5 Things To Ponder: Words Of Caution

The financial markets have not done much since the beginning of the year but that is not necessarily bad news.  Despite Russia’s annexation of Crimea which sparked threats of military conflict, the Federal Reserve tapering asset purchases, massive “polar vortexes” and less than impressive economic data – the markets have remained mostly resilient. I discussed yesterday that there are signs of deterioration in the market internals which are typical of market tops. 

Howard Marks once wrote that being a “contrarian” is a lonely profession. However, as investors, it is the downside that is far more damaging to our financial health than potentially missing out on a short term opportunity.  Opportunities come and go, but replacing lost capital is a difficult and time consuming proposition.  So, the question that we will “ponder”this weekend is whether the current consolidation is another in a long series of “buy the dip”opportunities, or does “something wicked this way come?”  Here are some “words of caution” worth considering in trying to answer that question.

1) Born Bulls by Seth Klarman via Zero Hedge

In the world of investing there are only a handful of portfolio managers that are really worth listening to.  Ray Dalio, Howard Marks and Seth Klarman rank at the top of my “read every word” they say list.  In this regard, I suggest that you take some time this weekend to read Seth’s year-end 2013 investor letter which details the many dangers that lay ahead.  The problem is that most investors are blind to those dangers as they continue to follow the madness of crowds.  

“In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test. What investors see in the inkblots says considerably more about them than it does about the market.

If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stocks probably look attractive, even compelling. Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. 

But if you have the worry gene, if you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about. 

A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.

There is a growing gap between the financial markets and the real economy.”