Seth Klarman on Bubbles & Crashes

How did that change how you looked at the world, and what lessons did you take from it? [17:45] SETH KLARMAN: I would tell you, I think every investor needs to be a student of history. It may not repeat exactly, but it certainly rhymes, and it is very valuable to understand — especially financial history for an investor. What were the worst moments? How did we go through a market crash in 1929 to 1933 and a Great Depression that lasted close to a decade? What must that have been like for the people at the time? How would one handle oneself if you were going into a period like that, when we know that even the greatest acclaimed value investor of all time, Benjamin Graham, went broke twice during that era? So it’s incumbent on all investors to be thinking, and maybe holding multiple inconsistent thoughts in their head at the same time: that I found this interesting opportunity today, this bargain-price stock for whatever reason — it’s out of favor, they cut their dividend, it’s a spin-off, it’s a bankrupt security that’s converting into a new equity. These things tend to get mispriced. But you’ve got a backdrop, from time to time. Today we have a backdrop of an expensive market and a bit of euphoric conditions. Is that dangerous? Dangerous. But we’re also at the cusp of maybe a groundbreaking new technology.

So over the 40 years it’s always been some of both — you’ve got a backdrop of something sometimes very depressed, sometimes very optimistic, but you’ve also got individual securities that are fluctuating around, maybe creating bottom-up opportunity. What I deeply believe is that value investors make money staying in the bottom-up. You might have a top-down view, you might say, yeah, it could be a bubble, it could be a problem, but bottom-up is where you’re going to devote your time. It keeps you anchored. If you have a portfolio of bargains, you’re probably going to do okay, if you’ve stress-tested them and if you’ve been intellectually honest about them and they really are bargains. [19:47] BARRY RITHOLTZ: So you mentioned Ben Graham. I’m curious as to who else were important influences on the development of your investment philosophy. I’ve read about Michael Price and Max Heine. Who affected you the most over the years? Who still affects you? [20:08] SETH KLARMAN: Reading Ben Graham was certainly a major influence on me, as he has been on essentially everybody in the value investing community. And then Warren Buffett, the real-life practitioner of Graham.

We read again this morning that 10% or 15% of some endowments’ entire endowment is in the one name SpaceX. So they’re going to want to sell. Employees are going to want to monetize and go from being wealthy on paper to wealthy in a bank deposit. So that’s a lot of stock for sale. And we have to sell that stock while apparently Google and Facebook need more money, and OpenAI and Anthropic need more money, and utilities need more money for power, and chip companies need to build new factories in America. There’s so much demand for money. I think we’re in a vulnerable place, where ultimately supply and demand for money determines the cost of capital. That’s true in the bond market, and it’s in effect in the stock market. So we might be looking at some supply-demand excess where prices soften just because there’s so much supply of securities and the need to monetize is so great by these private companies. [58:18] BARRY RITHOLTZ: So let’s talk about another imbalance between supply and demand through history, because Baupost has been around for over four decades. You’ve traded and invested through and survived all sorts of different market regimes — inflation, disinflation, the dot-com bubble, the financial crisis, QE and ZIRP, COVID, and more recently the return to, let’s just call it, normalized interest rates. Has anything changed since 1982? Is it just the same screaming from one crisis to another? Or do things eventually sort of moderate, do we learn from these experiences?

Business Insider reported on Klarman's 2022 year-end letter to Baupost clients, in which he warned that markets had entered a phase of speculative excess unlike anything since the late 1990s and arguably unlike anything in the prior history of the modern asset-management industry. He pointed to meme stocks, special purpose acquisition vehicles, and non-fungible tokens as evidence that prices had become unhinged from any disciplined process of valuation, and that the participants in those markets had begun to treat the absence of any conventional valuation framework as a virtue rather than as a warning. The letter argued that the post-pandemic bull market had encouraged an entire generation of investors to confuse rising prices with durable wealth creation, a confusion that history suggested would unwind painfully when the speculative phase ended and the underlying businesses reasserted their claim on the prices. Klarman's central concern was that the speculative phase had been funded by zero-rate policy and excess savings accumulated during the pandemic, and that the unwinding, once it began, would expose how thin the foundation of those gains had been and how much of the apparent wealth was a function of leverage extended against inflated collateral. He warned that inflation, having returned after a long absence, would force a structural repricing of risk that would catch leveraged investors offside and that would also expose the fragility of business models that had been built on the assumption that capital would remain nearly free indefinitely. He described the situation as one in which the apparent real returns of the prior two years had been an illusion sustained by monetary stimulus rather than genuine business progress across the economy, and as one in which the unwinding would be neither gentle nor predictable. The letter also took aim at the cultural infrastructure that had formed around speculation, including online forums that treated investing as a kind of multiplayer game and that rewarded participants for theatrical commitment rather than for analytical discipline. Klarman argued that the moment a market becomes a venue for entertainment, the discipline required to avoid permanent loss of capital erodes quickly, and that the cultural shift becomes difficult to reverse even after the speculative phase itself ends. He warned clients that Baupost would continue to underperform during speculative phases and asked them to remain patient, reminding them that the same posture had allowed the firm to act decisively in 2008 and 2020 when forced sellers emerged from the wreckage of those cycles and when the assets that had been unobtainable during the euphoria became available at prices that finally reflected a margin of safety.

Klarman's 2008 letter catalogues twenty lessons from the financial crisis that he argued investors had failed to learn. His central observation was that an entire generation of market participants had come to believe that central-bank action and innovation in financial engineering had eliminated the possibility of system-wide loss. He saw that belief, not the housing market itself, as the precondition for the eventual collapse. He argued that the mania had been built on layer upon layer of low-quality credit, each tranche of which had been rated by agencies paid by issuers, insured by counterparties whose own balance sheets were impaired, and bought by investors who had not read the offering documents. The complexity was not accidental - it concealed the absence of true underwriting. Each link in the chain assumed someone else had done the diligence. The lesson Klarman drew was that the absence of recent losses breeds the conditions for the next loss. He warned that even after 2008, the structural response - bailouts, quantitative easing, fiscal stimulus - would teach market participants that downside had been socialized. That expectation would, in turn, set up the next episode of moral hazard. He treated the post-crisis regime as the soil in which the next bubble would grow, not as a guarantee that bubbles could no longer occur.