Market Musing - What Past Cycle is this Most Like, Why Tech is Getting Worse

“We are looking to see quite clear restraint in the bargaining process because otherwise, it will get out of control…I’m not saying nobody gets a pay rise, don’t get me wrong, but I think, what I’m saying is, we do need to see restraint in pay bargaining.” – Bank of England Governor Andrew Bailey February 4^th, 2022

“I am today ordering a freeze on all prices and wages throughout the United States” – President Richard Nixon August 15^th, 1971

There is a certain degree of comfort in comparing current market dynamics to past bull and bear markets. The reason that we do this is the present and future are inherently unknowable and thus, having a certain degree of understanding of past historical events gives us a road map to understanding what might be next. This can be a dangerous way of thinking, applying the facts of the past with the facts of the present day. While there are certain dynamics that mirror each other in every market cycle we must also confront the uncomfortable truth that every market cycle in history is distinctly different from the previous one. The crash comes only after it has sufficiently sucked the last buyer in and exhausted even the most vocal critics. The human condition only allows us to be ridiculed and incorrect for so long before we cease voicing our objection at all. That does not mean we capitulate and buy, but it does mean that these market forces are incredibly strong and fighting that tide and flow of funds seems to many to be a fool's errand. After all, everyone is making money in a bull market environment so why would some old fud want to come and ruin the party for the rest of us?

While we can never be certain of the timing of any bull or bear market, there is some practical lessons to be gleaned from studying the market dynamics of the past. Not so that we can know what is to come next in some sort of "time the cycle" way, but more so to understand the fundamental mistakes we continually make as human beings and what assets are positioned to do well in the economic environment of the future. 2008 to today has been dominated by easy money, cheap or no cost of borrowing, huge inflation in financial assets along with the suppression of volatility through artificial means. It is my contention that the low levels of inflation since 2008 were largely on the back of US shale oil growth keeping energy prices marginally cheap, alongside no real growth in physical economy but instead our investment went to Silicon Valley and high margin capital light tech/software firms.

The plan that was employed by the federal reserve post the 2008 financial crisis was meant to have a trickledown effect with the idea being if we make the cost of capital nothing that will incentivize spending and borrowing that will grow the economy. The actual result from artificially suppressing interest rates has been the slowest decade of GDP growth in US economic history. In addition, we have had an underinvestment in the physical world as capital has moved away from infrastructure type investments to the intangible world. These are all facts that exist in the current market cycle that did not exist in times past.

I bring this up because when you are comparing this current market to 1929, 1970, 2000, 2008 the question is always "but what is it MOST like". While there are probably lessons to glean from each of these historical events this market is without a doubt most like the 1970s bear market. The draw down was prolonged but fundamentally what is similar is we are entering into a period of higher inflation, high commodity prices, changing world trade both in how trade is executed and how it is settled, and that all comes on the back of a period of prosperity and low cost of living. While I do not think that we are going to see 22% interest rates I do think there will be a minimum of 3 years of double-digit inflationary spikes in the next decade. It simply cannot be that interest rates will be 2.5-3% and inflation 1.5% into infinity - and a lot of capital has been misallocated on the belief that we will return to an environment of no/low inflation and low cost of borrowing.

In terms of the way stocks have behaved similar to 1970 and the Nifty Fifty we are in a period of what I call one decision stocks. In the 1970s the Nifty Fifty were fifty companies that you could buy at any price and it did not matter because you would make money owning them. This brought price/earnings multiples for the largest, highest quality companies to 50,60 and even 70x earnings. Todays cant lose stocks are the Mag7 and before that it was FAANG - essentially a group of stocks that anyone can buy at anytime and make excess returns. There are already cracks showing in the Mag7 today that is highly correlated with AI build out that requires high capital expenditure to accomplish. The Mag7 today makes up 35%~ of the S&P500 with Broadcom and other chip makers exposed to the AI value chain bumping that value to nearly 50% of the S&P500. Meanwhile, all of the businesses that were FAANG and Mag7 prior to 2023 have become distinctly worse companies today than they were 5 years ago.

The entire appeal of the Mag7 type companies is that these are capital light, high margin businesses that generate tons of cash with little/no incremental capital. Today that has totally changed. Instead of being capital light the industry is requiring billions of dollars of incremental capital expenditure to fund the build out of AI infrastructure. This is key because there are two kinds of capital cycles - one that is demand/supply driven and the other that is simply capital driven. In the supply/demand capital cycle supply is tight and demand is high and that makes prices increase to bring on more investment to meet the rising demand. These kinds of cycles end when too much capital chases excess capacity that eventually floods the market in excess of what can be consumed by the end user thus, causing capacity to pair back and investment to be reined in. The other kind of capital cycle comes from too much capital chasing too much return. In a consumer staples business, for example, the demand is essentially stagnant and you know what the market can/will consume yearly. When there are high returns though in a new innovation like say, Nicotine pouches, returns are high on capital but eventually no matter how good the margins are and demand is too much capital will be spent to generate a reasonable return and the cycle falls apart.

This is the kind of cycle I think AI/Mag7 companies are in. There is no one that does not want their jobs to be done easier and faster so the demand for the AI product is nearly insatiable. The problem comes from the tremendous amount of capital being spent that will grow to such a level that the companies making the investment will no longer be able to generate acceptable returns. This will inevitably lead to a pricing war and a deflationary spiral on AI products where companies making these investments will compete with each other on price. This happens because there are low barriers to entry to the AI capex spend, any company that has deep pockets can spend billions to develop AI technology, making the industry itself fragmented and less rational.

When markets are fragmented it only takes 1-2 bad faith actors to start cutting prices and beginning a price war that will lead to a step down in earnings and associated returns on incremental capital. I bring this up to say this is all specific to the current market place as it relates to these being AI companies but the laws of Economics 101 always work and this is nothing new. High returns draw in capital and more capital leads to poor returns over time through too much capital on a gross basis or too much capital bringing on new supply that cannot be consumed.

It is my contention that from now through 2035 we are going to experience higher levels of inflation, worse large cap/index returns, better individual stock picker performance relative to indexes, higher commodity prices, and a generally more volatile marketplace than we had post the GFC. The question you should now ask yourself is first is there any legitimacy to what I am saying here and two, how can one invest in what is positioned well to outperform in this kind of environment or, more importantly, what is sure to perform poorly in the environment I have described? A helpful exercise, if you find what I write here compelling is to explore the 1970-1982 market - what worked, what did not and why.

This is not market timing that I am doing here - instead what I am rationalizing is what is most likely to occur. The world moves in massive cycles and I am simply an observer of where we are today relative to past markets. From 1970 to 2021 the cost of borrowing went from 22.25% to 0% - do we think that is going to happen again in the next decade? Even if inflation and the cost of borrowing normalize to a historical mean, this would mean the last 30 years has been anomalistic, no? Given the last 30 years has been an outlier in terms of inflation and the rate of borrowing, what mistakes might we have made as a society during that time that led to misallocation of capital?

Private equity, private credit, real estate, large cap public equities, etc are all positioned, in my view, to blow up and meaningfully underperform in the next 10-15 years simply because of what is known as the base rate. Statistics are a helpful guide when assessing what is possible and probable in the world of investment. If you do 150% in a single year in your personal portfolio returns, how likely is it that you are going to replicate that success over any meaningful period of time? Is it not more likely that outsized returns will eventually be met with mean reverting returns over a long enough period of time?

If you believe that about your personal investment performance, then one could reason that this is true of entire asset classes as well.