Would you rather make money or be right? (part 2)

Just under two years ago now, we wrote a short note that encapsulated the idea behind how we managed – and continue to manage – risk and exposures. The idea that the market is an animal that can be tamed and brought under control, by virtue of a handful research notes and excel models, is one that was born out of a previous regime, one that knowingly or otherwise put the pursuit of “fundamental” value as the end goal of investing.

Of course, the past few years have laid bare how fallacious that ideology can be. Sure, the axioms about the “long run” continue to hold true: that the market in the long-term is a weighing machine, but in the short-term is a voting machine. But the gap between short-term and long-term is no longer a determinable figure – just ask the inexperienced short-sellers that incinerated their capital on fundamentally-sound calls through the past decade.

They may be having their day in the sun right now but having a short come down -90% after being up 100x still leaves one out the money by 10x.

The point is that notwithstanding fundamental views, the biggest mistake we can make as managers is to let ideology – including the ideology of “fundamentals” – stop us from making the right trades. What are the right trades? Those that make money.

That’s what we get paid to do. We don’t get paid to be right – that’s for the pundits and influencers on YouTube, Twitter, podcast platforms etc. There’s certainly no shortage of people with an opinion at this time, prognosticating one view or another. In fact, we can’t think of a greater tragedy than being “right” but at the wrong time (or any other caveat of “wrongness”), leading to losing money because of a badly structured trade.

Where does that put us right now?

Well, without mincing any words, we find ourselves in easily the most complex market situation in the past 15 years, if not more. From bank runs to credit crunches to inflation to central bank intervention to crypto at risk of being de-banked to a nascent but nonetheless exponentially growing AI narrative to abundant and growing dry powder (read “cash”) in a regime of potential monetary re-expansion – quite a mouthful, that list, and we’ve barely scratched the surface of complexity here.

Every week for the past three or four, we’ve seen developments that are reminiscent of some of the most dramatic market moves (both up and down) of recent financial market history. Sure, most of these episodes ended in tears, but the problem with history is that it only ever rhymes rather than repeats. Figuring out the nature of the rhyme is the difficult part, because the playbook – timing, trades, and the aftermath – is never a perfect replica.

We don’t have a crystal ball or some very special insight into these – but as always, these posts minimally help us to articulate and organise some of our thoughts. Additionally, they’re an invitation to discuss – especially where anyone disagrees with us, we’re always keen to know, and where necessary, be corrected.

Here’s our attempt to lay out what we see in play and zoom out to see a much bigger picture.

Banking system stability

For the moment, the dominos seem to have stopped falling, though it’s hard to tell if this continues. Silvergate, Silicon Valley Bank, Signature (though its closure and seizure remains under debate) and Credit Suisse make for quite a list of casualties. The former three could be bucketed as less significant and – perhaps with the apparent crypto connection – be blamed on the fallout from FTX. We wouldn’t be so quick to draw that causal link, although Silicon Valley Bank did find itself in the heart of a different liquidity deluge, in the land of PE and VC, which we wrote about quite some time ago now.

Indeed, if we had put on the trade to short SIVB when we put out that note, we’d be swimming in a lot of red. Reminder: being right doesn’t immediately translate to making money.

The story at Credit Suisse appears very much unrelated – after all, they’ve had no shortage of issues over the past few years, from management scandals to exposure to Bill Hwang’s Archegos to everything else in between. Furthermore, the writedown of their AT1 credit, even as it’s emerged that the writedown to null value was in accordance with a provision in the offering prospectus, has left many reconsidering the actual value of these subordinated debt instruments – regardless of issuer.

And that’s where things start showing their linkages. All of a sudden, the market is thinking about the capital base of every other bank and the sanctity (or lack thereof) of their issued capital instruments, and everyone’s scrambling to check prospectuses which were either too long or too tedious to read when they were issued.

At the same time, we receive almost-daily proclamations of central banking officials from all around the world assuring the public that banks and the banking system are safe, that the trifecta of “SI” banks (silvergate, silicon valley, signature) were an anomaly, and that CS was also an idiosyncratic case which has been contained through a merger pushed through in a manner that will probably feature in corporate and regulatory case studies for decades to come.

Deposit guarantees? No, not exactly, not yet – the ongoing evolution of the regulatory stance on the sanctity of deposits (should depositors be responsible for credit-checking their banks for counterparty risk?) is so fluid that between the time we save this post and the time it is read, things could have drastically changed.

Ultimately, if banking were just a closed circuit of cash flowing around, stored in one bank or another, the system would never technically be insolvent – it could be imbalanced, with some banks having the bulk of liquidity, while others close up shop for lack of deposits, but the system as a whole would retain its integrity.

The problem is that the fiat system isn’t a closed loop, and outflows are possible. And that takes us to the second point of interest that we are pondering.

Crypto

The escape valve we didn’t need (yet). That was the title we gave another note we put together last year.

For anyone who may have missed this – entirely possible if you didn’t have eyes on crypto twitter – there was a huge bet accepted by one Balaji Srinivasan, formerly of a16z and Coinbase, and best known for his incisive thoughtfulness on all things crypto, that Bitcoin would go to $1m apiece within 90 days.

His acceptance of the bet has been spun by his critics as a publicity stunt, often reported as him making a bet – in his defence, as is shown by his tweet being a reply, he did accept rather than initiate the bet. But the bet wasn’t that Bitcoin was going to $1m per se – rather, it was a bet around whether the US enters hyperinflation.

Bitcoin, more so than any other crypto instrument, as the escape valve store-of-value alternative asset to hyperinflation ticks all of the right boxes, like it or not: sure, it won’t work in a nuclear apocalypse because there’s no electricity, but neither would anything other than tinned food and clean water. Short of that, it’s portable (private keys easy to bring around), easy to transact, largely accepted as “not a security” and sufficiently scarce to command a scarcity premium.

To be clear, Balaji himself has admitted his acceptance of the bet is purely ideological, and he has been nothing but consistent in his ideological views on Bitcoin as the ultimate safe asset. But as his calls – which many have branded sensationalist – to his large audience grow ever more sonorous, so too are the calls on the other side: the grinding wheels of regulation that, intentionally or simply coincidentally, crack down relentlessly on the crypto ecosystem.

From the Wells Notice served against Coinbase – arguably the most pro-active company in crypto, that literally goes to the SEC and begs for regulatory clarity which has so far been denied to them – to the seemingly baseless seizure and shutdown of Signature Bank on fears of insolvency when there were no major issues (other than them running a crypto payments system called Signet, similar to Silvergate’s SEN), to the ongoing removal of fiat on/off ramps into crypto by exchanges seeking to comply (e.g. Kraken disabling ACH transfers), if actions speak louder than words then it isn’t a long stretch to believe that Balaji’s claims that access to crypto – at least to the USD and US banking system – is being cut off. No surprise that with dwindling USD payment rails, liquidity in crypto is also taking a hit.

To what end? If crypto were an escape route, and they’re being blocked, then everyone needs to be kept inside the system. And that’s where the original response by Balaji to the bet proposer comes into play: hyperinflation.

Or in the style of crypto twitter: “Moar liquidity. MOARRRRRR!!!!!”

Then all of a sudden, in the face of explosive nominal inflation (on that note – check out UK inflation dishing out yet another 10%+ print), only two things remain important: real value and real pricing power.

Does that translate into something good or bad for stocks? Or crypto? As always, “good” and “bad” are determined in the context of the prevailing narrative, and the only real guide that’s reliable is price action itself.

Artificial Intelligence

With all of this forming a backdrop of a tunnel of uncertainty, the only thing that looks like a light at the end of the tunnel is the rise of AI – at the very least, that’s a narrative that’s driving things up right?

While GPT4 is still (thankfully) unable to write blog posts to perfection, nor plan itineraries for travel that account for travel time to a recently relocated airport, it is getting there. ChatGPT’s emergence in the public domain has been nothing short of sensational (in the right way), capturing the imagination of what AI can do.

For the moment, the instrument of choice chosen by the market seems to be NVDA – a prime example of how a dominant narrative overrides any consideration of fundamental value. A handful of other names are emerging as possible alternative plays, including Microsoft, but options for other plays for the upside remain elusive.

On the flipside, it is becoming increasingly clear that for the knowledge economy on which we have relied for many decades, the light at the end of the tunnel could well be an incoming train.

Even now, from our own experience, basic work like financial analysis, legal drafting, travel itinerary planning and meeting scheduling – or even serving as a 24/7 personal assistant organising daily tasks and managing a to-do list – are all functions that ChatGPT can easily undertake. None of these require immense depth of reasoning, just organisational skills and a good memory.

Critics may argue that the output from ChatGPT isn’t perfect – and they’re right. The output often needs additional review before being accepted for use in whatever end use case it may be, but wouldn’t that be the same if the work were done by a human?

After all, whether it’s the presentations put together by a junior analyst, an itinerary for a trip handed to you by a travel agent or a draft contract put together by a junior solicitor or paralegal, short of doing it yourself, the next most prudent thing is to find a good assistant and review the work nonetheless. If the assistant is good, the need to amend post-review is lower.

ChatGPT on GPT-4 mode is an assistant that basically passes almost all major standardised testing exams in the top-10 percentile. For 24/7 access, no sick days off, no complaints and with a current limit of 25 messages per 3 hours, we can EACH get an assistant that does all of the above (and more – just look on twitter for all the other creative use cases for ChatGPT others have come up with) for the grand total of US$20/mth.

Here's the problem: for those who seek their fortunes and careers in the knowledge economy, GPT-4 doesn’t render it unnecessary for young professionals to acquire its capabilities “because a machine can now do it”. Rather, it renders it MANDATORY to perform AT LEAST as well as GPT-4 – that’s a high bar that’s been set, and it will only get higher, and probably much more quickly.

Either everyone now has to learn how to jump higher, or they need to look for a different game to play.

Superposition

We’re living in a world where the monetary system threatens to go back into hyper-print mode at the cost of hyperinflation, where contradicting forces of tightening and easing seem to coexist. At the level of individual people and businesses, inflation is rampant but business is still good (for now). Our world seems to exist in multiple states at the same time, depending on who is observing it – and the thing is all of those opposing viewpoints are correct, all at the same time.

The intelligentsia are looking upon this and calling time on the fiat monetary system – does that come to pass? Who knows, but the powers that be seem to be behaving in a way that is consistent with them fulfilling the very same prophecies they seek to debunk.

And underneath all of the chaos, we have an emergent technology that has the potential to revolutionise our entire labour market, upending the systems of value on which we have relied for decades. What does it mean to be competent? How good is good enough? And for those that don’t make the cut, where do they find their niche in the world?

In fact, how long will it take before every business in the world works out the value of AI and turns the blades of cost-cutting towards their wage bills? And what does that do to the rest of the macro narrative that’s currently in play, particularly in terms of policy, liquidity and markets?

After all, we did say the world was the most complex it’s been for a long time.