Thinking, Long and Short About Capital Markets

Fluctuations in capital markets are a tale as old as time. We at Prime Movers Lab keep a close eye on long-term macro trends in order to spot shifts in investor needs, desires, and sentiment. But it’s important for our investors to know what to look for, as well. The ability to identify market trends and learn from significant historical events will set any investor miles ahead of the pack.

To be clear, the following is not investment advice. It is just a quick touchpoint about where we are in the turbulent financial galaxy.

Look before you leap

For context, lots of people make money in commodities such as gold and Bitcoin. But venture capitalists tend to gravitate toward long equities. If they don’t, then they’re probably in the wrong business. I have been involved in long equities since 1977 when I put my Bar Mitzvah money to work in a few entertainment IPOs that did spectacularly well, and then miserably failed. As I sheepishly shifted my gaze from Ferraris to bicycles, I learned an important lesson: Pigs eat; hogs get slaughtered.

Being a long equities person for a sub-category doesn’t mean you need to (or should) be bullish all the time in your own portfolios. As VCs, we are idea-sellers of a nice-to-have category, so we are tainted by a lot of negative bias from idea-sellers of the must-have categories. We’re constantly struggling to pinpoint where we are in the capital markets cycle at any given time. Because of this, we risk being right, but at the wrong time. This can result in bad investments due to errors not in ideation, but rather in timing.

Lucky for us, we have centuries of experience to rely on when making investment decisions.

Above is the stock chart I use for broader presentations like this. You can see that we exist today in an era of phenomenal equity prosperity. Warren Buffett writes endlessly about this “anomaly.” From roughly 1890 until about 1950, virtually all of the returns from the S&P 500 (call it the “market”) were from dividends, which you can see below.

Over that 60-year time frame, the market was generally flattish, even when adjusted for inflation, although it was not without points of huge market volatility. To me, the charts read almost like a history book that’s still adding pages every day. It’s worth staring at these for a while. But for now, imagine making virtually nothing from a market for over half a century.

Believe it or not, it happened.

A history lesson in long investments

To set the stage, consider the enormous bull market that began when Reagan came into office and, but for a few hiccups, has continued unabated into the present. The price-to-earnings ratio of the market has also grown massively over that time period, due largely to the influence of truly global markets, new technology, looser government regulations, and a “peace dividend” since WWII that continues to this day. To put it briefly, even in its darkest times, 20th century America has consistently enjoyed a booming market.

For example, imagine you invested in an S&P 500 ETF on the worst day before the collapse began in 2007. Today, you’d still be way ahead of zero, the bond market, and what most VCs returned. So market timing in this sense only matters for short-term traders, not for long-term investors. Generally speaking, VC funds minted circa 1995 returned something like 9x on average in that five-year period. Sucked into the dot-com bubble vortex, VC funds minted circa 2000 returned, on average, about half the capital invested.

That said, is it inconceivable to me that we might regress to the mean in the modern era, and that equity multiples could decline — a lot — from here? It wouldn’t shock me, no. But a very fast decline would. Barring a detonated nuke, Covid 2: The Revenge, or some other exogenous force like my telescope finding E.T. waving back and then enslaving humanity, I don’t see any cause for concern. However, even with a regression to the mean, we’d still grow earnings. Our P/E multiple would just get sliced in half, and we’d be a flat market for a very long time — albeit with dividends at about 3.4% or so. I grew up in an era where the P/E ratios were mid-teens; today they’re late 20s –about the same as the aging golf clubs in my untouched bag.

Note in the first chart that the market usually corrects about 50% from peak to trough, and for most normative brokerage “margin accounts,” the maximum borrow amount against all assets is 50%. Only riverboat gamblers, Somali pirate warlords, and those with a death wish borrow anywhere close to that level, but their demise is what much of Wall Street looks for to signal the end of bear markets. In these scenarios, you’ll see big sudden liquidity-driven drops to below-cash-value of highly speculative stocks with no real earnings that were darlings at one time At this point, the 50% margin people get carried out on stretchers into Bankruptcy Land, and the value buyers squirreling away nuts in their cheeks for the winter pop in and put a bottom on the market.

This was very much the pattern in the last three bear markets I lived through professionally. When a margin account violates the 50% threshold, the brokerage is instructed to sell at any price, and buyers take advantage of that edict by lowering their offer prices massively. Wall Street did a lot of this a few years after the dot-com bust crushed the river boaters, and made a fortune by being patient against the blind greed and untoward optimism of others.

Goes to show, it (literally) pays to be long-term greedy, not short-term greedy.

And now about those pesky inflation fears

Many factors contribute to inflation. It is not just about governments “printing money,” although that is one key ingredient. Generally speaking, governments around the world spend money poorly. Nonetheless, hopeful lenders have historically allowed them to take on debts they cannot repay. Most of that debt is in fixed-rate status. For example, Germany paid a 6% rate to borrow money through most of the ’90s, at scale. So, for a 30-year note, Germany still has to pay that 6% rate, even though world rates today are vastly lower.

If we experience inflation, it makes it way easier for Germany to pay back its fixed 6% money and presumably refinance at much lower rates. Yes, duh. However, journalists and other would-be pundits don’t seem to understand that it is in everyone’s best interest to “cause” inflation now so that the world’s borrowers don’t go bankrupt in a soft economy.

That said, we’ve been trying to get there for two decades now, with no tangible results until very recently. Today’s supply chain issues, coupled with Covid-induced afflictions, means the jury’s still out as to the details of the pop we are experiencing now.

If we do achieve inflation, here’s a framing question: Let’s say you could lend your money to the New Zealand government with virtually no risk by buying their flavor of 10-year-paper at, say, 5% a year. Wouldn’t you be happy, then, to take 10% (or 20% or 30%) of your long-equities money off the table and de-risk a bit, while still doubling your money (ignoring taxes) every 14 years or so? Many people would. So, if safe-government rates (and New Zealand has very few enemies today, so it is considered the safest paper on the planet, more or less) go from the 0.25% they live in today to 5%, then you’d expect demand for long-equities to go down a fair amount, and for market prices to adjust. That is, growth company P/E ratios go from 30 to 18 or less.

Peace, love, and inflation

The latest theories I’ve started to buy revolve around the notion that we are entering the precursor period to an era analogous to the ’70s. A period during which we had vicious uncontrollable post-Vietnam War inflation, making the basics so unaffordable that old people living on fixed incomes had to live in their station wagons parked down by the river. President Gerald Ford was powerless to do much of anything after the whole Nixon-pardoning thing, and when Jimmy Carter came into office, he made the abolishment of inflation a big priority. The old people who voted him in were, ironically, its worst victims.

Notionally, the Federal Reserve and politicians are decoupled; however, in this case, the Fed followed the mandate and raised rates and bank strictures. Banks were required to keep more money in reserve rather than lend it out. Over a painful go-nowhere-ish market in the ’70s, it worked. Inflation went way down; the economy died, and the market from peak to trough was cut in half. When the 50% margin people were carried out, “everyone” got long again and cleared the path for junk bonds, a real estate boom, Madonna, and neon ’80s fun.

Where does that leave us today?

If you buy the slow torture inflation choke view of where things go (keeping in mind that we need to see active volatile inflation for a few years before the Fed will likely want to start to choke it back), then that process doesn’t really begin until… 2025? 2028? I have no idea when it will happen, but I do know we have to make money cheaper so the world can keep spinning without Singapore bailing us all out all the time.

This is, in part, the reason I sleep well at night with my macro hat on. In the long run, long equities should continue to be fine. (Insert that whole “be long term greedy, not short term greedy” thing here). So am I worried about 2030? Sorta.

If you read the fine print around the Biden Tax Plan, the rhetoric is, in essence, a kind of inflation control chain. It chokes off incentive to invest in risk capital (i.e. the nice-to-have kind of investing you’d do in venture capital vs. the must-have kind of investing you’d do for your 401k, IRA, and personal dividend flows).

It primarily targets the wealthy and high earners. In California, for example, the new system would do away with long-term gains and lower tax rate favorability, and move everything to ordinary income rates of 39.6%. Those earning $1M or more are then taxed 13.3%, which is targeted to move to 16.8% next cycle. On top of that, you’ll have Obamacare, which is 3.8% (but federally tax-deductible, so think 2%), plus another 3% or so for Social Security and various other taxes. All this for a marginal tax rate grand total of about 61.5% tax on the marginal dollar above that first $1M of gains.

That means an LP, GP, or other partner having a dandy year gets a $10M distribution. Under this plan, they only keep $3.85M of it. Interest in risk capital changes dramatically at those levels, and while this is still just a political football, if we get anything close to those numbers for taxes levied, I anticipate it will cause dislocation in the markets we play in. It won’t be catastrophic — rather, more like the way inflation curbs work. And not especially pleasant for anyone talented, hard-working, or lucky. Era-adjusted, something like half of VC dollars are from individuals; the other half are from non-tax-paying institutions and endowments. If things do play out as feared, institutions will carry vastly more power in the VC-LP world going forward.

That said, the near-term numbers are scarily odd. We haven’t had a Covid-like event since the 1918 Spanish Flu, and in that case, WWI sort of washed over everything economy-related. Many in the Biden cabinet believe that the inflation numbers we are seeing in lumber and milk and semiconductors are a blip -– a pig in a python, as it were. They believe we’ll have two or three quarters of big up numbers, normalizing to pre-Covid Era levels. But then inflation figures will abate to a normalized 2ish percent or so. This would indicate that our economy is a whole lot weaker than we probably think it is, and with no more free money to give out to the world, the Fed will be powerless to do much of anything.

Long-term risk, high reward

Over time, I feel great about where things are heading for those who leverage technology and/or intellectual capital today. Not so great about where things are heading for those who do not. I think compounded financial and intellectual capital will continue to widen the schism between this country and the other countries of the world. And that at some point, the peace dividend we’ve all been enjoying will be cut short.

Here’s to hoping that the era of hot wars is an era very few of you can even remember. But we can’t really plan for that end-peace-dividend event. So, for now, man plans and God laughs, right?

Prime Movers Lab invests in breakthrough scientific startups founded by Prime Movers, the inventors who transform billions of lives. We invest in companies reinventing energy, transportation, infrastructure, manufacturing, human augmentation, and agriculture.

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