Seth Klarman: What's Driving The Current Market Rally And The Big Questions

Interesting article Seth Klarman: Why Most Investment Managers Have It Backwards

Some interesting passages.

• The current rally
  
  Klarman called the market rally that began in March “increasingly speculative” and driven by investors who “looked for and saw green shoots – or thought they did.” He questioned whether we can know if things are “stabilizing or pausing before they get worse.”
  
  Recently, Klarman has spent a lot of time thinking about what a bear market rally would look like. He concluded that it would closely resemble the current rally – a bold move, fueled by speculation based on green shoots or similar wishful thinking, led by more speculative securities.
  
  The rally has led some investors – who six months ago would have “cut a deal with the devil to stabilize their portfolios” – to resume speculating on shares that have risen two- or three-fold in the current rally.
  
  “The pressure not to lose has been replaced by the pressure not to miss out,” he said, and that fear leads to speculation, not investing. Indeed, such speculation combines the two motivations that are anathema to rational, long-term investors like Klarman: “The fear of missing out on a rally is greed, not fear,” he said.

• The big questions
  
  Investors face serious questions, the least of which may be whether the recent green shoots that have cropped up are for real. Klarman said investors must determine the right multiple to pay for companies that benefit from government backing and when government intervention will end.
  
  Markets will pay a price for government actions, but he is not sure whether that price will be inflation, a loss of faith in the dollar, or both.
  
  Another dilemma is whether Americans would be willing to accept the pain of slower growth, if that turns out to be the only way out of the crisis.
  
  The biggest question in Klarman’s mind concerns moral hazard, and whether the government has created “the mother of all moral hazards” by instilling a belief in investors’ minds that all crises can and will be solved by government actions. Such a belief, he fears, would skew every investment decision toward unnecessary risk taking.
  
  In the Dr. Seuss book, The Cat in the Hat Comes Back, a house-crashing cat leaves a pink stain around the bathtub after helping himself to some cake. All attempts to clean the stain fail, as the mess is spread elsewhere – to a dress, a wall, a pair of shoes, and eventually to an entire yard-covering spot.
  
  Klarman fears government actions to deal with the financial crisis are merely repositioning — and expanding — the stain. “Our over-leveraged, over-consuming population has been living beyond its means,” he said, surviving by borrowing from foreigners. Many individuals and governments are effectively insolvent, and we are tackling the problem with more debt while keeping incompetent lenders in business.
  
  Klarman did not say whether he believes the government’s actions will work, or whether they will be forever shifting the location of the stain.
  
  Seuss’ tale, incidentally, ends as Little Cat Z takes off his hat and unleashes a “Voom” – perhaps a precursor to the TARP program – which magically cleans up the yard and restores order in the home.