The Downsides of Free Money
December 22, 2022
BluOr Bank Investment Portfolio Manager
Looking back over the past two and a half years at the extraordinary post-Covid boom in the technology sector and its subsequent bust, one question comes to mind – was any of it real? Let’s take a look back in time to see how we got here.
On March 23, 2020, after having fallen nearly 35% in just over a month, the S&P Index bottomed out. Lockdowns had only just begun a few weeks prior. Nobody knew what to do. Toilet paper and buckwheat were sold out. Yet financial markets, given decisive action from central banks to prevent a liquidity crisis, sniffed out that the world in fact not going to collapse. Despite all of the problems that followed, for the next 18-20 months, markets moved in only one direction. Up and to the right.
Technology companies, of course, led the way. We were told we were entering a new paradigm, one in which technology would enable a decentralized work-from-home world and where cryptocurrencies would be the backbone of the new decentralized financial system. And now, it would be easier than ever before for anyone to participate on the financial upside of this evolution! Just open your app of choice and start gambling, that is, investing. Don’t be distracted by the colorful UX design and confetti animations.
Why wouldn’t you want to bet on the companies who are changing the world? The exponential growth names that have immeasurable market power thanks to network effects, reams of data and the advanced technologies that let them endlessly expand market share. What is the total addressable market? All of it.
Supply constraints might be going on in the real world due to the lockdowns, but they do not exist here – everything is digital and instant.
And one thing was certainly not in short supply during this boom – money.
Through no fault of our own, my whole generation has been conditioned over the past decade to a world of falling (and for a period negative) interest rates, nonexistent inflation and lackluster real economic growth. At the same time the real world seemed to stagnate, the online world flourished. With the rise of smartphones and social networks, the internet became the center of our lives. Cloud computing transformed business operations, which together with new productivity tools enabled a high-growth startup ecosystem to be born. The economic potential seemed limitless.
However, it turns out that these economic conditions contributed to poor decision-making. Low interest rates and central bank stimulus meant that there was so much cheap money looking for a home that injecting it into tech startups or newly minted IPOs made a lot of sense. With the real economy stagnating, why bother investing in traditional businesses when the promise of hyper-growth and a global market is right there?
Does the company make any profit? It doesn’t matter, it’s all about capturing market share now, we’ll worry about profits later. It doesn’t really even matter when later is, so long as the number is big enough. With discount rates at zero, the value of your future cash flows tomorrow is the same as it is today!
And so we entered a world where unprecedented sums were flowing into the technology sector, pushing valuations up to dizzying heights. Aggressive venture capital with deep pockets like Softbank’s Vision Fund led the charge, throwing money at anyone who would take it and forcing other venture capital funds to do the same just to stay in the game. Excess capital flowed into countless unprofitable and unproductive ventures that should have never been funded, and private companies that should have remained private went public to feed the insatiable appetite of investors.
Forget due diligence. All you need is someone else to buy the narrative. And with the increase in liquidity following the Covid crash, people were paying up.
But, as with any bubble that inflates, at some point that narrative gets tired and there’s nobody left to sell the dream to. The S&P 500 Index peaked at the beginning of this year, with most of the big tech names already showing signs of being worn out a few months prior. Some of the best and biggest names like Google and Meta have been cut in half. There are many others down even more.
So what happened?
For one, the pandemic ended and clobbered the business models of companies like Zoom, who’s stock prices had grown astronomically thanks to the fast adoption during the days we were all working from home. Years of growth were pulled forward, but that growth turned out to be unsustainable.
It is also true that the consumer internet itself is largely established. Internet, social media, and smartphone usage is saturated, especially in the West. So much of our daily attention is already absorbed by the internet that there just is not much more to give. This increased competition for eyeballs makes the whole space a more zero-sum game. Even the coming AR/VR revolution will run into this problem. Just another way to access the internet, it can’t increase the number of minutes in a day.
But the biggest factor in the recent tech bust has been inflation. When it first started to pick up 18 months ago, everyone was saying that it was only transitory, caused by short-term supply disruptions. That was party true. But the other part of the truth is that flooding an unprecedented amount of liquidity into markets while engaging in extremely expansionary fiscal policy has unintended consequences. Forced to respond, central banks worldwide have tightened financial conditions to combat the rising inflation. We’ve gone from a world where interest rates were near or at zero for more than a decade to one hovering near 5% in the US and 2% in Europe in less than a year.
As central bankers withdraw liquidity, someone needs to step in to refinance or otherwise provide more capital. But there’s nobody there. Instead we’re forced to realize that our heightened expectations weren’t warranted and those outsized returns were merely byproducts of favorable circumstances and timing.
This collapse has exposed some examples of outright fraud, especially in the crypto sector, but there are overwhelmingly more of hubris. Over-optimism, overexpansion and profligate spending by tech companies on unnecessary pet projects and perks and bloated workforces is now backfiring and ending in layoffs and real economic pain for those impacted.
But, believe it or not, the whole market isn’t just the top tech names. These stock collapses have happened in the midst of an otherwise relatively resilient economy, with incredibly low unemployment and strong consumption growth. The S&P 500 is down from its peak a year ago, but only by about 16%. Yes, there is trouble on the horizon and high rates negatively impact everyone, but most of the pain in markets has been in the technology sector.
Elsewhere in the economy, there are solid companies that actually earn money and have strong balance sheets, that are doing just fine, even garnering positive returns for their investors and returning that money to shareholders. An interesting comparison is to look at the market capitalization for Berkshire Hathaway and Tesla. A year ago, Tesla was worth more than twice as much than Berkshire Hathaway. Since then, Tesla shares are down ~60%, while Berkshire is up 8%. Even still, there is probably more pain ahead for Tesla. Especially when you consider that Berkshire’s annual profit is two thirds of Tesla’s annual revenue!
The world is not collapsing, just the bubble in absurdly valued technology companies and cryptocurrencies that is now taking a generation of investors along for the ride. What does that mean for investors? My feeling is that many people will have to learn about what actually makes a good business. That means putting in the work and learning how to understand balance sheets and business models and learning about management. For a while, investing will become boring again.
At the same time, this does not mean the end of growth of the technology sector any more that the Dot Com Crash did. If the influx of easy money in the sector diminishes over the next decade, it will only mean more opportunities for talented investors who can identify good start-ups that are desperately short of cash.
The technology sector itself will probably transform in some respects. The consumer technology of the past decade will be commoditized and no longer be at the forefront, making way for new business based on AI technology and investments in physical technologies. Batteries will change the game in compact energy portability for things like robots and transportation. Biotechnology will transform medicine in ways we cannot yet fathom. Energy systems will be rebuilt with next-generation technologies that will harness many of the tools we have today and enable a whole new range of others.
A new boom will be born. The businesses and technologies they offer will change, but the froth, overconfidence and excess will repeat. Until then, we will just have to get back to the basics of what it means to invest.
So was any of it real? Obviously. It’s just the price that wasn’t.
The Latvian version of this article originally appeared in the December 2022 issue of Forbes Latvia.
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