Kass – You Should Listen Closely To The “Oracle Of Boston”

Civilization is hideously fragile . . . there’s not much between us and the horrors underneath, just about a coat of varnish.” – Charles Percy Snow, British Novelist, and Chemist

“All models are wrong, but some are useful.” – George E.P. Box, British Statistician

“To be absolutely certain about something, one must know everything or nothing about it.” -Henry Kissinger, Former U.S. Secretary of State

“But who shall dare to measure loss and gain in this wise? Defeat may be victory in disguise; The lowest ebb is the turn of the tide.” – “Loss and Gain,” Henry Wadsworth Longfellow, American Poet


“You may find a buyer at a higher price-a greater fool-or you may not, in which case you yourself are the greater fool.” – Seth Klarman


I have admired The Oracle of Boston, Seth Klarman, for decades. To me, he is one of the top five investors in modern investment history – in the class of Warren Buffett and Stanley Druckenmiller.

Klarman wrote one of the best books on investing – Margin of SafetyThe book is so valuable and rare that a new one sells for almost $1,500 today and used copies for about $1,000.

One of my favorite parts of his book (that I have quoted extensively over the years) focuses on what he calls Trading Sardines and Eating Sardines: The Essence of Speculation, in which the author discusses the importance of doing your homework and avoiding speculation:

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”‘

Like sardine traders, some market participants are attracted to speculation, never bothering to taste the sardines they are trading (or to do the fundamental analysis). Speculation, you see, offers the prospect of instant gratification. Many ask, why get rich slowly if you can get rich quickly?

Herd following and crowd behavior is a basic condition of speculation. There is comfort in consensus and playing along – those in the majority gain confidence from their very sizable numbers. I have repeatedly observed that today, many, knowingly or unknowingly, have become speculators. They may not even realize that they are playing a “greater-fool game,” buying overvalued securities and expecting-hoping-to find someone, a greater fool, to buy from them at a still higher price. (See Klarman’s quote at the beginning of today’s missive).

There is a great allure (and tendency) to treating stocks as pieces of paper that you frequently trade. Viewing stocks this way requires neither rigorous analysis nor knowledge of the underlying businesses. Indeed the act of trading (in and of itself) is exciting and can be lucrative, as long as the market is rising.

By contrast, value investors pay attention to financial and fundamental reality in making their investment decisions – speculators have no such tether.

Seth Klarman’s January 2019 Letter to Investors

Seth Klarman’s letter to his Limited Partners has received a lot of chatter in Davos and over the business news airwaves this week.

I found many of his concerns similar to the ones that I have outlined in my Diary over the last 12 months.

What follows are Klarman’s 15 major areas of investment concern – I promise that you will find many of them familiar:

1. The Bull Market in Complacency

“Last year once again demonstrated that markets can be confoundingly fickle. Well- known conditions and widely anticipated events, such as Federal Reserve rate hikes, ongoing trade disputes, and the unsettling behavior of an erratic president, were shrugged off by the financial markets one day and driving markets down the next. Is there a cumulative impact, where no one thing matters until the collective weight of them starts to? Is the market simply myopic, whereby it ignores signs of trouble until they become more immediate and it can ignore them no longer? It’s always hard to know why the market does what it does. That’s part of the ever-interesting challenge we face in traversing the twists and turns of fluctuating prices and evolving fundamentals. On any given day, the sheer number of players, behaviors, economic factors, and business developments defy anyone’s ability to fully grasp what is going on and why. That’s why we develop and follow a game plan that does not purport to tell us what to do moment by moment, but rather is intended to help us successfully navigate the most challenging tumult. This is the essence of value investing.“

2. Enter the New Regime of Volatility 

“The major U.S. stock market indices steadily gained ground for the first three quarters of 2018, before plunging in a highly volatile fourth quarter. Early in the year, those who had bet that the market would remain on a steady uptrend were briefly caught flat-footed when volatility surged higher. The most jarring example was the near complete wipeout and sudden liquidation in February of the exchange-traded note XIV, a retail product used by many traders to short volatility. (The name XIV is the reverse of VIX, the common measure of market volatility.) Since its inception in late 2010, this instrument had appreciated 14-fold into early 2018, and then it was shockingly wound down within a month after it had lost 95% of its value. By mid-April, however, volatility abated and the stock market resumed its seemingly habitual march higher…

Waves of selling swamped equity markets in the fourth quarter, as volatility surged. While in 2017 the U.S. equity market did not experience a single daily fluctuation up or down of as much as 3%, in 2018 there were 15 such days, 10 in the fourth quarter alone.”

3. The Changing Market Structure Poses Sizable Risks

“Generally rising share prices over the ensuing months more or less moved in tandem with higher corporate earnings, the result of massive fiscal stimulus, large corporate tax cuts, and historically low – albeit generally rising – interest rates. Cash continued to move into indexing strategies and out of the hands of active managers, with U.S. index fund holdings, after doubling from 2002 to 2009, nearly doubling again by 2018 (with important ramifications for market liquidity and corporate governance). Market pundits calculated that valuation multiples, with earnings assessed on a cyclically-adjusted basis, had reached the second-highest level ever (though reported earnings were more in line with historical averages). The economic expansion, clocking in at nine-and-a-half years, neared the longest on record. As usual in a bull market, the warm feelings generated by rising prices had the effect of overcoming any sense of looming danger in the hearts and minds of most investors. And as in all bull markets, skeptics lost both credibility and assets to manage. Many investors had evidently adopted the usual dubious emergency plan: Get out when the market starts to fall. In August, the bull market became the longest on record – at nearly 3,500 days and counting. It felt like forever…

As for algorithmic leverage, a growing amount of capital is today managed using model- based technologies to pick investments, many of which attempt to improve over time using artificial intelligence capabilities. (The Wall Street Journal recently estimated that 85% of all stock trading is now controlled by machines, models, or passive investing formulas.) The amount of capital invested in this way has grown massively since the last bear market, and no one can know how the various trading algorithms might respond to (or potentially even trigger) the next major selloff, especially after virtually an entire decade with low volatility. We simply cannot know how those algorithms might respond to new and unexpected conditions.”

4We Saw Who Was Swimming Naked In 4Q2018 and The Risks Associated With “The Negative Wealth Effect”

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Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Real Investment Advice is expressly disclaims all liability ...

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Gary Anderson 9 months ago Contributor's comment

Sobering article. When the POTUS disputes the concept that all men are created equal, and he is on video disputing the Declaration of Independence, then we have a serious problem in American politics.