With the tide out, who's swimming naked?

Warren Buffett once said, ‘Only when the tide goes out do you discover who has been swimming naked’. But what does that mean?

When conditions are good and markets are rising, most investments do well. This can occur despite some of these investments carrying some nasty hidden risks. When conditions turn negative, these risks become exposed, and can even imperil a company or asset.

Before we look at who’s been caught swimming naked in 2022, for context, let’s look at who was caught naked in two of the previous bubbles.

Dotcom bubble

The dotcom bubble was a valuation bubble. It began in 1995 and peaked in early 2000, with the Nasdaq increasing by 400% over this period. After hitting its peak, investors began to see the extreme valuations and began selling, first as a trickle then as a rush. Over the next two and half years the Nasdaq fell, giving up almost all the bubble’s previous gains.

Those swimming naked were the unprofitable dotcom companies that ran out of cash and declared bankruptcy. These famously included pets.com, Webvan, and boo.com. Sadly, many everyday investors were caught up in the crash, with estimates that 100 million investors lost around US$5 trillion.

Despite the carnage, out of the dotcom crash came survivors that included many of the big names of today, such as Amazon and eBay.

The dotcom bubble highlighted the importance of companies having sound business models that produce sustainable revenues and positive cash flow.

Global Financial Crisis

The seeds of the GFC began soon after the dotcom crash, where a combination of low interest rates and lax lending standards produced a boom in home ownership and house prices. These loans, many of which were sub-prime, were packaged up by banks and sold on to investment banks who carved them up into exotic and complex products, and on-sold them to others.

However, once property prices began to fall and ultimately crash, the whole house of cards came down.

Those swimming naked included banks, investment banks, insurance companies and many other financial services holding companies. Credit ratings agencies were also caught naked as they incorrectly rated these products. Millions of homeowners lost their houses, investors lost a fortune, and almost every downstream business was impacted by the ensuing recession. The market finally picked up after massive government stimulus and bailout packages took effect.

The GFC showed us that when bubbles burst, not all problems are seen on day one. Just like dominos, one problem can trigger another, which triggers another.

Today’s Market Crash

Turning our eyes to today, here’s a list of who’s been caught sans bathers:

• Cryptocurrency. With more than 19,000 cryptocurrencies in existence, many have been calling this a bubble for a while. This year alone crypto’s flag bearer, Bitcoin is down 55%. In total market value, cryptocurrencies have dropped from US$2.9 trillion in Nov 2021 to just under US$1.0 trillion today. Cryptocurrencies (unlike stocks, farms, and investment properties), produce nothing, and hence have no real underlying value. Buffett and Munger believe the long-term value of cryptocurrencies is zero, though they are unsure when this will happen.
• Non-Fungible Tokens. Related to cryptocurrency, NFTs are block-chain based certificates of ownership, typically of a digital asset such as a piece of digital art. The true value of these assets has always been questionable, but they too have been caught up in the recent downturn. NFT sales volumes have decreased 75% since May, and values have crashed by about 70% too.
• Unprofitable Tech. In rising interest rate environments, investors tend to avoid high risk companies. This has played out over the last six months with the tech heavy Nasdaq down around 25%. Some falls have even been greater. Cathie Wood’s ARKK ETF, which contains a trove of ‘disruptive’ tech companies, has fallen 70% since peaking in 2021.
• SPACs (Special Purpose Acquisition Companies). Big in the US, SPACs are listed shell corporations with wads of cash, that typically merge with speculative companies, allowing them to list quickly and avoid the IPO process. Of all the SPAC mergers completed and public, there has been an almost 50% fall in value this year. Today, the number of SPAC deals has almost dried up completely.
• Investors buying on margin. Given the large falls in growth stocks, those that have bought on margin, may have faced a margin call at the worst possible time in the cycle (i.e. the bottom of the market).
• Though not technically ‘swimming naked’ many companies could also get caught in the economic slowdown. In the US, profit warnings have already been received from the likes of Target, Netflix, Amazon, and Microsoft.

How far along we are in the unwinding of this bubble, we don’t know. Perhaps the tide will continue to go out further revealing more naked swimmers, or perhaps the bulk of the selling is over. A lot still depends on how quickly the real-world problems such as inflation, the global supply chain, and the Ukraine War are resolved.

Here at InvestSMART we ensure our investors have well fitted bathing suits. Our portfolios use exchange traded funds (ETFs) to provide diversified exposure across a range of asset classes. When you look at the investments used for Australian and international shares, they’re ETFs investing in blue chip businesses.

These are well established companies, with business models that have stood the test of time through the above-mentioned ebbs and flows. They’re businesses that have a long track record of paying dividends to investors. This is important because even in downturns, as an investor you’re still receiving a return. You can see the ETFs we hold in each portfolio by clicking on Holdings when viewing each portfolio.

Enjoy your swim, keep your bathing suit tidy and stay between the flags.