Quote of the Day: The artificiality of today’s markets is pure Truman Show

Welcome to “The Truman Show” market. In the 1998 film by that name, actor Jim Carrey is ignorant of the fact that his life is a hugely popular reality show. His every action, unbeknownst to him, is manipulated while being broadcast to millions of TV viewers worldwide. He seemingly lives in an idyllic seaside community where the manicured lawns are always green and the citizens are always happy. These people are, of course, actors. The world Truman inhabits turns out to be phony: a gigantic sound stage created for a manufactured “reality.” As Truman starts to unravel the truth, his anger erupts and chaos ensues. 

Ben Bernanke and Mario Draghi, as in the movie, are the “creators” who have manufactured a similarly idyllic, if artificial, environment for today’s investors. They were the executive producers of “The Truman Show” of 2013. A global audience sat in rapt attention before this wildly popular production. Given the U.S. stock market’s continuing upsurge, Bernanke is almost certain to snag yet another People’s Choice Award for this psychological “thriller.” Even in “The Truman Show,” life was not as good as this for investors. 

But there is one fly in the ointment: in Bernanke’s production, all the Trumans – the economists, fund managers, traders, market pundits – know at some level that the environment in which they operate is not what it seems on the surface. The Fed and the Treasury openly discuss the aim of their policies: to manipulate financial markets higher and to generate reported economic “growth” and a “wealth effect.” Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored, and markets go asymptotic. The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding. The artificiality of today’s markets is pure Truman Show. According to the Wall Street Journal (12/20/13), the Federal Reserve purchased about 90% of all the eligible mortgage bonds issued in November.

Like a few glasses of wine with dinner, the usual short-term performance pressures on most investors to keep up with the market serve to dull their senses, which makes it a bit easier to forget that they are being manipulated. But what is fake cannot be made real. As Jim Grant recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.” According to John Phelan, a fellow at the Cobden Centre in the U.K., “the Federal Reserve has become an enabler of the financial havoc it was designed (a century ago) to prevent.”  

Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist so 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 wants to exit the dome until they’re sure everyone else won’t stay on forever. 

A marketplace of knowing Trumans seems even more unstable than the movie sound stage character slowly awakening to reality. Can the clued-in Trumans be counted on to maintain their complicity or will they go off-script? Will Fed actions reliably be met with the desired response? Will the program remain popular? Could “The Truman Show” be running out of material? After all, even Seinfeld ended. 

Someday, the Fed’s show will be off the air and new programming will take its place. And people will debate just how good it really was. When the show ends, those self-deluded Trumans will be mad as hell and probably broke as well. Hopefully there will be no sequels.

(bold mine)

This is from investing guru Seth Klarman in his Baupost Group's latest letter as excerpted by the Zero Hedge. 

And that someday, bubble worshipers will be asking "how did it come to this?"

Amid ‘Too Few Opportunities’, Value Investor Seth Klarman Returns Money to Clients

Unlike most of the industry participants who practice consciously or unconsciously the principal agent problem by continually talking up their businesses and or take on a beta (momentum chasing) approach  regardless of the risk environment, Seth Klarman value investor,  billionaire fund manager and founder of the Baupost Group, the seventh largest hedge fund in the world with $26.7 billion in assets, takes an admirable position by announcing the voluntary return of client’s money by the yearend due to “too few opportunities”. 

From Institutional Investor’s Alpha via the Zero hedge (bold from zero hedge)

Seth Klarman’s Baupost Group has decided to return some money to investors at year-end, but it has not yet determined the amount, according to a person familiar with the firm’s plans. 

This would be only the second time Baupost returned money to investors in the Boston-based investment firm’s 31-year history. The previous time was in 2010, and Baupost subsequently raised money in early 2011.

...

In a letter dated April 29, Klarman said the goal is “to better match our assets under management with the opportunity set we see for new investments.” The decision was made, in part, after a series of discussions with clients on the firm’s quarterly webcasts with investors. The firm’s goal is to keep assets under management at $25 billion, according to the person familiar with Baupost.

...

Baupost’s performance is even more impressive given its penchant for holding large amounts of cash. It has averaged 33 percent of assets in cash, and its cash balance can reach as high as 50 percent. It is now in the mid-30 percent range, up slightly from 32 percent at year-end.

...

However, the firm does not use leverage to try to boost returns.

...

“Our willingness to invest amidst falling markets is the best way we know to build positions at great prices, but this strategy, too, can cause short-term underperformance,” Klarman explained in an investor letter earlier this year.

Why? Given perhaps Mr Klarman’s latest outlook where he said "if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse. For if you must rescue everything, then ultimately you will be able to rescue nothing” then the action above means that he seems more concerned with the return OF investment rather than the return ON investment or even management fees. 

Mr. Klarman would rather sit on the sidelines and wait until the right moment.

For value investors, return on investments has always been from siting and waiting. 

At least Mr. Klarman has more than enough to see him through the waiting period.

Seth Klarman: For if you must rescue everything, then ultimately you will be able to rescue nothing

It is simply breathtaking to see how financial markets have been hostaged by, or have become almost entirely dependent, on central bank utterances and actions. Markets experiences adrenaline rush or convulses depending on whether central bankers signal continuity of inflationism or not. Such volatilities are signs of the massive distortions and mispricing of the risk environment.

The legendary value investor and billionaire Seth Klarman has an apropos take on the sustainability of the de facto stimulus driven marketplace and economy. (As quoted by Zero Hedge; bold and italics original)

Is it possible that the average citizen understands our country's fiscal situation better than many of our politicians or prominent economists?

Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions.

They regard with skepticism those who don't accept that we have a debt problem, or insist that inflation will remain under control. (Indeed, they know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station.)

They are pretty sure they are not getting reasonable value from the taxes they pay.

When an economist tells them that growing the nation's debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute. They know the trajectory we are on.

When politicians claim that this tax increase or that spending cut will generate trillions over the next decade, they are properly skeptical over whether anyone can truly know what will happen next year, let alone a decade or more from now.

They are wary of grand bargains that kick in years down the road, knowing that the failure to make hard decisions is how we got into today's mess. They remember that one of the basic principles of economics is scarcity, which is a powerful force in their own lives.

They know that a society's wealth is not unlimited, and that if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse. For if you must rescue everything, then ultimately you will be able to rescue nothing.

They also know that the only reason paper money, backed not by anything tangible but only a promise, has any value at all is because it is scarce. With all the printing, the credibility of our entire trust-based monetary system will be increasingly called into question.

And when you tell the populace that we can all enjoy a free lunch of extremely low interest rates, massive Fed purchases of mounting treasury issuance, trillions of dollars of expansion in the Fed's balance sheet, and huge deficits far into the future, they are highly skeptical not because they know precisely what will happen but because they are sure that no one else--even, or perhaps especially, the  policymakers—does either.

Seth Klarman's Forgotten Lessons of 2008

Interesting insights from market guru Seth Klarman, courtesy of My Investing Notebook

(all bold highlights mine), [my comments]

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

``One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

``Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

[In a world of fiat money, one must realize that bubble cycles are its main feature. It's all a matter of understanding and timing the cycles]

2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

[Bubble mechanism is generally a feedback loop between prices and collateral values]

3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

["Risk comes from not knowing what you are doing" or "the dumbest reason in the world to buy a stock is because it's going up" to quote Warren Buffett.]

5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

[models function as scientific rationalizations to peddle unrealistic premises]

6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

[For a value investor-yes, averaging down is a commendable approach, but for traders the play is different]

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

[the danger from financial innovation stems from elite political entities gaming the system]

11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

[rating agencies are part of the network of political enterprises]

12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

[leverage is the fuel of all bubbles]

15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank's management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

[Amen!!!!]

18. When a government official says a problem has been "contained," pay no attention.

19. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

[except for leverage speculators, all the rest compose of the political networks]

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

[I'd like to add: "Blue chips" are risk free!]

2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

[digging and filling holes on the ground as proposed by the mainstream will]

6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

[not unless taxpayers shoulder the losses]

8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

[this called confirmation bias]

9. The government can indefinitely control both short-term and long-term interest rates.

10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost.

[this is a fairy tale relied upon by the government and the mainstream]

(Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)-[Indeed!!!]