Since the Global Financial Crisis, we have operated in an environment where money has been “cheap”. When the Federal Reserve lowered the funds rate to a range of 0 to 0.25% during the heart of the pandemic, some might have even described money as “free”. Established companies could raise debt at historically low rates for any number of projects. Young startups could access venture capital to fund their operations as they searched for a path to profitability. And private equity firms had capital to lever up their portfolio companies to boost returns and de-risk their investments. Lower interest rates and over $14T in fiscal and monetary stimulus[1] worked together to stimulate the economy. With interest rates approaching near zero, governments, businesses, and consumers had ready access to money whenever they needed.
“Money” can be broadly defined as “a commodity accepted by general consent as a medium of economic exchange”. People use money to purchase value or they use money to create more money also referred to as “return” or “yield”. Where that money gets invested is based on the individual investor’s appetite for risk along their investment “risk curve”. The further out on the risk curve the investor ventures, the higher the potential, and expected, return. Most investors have a point on this curve where they feel most comfortable, a native habitat. This is the place where that investor feels that the level of reward they are seeking can be achieved at the level of risk they are comfortable with.
Example Risk Curve[2]
U.S. Government debt in the form of 3-Month Treasuries is often considered “risk free”. The return an investor will receive is relatively low, but an investor can assume that the U.S. Government is unlikely to default on its debt within the next 3 months. This is the left side (starting point) of an investor’s risk curve. If an investor desires a higher return and is willing to take on more risk, they move up the curve in search of more return. From 3-month US Treasuries, an investor can take a short step to longer maturity government bonds which are riskier because there is more time for the government to default. And the options continue: corporate debt (public company bonds), public equities, hedge funds, private equity, and out to venture capital, real estate, and eventually more obscure moonshot opportunities in crypto and other ventures. The options along the risk curve are endless.
With interest rates as low as they were for so long, investors were no longer receiving their expected rate of return at their given risk appetite. And so, they were forced to move up the risk curve to achieve their desired return. Investors accustomed to receiving 3% interest on 10-year treasury notes had to move to corporate debt to achieve a 3% yield. Corporate debt investors had to “reach for yield” within lower sub tranches of debt and so on and so on. When investors begin to move outside of their native risk habitats, strange things start to happen. The investment landscape becomes unbalanced, and investors seemingly begin to behave against their own interests. Money begins to chase fewer and fewer opportunities, and investors become willing to accept lower returns for their money by paying higher valuations (on earnings or revenue multiples). Investors quickly forget that they are stretched further up the risk curve when other investors pile in after them boosting the returns of those who reached first. As investors observe others making loads of money, FOMO leads investors to ignore their typical due diligence standards and invest in companies that have no Board of Directors, no audited financials, and are incorporated in the Bahamas. “He’s an innovator.” “He attended MIT.” What could go wrong?
From this behavior, we get meme stocks, money created out of thin air, and venture like investments going public when they have no business being publicly traded. During times of euphoria, frauds and scams proliferate. An investor’s vision gets blurry when it’s raining money, and it becomes challenging to differentiate real investment opportunities from deals that are truly “too good to be true”.
In a cycle as old as the market itself, these are all the standard signs of a market bubble. This is nothing new. Free money changes behavior and drives people further and further up the risk curve searching for returns. But free money is unsustainable. And during our recent cycle, the free flow of capital led to rampant inflation. The Federal Reserve’s response to inflation is what has finally broken the current cycle.
In our last letter, we discussed how the Federal Reserve is aggressively raising interest rates and unloading their balance sheet to beat back inflation. The free money is now drying up. And as the tide flows out, investors realize just how much risk they were taking in their search for returns.
“You don’t find out who’s been swimming naked until the tide goes out”
– Warren Buffett
As money dries up, frauds are uncovered, and investors flee to safety. As investors observe other investors getting burned, they remember the habits required to make good investments. I’m not sure what the opposite of FOMO is, but that is how investors behave, thereby pulling even more money out of the market, frequently in excess to the downside. Investors become more judicious in where they will invest their funds, and businesses with flawed business models atrophy and die as it becomes harder to raise fresh capital.
As interest rates rise, investors are now migrating back down the risk curve. Investors who had moved on from investing in risk free treasuries realize that 3-month treasuries are currently yielding 4.3% which is an attractive yield for them. And so, they move back downstream to their native habitat. And because all investors can now receive 4.3% interest on their money virtually “risk free”, the standards for additional risk are raised. To take risks up the risk curve, investors must be confident that they can receive a reward that is worth the additional risk. Meaning not just a higher return, but also a likelihood that such return will be realized. Sober decisions are made. Valuations for investments across the investment universe come down because investors demand a higher return.
That is where we find ourselves now. Markets have fallen over the past year, and we seem to be back to a more rational environment. Corporate management teams are becoming more disciplined as they cut costs and headcount to prepare for whatever market environment lies ahead.
What does this mean for our investments in equities? We believe that we are now entering a “stock picker’s market” where good investors have the opportunity to separate themselves. We may not see much movement in the indexes: high quality companies will shine, however, the indexes will continue to be burdened by underperforming “zombie” companies with limited access to capital. Our expectation is that volatility will continue to be driven by market concerns around a recession and how deep it will be. Corporate earnings will be a key focus for investors in 2023.
There are reasons to be optimistic as there are numerous indicators pointing to a recession that will be mild: jobs continue to outpace workers available, businesses have built up solid cash cushions, the expected rise in unemployment could be modest, and household finances still have less debt and more savings built up from the pandemic.
There are many studies highlighting reasons to remain bullish for stocks in light of the current market environment. In previous inflationary periods, corporate earnings growth remained robust and the S&P 500 supported mid-teens earnings multiples when sustained inflation was kept below 6%. And in general, earnings growth remained strong in all but the highest inflationary periods. Finally, the valuation decline in 2022 should provide a buffer from future steep market declines.
Our outlook for equities remains positive.
Welcome to the end of free money!
[1] $14T total for G20 economies ($5T from the US) and the largest stimulus as a percentage of GDP in world history.
[2] Source: https://www.forbes.com/sites/rahulrai/2021/11/16/a-tale-of-two-cities-the-federal-reserves-growing-influence-on-bitcoin/?sh=535d359e783b
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