American International Group Inc (AIG), Wells Fargo & Co (WFC) – The Fed: What Great Investors Have to Say

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Seth Klarman and Warren Buffett. Sources: 100WHF and Aaron Friedman.

Next year, the Federal Reserve will have a new chairman. It may also have a new policy: a tapering of quantitative easing.

Uncertainty around the future of interest rates — and the Federal Reserve as a whole — causes investors to make interesting, and sometimes dangerous, assumptions. Last week, a group of economists published a note outlining their recent studies.

Here’s what economists have to say: If Larry Summers becomes the new Federal Reserve chairman, it may shave as much as 0.75% from GDP and slow job creation by as many as 500,000 jobs over the next two years, according to their report.

What can you really know about the economy’s future?
Everyone has an opinion on Wall Street, and this is doubly true when politics plays into financial markets. Bernanke’s successor will be selected by President Obama, which makes the future Fed chairman all the more interesting.

But what can we really know about the Fed and interest rates going forward? Can we really know whether or not Larry Summers as Fed chief would cut potential GDP by 0.75%?

I went back to one of my favorite books by Seth Klarman, Margin of Safety — a book that may be more popular if it weren’t for its $1,000-plus price tag.

On page 127, I found very classic, very Foolish-style wisdom on interest rates and forecasting:

I believe there is no “correct” level of rates. They are what the market says they are, and no one can predict where they are headed.

High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa. Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact.

A more timely quote comes from Warren Buffett at the most recent Berkshire Hathaway Inc. (NYSE:BRK.A) annual meeting: “QE is like watching a good movie, because I don’t know how it will end,” Buffett remarked.

Shouldn’t great investors have an answer?
Since 1982, Seth Klarman’s Baupost Group has managed annual returns of roughly 19% per year, despite the fact that his fund often holds cash positions equal to 25% or more of assets under management.

Warren Buffett, of course, managed 20% annual returns well into the 1990s. Now, his portfolio at Berkshire Hathaway Inc. (NYSE:BRK-A) is so large that it’s beginning to show signs that it may only roughly match the returns of the stock market as a whole.

Shouldn’t great investors have unique insight into the future?

Obviously, the best investors have some insight into the future. But where their insight lies rarely fits with the broad economy or interest rate forecasting. It lies in business analysis — knowing a business inside and out.

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