The S&P 500 index is up 7 percent from the Nov. 8 election through Tuesday on growing optimism over Trump's economic plans for deregulation, tax reform and infrastructure spending. But the hedge fund manager said the market is "ignoring" the downside risks from the administration's anti-trade proposals.
"While they might be popular, the reason the U.S. long ago abandoned protectionist trade policies is because they not only don't work, they actually leave society worse off," he wrote. "The anticipated fiscal stimulus and protectionist policies amidst sub-5% unemployment could prove quite inflationary, which would likely shock investors."
Even though the U.S. dollar index is up more than 2 percent since the election, Klarman is now worried about the greenback's place as the world's reserve currency.
"If things go wrong, we could find ourselves at the beginning of a lengthy decline in dollar hegemony, a rapid rise in interest rates and inflation, and global angst about the stability and wisdom of American leadership," he said.
Klarman also agreed with the recent prediction of his hedge fund peer David Einhorn that the new president will lead to more market uncertainty.
"Trump is high volatility, and investors generally abhor volatility and shun uncertainty," he wrote. "Personally, I'm troubled by Trump."
Baupost did not immediately return a call and email for comment. Large portions of the 19-page letter, which is much sought after on Wall Street, are used to criticize Trump, including calling for the president to stop tweeting.
Klarman did not specifically say the firm is positioning for such a Trump-led collapse in the markets, just that it stands to ready to play defense if such as scenario starts to unfold. The hedge fund manager does acknowledge the chance that Trump, with the help of a pro-business Cabinet, stimulates the economy and markets positively.
"The Trump presidency could, in the best case, mark a point of renewal for free market forces. The pro-business tilt of the Cabinet is unmistakable, though the melange of backgrounds, viewpoints and, in many cases, limited Washington experience do not suggest consistent policy direction," the letter said.
— CNBC's Michael Bloom contributed to this story.