Reflections on 2022

The year the tide went out

This post was meant to go out a few days ago, a delay I will blame on holiday celebrations and the college football bowl games. But let me wish you all a belated happy New Year. My hope is that 2023 will be less ‘eventful’ than this past year, but I certainly would not bet on it. I will be teaching three courses this term, and so may not blog as much as in the recent past, which is perhaps something for which we can all be thankful. But please do not mistake my periodic quietude for a lack of interest in what is going on around us in the world of finance. I will be paying close attention even when I am not writing, as should you.

I for one will not be sorry to see the end of 2022, a year of war, inflation, financial scandal and decimated investment portfolios. As I noted in several prior posts, paraphrasing the unlikely combination of Warren Buffett and Mark Knopfler, it is only when the tide goes out that we discover who has been swimming naked and how much garbage has been floating around in the sea. And 2022 was the year in which the financial tide finally rolled out, after a 12-year bull market, leaving behind a pile of smelly financial carcasses washed up on shore.

This year’s list of financial casualties is a long one, featuring the likes of Elon Musk and Twitter, Sam Bankman-Fried and FTX, Ryan ‘Papa’ Cohen and Bed, Bath & Beyond, and a succession of executives and board members at Credit Suisse. This was also the year in which Russia invaded Ukraine, China remained in covid lockdown, inflation hit levels unseen since the 1970s, and central banks began raising rates and unwinding QE. Major stock markets fell 20% or more, bonds fell almost as much, crypto crashed and SPACs disappeared. The cost of government borrowing doubled or tripled and the market value of several major currencies collapsed relative to the US dollar. Queen Elizabeth died after reigning for 70 years, shortly before the implosion of her last appointed government after only 49 days in power. Elizabeth Holmes and Sunny Balwani of Theranos were sentenced to long terms in prison, where they may soon have company from their counterparts at FTX. And Argentina again made headlines, this time not for defaulting on its debt (that was Russia), but for winning the World Cup. In a tournament played during November in Qatar of all places.

It is probably an exaggeration to say that 2022 may turn out to have been as consequential as the years 2008 and 2020, but it was nevertheless a year in which a lot happened financially across the world. And almost none of it was good.

Bear markets can be painful but they do have some merit, recalibrating values and reminding us of basic tenets of finance which we tend to forget during bull markets, when everything is inflated including our stock portfolio, our spending and our egos.

But what should we have learned during this past year? Probably more than we did, or more than we will remember once the markets turn up again. But here are a few things that occur to me now, as I reflect upon the events of this past year:

Stuff happens. I never thought I would miss Donald Rumsfeld (and I don’t), but I will concede that he had a captivating way of making outrageous statements that other public officials might think to themselves but would never say out loud in public. Like his “stuff happens” quote about the disorderly aftermath in Baghdad following the US led invasion of Iraq in 2003. And I think Rumsfeld would have agreed with me when I say that this past year was one in which a lot of unexpected ‘stuff’ happened, some of great consequence, most notably Russia’s invasion of Ukraine. I do not think it is an exaggeration to say that but for this one unanticipated event, 2022 might have played out quite differently than it did. And this is true not only in military and geopolitical terms but in financial and economic terms as well. The war in Ukraine has wreaked havoc on the global energy markets, stoked inflation across the world and caused government budget deficits to explode (particularly in Europe). The war continues to rage, with unspeakable carnage inflicted daily on the people of Ukraine and no clear end in sight. As a result of this one decision by Vladimir Putin, the state of the world and our collective future has been changed in ways that none of us may ever fully understand.

Everything is OK, until it isn’t. The year 2021 was a great one from a financial and economic perspective. Covid disruptions were quickly disappearing, interest rates remained low, US consumers were flush with cash, the real economy was picking up speed, unemployment hit new lows and the stock market boomed. Yes there were some troubling clouds on the horizon, most notably with inflation, but the near term forecast(s) looked generally good. Everything seemed OK, until it didn’t.

By the end of January 2022, the S&P 500 had fallen 10% and the Nasdaq was down 15%. A month later Putin unexpectedly invaded Ukraine, shaking the world to its core and driving capital market prices down farther. In April, Elon Musk announced without much conviction that he would buy Twitter and was later forced by a court to go through with the deal, after which he proceeded to trash the company he had just acquired. While this was happening the stock market repriced Tesla’s equity down 65%, fueled in part by Musk’s distraction and his own sale of Tesla shares to fund the Twitter deal. The crypto DeFi economy was at long last exposed as a hotbed of hype, mismanagement and fraud, with FTX being only the most publicized example.

Some of these events were anticipated, but many were not. Which is how the world seems to work, as Donald Rumsfeld could have told us. We all spend a lot of time worrying about the ‘known unknowns’—will there be a recession this year and what will it look like?—but it is the ‘unknown unknowns’ that seem to get us in the end.

Regulation does not remove risk; it just moves risk. For much of my professional career, systemic financial risk has been centered in and around the banking system. But this has changed over the years, most notably in the wake of the 2008 global financial crisis. US banks and their international counterparts are now much better governed, with better risk management and more capital and liquidity, than at any other time in recent history. But many of the financial risks that used to reside in the banking system have now moved into the so-called ‘shadow banking’ sector, to non-bank financial institutions that are often more opaque, less regulated and more poorly governed than are the big banks. Rocket Mortgage is now the leading US home lender, and similar trends are playing out in other sectors of the financial services industry. The systemic risk that we used to associate with banks has not gone away, it has simply moved, into shadowy sectors of the economy where it is less transparent, less regulated and less well understood.

Central banks are powerful, but not omniscient. This has not been a good year for the reputations of central bankers, most notably Jay Powell and his colleagues at the Fed. Inflation this past year hit double digits, levels not seen since the 1970s, causing the Fed and other central banks to tighten monetary policy and raise rates, perhaps somewhat later than they could or should have. This seems to be the popular consensus opinion—that Powell’s Fed was late in raising rates, contributing to the big jump in inflation—but I am not entirely persuaded. The seeds of today’s inflation were sown many years ago, in the aftermath of the 2008 financial crisis and the widespread adoption by central banks across the world of zero (or negative) interest rate policies and unprecedented amounts of quantitative easing, which distorted investment decisions and capital allocation for over a decade. And inflation today would likely be much lower than it is but for the pervasive and continuing supply imbalances (and shifting demand patterns) resulting from the global covid contraction of 2020 and Putin’s February 2022 invasion of Ukraine, neither of which had much to do with monetary policy or the level of interest rates here or abroad. Central banks remain powerful actors in our global economic and financial system—’Don’t fight the Fed’ remains sound investment advice—but central bankers are not omniscient and they never have been. The Fed’s crystal ball is no clearer than ours, something we learned again this past year.

Value is not (always) the same thing as price. This is a core tenet of investment strategy and corporate finance, at least outside of Wall Street and the University of Chicago, which we forget at our peril. As Warren Buffett likes to say, “price is what you pay; value is what you get”. Elon Musk may have paid a ‘price’ of $44 billion for Twitter, but he likely did not get anywhere near that much in fundamental ‘value’, even before he took a torch to the Company’s business. And something similar may be playing out now at Musk’s other company, Tesla, which saw its share price fall 65% during 2022. But did the fundamental value of Tesla also fall 65% this past year? No, it did not.

What happened in 2022 was that investors finally took a hard (and long overdue) look at Tesla’s business and financial fundamentals and concluded that there was simply no way the equity of this company could have an intrinsic value anywhere near $1.2 trillion, even at last year’s low level of interest rates. And so they started dumping the TSLA shares—as did Elon Musk by the way, to the tune of $30 billion or so—which drove down the Tesla share price to where it ended the year. This was a 65% drop in share price and an $800 billion loss in market cap (share price times number of outstanding shares). This is quite shocking when you think about its—which Elon Musk and other Tesla shareholders certainly do—but it doesn’t mean that the TSLA share price cannot or will not fall farther. Even a stock down 65% can still lose another 100% of its current price. In the end, fundamental value considerations will generally win out over speculative investment hype and it may be that the stock market’s re-valuation of Tesla has only just begun. (As I write, TSLA is down another 13% today, knocking another $50 billion off Tesla’s market cap.)

When Genius Failed, Again. If you don’t know the story of Long-Term Capital Management you should, and I recommend that you read Roger Lowenstein’s excellent book, When Genius Failed. What you will learn from this book is that there is sometimes a very fine line between ‘genius’ and ‘reckless’, and many smart and otherwise sophisticated investors become so captivated by the suggestion of the former that they ignore obvious warning signs of the latter. (The same thing happens in corporate board rooms by the way.) This is what happened with LTCM and it appears to have happened again this past year at several companies, most notably with Elon Musk at Twitter and Sam Bankman-Fried at FTX.

Much of the press coverage of both Twitter and FTX focuses on the bizarre behavior of the sponsors (Musk and SBF), but I think we should also consider what these situations tell us about the judgment of the individuals and firms who invested their own and other people’s money in these two companies and financially enabled SBF and Elon in the first place. Take Sequoia Capital for example, which invested in both FTX and Twitter. (Ouch and double ouch!) According to press reports, Sequoia decided to back SBF (and perhaps Musk) not in spite of his outrageous behavior but because of it. “I just LOVE this sponsor”, said one Sequoia Capital partner about SBF during an investment pitch in which SBF spent the whole time playing video games. And Sequoia invested $800 million of its clients’ money in Musk’s overpriced Twitter deal notwithstanding Elon’s increasingly erratic personal behavior with respect to both Twitter and Tesla.

Sam Bankman-Fried is no doubt a smart guy (he majored in physics and math at MIT) and Elon Musk is considered by many to be a rare business genius, the Thomas Edison of our time. But even if Elon Musk and SBF have in the past displayed elements of business genius—Musk certainly has although I am not sure the same can be said of SBF—by the end of this year it had become eminently clear to anyone who cared to look that both of these individuals were also reckless (or worse). Their recklessness overtook their genius and the damage they caused to others has been substantial. And those who facilitated this behavior, firms like Sequoia and others, also bear some degree of responsibility.

The importance of Corporate Governance. This past year has demonstrated once again the importance of sound corporate governance, by which I mean more than politically correct ESG box ticking exercises. In the case of both Twitter and FTX there was no ‘corporate governance’ in any meaningful sense. The investors in both companies failed to obtain even rudimentary governance rights, like board seats and possibly voting shares. (I’m not sure). Elon Musk is the CEO and sole director of Twitter and he calls all the shots himself, without much if any input from other company executives let alone his co-investors. And Musk purports to make important strategic decisions after consulting the results of bogus user polls designed to tell him what he wants (or expects) to hear, which seems only slightly better than managing by Ouija board. At FTX, the newly appointed CEO (the successor to SBF), whose job is to liquidate the company, says that never in his 40 years of professional corporate restructuring work has he seen such a complete failure of financial controls, managerial integrity and competence, in a word governance. Which is quite something coming from the man who was tasked with liquidating Enron.

And what about Theranos, whose top two executives are now on their way to prison? Unlike FTX and Twitter, Theranos did have at least the appearance of a functioning board of directors, albeit one stuffed with aged and disengaged figureheads who for the most part knew very little about the Company’s business and who repeatedly failed to exercise any real oversight of senior management, even after reports of the apparent fraud were made public. And yet it seems likely that none of the Theranos directors will be held legally or financially responsible for the losses that occurred on their watch. Can we possibly think this is OK?

The failure of corporate governance was demonstrated this past year not only in extreme cases like FTX, Twitter and Theranos—and in the virtual reality worlds of SPACs, meme stocks and all things crypto— but also at a swath of more mainstream companies who were at least trying to behave responsibly. Mark Zuckerberg really did (and perhaps still does) believe that VR will be the next big thing and Facebook (Meta) made a huge financial bet on this view of the future, likely with little pushback from his board. (I am speculating here.) Credit Suisse has been dealing with the consequences of dysfunctional governance (and management) for years now, and they just can’t seem to get out of their own way. Netflix and Peloton confused a covid induced spike in product demand with some sort of new normal, a clear case of corporate myopia facilitated I suspect by weak corporate governance. And then there are the airlines, led by Southwest, who continue to believe that customer service is an oxymoron and who continue to finance their businesses in ways that require regular government bailouts, most recently in 2020, 2008 and 2001. And the list goes on.

Character Matters. JP Morgan (the man, not the bank) famously said that the single most important element of a credit decision was the character of the borrower. Not money and power, but character and trust. Which seems to me a maxim that we should all remember and reflect upon, individually and collectively, more often than we do. (A failure of which JPM himself was also guilty from time to time). And if we learned nothing else this past year, I hope it will be this: Good character—by which I mean personal honesty, integrity and responsibility, in action and intent—matters greatly, not just in our leaders but also in our followers and facilitators, financial or otherwise. For while the costs and consequences of bad character can remain dormant for long periods of time, they will inevitably come to the surface when the tide goes out. And when they do, it won’t be pretty.

Which is exactly what happened in 2022.