News & Resources

+ - + - + - + - + - __ ? - Vol. 18

May 27, 2022

Pattern recognition is an important element in how we learn and make decisions. Over the millennia of human evolution, the ability to uncover relationships in our environment has been a determinant in natural selection because it allowed for more effective hunting campaigns and helped inform which plants to avoid eating. On a social level, we get conditioned to behave with manners and politeness based on the feedback we receive when acting otherwise. However, there’s a dubious side to this brain hack. Patternicity (or apophenia) is a tendency to imagine links between random events, leading to irrational behavior. 

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Back in our cave-dwelling days, the cost of underreacting to some noise in the bushes could be the difference between getting some unnecessary exercise (running away from the wind) or being a predator’s lunch. In today’s more complex world, believing in spurious correlations or the illusion of control give rise to conspiracy theories and destructive mindsets. Here’s an example of the latter from PsychCentral:

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These biases have the potential to be particularly painful in an investing context. Believing in a false cause/effect relationship might lead to a poor assessment of risk/return prospects and mistaking luck for skill can cause a portfolio manager to dismiss thesis-changing information; continuing to hold an asset all the way down. Cem Karsan became one of my favorite investors to follow on Twitter because he blends option activity and the associated dealer hedging implications into his market analysis. I believe that the increased reliance on passive strategies can result in flows dominating fundamentals for extended periods. In a recent thread, he discussed the consequences of refusing to update one’s perspective in the face of new information:

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Cem goes on to caution readers that the confluence of societal angst, significant wealth disparity, withdrawn monetary stimulus and deglobalization are likely to usher in a new regime where go-forward growth trends will have to be revised lower. As a result, the pace of innovation will slow and Palo Alto (a proxy for venture capital) is “in the process of being choked off.” Investors should beware of “snake oil” salespeople claiming otherwise and maintain high levels of liquidity through this period of flux. 

As mentioned above, an unwillingness to adjust your perspective can have negative portfolio implications, so these are important warnings to heed. However, it would be naïve to infer that Mr. Karsan is saying that innovation, growth, and VC will cease altogether. A change in trend can (and has) lead to significant revaluations, but it still means that there are improvements made at the margin. 

While the slope of the trend line can fluctuate depending on the time frame observed, it’s rare that a secular trend stops abruptly.

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The pandemic has provided many excellent examples of generally smart people placing too much emphasis on current events when updating their outlooks. James Altucher is a hedge-fund manager, author, podcaster, and entrepreneur. In August of 2020, he penned an essay proclaiming that: NYC is Dead Forever. Here's Why. His conclusion was based on the assessment of some recent trends like retail transitioning to online channels and an aging population moving to quieter homesteads - both of which were exacerbated by the lockdown measures to contain COVID. But surely these were temporary, no?

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Now, Altucher does make a living from a media presence, so it’s possible that his motivations were influenced by the headline-grabbing assertions, but his reputation is also based on an ability to see through the noise, so it seems like this was his honest assessment, which we now know was incorrect.

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As aerospace stocks tumbled on fears that travel bans would rot balance sheets, even the Omaha Oracle sold his shares because he believed the business prospects had been impaired. Prior thereto, the case for owning equity in the airlines was based on a trend of persistent air travel growth and improved operational execution, but the shock delivered by the pandemic was believed to have broken this foundation. Again, with the benefit of hindsight we can say that this hasn’t played out as expected:

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It’s important to note that I’m not dunking on any of these forecasts gone awry. If I had $0.01 for every time that I was right, then I could maybe buy 75 LUNA. However, as we continue to move through choppy economic and market conditions, I think that it’s important to remember how difficult it is to stop a massive body in motion. As Cem Karsan notes, it’s critical to understand the forces underlying a particular tendency, which is where I believe the estimations above went wrong. People want to live in NYC because of its essence. The metropolis has rich history steeped in creativity, entrepreneurial spirit, and grit. While some might tire of the big city, there are many on the doorstep waiting for a chance to participate in its legacy. Also, following nearly two years stuck at home, people want more than ever to experience different cultures, smells, and tastes. Of course, policy response was huge in getting activity back so quickly.

In 1979, the U.S. 10-year Treasury yield averaged 9.43%, inflation was 11.35% and an August edition of BusinessWeek’s cover story proclaimed that equities were dead:

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If you’d purchased $100 of the S&P 500 in that year and reinvested all dividends since (which was possible because the first Index fund launched in 1976), then your investment would be worth $12,834 today. The article arrived at the dismal (and painfully incorrect) assessment that stocks were likely to be poor sources of return due to demographic changes, inflation, and competition from alternative assets. However, the authors failed to appreciate that stocks are proxies for overall economic growth and innovation. There are, indeed, cyclical components to these measures of progress. However, they both compound, which means that over longer time horizons the difference between start and end positions can be humungous.

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Six or so months ago, the mood in digital asset markets was euphoric. New Layer 1s were launching successfully, NFTs were mooning and there was plenty of capital around to prop up TVLs while yield mercenaries rotated across the latest DeFi protocols. Today the tone is “down only”, and the media is focused on the industry’s shortcomings. Some have even been so bold as to write web3’s obituary:

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Are prognostications like the above falling into the same trap that claimed the pandemic doomsayers or are they practicing prudent Bayesian updating à la Cem Karsan? Unfortunately, we’ll have to wait for the passage of time to know for sure, but let’s try to dig into this a bit. Borrowing from the Jam Croissant Playbook, we can forecast the outcome by trying to comprehend the underlying forces that have been driving digital asset adoption. 

While I believe that the greatest potential for web3 is through an integration with the incumbent system rather than trying to replace it, a powerful force driving adoption so far has been dissatisfaction with the current power hierarchies. For example, Bitcoin’s genesis block contained an easter egg which referenced an FT article: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” Also, important crypto cultural figureheads like Cobie have stated that witnessing the hardships borne by family members as a result of the Great Financial Crisis without accountability at the executive or regulatory levels was a catalyst for getting involved. The blockchain space isn’t without its faults, but relative to the longer history of corporate greed, younger generations probably still place greater trust in the decentralized and transparent vision of web3. On balance, the societal angst that is meant to weigh on future growth rates probably supports the digital asset narrative.

Computers are more entwined with our lives today than ever before. Do you think rising interest rates and consumer price indices are likely to derail that phenomenon? I’m not sure they’ll have much of a negative impact on screentime at all. As valuations in the technology space come down, a reasonable assumption is that the founders may be reluctant to raise capital (if it’s even available). However, there are many large operators with significant cash balances who will be looking for sources of future growth and while this may not necessarily be in the digital asset space, some of the biggest players are reassessing their strategy in that respect. Here’s Instagram’s CEO, Adam Mosseri with WIRED:

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One of the most compelling attributes of web3 is its focus on open-source projects. The blocks of code that underpin these ventures can serve as Lego blocks for others to assemble in novel ways. Such experimentation can lead to important innovations without significant monetary investment. The Federal Reserve can take away the punchbowl, crimp levels of household wealth and send the economy into recession, but many projects remain well-funded, and hobbyists will find the time to build. The effect will be a compounding of ingenuity from the current base, so even if growth rates slow, the capabilities of future projects will be greater than today. 

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During economic slowdowns, advertising budgets get slashed, but it’s not as if commercials cease to air or banner ads disappear. We’ve seen several consumer-facing businesses explore NFTs to create deeper meaning with their clients. The direction from the tops of these many organizations will determine the extent to which they will continue with web3/metaverse investments, but a wholesale abandonment of the initiatives seems unlikely. As these new entrants develop and hone go-to-market strategies for this emerging space, their successes and failures will provide the foundation for subsequent experimenters to build off – again resulting in a compounding effect. 

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Generally, I agree with the Karsan thread. We’re witnessing a meaningful departure from a regime of globalization, persistently low inflation, and waning borrowing rates. The elimination of “free money” will indeed have profound impacts on capital allocation, growth rates, and asset valuations. Yes, this ushers in a bunch of negative sentiment, but a slower growth rate isn’t the same thing as the death of a city, industry, or technological movement. It’s unlikely that tech stocks, crypto and other long duration assets rebound as hard as Manhattan rents or air travel. And no, the current and coming hard times won’t feel as exciting as the preceding bull market. But many will keep building and this cycle will provide yet another example of how the change in the steepness of a secular trend doesn’t imply its slope has flipped. 

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In the coming weeks we’ll dig into a couple areas of web3 that I believe can put up substantial growth figures, even in a bear market. The current developments in blockchain gaming and social apps is exciting.