Every once in a while on Wall Street there is what is called a “washout”: a cataclysmic shift in the market that swaths of the investment community do not survive. Wall Street is standing on the edge of such an event. So if you want your “billionaire tears,” you shall have them.
Why now? Well, after more than a decade of keeping interest rates near zero, the
is all but assured to raise them multiple times in the coming year to fight inflation. In the world of finance, these hikes are akin to messing with the Earth’s gravity. Assets that were once attractive — companies that used cheap capital to grow rapidly without making a profit — will be shunned. Some of the investors who ate up those growth stories will go out of business. This is not a drill. It’s the beginning of a
. And based on conversations with some of the most elite investors on Wall Street, it’s clear that this drop isn’t a months-long process. It’ll take a year or more.
“I think there’s going to be a few people who’ve really gone over their skis and will get hurt badly,” one billionaire value investor told me.
Silly season’s over, folks
Before the pandemic, the most pressing problem for central banks around the world was the meandering recovery from the financial crisis. Growth was sluggish, and inflation was well short of their target, prompting the Fed and others to keep interest rates historically low to encourage banks to give out loans and juice the economy. A side effect of making money easy to borrow was that all kinds of garbage ideas could get funding and all kinds of garbage companies could stay in business. Combine that with lax corporate law enforcement and you have Wall Street without consequences. Investors were champing at the bit to pile into companies that used fantastical metrics, like WeWork, and lapped up every utterance from billionaire CEOs who promised flashy technology but consistently underdelivered, like, say, Elon Musk.
And that was before millions of bored, homebound Americans jumped into the market via Robinhood and other trading apps. Armed with their pandemic-era stimulus checks, they bought crypto, piled into blank-check companies called SPACs, and joined message boards claiming that stocks like AMC and GameStop were going “to the moon.” Awash with capital, companies — especially in tech — saw their valuations leave Earth’s atmosphere and make a home somewhere on Saturn. Short sellers were culled. Value investors went into hiding.
“We really did hit peak stupid, but peak stupid extended beyond truly, truly stupid and then we went to bottom-of-the-ocean-rare-earth-metal-companies stupid,” the value investor told me.
This is the kind of bubble a financial professional should see forming — one where investors lose sight of fundamentals like profitability and cash flow and embrace a kind of Beanie Baby zeitgeist. In fairness, on Wall Street you can make a lot of money dancing to the music at a bubble party. Or you can stand by the snacks and watch. What you cannot do is pretend that the music will never stop.
Never get high on your own supply
The pandemic handed central banks a different economic problem: inflation — a result of paper-thin supply chains, a lack of workers, and everyone’s new habit of online shopping. The Federal Reserve’s goal is to keep inflation humming around 2%, and in the years following the financial crisis the US economy consistently failed to reach that benchmark. Now, thanks to the pandemic, inflation is coming in above 7%.
The Fed’s playbook to fight inflation is to pour a little cold water on the economy in the form of interest-rate hikes. That means debt gets more expensive to pay down and investors start taking a closer look at how companies generate cold hard cash — not in 10 years, but over the next several quarters. Now is the time for companies to get their financial houses in order, because this shift is happening fast. If they can’t — well, we know what happened to Pets.com.
“People got really sold on story stocks,” one short seller told me. “We treated fundamentals like some kind of boomer afterthought, but when the bubble pops, all you have left are fundamentals.”
That means all those hot meme stocks, SPACs, and growth stories need to prove their current business is worth those sky-high valuations, or be washed out with the market rout.
Take, for instance, the most recent class of hot companies to go public. The last few years saw record-breaking M&A activity as companies rushed to hit the stock exchanges while investors were pliant. But the short seller predicted that that cohort of IPOs would “dramatically underperform” the market. Companies like Coinbase (down almost 25% year-to-date), Robinhood (-35%), Beyond Meat (-19%), and DoorDash (-32%) were hot when they went public but now face a reckoning. Even the granddaddy of growth-over-everything stocks, Tesla, is down almost 30% this year.
And those SPACs? Because of their special regulatory status, the companies these investment vehicles take public receive less scrutiny than companies going through typical IPOs. That lax oversight and the historic rush of companies going public via the
process over the past three years likely mean there is a “buffet” of low-quality or downright scammy companies for fraud finders to investigate now, the short seller said.
Obviously some big money has been pushing these stocks — not just the bored Reddit-inhaling day traders who were wooed by meme stocks. And the sillier the growth-stocks-or-bust bubble got, the more convinced even the most seasoned investors became of their positions.
“What we’re seeing here is a removal of
,” one hedge-fund manager based in Pennsylvania told me. “The
will exist until all these guys are out of business.” To this investor — and to many on Wall Street who clung to the religion of healthy balance sheets during this bubble — there is a sense of schadenfreude about what’s going to happen to those who helped inflate the bubble. When I called him during a recent market rout, he was out doing work around his farm. “I’m in CVS and Occidental Petroleum,” he said as he explained why the market beating didn’t worry him. “Who cares if a bunch of garbage stocks fall out of the sky?”
Investors Like Cathie Wood — perhaps the most starry-eyed of all the investors betting on moonshot (at best) technology who’ve caught fire during this bubble — will soon come to find that precious few are interested in a stock that might quadruple in five years if it can’t show how it will generate the cash to fund its business until then. Wood’s Ark Innovation ETF made a truckload of money for investors in 2020 until its peak in early February 2021 (yes, during all the meme-stock insanity). But since then Woods’ ETF has cratered, losing about half its value from its peak to its current trough.
And it’s not just a few TV-regular investors who are going to be swept away by the market’s washout. Billions of dollars are being put to work on ridiculous fads all over the country, from small wealth-management firms to storied hedge funds.
“There’s a bunch of Cathie Woods out there who just aren’t on TV every day,” the value investor said. “I would put Tiger Global on the list.”
In the past few years some hedge funds have thrown away, well, hedging in favor of turning their funds into venture-capital firms. Tiger Global is one of those firms known for aggressively courting startups and jacking up their valuations to astronomical prices. Jamie Powell, writing in the Financial Times, whimsically called it “pay and spray.” As the Nasdaq falls it is pulling down private startup valuations with it.
In other words, we have a long way to fall, but this isn’t 2008 when the collapse of the economy pulled the stock market down. This time the problem is the stock market and its unrealistic valuations. Wall Street got high on its own supply, and now it’s time for a comedown.
There is no white knight
In the old economy there was the “Powell put,” a shorthand for the belief among investors that “Daddy Powell” (the internet’s creepy shorthand for Federal Reserve Chairman Jerome Powell) would let the stock market fall only so far before he made the Fed step in. This idea was calcified when the Fed came to the rescue after a sharp sell-off at the end of 2018 into early 2019.
As a result, there are some in hedge-fund land who do not believe Powell has the stomach to hike rates to the point that inflation is tamed. In a January note to clients, Mark Spiegel, the founder of Stanphyl Capital, wrote that rising rates may lead to government budget cuts as the federal debt becomes more onerous to pay. Because of that, he mused, the Federal Reserve won’t move interest rates as high as needed to fully rein in inflation. Such a dramatic series of hikes could force politically painful cuts to the federal budget. “Powell doesn’t have the guts for that,” he wrote, “nor does anyone else in Washington.”
Maybe, but President Joe Biden has not signaled that he cares to step in and save the stock market. In interviews, he and his staff have stressed the Federal Reserve’s independence and expressed confidence in Powell’s handling of the central bank, contrary to his predecessor. And politically, Biden’s focus is more on prices at the pump, not the ones on Wall Street. In a recent Gallup poll, four out of five respondents said they expected inflation to grow over the next few months; in another, half of respondents said rising prices had caused hardship for their families.
That’s all to say there is no one coming to save the stock market. There are no more stimulus checks, no more Fed puts, and — based on Democrats’ inability to pass Biden’s Build Back Better plan — no more major cash infusions coming from the federal government. The good news is that (inflation aside) the real economy is looking strong, wages are going up, unemployment is down, and a receding pandemic should help to clear clogged supply chains. It’s going to be a wild ride for Main Street 401(k)s for the next year or two, but if you can take your eyes off your balance and stay diversified, you’ll recover. Wall Street’s masters of the universe, however, face an extinction event.
Hiking rates from their decade-plus doldrums is nothing short of economic regime change. The stock market we had before isn’t coming back. It will take a year or two of the highs getting lower and the lows never bottoming before it’s all over. After that, we’ll be living in another world. In the meantime, get your bathing suits on and prepare for the washout.