Seth Klarman: ‘Stock market is a story of overreactions in both directions’

Billionaire investor and Hedge fund manager Seth Klarman once said – “The Stock Market is the story of cycles and of the human behavior that is responsible for overreactions in both directions”

In this article, we will try to understand Seth Klarman’s quote in greater detail. It is quote that is important to understand because for the smart investor, a market overreaction ends up becoming a market opportunity.

Sometimes, a once-in-a-lifetime opportunity.

When Covid was declared a global pandemic and lockdowns were announced across the world, the stock markets crashed.

And they crashed like the world would end and businesses would be shut down forever.

Stocks were available at 5 to 10-year low prices – yet there were very few buyers.

Clearly, the Covid crash was an overreaction on the downside.

Then, something changed. The markets suddenly turned. Initially there was disbelief, everyone thought the market will bounce and crash again.

Even while streets remained deserted and most businesses were struggling to survive, the rally on the upside was relentless for the next 18 months. Stocks hit all-time-highs.

Investors who weren’t interested to buy at 5-year lows, were more than willing to invest after the same stocks had risen 5 times or more!

The overreaction was now on the upside. And like always, this marked the beginning of a new cycle.

This pattern which occurs due to human emotions like greed and fear – will keep repeating in cycles. And these cycles are common across all asset classes, including real estate, commodity and the more recent example being Cryptocurrency.

There will be overreactions on both directions, and this overreaction is what creates opportunities for investors.

Warren Buffet had once famously said “Be fearful when others are greedy and be greedy when others are fearful”

When most market participants are greedy, there tends to be an overreaction on the upside. This is the most difficult time to sell and build a cash position. But selling at this time could be very painful in the short term, but will prove to be the right decision when the market eventually turns.

When most market participants are fearful, there is an overreaction on the downside. This is the most difficult period to buy, simply because there is extreme fear among participants.

The reasons will be different each time. It could be a global pandemic like Covid, a financial crisis (like 2008) or a sudden outbreak of war like the one which took place in Ukraine. The next crash will carry a different reason. Courage to buy at this time will, in most cases, give you the best returns.

Access to information has become extremely quick. Breaking news is published on Twitter within seconds.

Due to this, the speed and frequency of these cycles has increased and will increase further with time.

When there is a positive news, everyone tries to buy at the same time. Sudden spike in demand leads to low supply resulting in prices sky-rocketing.

The impact of a negative news or even a rumour is more severe. Very few people wait to verify the news, before they sell. Sometimes selling is automated. All of these factors lead to huge selling pressure during a small period of time. Even genuine buyers who see value cannot match up and the prices crash.

Traders or even investors who learn to take advantage of these overreactions will end up getting the best returns from the market.

Keep observing the market, there is a lot to learn.

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