen as stability? A policy that creates such "stability" and from which there is no apparent exit is seen as wise and even successful? And the policy must be continued because it was so ill-conceived that it cannot be ended? The Greenspan-Bernanke put exists because even the hint of a minor economic downturn has for decades been viewed by government officials as a crisis so extreme that it must be warded off at all costs. Thus, we have created the twin illusions of limitless prosperity and the taming of economic volatility at the high cost of ever-expanding deficits, overleverage in the consumer and government sectors, extreme moral hazard, and episodic market meltdowns. Economist Hyman Minsky has posited the simple but brilliant notion that stability leads to instability. Low economic volatility, by enticing lenders to make low-cost loans available to historically risky borrowers and by encouraging borrowers to take on ultimately unaffordable debts, creates conditions ripe for destabilizing credit hubbies to form, expand, and eventually collapse.

    While zero rate policy is somewhere between financial catnip and heroin to investors, one of the most powerful concepts in finance is reversion to the mean, Jeremy Grantham is perhaps the most articulate proponent of this concept. Across all markets and asset classes, valuations eventually revert to the mean. While you can never tell in advance precisely when they will end, all bubbles, which he defines as valuations more than two standard deviations above trend-line, eventually reverse. The psychology that allows bubbles to form always breaks, sometimes on a dime. This is not just theoretical; looking back over the centuries, Jeremy has the data that prove it.

    The daily cheerleading pundits exult at rallies and record highs and commiserate over market reversals ; viewers get the impression that up is the only rational market direction and that selling or sitting on the sidelines is almost unpatriotic…. in a world where differences between investing and speculation are frequently blurred, the nonsense on the financial cable channels only compound the problem.

    Alan Greenspan's mantra was that the Fed couldn't possibly identify financial bubbles before they burst; it is better for the government to clean them up after they implode. I couldn't disagree more strongly. Asymmetrically truncating investors' downside risk, without an equal and opposite intervention to limit bubble-like upside, is highly pernicious. For decades, financial institutions and individual investors have come to expect limited financial market downside due to such government interventions. With downside artificially constrained and upside driven by the forces I've described, a purported era of "Great Moderation" prevailed through 2007 - one of low volatility and shallow downturns. Such conditions were used to justify increasingly lax lending standards (because few loans went bad amidst steadily rising asset values) and, because of the availability of credit and its low cost, a monumental expansion of leverage. All these things that propel markets higher, that limit downside volatility, that drive perceptions of risk lower, sow the seeds for periodic collapses such as the one in 2008, that are far more devastating than would happen otherwise.

    Two problems are upon us at once: short-term stimulus that is unaffordable and unsustainable entitlements that must be reined in. But restoring fiscal sanity by reducing spending and raising receipts will be bad in the short run for the economy and financial markets. What Treasury official or politician would want the cash spigot turned off before a recovery is certain? Recipients of government handouts would grumble at the prospective termination of government policies that offer them outsized benefits. We've seen what that looks like in cities across Europe. Which explains the endless chorus of "but not yet." One sees this in editorials and commentaries, such as the ones saying it's time to close down bankrupt Fannie Mae and Freddie Mac, but not yet, because doing so might harm the housing market. There will never be a good time to end housing support programs, reverse quantitative easing policies, or reduce massive budget deficits—because doing so will restrict growth and depress stock prices. Nor will there be a good time to cut entitlement programs or to solve Social Security or Medicare underfunding. Most will always agree the stimulus cannot go on forever, that excessive entitlements must be reined in, "but not yet"

    Government effort to pump stocks higher is expensive and distortive. And if the impact will only be ephemeral, if what goes up is certain to come back down, then the consequence is bound to be increased volatility, more financial catastrophe, and possibly an endless cycle of propping up followed by collapse, perhaps with greater and greater amplitude and, looking back, ultimately without any purpose other than as a short-term palliative for psychological or political purposes.

    Government manipulation of stock prices to unnaturally high levels is economically destructive because the wrong market signals are sent and society's resources are potentially massively misallocated. It also at least temporarily accentuates wealth disparities that undermine social cohesion. Indeed, they may have coaxed out additional production of assets already in excess supply, such as housing and office building which, if truly unneeded, would only exacerbate losses in the next economic downturn. Worse still—and this is one of my great fears--I'm certain that in the minds of Fed and Treasury officials, government actions since 2008 have been a great success and as such will figure prominently in the playbook they will leave on the shelf for their successors

    There is no precise level where debt becomes excessive. It depends on the vicissitudes of investors and the vagaries of the markets. When asked how he went bankrupt, Hemingway's character, Mike Campbell, in The Sun Also Rises, answered, "Gradually, and then suddenly." An unknowable tipping point looms over the horizon. When we reach it outsiders and U.S. citizens alike will become increasingly suspicious of our creditworthiness causing interest rates to rise and the dollar to decline. No one knows precisely how much debt is too much, or at what moment the tipping point will be reached. It's like driving a car with a faulty navigation system along a steep mountain road on a moonless night. Sooner or later, you're going to plummet over the edge. By the time we reach that point, it will likely be too late.

    We borrow heavily, spend a lot but invest very little, fail to address long-term problems allowing them to fester and compound, and leave ourselves at the mercy of creditors with little or no room for error. Should disaster suddenly strike—an act of God, a war, another Wall Street or financial market implosion—we would be in great trouble. No rational investor would want to rely on prayer or divine intervention for their future viability. No country should, either. I certainly don't think we should feel good because we are less of a basket case than Europe or Japan. Getting our affairs in order to where we once again build in a margin of safety will take considerable time. We must get started right away.