"Bulls will patiently explain that 'it is different this time.' pointing to low inflation, high corporate profits, increased productivity, world peace (sort of), reductions in government spending, and the like. Of course, any contrarian knows that just as a grim present is usually a precursor to a better future, a rosy present may be a precursor to a bleaker tomorrow. Without me listing all the things that could go wrong, simply consider that none of these virtuous factors are cast in stone. Just as seeds are sown during the seven lean years that allow the seven fat years to ensue, so does the reverse hold true." -- Seth Klarman (Trades, Portfolio)
The above quote is taken from one of Seth Klarman (Trades, Portfolio)'s letters to investors of his Baupost hedge fund.
In the letter, Klarman expressed concern about the euphoria taking hold of investors and about rising equity market valuations. These warnings could have been issued at any point in the past few years, but instead, they come from 1995, five years before the first internet bubble popped.
This historical letter from the author of "Margin of Safety" displays a brilliant example of the "this time it's different" mentality. For example, the letter went on to say:
"People with no previous investment experience are starting hedge funds. Everyone seems to know someone who owns stock in a company that has just come public, not to mention the certifiable mania among the general public to own mutual funds and Internet stocks."
Granted, this quote is more suited to the crypto industry, although there are still some parallels with the rest of the investment universe. Rather than mutual funds, however, investors are rushing to buy low-cost passive tracker funds and Internet stocks.Â
The one difference between today and the environment in 1995 seems to be that Wall Street analysts are, broadly speaking, more cautious about the outlook for equities. Klarman mentioned, "Just a few days ago, the last remaining bearish Wall Street market strategist turned bullish." Today, there are still quite a few bearish analysts out there, and most of the analyst community is only cautiously optimistic, not outright bullish.
Still, much of the rest of the letter rings true. Klarman said that "dangerous lessons are being learned by many investors" as they profit in ever-rising markets, without having to cope with losses. "Virtually everyone 'knows' that over the long run, stocks will outperform other investment alternatives," he went on to say before mentioning the market's cycle in 1974 and 1982 when almost "no one thought" of the market's long-term potential as they rushed to dump stocks.
The decade-long bull market had lulled investors into a false sense of security:
"So after a record-setting thirteen-year bull market, proponents of this viewpoint are ignoring the high price they must now pay to purchase equities. Another dangerous notion is that dips in the market always represent buying opportunities," Klarman wrote.
It is worth revisiting this letter more than 25 years after it was first published because of the parallels between 1995 and today. Many investors active today have not seen a bear market in its full glory and will likely be taken by surprise when one emerges.
Of course, it is impossible to tell when the next bear market will arrive, something Klarman even acknowledged in his 1995 letter. And trying to guess when the market will next decline by 20% or more is most likely a waste of time and effort.
Instead, it is better to be prepared by seeking out stocks trading at low valuations, equities that are likely to perform well in all market environments. As Klarman concluded in his letter:
"We have said before and will repeat here that you do not really need Baupost to invest your money in bull markets. An index fund could likely perform better. The true investment challenge is to perform well in difficult times. It is unfortunately not possible to reliably predict when those times might be. The cost of performing well in bad times can be relative underperformance in good times. We have always judged that a worthwhile price to pay."
Disclosure: The author owns no share mentioned.
