🎶 The Music Stopped

Originally Published: May 24, 2022 (here)

The music was on, and boy, did we dance. It would’ve been a crime not to. But the night turns into morning and we are feeling a hangover worse than ever before.

Welcome to this month’s episode: Markets.

It’s no surprise purchasing power is decreasing, public equities are taking a beating, and consumer debt levels are looking unstable. Though, in the face of all this, in the words of Brad Gerstner, “technology’s value creation and positive impact on humanity has never been steeper - but wars and economic cycles remain… Embrace the first, but survive the second.”

We’ve got a lot to unpack today. Let’s begin.

Value Creation of a Country

Every year the United States measures its value by calculating the total goods and services produced by the country, formally known as gross domestic product (GDP). When new capital is introduced into the system, its intended purpose is to ultimately create more goods and services. For the sake of today’s conversation, I took into account the amount of money printed by the federal reserve and analyzed whether it had a meaningful impact on America’s GDP. The results of this observation unveiled a misuse of capital, and unfortunately, a dark, but unsurprising truth that begins to explain the current market downturn.

Money Supply vs. GDP

These past two years, the fed printed an insane amount of money. The chart below indicates the steep rise in M2 money supply - the total volume of currency held by the public.

5-Yr U.S. M2 Money Supply Chart

The purpose of releasing this capital into the hands of the public was to “stimulate” the economy. The best measure of economic stimulus and health is GDP. Charted below.

5-Yr U.S. GDP

GDP seemingly does go up and to the right, but if we dig into the numbers, we see a not-so-pretty picture. The quick math below comparing money supply to GDP indicates the new money created was not used productively.

GDP-to-M2 Ratio

The goal of a country should be to maximize the market value of goods and services created as the available resources (i.e. money) to create G/S increases. Theoretically, this multiple should get higher over time, but at the very least, remain constant. For example, if you can make 5 burgers with $10, you should, at the very least, be able to make 10 burgers with $20. If this multiple trends downward, it’s safe to assume capital is not being allocated in a productive manner.

In our case, we had more resources, but did not create more value.

Instead, money flowed directly into financial assets (skipping actually creating value) and inflated the paper value of stocks. We didn’t really use the money printer to stimulate the economy. We used it to create asset bubbles.

Stock Market Correlation

If that’s not enough to make you believe, something I read in Chamath’s most recent annual letter left my mouth wide open.

“Since 2018, the correlation between the S&P 500 and M2 YoY growth was 0.92! In layman’s terms, as ‘the money printer went brrr,’ the stock market went up dollar for dollar.”

When the government releases capital into the system, it is meant to stimulate the economy i.e. create new businesses, jobs, and goods and services. Instead, capital flowed directly into financial assets. As a result, the paper value of stocks rose, but the actual productivity remained flat. We’re now witnessing the artificial bubble pop, and admittedly, it’s been quite painful to watch.

The Domino Effect

Public Markets:

1. Money floods the system (M2 money supply goes up)

2. Consumers feel more wealthy and begin to purchase goods and services at a rapid rate (high demand)

3. Too many dollars chasing too few goods (low supply)

4. In response, businesses raise prices (inflation)

5. Fed increases rates to discourage borrowing and spending (leads to high cost of capital, but meant to cool demand and lower inflation)

6. Fundamental valuations fall due to higher cost of capital, higher hurdle rates stall professional investors, retail investors sell-off shares to cover the rising cost of everyday goods (lower share prices)

Private Markets:

1. VCs use public comps to price valuation rounds (private market corrections)

2. The venture ecosystem has less liquidity to deploy (slower capital deployment cycles)

3. Firms are waiting for the market bottom (risk-off strategy)

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