Seth Klarman is not an investor you would read about much in business media. He is one of the more reclusive kinds out there. He rarely speaks in public or grants interviews.
Klarman is known for his very deep value investing style and willingness to pursue value where others get very nervous. Some people, in fact call him Warren Buffett of his generation.
Late last year, he returned US$ 4 billion cash to his clients (from a fund size of around US$ 30 billion). In fact, Klarman has had about 30% of his fund’s assets in cash over the past two years as he has long been concerned about the state of the financial markets and typically looks for deeply-discounted situations.
In a recent letter to his clients, Klarman has warned that the QE (quantitative easing) stimulus bubble has become unsustainable and will burst at some point in time.
He has noted that “most” investors are downplaying risk and this “never turns out well,” noting that most people are not prepared for anything bad to happen. He wrote in his letter (emphasis is mine)…
No one can know what the future holds, but any year in which the S&P 500 jumps 32% and the NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance.
It might not look like it now, but markets don’t exist simply to enrich people.
Against today’s backdrop of never before witnessed manipulated markets, Klarman writes…
Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.
When will this happen? Maybe not today or tomorrow, but someday.
When the markets reverse, everything investors thought they knew will be turned upside down and inside out. ‘Buy the dips’ will be replaced with ‘what was I thinking?’
Just when investors become convinced that it can’t get any worse, it will. They will be painfully reminded of why it’s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain.
They will be reminded that it’s easier to buy than to sell, and that in bear markets, all to many investments turn into roach motels: ‘You can get in but you can’t get out.’ Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill-prepared will find there’s a long way to fall.
Few, if any, will escape unscathed.
If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about.
Should You Hide in the Bunkers?
There is no denying that this stock market – in the US or in India – is built up on a lot of fake currency. However, since I am yet to hear my barber offering stock advice, I am not sure if we are already in a “bubble-about-to-burst” zone or not.
But there surely are signs that this bubble has entered a dangerous territory now, as seen from a few of these headlines…
Plus, I am being bombarded with messages with companies promising to make me a ‘microcap millionaire’, promising me my ‘retirement in two years flat’, and also recommending stocks that could earn me 10% in a few minutes!
Robert Shiller, the author of Irrational Exuberance, once said…
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.
Now, while that excitement is still non-existent today, if the stock prices were to continue to scale higher, that day is not far I believe.
So, what should you do as of now?
Pull out all cash from stocks and invest in the ‘safety’ of bank deposits?
Or put in more money in the stock market with the expectation to make quick profits and exit just before the bubble bursts?
Well, I have no specific answer to what you ‘must’ do with your stocks in these times, but Seth Klarman definitely has.
Read this following excerpt from the 2010 annual letter of Klarman who was (and continues to be) shocked at how quickly investors have returned to the risky behavior that got them in trouble in 2008.
Here are 10 lessons outlined by Klarman that investors should not forget from the 2008 crisis. In fact, Klarman had highlighted 20 lessons that you can read here.
But these are the 10 most important in my view that you must read now, and apply in your investment process to deal with any future bubble build up that can destroy your savings like it may have done in 2008.
10 Investment Lessons from the 2008 Crisis
- Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
- When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
- Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
- Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
- Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
- The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
- A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
- You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
- Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
- Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
Remember these lessons, make them part of your investing checklist, stick with quality businesses (Prof. Sanjay Bakshi outlines the reasons here), and remain invested for the long run.
Don’t speculate on stock prices, and please don’t get over-confident seeing your stocks rise with the rising tide.
Finally remember what a wise man once said – “In the stock market, history doesn’t repeat itself, but it does rhyme.”