When the Music Stops📉
Market cycles aren't over until the music stops. Has it already happened or are we just getting started? Take a deep dive with me on market cycles, the impacts on VC and why this time is different.
Happy Monday!👋
I originally had the idea for this piece back in November of 2021 as I watched public growth equities begin an epic collapse. At the time, I was very confident that we were headed for trouble in the broader financial markets, which would eventually trickle down to Venture Capital (VC). Given that I’ve only been immersed in VC for about 2 years now, this was the first significant draw-down that I’ve had a front row seat to. I was deeply intrigued how this was all going to play out.
I did some initial research to solidify my position and understand beneath the hood what was about to happen. What I found was that from top to bottom, capital markets are closely intertwined. Like the human body, if you have injury in one place, by altering your daily mechanics, you eventually will break something somewhere else.
Unlike the human body, I found the potential breakage to play out rather methodically. Like the crescendo of an orchestra, the destruction starts quietly from the pit. The audience hears it faintly, but the sound is so soft that it remains unrecognizable at first. More sections of the orchestra join in, and the dynamics of the sound change. More and more of the audience grow keenly aware that the sound is building. Eventually, the entire audience feels the climax of the crescendo. No one can hide from the overwhelming sound that envelops the room.
By the time the crescendo has climaxed, the crowd is left in awe as the dust settles and the soft sound of violins gently weep.
Next, the diminuendo begins, and we do it all over again.
The parallel that I just described is a market cycle that ripples throughout the global economy. It’s been a long while (?) since we’ve lived one, so this is a new phenomenon to many young market participants.
The reality is, these cycles are necessary, but nasty. They are journeys of beautifully chaotic paths needed to restore economic homeostasis.
This is going to be a fun one. Let’s go!
-Myles
Disclaimer: This is not investment advice. I am not a registered investment adviser. I don’t know where the markets will go. You should do your own research.
Market Cycles: How it All Works
Before we dive in, let’s do a tl;dr of how market cycles work:
The Way Up (Diminuendo): Cost of borrowing (interest rates) is low. As a result, the consumer borrows more and spends more, which typically has a positive impact on GDP and the stock market. People’s 401Ks are going up, creating an illusion of wealth, which leads to a spending flywheel. Higher demand for goods & services, assuming supply can’t keep up, eventually turns into higher inflation. In this environment, there are heavy cash inflows to growth stocks and VC.
Something Happens: The good times are still rolling, but the bond market starts to look downfield and see trouble (i.e. recession, rising interest rates, something else, all of the above). Institutional investors begin rotating from riskier asset classes such as growth stocks and VC, to more stable asset classes such as value stocks, real estate or cash. The market begins to sputter. The sound begins building from the pit.
The Way Down (Crescendo): The Fed begins hiking interest rates which encourages people to save vs borrow. This destroys demand in the economy because the consumer has a higher incentive to put their dollars in a bank and earn higher interest rates. Because the public markets are efficient, they begin pricing in higher interest rates which are inversely correlated to valuations. Risk assets such as growth stocks feel it first, then it spreads. Eventually, this all ripples through the economy. Prices of goods & services begin to fall due to lower demand. As a result, companies begin to do mass layoffs because they aren’t able to sell as much and are forced to lower prices, which negatively impacts margins. The climax…everyone can now hear.
Here is a graphical representation of the psyche of an investor as a market cycle plays out:
For growth stocks in particular, we’ve been in the Anger-Disbelief range for most of 2022. The broad indices have yet to do any sort of capitulation. Due to several macro economic indicators flashing warning signs, many believe that we’re headed toward a broad-based market contraction in the first half of 2023. This would be the continuation & broadening of a Bear Market that started in 2022. However, it’s been a very odd market cycle due to the impacts of Covid. If everyone knows that a recession is coming, it just feels too obvious.
One thing is for sure: How we got to this point of the market cycle has been nowhere close to normal. What happens from here is anyone’s guess.
The Diminuendo: This Time It’s Different
When investing, there’s a saying: History doesn’t repeat itself, but it rhymes. This essentially means that causation can be different, but the ultimate end result tends to be the same. Sir John Templeton, an investing pioneer, was also famously quoted saying that one of the most dangerous things an investor can ever say is, “This time it’s different”. This essentially means that an investor ignores the echos of history and remains steadfast in their position. If you pick a few anecdotal data sets, one can find plenty of echos of the past in this current market cycle. However, I’ve read piece after piece that tries to find parallel markets, none of which are able to properly reflect the current market cycle that we are in. So, dare I say…This time it’s different.
Cost of Borrowing
First, let’s start with what’s not different: When the cost of borrowing is cheap (i.e. interest rates are low), people are going to make poor choices. When you make decisions in a Utopian World with the assumption that things will remain euphoric, bad things happen. Put simply: People make long-lasting, bad decisions when things are good because they assume that the good times will never end. Eventually, collective society typically has to pay for other people's mistakes in some fashion. Oftentimes, these payments go unnoticed, but sometimes, as was the case with the subprime mortgage meltdown, everyone pays big.
Guardrails are a necessary function of society. We need them to keep our egos that lead to excesses in check. There's a reason that our entire society is built off of the most beautifully unproductive piece of paper that we've ever seen: The Constitution. It's beautifully unproductive because it stops generation after generation from making too many big mistakes that have the potential to ruin our society. It's ironclad to protect us not from foreign enemies...but from ourselves. The articles of the constitution are the guardrails for our society.
Similar to the constitution keeping our society in check, interest rates serve as guardrails for financial decisions. When interest rates remain low, this results in a low barrier to borrow. Interest payments are lower, thus backend borrowing ratios are lower, resulting in more money being lended to a wider array of socio-economic backgrounds. This sounds admirable, but ultimately when lending conditions begin tightening, this does not end well for anyone, especially people that sit on the lower end of the socio-economic scale.
Since the 1970s when the Fed Funds Rate began being used for monetary policy, we just experienced the lowest rate decade ever:
This has resulted in an incredible run for risky assets such as growth stocks and VC. This has also lead to irrational exuberance and has served as a key contributing factor to extraordinary inflation.
So, let’s recap here. All else equal:
Consumers of all socio-economic backgrounds are feeling good. They’re borrowing and spending lots of money.
People feel richer because stocks are going up. Stock prices go up, people get paid more which is felt at all levels of the economy. Higher stock prices also leads to upper-middle and upper class consumers 401Ks feeling richer. More vacations and luxury purchases ensue.
This all sounds great, but all good times must come to an end, right?
Fed Balance Sheet Manipulation
Now, let’s talk about what’s new over the past ~10 years: Manipulation of the Fed Balance Sheet. This form of monetary policy was created in the wake of the 2008 financial crisis for the sole purpose of stimulating or cooling the markets.
There are two ways that the Fed can manipulate their balance sheet, and both tend to have extraordinary effects on the market and the economy:
Quantitative Easing (QE): The Central Bank (i.e. Fed) purchases government bonds and other financial assets. This increases the money supply, raises the prices of bonds, and in turn lowers their yields. Because stocks are generally inversely correlated to bond yields, they will rise in a QE environment.
Quantitative Tightening (QT): The Central Bank sells government bonds and other financial assets. This decreases the money supply, lowering the price of bonds, and in turn raising their yields. Stocks go down.
At the time of this writing, The Fed is currently in a QT motion while simultaneously raising interest rates at one of the fastest clips in history. The reason? We just increased the M2 Money Supply by ~35% in a 2 year span, the fastest and most aggressive in history:
Couple a low interest rate environment with unprecedented increases to the M2 Money Supply, and you have the recipe for some significant pain to be felt.
But, why would the Fed do such a thing?
COVID-19: The Great Injection
The Fed began QT and Interest rate hikes in late 2018, and by late 2019, the US financial systems began experiencing liquidity issues, leading to a “taper tantrum”. Many macro indicators began flashing recession, but they were not conclusive. It appeared that we could be heading for the end of a market cycle, but the natural order of this cycle was completely derailed.
In March of 2020, we all know what happened: The World stopped. A once-in-a-century pandemic forced World governments to do controlled and extended lockdowns that in some areas stretched on for over a year. The service industry was flipped on its head, almost immediately becoming overly dependent on the State.
All of this led to monetary and fiscal stimulus that the World has never seen: The Great Injection (see what I did there?).
All of a sudden, the risk/reward equation of staying home vs going to work was a no brainer. A good part of our society was paid considerably more than they ever were pre-pandemic. The combination of lockdowns and uncanny stimulus led to bizarre supply/demand imbalances, particularly around physical goods. While demand for services went to near zero, the World could not produce enough physical goods to satisfy unprecedented demand:
Further exacerbating the supply shortages was that we already had an issue with labor supply coming into the pandemic. Put simply, due to an aging society, our labor supply has been weakening for decades. This all really started occurring in the 1980s, but it has yet to get any better, only worst. Governments have attempted to combat this by using debt to increase productivity. Unfortunately, due to low interest rates, companies have been inefficient with their use of capital which has created falsehoods in our actual GDP growth. Covid-induced forced resignations and early retirements have contributed to significant damage to the global supply chain. An already frail system became much worst.
The sum of the parts has resulted in stubborn inflation that hasn’t been felt since the “Volcker Era” of the late 1970s/early 1980s. I recall my parents telling me that the first home they purchased was at an astonishing 20% interest rate. I thought this was nothing more than a, “I walked 5 miles to/from school in a blizzard” type story. Fact indeed.
The Fed, initially incredulous to the stickiness of inflation coming out of a once-in-a-century Pandemic (“transitory”), arguably waited too long to begin hiking rates. But alas, demand destruction is well under way and the bond market thinks we’re in for a crash landing. The Crescendo Begins.
The Crescendo: Where We are Now
When the Fed starts raising interest rates while simultaneously conducting record-setting rates of Quantitative Tightening, the crescendo begins building up in the economy. First, the more speculative asset classes such as growth stocks and crypto begin to rapidly decay. Unless you have exposure to these asset classes, you don’t hear the sound. Next, the QQQs start to turn over, typically led down by lower quality, high cash burn stocks. Eventually the sickness spreads to higher quality technology names that are more well known such as META, GOOGL and AMZN. Next up, the major indices such as the SP500 and Dow. The volume increases and the dynamics begin to be felt in not only in their 401Ks, but in other areas such as home values. Enter…Demand Destruction.
Demand Destruction
I don’t want to sugarcoat this at all: When the Fed says “raise interest rates”, this is translated to:
“We are going to destroy the consumer until they stop spending and hope that we don’t break anything big along the way.”
Full stop…raising interest rates is intended to make the consumer feel pain.
When rates go up, liquidity goes down. Eventually, people’s wealth decreases, making them feel less wealthy. Some continue to borrow and spend. Eventually the consumer rolls over and simply stops paying exuberant prices for goods and services. The less financially prudent begin defaulting on debt, and many go bankrupt.
Before that happens, people continue to spend to try and maintain the “good life” lifestyle. They do this by expanding debt and depleting savings, which can be seen happening at an alarming pace below:
Because ~70% of GDP comes from consumer spending, it’s no surprise to see the chart below which is the 10yr Treasury Yield - 2yr Treasury Yield (AKA the 10yr/2yr Spread). When the yield on the 2yr is higher than the 10yr, that means that as an investor, you expect to be compensated higher for investing your money over a shorter period of time due to a perceived elevation of near term risk.
Since 1950, when the spread becomes “inverted” for at least a few months, it has predicted a recession 100% of the time:
As you can see, we are deeply inverted and have been for months. Could this time be different? If you look at what is actually different, an inverted yield curve has never been preceded by a recession where the yield curve was not inverted prior. The million dollar question is whether this difference will ultimately lead to different results. We won’t know until 2023 comes, but let’s be clear: The bond market doesn’t think this time will be different. If they are right, the US economy as a whole is in for some pain, but it’s not all terrible for the VC industry.
Market Cycle: Impacts on VC
Over the past 10-15 years, our society has become obsessed with Unicornucopia (defined as a copious amounts of unicorns). The idea of “growth at all costs” has become all the rage, solidified in history by Reid Hasting’s book “Blitzscaling”. When a founder walks into a room to pitch a VC with the goal of getting to profitability and the VC says it’s a “pass” because the founder wasn’t “thinking big enough”, you know the scales have tipped too far. Don’t get me wrong, I still firmly believe that a company should aggressively push the bounds on LTV/CAC in most situations. However, when the tide rolls out, you can’t be the one swimming naked. There has to be a level of financial prudence and a plan to operate the business profitably in the event that you are forced to operate in a high interest rate environment for an extended amount of time.
The last time that our industry was forced to make this sort of pivot from a bout of irrational exuberance back to reality was the Dot-Com Bubble. Diving into this similar time period may give us a glimmer of what’s to come for VC.
Dot-Com Bubble
The mass adoption of Web 1.0 created a frenzied internet gold rush. Companies with zero revenue and immense cash burn were going public every day. Silicon Valley was booming. People from all walks of life were investing and feeling great because you couldn’t lose money. A good friend of mine once told me, “When your neighbor tells you to buy a stock at a cocktail party…it’s time to sell!”.
Around the year 2000, there were a lot of cocktail stock market conversations happening.
Similar to the current bubble, this was fueled by a decade of relatively low interest rates. Coming out of the 1980s, interest rates were close to 10%. For most of the 90s, rates remained around 4-5%, nearly 1/4 of the peak rate of 21% in the 1980s. This led to irrational market exuberance and a surplus of VC investments. Then, it all came down crashing.
From 2000-2002, the Nasdaq lost ~75% of its market value. This flowed through quickly to start-ups and the VC community as they move essentially lockstep in the chart below:
This can be seen in more granular quarterly data below. Note that VC investment dollars peaks in Q1 2000, which is the same time that the Nasdaq peaked:
Fast forward to now, and once again, as seen in the chart below, VC activity is following in lockstep with the Nasdaq, peaking in Q4 2021:
In theory, this makes sense. When the stock market goes down, Limited Partners (LPs) won’t have as much excess capital to allocate toward VC. This is because they typically allocate a targeted percentage of their entire portfolio to certain asset classes. As a result, once the market starts to crash, anyone who is raising a fund at that time will have a very difficult time doing so. Anyone who has a fund to deploy is typically in a good spot, but not great.
Ultimately, we can anticipate a few things that are guaranteed to happen from here:
Depressed Valuations (more below): Across the board, valuations are going to remain depressed for the foreseeable future.
Less Funds & Syndicates: The # of funds & syndicates are going to decrease quite significantly.
Start-Up Failures: Due to less dollars chasing these deals, the # of start-ups that fail is going to shoot up quite a bit. “Zombie” companies that never had a chance will no longer be funded, and we will finally have a much needed return to investing in financially viable business models.
Less Exits: At the time of this writing, major investment banks are starting to warn employees of less bonus pools. This is because the number of deals (i.e. companies going public or being acquired) is dropping, and will continue to do so until the Fed pivots and rates begin decreasing. This will undoubtedly also trickle down to GP’s fundraising efforts for veteran funds.
That all sounds depressing, but honestly, it’s necessary. There was way too much fluff happening in the VC World, and we needed to get splashed in the face with a cold pail of water to snap us back to reality. Valuations are finally coming back down to Earth, which is great for all market participants throughout both the private and public spectrums.
Valuations
Taking all of this in stride, the Dot-Com Bubble is information that we now have that we didn’t have in 2000. According to the Efficient Market Hypothesis, asset prices reflect all current information. Because there is less ambiguity around this cycle, I would expect valuations to be stronger through this downturn.
However, let there be no mistake, there is a great deal of uncertainty in the current macro environment. Uncertainty kills valuations. To illustrate this point, let’s use an example. Imagine that you’re reviewing an early stage deal. The entrepreneur is spot on in their pitch to the effect that they leave little uncertainty of the path that lies ahead. Furthermore, once you start your due diligence, you get into their model and you gain further conviction that the plan that they’ve laid out is realistic and there is a clear path to profitability. You’ve eliminated a great deal of uncertainty, and you aren’t the only one that sees the same thing. The round becomes competitive because the future profits are more certain, leading to increased valuations.
Because the macro environment is deteriorating and the future uncertain, even the great start-ups like the one mentioned above will feel the pain because there are fewer dollars chasing the same amount of deals. Demand goes down, and so do valuations.
So it seems pretty straightforward, right? Wait until you’re confident there is a bottom, and then begin deploying cash and grabbing those post-bear market vintages! Data suggests that the “bottom” might not be the best time to deploy.
When to Deploy?
Below is a visual representation of Internal Rate of Return (IRR) for annual vintages (i.e. if you launched a fund in 2000, what did it return to investors over the life of the fund) against the Nasdaq:
A few key takeaways worth noting:
Volatility: VC returns are generally less volatile than public market returns.
IRR Trend: VC returns continue to trend up, even through the Great Recession in 2008-2009.
Post Bear Market Boom: When you come out of a recession, the VC vintages of the subsequent years are always higher than investing at the bottom.
The last point was rather peculiar, as you’d expect that if you were buying at the bottom, you’d have higher returns. However, this dynamic makes sense because there’s simply less liquidity to support the companies that need to raise cash coming out of the recessions. Put frankly, many are still going out of business coming out of the recession because they can’t raise capital for operations. Another plausible key factor is that the time to exit is likely longer, which can destroy IRR (thanks for the thought collaboration on that Elliott!).
Ultimately, I am very opportunistic in this current cycle. There are plenty of great companies out there raising, and honestly the noise of founders/companies that just aren’t investable is beginning to fade away. This is a good thing. Over my career investing in public markets, I’ve learned that timing the market is incredibly difficult. My best investments have been made by conducting deep market research to find incredible TAMs, and picking top teams solving big problems in these markets with significant unfair advantages. I invest in these companies over time using dollar-cost averaging, which helps to blunt the impact of market cycles. Sporadically, I’ll take risk off for a multitude of different reasons.
It’s more difficult to deploy this same strategy in VC given illiquidity. However, by understanding where we are at in a market cycle can help you make more prudent decisions around when to deploy. Whether investing in publics or privates, one thing is certain: Valuations Matter. You can’t deploy all of your capital at the top of a market cycle. If you do, when the music stops, you’re in for some serious trouble.
When the Music Stops
As you can see from the data that I’ve outlined, we’re in the thick of a market cycle that has evidently not hit the climax of the crescendo. Nearly every single macro indicator is signaling a deep recession is imminent. It’s too obvious.
With that, the major indices are NOT pricing in a deep recession. What gives? If you’re in the camp that a recession is imminent and that the music has yet to stop, then look no further. But if you want to understand why things might be different this time, consider the points below:
Yield Curve Inversion: An inverted yield curve has never been preceded by a recession where the yield curve was not inverted prior. In my opinion, this is huge, and is not being talked about enough. This could end up being one of the biggest false flags in the history of the market.
Inflation: QE and stimulus aside, the cause of persistent inflation has a lot to do with the lack of labor supply and an incredible demand for physical goods that was artificially created due to government-forced lockdowns. The latter demand imbalances have over-corrected to the point of significant deflationary pressures.
GDP: We just experienced two consecutive quarters of negative GDP, and during this time period, the Fed was raising rates more aggressively than it has since the 1980s. This hasn’t happened since the Stagflation years of the 1970s. Back then, the Fed was just beginning to use interest rates as a tool to better control inflation. Have we already been in a recession that has been weirdly disguised by a combination of an aging society & imbalances created by Covid?
Fed Balance Sheet: Everyone is expecting the Fed’s balance sheet to be brought back down to zero at some point. Why? Well, because that’s the way it was for nearly 100 years. However, I don’t think many market participants are expecting for the Fed to ALWAYS have assets on their balance sheet moving forward. Could this be the new normal?
Capitulation: Does the end of a cycle have to always end with capitulation (crash)? For example, we’ve been in a bear market for nearly a year now (growth even longer). There is no clear and fast rule on there having to be some sort of market capitulation to end a bear market, but given the volatility of previous cycle ends, we are trained to expect this now. Maybe with the new tools (balance sheet manipulation), the market crashes of the past are now simply an artifact of the pre-Great Recession times.
So what do I think is going to happen? There are few sure things in life, but in market talk, one sure thing is that the music always stops. How loud the crescendo ends up being before the music stops is the question that needs to be answered, and that is anyone’s guess. What I can tell you is that most people are hearing the crescendo loud and clear now, but to me the sound is muffled. This cycle has been fundamentally altered by Covid.
Could it be that the violins have already gently weeped and the diminuendo has begun? Time will tell…