We're in the eye of the crypto storm, what comes next?
One of the most life changing years I had was back in 2008, working as a stock analyst at Morningstar while the market was crashing. Everything I learned at university and through reading books was thrown out the door.
It wasn’t so much the fact that the market was crashing. There had been similar crashes previously. It was more a case of the ongoing, continuous destruction of value and the fallout particularly among retail investors who had over committed during the good times.
We all looked back at the tech crash of 2001 for guidance. The charts looked similar. Nobody thought it was going to get as bad as 2001, but it ended up being worse. Working as an analyst, writing research and advising clients was like going to war on the front lines and taking a pounding everyday.
The important thing was showing up, learning and becoming stronger. That’s what most soldiers with battle scars will teach you. I learned a couple of really important lessons back then which I think can be applied to the current crypto collapse and flow-on effects.
Lesson number one. When there is a contagion in markets, everything is risk off. Anything is possible. The world’s safest and most reliable organisation can go down. Nobody is safe, so assume nothing. Anything can happen. Contagion is usually a very rare event, Lehman Brothers was a perfect example. FTX, Binance or something else could be the next one.
We don’t need to know what the event is, we just need to know that it could happen and when it does, we need to stand back and become hyper paranoid about protecting our capital.
A crypto coin collapsing somewhere could cause a retail bank to collapse on the other-side of the world and take down an investment bank or even a central bank. Risk multiplies quickly. Contagion is about the velocity of change.
Lesson number two. Large markets don’t move in straight lines - neither upward, downward or sideways. One of the best pieces of research I read was from a mentor of mine writing about buying Australian banks when they were on their heels in 2008. Banks around the world were collapsing. It was a brave call. The title of his research piece was to buy “Straw hats in winter”.
He was right. It was an amazing time to buy, the losses of 2008 were nothing in comparison of the gains that came in the following decade.
When everybody heads for the exit gates and when the front page of the newspaper is talking about the billions of dollars lost, it’s time to start planning and preparing. Nobody can pick the bottom. There is no precision, no chart, no algo. It’s all guesswork.
It’s not about picking the bottom, it’s about position size, asset allocation and buying quality investments.
Position size and asset allocation is the single most important part of becoming a successful, long term investor. It’s not necessarily about diversification because again, as we have seen, different asset classes can all move down together when there is a financial shock to the system.
Position size is about risk management. It’s better to have 10% of your portfolio in ultra risky exposures and 90% in cash than have 100% in what you believe is medium risk. Plan for the worst, hope for the best. In the end you will survive and thrive.
Asset quality is hard to measure in periods of contagion. If you’re buying individual stocks you’ll need to do a lot of research. Usually management with high integrity and skin in the game is a good quick reference point.
A good Chairman is a sign of a well run company. But there’s a lot more to it. If you don’t have time to think about individual stocks, market based ETF’s are a good alternative.
Lesson number three. The reason why we didn’t go into a depression in 2008 and we bounced back stronger was because central banks came to the rescue. Rightly or wrong, they bailed out the system. We had record amounts of money being printed, rates being lowered which brought us bigger problems that we are now dealing with.
Central banks will be tempted again if there is contagion. I find it very difficult to believe that they will have enough political and social will to sit as bystanders if the global markets collapse.
The door will eventually be open for more intervention even if inflation is a problem. When central banks get involved, contagion will eventually subside and things will go back to some type of stability. Until the next blowup.
What’s the bottom line and what happens to crypto?
The crypto collapse we’ve seen this year has the potential to cause a contagion event. It’s a really poor asset class to have exposure in and just as we didn’t think 2008 could get as bad as 2001, the lesson is that it could actually get worse.
Anything is possible. The crypto universe can fall another 90-95% in value. If you can’t afford to lose more, you need to get out.
The US Fed’s decision to raise rates aggressively is having a cascading impact on markets. Tech layoffs are a sign that the economy we have in its current form is breaking. Real estate markets are in a freeze. People are starting to panic.
If the US Fed wanted to change risk dynamics and create caution, I believe they have done a good job. If crypto gets worse, we’ll see central banks move away from their inflation war towards a more diplomatic stance where they are again tempted to intervene to save the markets from contagion.
What happens in crypto could end up impacting everything. It’s a great time to be thinking about being contrarian. While everyone runs for the exit, the smart money will be looking to buy. I’ll have an update to my model portfolio, with asset allocations, next week.
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