In the spirit of the midterm elections, today I’d like to elect a 2022 poster child for the excess, hubris, and recklessness that always gets exposed during a bear market.
And there are a few great candidates, which I’ll get to in a minute. But first, let me share my nomination process with you…
Like I just said, there are always a few bull market superstars whose bad decision-making gets exposed when the tide turns to a bear market.
My favorite quote to describe this phenomenon comes from Warren Buffett: “When the tide goes out, that’s when you find out who’s been swimming naked.”
Great quote. Because we all know very well that on any given summer day at the beach, there are plenty of people that we’d be just fine with seeing naked and plenty of others that we would not, thanks all the same.
Buffett himself would fall in the “thanks all the same” group. Nobody wants to see that.
But fortunately for us all, Buffett knows how the liquidity tide works, perhaps better than any investor in the world today. The tide rises when interest rates are low, and money is cheap, and it inevitably and dependably goes out when money gets expensive.
Uncle Warren never gets caught with his pants down. His company, Berkshire Hathaway (NYSE: BRK), has been impervious to the changing tides for 70 years. The list of companies out there that might have benefitted from some of Buffett’s downhome wisdom is very long…
A Brief History of Bubbles
Back in 2000, after Fed Chair Alan Greenspan popped the internet bubble with a 50 basis point rate hike on March 13, the parade of the undressed stretched as far as the eye could (but didn’t want) to see.
2000 – 2001 saw 2.67 million personal bankruptcies and 75,571 corporate bankruptcies. Both categories were records at the time.
263 corporate bankruptcies in 2001 were public companies, another shocking record.
Shocking because public companies (those whose stock you can buy on an exchange like the NYSE) have much stricter accounting requirements than private companies. Earnings reports and balance sheets are public record, updated, and published every three months. They are regulated by the SEC. And if it's a bank, the Federal Reserve is also looking over its shoulder. They have compliance departments and officers. They have huge investors like pension funds that dissect quarterly financial reports down to the penny.
And yet nobody notices they are skinny-dipping until it’s too late.
In 2008 and 2009, a total of 348 public companies went bankrupt. But it wasn’t just marginally viable internet companies and fraudulent “new economy” stocks like Worldcom and Enron that went down…
In about 8 months, from June 2007 to March 2008, investment bank Bear Stearns fell from a $20 billion company to a fire sale buyout at $400 million. It was worse for Lehman Brothers, which went from a value of $60 billion in February of 2007 to essentially zero on September 15, 2008, when it declared bankruptcy.
One last example: over 100 U.S. oil companies went bankrupt when the price of oil fell from 2014 highs of well over $100 a barrel to 2015 lows of $35 a barrel.
Easy Money + Great Story = A Poor Investment
A couple of common threads connect each of these mass bankruptcy events. One is monetary, the other is emotional.
On the monetary side, cash flow was at high tide. Before the internet bubble popped, tech companies were taking in hundreds of billions from individual investors, venture capital firms, and investment banks, who all wanted in on the unbound potential of the internet.
Before the financial crisis, bundling mortgage loans into mortgage bonds and then selling them was the easiest money investment banks like Lehman ever made. And insuring those bonds was the easiest money insurance companies ever made.
Before the oil bubble popped, drilling a hole that could produce oil at $50 a barrel that could then be sold for $120 a barrel, well, let’s say there was no shortage of investment capital.
On the emotional side, it was “let the good times roll.” The growth thesis was believed to be ironclad in each case. E-commerce was an unstoppable exponential force. In the history of the U.S., mortgage default rates had never gone above 2%. The steady increase in oil demand would support oil prices for decades.
In each case, cheap money and good times made it seem like risk had been conquered.
And so balance sheets and business plans were not built to account for the drop in spending that comes with a terrorist attack on top of a recession, or mortgage default rates that not only topped 2% but went to +4%, or a decision by Saudi Arabia to flood the oil market with its oil and crush prices.
How’s the Water Today?
Today, with interest rates approaching 20-year highs, and the monetary tide pretty darn far from its high water mark, we’re seeing some skinny-dippers sheepishly shuffling around in ankle-deep water…
Did you see the look on Mark Zuckerberg’s face when apologizing to the 11,000 people he was firing from Meta (NASDAQ: META)?
I can only imagine what a fortune of $100 billion does to one’s self-confidence. Likewise, I’ll never have to know what blowing $70 billion on an ego-driven escapade into the metaverse feels like. But I bet it doesn’t feel so good. Especially when the reality of Zuckerberg’s metaverse is still years away, real-world advertisers are abandoning Facebook in real-time, and the kids are all hanging over at TikTok’s house.
This story is far from over.
Elon Musk is standing in deeper water than Zuckerberg, for sure. But still, he’s looking a little cheeky with his Tesla shares down 50% since he confirmed that he would indeed follow through on his purchase of Twitter.
But if I had to pick one area of the stock market that appears to be already stripped bare by the receding liquidity tide, it’s cryptocurrency.
I couldn’t even find an up-to-date number for the number of cryptocurrencies that have failed this year. The best I got was a report from May that pegged the number of failed crypto at 2,452.
The total value of the crypto market has fallen 70% this year, from a little over $3 trillion to about $1 trillion. $2 trillion in real money value has gone up in smoke.
And there have been some spectacular failures.
The collapse of the Terra/Luna stablecoin was a good one. A stablecoin isn’t supposed to be volatile. The whole point is that the Terra cryptocurrency was pegged to the US dollar and should reflect the dollar’s stability. But Terra/ Luna came up with some wacky dividend scheme to encourage investors to buy in. The dividend was completely unsustainable, and the cryptocurrency failed. And that, in turn, was the death knell for $10 billion crypto hedge fund Three Arrows Capital, crypto broker Voyager Digital and crypto lender Celsius Network.
Crypto exchange Coinbase (NASDAQ: COIN) gets an honorable mention. Once touted as the ultimate safe way to play the crypto market, its shares have fallen from highs around $350 to $50. But, it hasn’t failed – yet – so it doesn’t qualify as anything more than a cautionary tale.
I think crypto exchange FTX has to be the winner. Holy moly, what a story. The founder, Sam Bankman-Fried, became a billionaire through huge investments from venture capital firm Sequoia Holdings and the biggest money manager in the world, Blackrock.
The funny thing, these heavyweight investors didn’t know if the founder had a Board of Directors or any oversight mechanism to manage risk. And I guess they didn’t care much, which is rather scary. I want to think the so-called smart money was aptly named.
The net result was that FTX founder Bankman-Fried had free reign to do whatever he wanted with billions of dollars.
So he transferred money into his own trading firm. He “invested” in other cryptocurrencies and exchanges, even spending $240 million to keep the BlockFi exchange from failing. He even bought the naming rights for the Miami Heat’s arena for $135 million.
As the ongoing free fall in crypto valuations was wiping him and his company out, he tried to imply that the FTX exchange’s assets were backed by the U.S. government.
Yesterday, reports were that Bankman-Fried was trying to arrange a $9 billion cash injection to stay afloat. Today, Bankman-Fried stepped down as CEO, and FTX declared bankruptcy.
Ladies and gents, we have a winner.
What this means for cryptocurrency and exchanges remains to be seen. But one important takeaway is how, ultimately, markets become self-regulating. The SEC, the Federal Reserve, and even Congress tried to find ways to regulate the crypto markets, albeit halfheartedly. The markets have pretty clearly done their job for them. Investors are now keenly aware of the risks, and the companies and exchanges will have to make the changes necessary to assure investors that these are not fly-by-night schemes.
That’ll take a little while, as it always does when a bubble pops.
Until next time,
The Profit Sector