We begin each year staring in the mirror of our work. Every journey requires self-encounter along the way. What did we get right and wrong? What can we improve upon?
In 2022, we published 22 investment insights, 11 interviews, 6 dinner notes, 6 notes from our Slack community, and 21 notes to self—a total of 66 reflections.
The bear patrol
We were increasingly aware of warnings signs around the end of last year. We wrote about the similarity between the Go-Go Years and our YOLO market, the great buying panic, the billionaire space race, and the rise of digital assets feeding our penchant for speculation.
Then one of our long-standing prophecies was realized. In April 2017, we wrote: “Elon Musk embodies the cult of personality that investors are attracted to in the final stages of the bull market. Sell Tesla only when Elon Musk is crowned as TIME’s Person of the Year.”
Elon is the poster child for the hopes and dreams of this bull market. The TIME cover, then, was an omen; we’re getting close to the end. Stocks fell for three weeks in a row to kick off the year. Tesla’s shares are down 66 percent in 2022.
The bull market for ARKK, SPACs, renewable stocks, and some work-from-home names was already over. We wrote as much. But we were still looking for a move to the 5,000-level on the S&P 500 before being a rampant bear.
A vigorous debate ensued in our community-powered Slack group. Everyone was growing nervous and rightfully so.
Since we only had one rate-hike cycle in the last fifteen years, our initial thinking was that it’s easy to forget how markets adapt to monetary tightening; stocks face double-digit declines, and the curve flattens. We figured financial markets are simply adjusting to a new rate hike cycle. We were wrong.
The ever-shifting zeitgeist
It was in March that we turned bearish.
We observed how every decade there is a theme that captures the zeitgeist and expresses itself as investment mania. It was gold in the 1970s, Japan in the 1980s, Nasdaq in the 1990s, and China and commodities in the 2000s. As more investors are lured in by the big gains, a classic bubble forms and ultimately pops.
Nothing captured the investment zeitgeist of the 2010s better than venture capitalist Marc Andreessen’s prescient 2011 article, “Software is Eating the World.” Cloud stocks soared nine hundred percent between 2013 and 2021 and were trading at an average of 16 times forward revenue at the top.
“The best decision an investor can make is to avoid the popular zeitgeist when a new one emerges,” we wrote. “Gold did terrible in the 1980s, Japan kept sliding through the 1990s, tech was weak in the 2000s, and China and commodities were a disaster from 2010 onwards. Now it’s software’s turn.”
When we said last fall that the race to zero emissions will be the investment zeitgeist for this decade, we should have gone even farther and advised against investing in tech stocks.
The BVP Cloud Index is down 40 percent since March and 62 percent from its November 2021 peak.
Instead of advocating shorting the highs in April and August, we were developing a framework to identify a bottom. This was a mistake. A member told us on Slack: “I don’t think there’s anything more important than getting multi-year directions right, and once you do, knowing not to fight them.”
Inflation-schmation
Inflation anxieties have remained since the pandemic, but they intensified after Russia’s invasion of Ukraine, when oil prices soared to $130 per barrel.
We still believed that inflation would peak in the first quarter as base effects fade, and year-over-year comparisons will begin to look less startling. Core inflation peaked in March and the headline rate peaked in June.
In April we noted that a rise in real interest rates would pose a headwind for zero-yielding commodities, surprising investors who, according to the Bank of America fund manager survey, held the largest net overweight in commodities ever. This was after commodities returned 40 percent in the last three months. The largest three-month gain was 42 percent in 1973.
Prices for oil and base metals dropped by more than 40 percent. Many commodity stocks declined by 50 precent. Lumber, soybeans, cotton, and wheat all finished the second quarter at or below their March levels.
We disagreed with the popular narrative that the Fed has to plunge us into recession to kill inflation.
Rather than the experience of the Great Inflation during the seventies, we reckoned a historical comparison more appropriate to our understanding was the surge in inflation in 1951; following the Korean War it was significant but temporary, and it posed no lasting damage to the US economy.
Our era, like the early 1950s, is characterized by pent-up consumer demand, war-induced uncertainty, and a Fed policy moving from offsetting a national crisis to fighting inflation. Within the next year, we anticipate that inflation will return to levels that will be acceptable to policymakers and will do so without significant job losses. Since June, inflation has risen at a yearly rate of just 2.5 percent.
The Fed vs Mr. Market
The Fed was on the verge of repeating history by hiking rates aggressively. But rather than following in the footsteps of his revered predecessor, Paul Volcker, we believed that Fed chairman Jerome Powell was emulating Alan Greenspan’s activist monetary policy approach from 1994.
Greenspan said that he supported higher interest rates because he “very consciously and purposely tried to break the bubble and upset the markets in order to break the cocoon of capital gains speculation.”
Individuals, for example, invested a record amount in stock and bond mutual funds in 1992 and 1993. Gross fund purchases totaled $876 billion in those two years, nearly equaling the total amount purchased from 1970 to 1989.
Surprisingly, after losing 10 percent from its January 1994 peak, the S&P 500 had already bottomed out on April 4—before the first 50 basis points rate hike. It never went lower that year despite the 225 basis points of interest rate hikes still to come. Bond yields peaked in October 1994, ahead of the peak in the fed funds rate in February 1995.
What followed was a bull market in both stocks and bonds. Counter to the inflationary setup which destroys the value of bonds and risk parity portfolios, we expected to enter a similar sweet spot.
The S&P 500 bottomed alongside the first 75 basis points interest rate hike on June 16. Despite three additional 75-basis-point increases, the terminal rate being lifted from 3.5 to 5.1 percent, the 10-year yield breaching 4 percent, the dollar rising 10 percent, inflation concerns resurfacing, and earnings being downgraded, the S&P 500 is higher over the last six months.
We thought that the 10-year Treasury yield would peak around 3.5 percent, but we underestimated how high the terminal rate will be in this cycle. The 10-year yield peaked in October at 4.3 percent. Short-rate expectations are unlikely to be revised much higher, and inflation data is now moving from a tailwind for higher yields to a headwind.
A common assertion was that markets won’t bottom out until we see clear signs of a dovish central bank pivot. We disagreed with this.
Markets are anticipatory in nature. Quantitative tightening didn’t frighten us. It matters where you start. The macro setup was precarious heading into the great monetary unwind in October 2018. Today couldn’t be more different.
We posed the question: “What if the greatest trick the market ever pulled was convincing investors that we’re still in a bear market?”
Doom and gloom
While concern about a recession has been present and is growing, we have been more sanguine. A historic drop in consumer confidence and bearishness shows up in the survey data, but consumer spending has held up.
We wrote: “The US economy is far more resilient to higher interest rates than bears like to believe. Despite an overall increase in consumer borrowing, the boost to incomes and the fall in interest rates have resulted in unprecedented declines in the household debt-to-income ratio, which is at its lowest level since the mid-1990s. And the cost of servicing debt relative to income is at its lowest point since at least 1980 when the data series began.”
We reminded members that we’re not just living through an extraordinary inflationary period; it goes hand in hand with highly elevated nominal growth. A mild contraction in an inflationary environment doesn’t matter that much as nominal growth may still be positive. And given that that corporate earnings are nominal, they would hold up better than investors expect.
It wasn’t like that for the last forty years. When inflation historically averaged about 2 percent, a recession would result in negative real growth, low or non-existent nominal growth and a concomitant decline in earnings, leading to lower stock prices. Any downturn that happens now may be different.
Silicon Valley was experiencing a confined downturn, we argued, similar to the shale bust of 2016. Many tech companies would see layoffs, falling salaries, and worthless stock options, while San Francisco would see declining house prices and despair that lasts up to five years. Rest of America keeps humming along.
A few good years
With all the volatility and noise, we decided to zoom out. Admittedly, we forgot that a secular bull market is in progress. This is important.
During the secular bull market from 1950 to 1968, the S&P 500 increased by 445 percent despite three recessions, the Korean War, the Cuban Missile Crisis, the assassination of President Kennedy, and the race riots of the 1960s. There were three intervening corrections of more than 20 percent.
During the secular bull market from 1980 to 2000, the S&P 500 gained 1,400 percent despite two recessions, the stock market crash of 1987, the Japanese bubble bursting, the Savings and Loan crisis, the first Gulf War, the Asian financial crisis, and the Russian debt crisis. Three corrections of more than 20 percent occurred throughout this period as well.
Our current secular bull began in 2013, decisively breaking above the confines of the post-2000 secular bear market. The S&P 500 has increased by 220 percent despite the shale bust, the US-China trade war, a global pandemic, unacceptably high inflation, the Russian-Ukraine war, and Europe’s energy crisis. This secular bull cycle is still just two-thirds of the way done.
This matters because a cyclical bear market (a decline of 20 percent or more) inside a secular bull has been less severe in terms of magnitude and duration than in secular bear periods.
Looking at past cyclical bear markets, the S&P 500 declined 27 percent on average in secular bull periods but fell 43 percent during secular bear periods. Whereas it took an average of 9 months to recover its previous highs during secular bull markets, the recovery took an average 48 months during secular bear markets.
This gives us confidence that the lows are in, and the S&P 500 will quickly return to the highs next year. Now that Tesla and Apple are correcting in a flat market, it also takes away the risk of a major index break lower. Those are the last two big names to join the correction which suggests we’re close to the end.
We recently turned bullish on China. Putting the weak economy, surging infection rates and public demonstrations to the side, we listened to the market. China plays held steady amid a flood of unfavorable news reports. “The market is discerning the future,” we wrote, “the pivot to growth has begun.”
Community Wisdom
It would be impossible to condense all of the daily insights obtained in our Slack group.
In January, a member who guided us through the crypto bull market shared that his biggest concern was “the lack of marginal buyers.” Another member stated: “I believe now is the most dangerous time for average retail investors.”
“The flow picture looks quite poor,” a member wrote in February. “A legendary old school macro guy told me a decade ago: ‘This bull market will go on until we print sub 4 percent unemployment, earnings beat everywhere, and the market sells off.’ I am bearish.”
Prior to Russia’s invasion of Ukraine, we discussed Putin’s key speech and the ramifications. A member stated: “It was unprecedented in many ways, laying out deep and bitter grievances not for the Soviet Union but for nineteenth century Russian Empire. This is an angry country that feels aggrieved. It’s dangerous. And at a time when the West is lacking leadership and is fighting its own ghosts.”
Another member shared this Albert Camus quote: “When a war breaks out, people say: ‘It’s too stupid; it can’t last long.’ But though a war may well be ‘too stupid,’ that doesn’t prevent its lasting. Stupidity has a knack of getting its way; as we should see if we were not always so much wrapped up in ourselves.”
As the Fed embarked on a tightening cycle, a member noted that “central bank policy was meant to be a stabilizer (calm things down when too hot, nudge activity up when the economy is down), but it may now be doing the reverse: tightening into a slowdown.”
“We have entered a new regime where developed markets are constrained from the monetary side while largely unconstrained from the fiscal policy side,” said another member. “Slack has largely disappeared; expect high economic volatility accompanied by low potential GDP growth. Booms and busts will be more frequent and with higher amplitude.”
The discussion raged all summer long.
“What if the Fed staying tighter for longer as inflation lingers unacceptably higher for longer leads to a very inverted curve for longer?” asked a member. “A deeply inverted curve does not incentivize a lot of liquidity induced risk taking. If you believe inflation settles somewhere north of 3.5 percent and the Fed finds that unacceptable, then the front end has some work to do (go higher).”
The 2-year yield jumped 150 basis points over the next three months.
“So many data points like wages and loan growth are significantly above levels consistent with a 2 percent inflation target,” another member added. “What if the Fed has to hike to 5 percent eventually? The Fed funds rate is being significantly underpriced. At Jackson Hole the Fed may actually cite that the neutral rate is too low. If that occurs, the window for risk is closing fast.”
This was prescient. In an uncommonly succinct and direct speech, Powell said that the neutral rate was not a place to stop or pause tightening: “We will keep at it until we are confident the job is done.” The S&P 500 fell 17 percent over the next two months.
By mid-October, a more positive tone emerged in our Slack community.
“We are no longer short US equities,” a member shared. “The risk/reward to bet on higher risk premia is no longer as attractive as it used to be. The mistake that many made this year was focusing on the earnings picture rather than Fed and inflation dynamics. I think the next mistake is hesitating to load up on risk when the data turns quite soft. Weak data equals good news.”
Another member agreed: “Credit is poised for a pretty significant rally. I can see high yield spreads in the low 400s by year end.”
A member shared the mood in crypto and Puerto Rico: “Most people are still hopeful and optimistic about the future of crypto which is rather troubling—I would like to see more people having the ‘wait this whole thing is kind of a scam’ type of realization that happened in 2018. As of now most are still okay with waiting it out, no matter how bad their losses have been.”
This was before the FTX bankruptcy.
Afterwards, he remarked that this could be the “season finale” for the crypto bear market: “I don’t think this is a big deal because of the trust it broke within crypto. Most crypto capital will forget about this in a month and be trading on Binance by then. It’s a big deal because of the regulation it will bring. Prices will continue to move with animal spirits. If anything, it may get even bigger moves to the upside since FTX offered so many opportunities to short coins.”
Another member joked: “The ECB just predicted the end of Bitcoin, LOL, probably nearer to a bottom then.”
We discussed China all year long, but especially around the contentious Party Congress. A member noted that China made a U-turn on Hong Kong and Macau covid zero policy, which means that the mainland may reopen soon. The protests will “blow over” another member shared from the ground.
Once Beijing began loosening covid restrictions, a member inferred that they are trying to spread covid “as much as possible” before the Chinese New Year in early 2023. Another said that he’s pretty bullish, although “it feels scary as hell, and I want to get out.” He knows better.
Do you now comprehend the importance of the Stray Reflections community?
Our ability to deal with a world that is becoming more complex is limited. On our own, we can only comprehend a small, distinct portion. Our talents, our minds, they’re different, and experiences vary from one investor to the next. Because all of us are smarter than any of us, we can hold each other to account and prevent blind spots.
Global Events
After a two-year hiatus, we restarted The Most Interesting Dinner in The World series in 2022. Events were held in Toronto, London, Los Angeles, San Francisco, Singapore, and Montreal.
In March in Toronto, the mood was bearish. “Who is playing by bear market rules?” we asked. Nearly everyone in the room nodded solemnly. “Sell rallies,” said one of the participants. “There is more pain to come.” Everyone agreed that valuations had peaked for the cycle.
A member shared that we are setting up for a massive carnage in the bond market. “The Fed is about to stop buying Treasuries, inflation is out of control, and America’s use of central bank sanctions against Russia is going to make many countries rethink using the US Treasury as its currency reserve.” The 10-year Treasury is no longer the “safest geopolitical risk asset.”
In Palo Alto, there was a palpable sense of gloom, a fear that the good times are not only over, but that there is no sign when they will return.
“The macro backdrop is the worst I’ve seen in my career,” said a participant. “While everyone is focused on multiples, it’s the earnings side that now concerns me.” Another participant remarked the “tape looks horrible” and that “Apple and Microsoft are the last men standing.”
A participant was bearish on semis. “There’s good reason to believe that companies overspent in IT and pulled forward sales from future periods,” he argued. “Semis have seen the highest inventory build ever.”
After spending time in the Bay Area, we traveled to Los Angeles to host another dinner. Away from VC circles, there was some optimism.
“Yield curve inversion normally precedes a recession, but often with up to a two-year lag,” said a participant. Another believed that the Fed is approaching peak hawkishness. A few attendees were expecting a march to all-time highs, although admitting it will feel like picking up pennies in front of a steamroller: “Alas, that is our collective and chosen professional risk!”
In London in July a participant shared how bear market psychology follows a progression that is similar to what psychologists call the five stages of grief—denial, anger, bargaining, depression, and acceptance. “We’re still in the anger stage,” he said. “The bear market for stocks isn’t over.”
“If you had known that Russia would attack Ukraine and about the harsh sanctions put in place by the West, would you have predicted the ruble would trade as it has?” asked a participant. “Absolutely not.”
Since the invasion, the ruble increased by 31 percent against the US dollar and by 70 percent against the haven Swiss franc. This served as a reminder to “forget all priors” and always approach markets with a “strong dose of humility.”
We travelled to Singapore in advance of China’s 20th Party Congress in order to get the perspectives of our Asian community.
“China has lost its animal spirits,” a participant observed, noting the $1.3 trillion in stimulus measures aren’t doing much to stimulate the economy. “Could slowing export momentum compel Beijing to scrap its zero-covid policy in an effort to boost domestic demand?” another attendee hinted. Someone brave spotted an opportunity in buying bonds of property developers.
A participant foretold Japan’s tweaking of its yield-curve control policy and how it could lead to another selloff in global duration. “What happens in Japan doesn’t stay in Japan,” he remarked. He was cautious owning bonds despite the surge in global yields. But he was bullish on the yen.
Our final dinner was in Montreal. Aside from discussing how inflation volatility represents the greatest challenge to investors—a portfolio purely positioned for inflation runs the risk of losing money when inflation is declining—we talked about sleep, the tragedy of horizons, leadership, and building up people. There was love, laughter, and lots of wine.
We have already planned our events calendar for the next six months. We’re excited to bring the community together in Toronto (Jan 26), New York (Feb 16), Miami (March 16), Singapore (April 19), London (May 25) and Boston (June 14).
Salon Series
We held exclusive talks with the smartest and brightest minds in our community across a range of topics, including geopolitics, crypto, Silicon Valley and tech, uranium, biotech, and commodities, with a good dose of introspection.
As life settled into a post-pandemic “new normal,” David Steinberg (Marlowe Partners) joined us to discuss which habits will stick, and most crucially, how should we invest around it. He unveiled the bullish opportunity in the travel sector.
Marcel Kasumovich (One River) joined us for a fascinating dialogue around the future of digital assets. We discussed how investors are overestimating the change that will occur in the next two years, sending crypto prices way ahead of fundamentals, and likely leading to a prolonged crypto winter.
Our salon with Marko Papic (Clocktower Group) considered the birth of a Machiavellian America, which is countering geopolitical rivals by inciting conflict. The situation in Ukraine–but also with Taiwan–are great examples of this strategy.
Sebastian Mallaby, author of an excellent new book, The Power Law: Venture Capital and the Making of the New Future, joined us to discuss the Silicon Valley Age and determine if we’ve reached the end of the cycle. History has a lot to teach us about what will happen next.
After Russia’s shock invasion, doubling down on renewables only exacerbates the energy and materials shortages required for the global energy transition. Sean Maher (Entext) joined us to explore the radical changes and how to capitalize on the new climate zeitgeist. This was the year’s most popular salon.
After a challenging time for his machine learning fund, Dario Villani (Duality Group) joined me to share where things went wrong, why embracing failure is a perfect companion for a successful journey in risk taking, and how he’s pushing forward on his imperfect path to greatness.
The pursuit of a dream is fraught with failure, but those that succeed have a different approach to defeat. Dario was brimming with wisdom, sharing lessons from Jim Simons, Steve Schwarzman and math wizards Srinivasa Ramanujan and Maryam Mirzakhani.
On popular demand we assessed nuclear power’s long-term prospects with Michael Alkin (Sachem Cove). While a substantially larger nuclear component is required for an orderly, economical, and politically viable transition to zero-carbon electricity, the case for uranium equities isn’t as simple as you think.
Marc Schneidman (Acquilo Capital) joined us to discuss biotech’s exciting new era. The accelerating pace of drug development, and the translation of genomic information into actionable insights for disease treatment offers tremendous opportunity for innovative companies to address unmet medical needs.
We turned to Abhijit Chakrabortti (Brevan Howard) for his perspective on the economic and earnings outlook. Is it really as bad as everyone thinks? He cautioned us against investing in high-quality tech names like Microsoft and Google prior to their decline in the fourth quarter.
The thing holding most people back is themselves. Once we settle into ourselves, we lose sight of what we can become. Tony Fadell instructed us to push beyond our boundaries. He shared what we must do to keep learning and growing, how to manage our own fears and anxieties, why it’s good to think of your life in terms of seasons, and the importance of having audacious dreams.
This has been a challenging year for many investors. How do you recover from a drawdown? What’s the trick to remember the mistakes you are most prone to repeating? Why is it so important to forgive yourself? Todd Edgar (Atreaus) joined us to discuss the emotional journey and ways to get back in the black.
Faith plays a much larger role in investing than our egos would like to admit. In this magical conversation with Brie Stoner, I explored the importance of having faith, the role of devotion, and the desire for integrity in our quest of being the best version of ourselves.
A New Year’s commitment
I say this a lot.
Stray Reflections would not exist without the participation and collaboration of our community; without the valuable exchange of ideas that allows us to make sense of things and keeps us returning for more; without the kindness and wisdom accumulated over the years just by being present with each other. I find it difficult to articulate the effect this has had on me.
Like the Irish playwright George Bernard Shaw, I am of the opinion that my life belongs to the whole community and as long as I live, it is my privilege to do for it whatever I can. To be worthy of serving you is to accept the responsibility of living and writing in a way that matters. This is not a sudden revelation. It is a commitment I renew each and every day.
