Value investor Seth Klarman (Trades, Portfolio) is notable for giving relatively few interviews and making almost no public appearances in general. I think this is a shame as individual investors can learn a lot from Klarman’s value-first philosophy, and in particular from his ability to identify when markets are getting out of hand. In his 1995 letter to investors in his Baupost Group, the guru discussed some of the hallmarks of overextended markets.
This time it’s different?
Klarman believes that a typical sign you might be living through market mania is denial by financial commentators that valuations can ever come down:
“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 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.”
It’s a pretty simple fact that, in life and in investing, what goes up has a tendency to come back down. Regression to the mean is a powerful constant, which means that if market conditions are good right now, then there’s a pretty good chance they will deteriorate down the line. Incidentally, this is why high consumer confidence is often an indicator of an overheating economy - ordinary consumers are typically the last people to realize that valuations have gotten too high.
Related to this, Klarman believes markets tend to top out when large numbers of laypeople start being sucked into the financial markets:
“Anecdotally, too, this market is greatly overextended. People with no previous investment experience are starting hedge funds. Everyone seems to know someone who owns stock in a company that has just gone public, not to mention the certifiable mania among the general public to own mutual funds and Internet stocks. Just a few days ago, the last remaining bearish Wall Street market strategist turned bullish, arguing that the “valuation paradigm” had changed”.
This passage brings to mind the possibly apocryphal story of Joe Kennedy, who said that he knew it was time to sell stocks in 1928 when he received a stock tip from a shoe-shine boy. When even people who really cannot afford to lose their money are drawn to stock speculation, you know it is time to get out. It was true in the 1920s, it was true during the dotcom bubble and it will be true in the future.
Klarman believes that anyone can make money in a bull market, and that simply buying an index fund is the best way of doing this. The trick to investing is not making money during the easy time, it is in prospering during the hard times, and one can only do so by not getting caught up in manic markets.
Read more here:
- Warren Buffett: Do Not Fear Volatility
- Warren Buffett: Are Stocks or Bonds More Risky?
- Buffett and Munger: Cultivate Curiosity and Mental Discipline
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