“History Doesn’t Repeat Itself, but it Often Rhymes.”

This famous expression (never actually said by Mark Twain) is frequently cited when trying to map the market terrain. The current downturn is no exception, with verses that rhyme with aspects of both the tech wreck in 2000 and the financial crisis in 2008.

The potential for revolutionary technology drove the market to price decades of progress in advance for the internet in 1998-2000 and crypto from 2020-2022. An economic contraction in part caused by leverage in the financial system followed the market crash in 2008 and may lurk below the surface again today. While it’s too soon to know the final stanza of this story, highlighting the past and potential paths forward help keep us centered in turbulent times.

Parallels with 2000

Innovative technology priced in years of success.

As a part of the run-up to 2000, internet-related businesses sported lofty valuations. Many were unproven ventures that took advantage of a receptive IPO market to raise capital. Once in the public domain, the market irrationally rewarded public companies that added “dot.com” to their name with a 74% pop in share price.^[1]

When the tide went out, lots of companies were swimming naked. Many cash burning machines without sustainable business models failed. Among the survivors, some, like Amazon, had sufficient resources to weather the storm. Others, like Google and Facebook, launched later with better timing for their products to harness the growing power of the internet.

The internet changed the face of commerce, but it took a decade or more for the infrastructure and adoption to catch up with the hype. The excitement around the new technology of the internet in 2000 ultimately proved correct. Every business has a website today, even those without “.com” in their name.

Blockchain technology has a similar feel. Fundraising for crypto start-ups was on fire the last few years, and valuations for both private rounds and traded tokens got out of control. I have never seen investment returns across a segment as high as those produced by crypto managers in 2020-2021. Greg Zuckerman wrote a book about John Paulson’s shorting of subprime mortgages in 2007 called The Greatest Trade Ever. The revised edition may have to be called The Second Greatest Trade Ever.^[2]

It’s too early to know if blockchain technology will be as important as its advocates believe. As the insatiable appetite for funding a crypto future recedes, many crypto projects and companies will go bust. Skeptics will poke fun at the limited number of use cases and prices paid for digital images of apes today, but crypto survivors may find new applications and foster a valuable community around NFTs over the next decade, just as Amazon and its brethren did after 2000. As the underlying blockchain technology and its applications develop, digital wallets and blockchain protocols may become as ubiquitous as email addresses and websites are today.

Overvalued stocks ‘eventually’ experienced multiple compression. 

The dot-com boom had an aura of euphoria that allowed tech stocks to rise to valuations untethered from economic reality. Pets.com epitomized the boom, spending twice as much on a Super Bowl advertisement in 2000 than it made in revenue the prior year.^[3] For a while, the tech sector could do no wrong. When market sentiment changed, overvalued stocks crashed to earth.

Growth stocks similarly experienced a decade of outperformance over value until the last few months. A whiff of a different economic future changed the most popular market narrative from growth and return on capital to cash flow and return of capital.

The challenge for market participants, as it was in 2000, is the word “eventually.” Timing markets is notoriously difficult. Skeptics on the way up are often worse off through the cycle after considering opportunity cost. Just ask the value investing community how the last decade has impacted their returns and businesses. It’s a phenomenon I wrote about last year in I Told You So.

Even worse, FOMO is ever present in a bubble, enticing skeptics to join the crowd late in the game. Market maestro Stanley Druckenmiller stopped fighting the tape in 2000 and bought internet stocks late in the game.^[4] We’ll soon see which fund managers got whipsawed this time around.

The stock market selloff did not affect the real economy (so far).

The real economic impact of the dot-com crash was limited to the technology sector. Value stocks soared, the economy continued to plug along, and the market pain proved short-lived.

The current situation has been similar until recently. Growth stocks began selling off in November, but businesses continue to show strong fundamentals. While rising inflation is starting to take a toll on cost structures, it has not yet impeded the top line.

Parallels with 2008

The stock market selloff is a leading indicator of a recession.

The market crash in 2008 turned into the Global Financial Crisis with the bankruptcy of Lehman Brothers. That event triggered a freezing of credit markets that caused global economies to fall off a cliff in the fourth quarter of 2008. Economic activity collapsed so quickly that governments resorted to unprecedented stimulus to stave off a depression.

Current economic indicators are worrisome. Should inflation persist, weakness in consumers, businesses, and governments will accelerate, and we could be headed into a recession or worse. We will have to see if this correction ultimately parallels 2000 or 2008.

Leverage in the system exacerbates the downturn.

Financial leverage magnified the impact of the market crash in 2008. Subprime mortgages were a small percentage of the mortgage market, but derivatives on subprime mortgages dramatically increased exposure in the financial system. Corporate balance sheets were highly leveraged as well, relying on robust credit markets to fund operations that proved problematic after the fall of Lehman.

After the GFC, leverage shifted from the hands of the consumer and corporations to governments. Massive stimulus in 2009 and again in 2020 left governments around the world with more debt than ever before. Near zero interest rates for a decade postponed any issues with debt. It remains to be seen what impact the leverage unwind will have on markets and economies.

What I’m Watching

The degree to which the stock and crypto markets follow a path like 2000, 2008, or something new remains to be seen. I am watching trends in inflation and the unwinding of leverage as indicators of the unfolding market challenge.

Inflation

Rising inflation is a consequence of both endogenous cyclical factors from money printing and exogenous pain from war and disease.

1. Interest rates. Two decades of monetary stimulus would be expected to put pressure on the Fed to raise interest rates and fight inflation. Can the Fed engineer a soft landing?

• Home prices. Rising interest rates lower affordability, which would otherwise lead to a fall in home prices. That said, supply is constrained in many markets, which would otherwise indicate housing should rise. Which governing input will win out?

• Energy and Ukraine. The war in Ukraine has caused a spike in energy prices, which in turn are a key driver of inflation. A resolution of the war could ease inflationary pressure. When will oil prices recede?

• Supply chains and Covid. The pandemic stopped the flow of goods around the world, and supply chains have not returned to their prior effectiveness. Eventually, this bottleneck will loosen. Can it happen soon enough?

Leverage

1. Crypto. Crypto investors point to this downturn as just another wild gyration in prices. However, stories abound that the financial leverage behind crypto tokens exploded since the last crypto winter in 2018 with the ascent of DeFi protocols. Will leverage exacerbate this downturn?

• Government. The Fed must find a way to reduce the debt created by stimulus packages over the last dozen years. Inflating away the debt is the most tried and true deleveraging, but higher rates would require spending on interest costs. If rates normalize, will higher interest costs constrain government budgets and reduce economic growth?

This may be the first time in my career that a significant market event feels like others I have experienced. The story I am telling myself and sharing with you may well say more about my age than my ability to forecast, but I can’t shake the feeling that I’ve heard this song before.