Markets are said to climb a wall of worry and investors have had plenty to worry about recently. With China’s first domestic corporate bond default too small to create big waves and the risks in Ukraine seemingly “fixed” overnight, stocks have quickly climbed the wall back to new all-time highs. We wonder what happens when they reach the top.
The bulls claim that today’s rich valuations are “justified” by low interest rates. Low rates force otherwise conservative investors out on the risk curve, or over the ledge, depending on one’s perspective. ZIRP (Zero Interest Rate Policy) also “supports” peak valuations in the form of minuscule discount rates. This is particularly convenient for sell-side analysts who can now justify just about any price for an asset simply by discounting its future cash flows back to the present at today’s unusually low rates. The rational investor should think carefully before jumping down this rabbit hole. In 1991, Seth Klarman aptly described today’s rabbit hole in Margin of Safety:
It is essential that investors choose discount rates as conservatively as they forecast future cash flows. At times when interest rates are unusually low, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low. When interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available.
Well put Mr. Klarman. And with 50% of Baupost capital on the sidelines today, we think it is safe to assume that “outstanding opportunities” are less available after mounting the wall of worry.