16 Oct 2015

Seth Klarman – Anatomy of a Stock Market Bubble

What will you learn from this post:
. Bubbles are always born with a perfectly rational reason
. It is usually associated with a sector or a concept which is taken too far
. Stocks move in only one direction – up
. Existence of a bipolar market
. Fundamentals don’t seem to ‘work’
. Future is valued richly compared to present
. Lessons from bubble

During the Internet Bubble during late 1990’s, US market witnessed steady up move from 6th January 1995 to 14th January 2000. The Dow Jones climbed 205%, while the NASDAQ composite index climbed 423% during this period. The period was characterized by multi-bagger returns in stocks belonging to few sectors like telecom, media and technology. In fact Seth Klarman quoted Buffett highlighting that bubbles are always born with a perfect rational reason. It is only an irrational extrapolation of that reason that can lead to a bubble.
Quote from December 8, 1995
Warren Buffett has pointed out that legitimate theories frequently lie at the root of financial excesses; good ideas are simply carried too far.

In 1996, Seth highlights how companies operating in or using internet for their business were getting high valuations, irrespective of their business model or quality of business.
Quote from June 21, 1996
The Fund's exposure to the U.S. stock market totaled only 29% of net assets at April 30, a level that reflects our opinion of the frothiness now present in U.S. share prices. Even the slightest association with the Internet is cause for an upward thrust in a company's share price. We know the current mania will end badly; we do not know when.

Bubbles are characterized by stocks moving in only one direction – up!! Because of this, the uninformed investors develop a positive feedback loop if they buy into stocks. The expected risk apparently vanishes as near term memory is seduced by rising stock prices. Hence investors tend to ignore the central tenant – stock represents a slice of ownership in a business – and start treating stocks as pieces of paper whose prices just move up. You would appear to be a fool to be not participating in this free money distribution party!
Quote from June 25, 1998
Call it a new era, if you want. The astonishing reality is that stocks have moved in only one direction (up) for so long that Perma-bull best describes most investors' expectations for the U.S. stock market.
The greater perceived risk is no longer that of being in the market but rather remaining on the sidelines, risk being defined not in terms of yield to maturity but rather yield to termination of the money manager.
Leaving this extraordinary party early, or contemplating not even going, isn't very appealing if all your friends will be there having a great time while it lasts, which appears to be well into the night.

During a bubble, investors tend to sell stocks which are not working (read prices not rising) and buy stocks which are seeing a steady appreciation in prices. This can often produce a bipolar market – cheap stocks keep getting cheaper and expensive stocks keep getting expensive. No one knows when and how this process will stop. But history and study of investments teaches us that such periods are almost always followed by a period of swift mean reversion. Value investors should patiently wait for such mean reversion to occur to ear their keep.
Quote from December 21, 1998
In a highly unusual year where the cheapest market sectors and asset classes became considerably cheaper while the most expensive areas went to the stratosphere, we did a poor job protecting capital. own a "nifty-fifty", several dozen widely admired companies seeming to promise an investment utopia of safety, stability, steady growth, and liquidity. Once again, no price is regarded as too high to pay for these characteristics. An illusion is created that owning these stocks is prudent, that not owning them is imprudent, and, lately, that owning anything else is downright irresponsible.

During bubbles, rational analysis of securities fundamentals does not yield immediate results. In fact sometimes it may be counter intuitive. The more naïve you are, the better will be your short term investment results. That’s because of market bipolarity.
Quote from June 24, 1999
One particularly irksome development is that fundamental research is today a significant impediment to good short-term results, as the most overvalued securities have steadily been the best performers and the most undervalued the worst.
A recent Wall Street Journal article was headlined: For Some Stocks, Price Doesn't Matter. Within the article, the co-manager of the billion dollar Stein Roe Young Investor Fund described how he had revised his investment strategy to cope with today's environment: "To own a company like AOL (America Online), you had to throw out traditional measures of valuing companies. We had to say we have to own what we think is the dominant franchise in the Internet. It was a space that as a money manager you simply have to be in."
Quote from December 17, 1999
Simply put, we are navigating through an unprecedented market environment, where fundamental analysis is thrown out the window and logic is turned on its head. We underperformed in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum, and very ironically, we got hurt not speculating in the U.S. stock market.

In a bubble, markets tend to give much higher values to future cash flows and assets than present one. This is because it tends to extrapolate growth at a high rate and for a long period in future to arrive at a high valuation for high growth companies. However, companies which have strong cashflows but are steadier might not receive fancy valuations as their high-growth counterparts.
Quote from June 24, 1999
Specifically, what may happen in the future is today valued with unprecedented enthusiasm while what has already come into being (buildings, stores, traditional businesses) trades at subdued, even depressed prices.

As discussed bubbles are always formed initially with some solid reasons. The reasons for internet bubble of the late 1990’s was grounded partly in technical factors like indexing and partly in fundamental like high and boundless growth promise of internet.
Quote from December 17, 1999:
First, there has been a decade-long increase in indexing activity, where more and more money is either overtly or tacitly invested to mirror the performance of market indices, especially the S&P 500 Index.
A second factor contributing to today's lofty market valuation is the cult of growth and momentum investment strategies, a bizarre emphasis on the trend of a company's results rather than on the absolute level of its performance.
The third factor impacting today's stock market is the Internet.

What are the key lessons to be learned from the Internet bubble-that growth cannot be infinitely be extrapolated, that valuation matters and that taking a high risk need not necessarily result in a high return outcome.
Quote from June 15, 2001
The correct lessons—price matters, trees don't grow to the sky, high risk does not necessarily correlate with high return, sometimes it is better to be risk-averse—have begun to be applied to technology stocks but not to most of the rest of the market. As we have said before, it appears likely that considerable pain must be incurred over a protracted period for investors to fully absorb these unavoidable lessons.

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