In Financial Markets, The Storm Is Always Perfect, and the Lessons Are Always Clear. That Doesn’t Mean We Always Heed Them, or Even Remember Them.

In financial markets, the storm is always perfect, and the lessons are always clear. That doesn’t mean we always heed them, or even remember them.

Three of the great market corrections of the last 40 years remind us that history may not repeat, but it certainly rhymes. That makes it easier to learn lessons from the past and to create some rules to live by — we’ve identified five.

But, let’s begin with a little history.

On Black Monday in October 1987, markets fell 20 per cent in one day, precipitated by computer-driven trading models executing portfolio insurance strategies. (By comparison, on the worst day of the stock market crash of 1929 - which ushered in the Great Depression — the Dow Jones Industrial Average only fell 12 per cent.)

Ironically, the software many firms thought would save them almost destroyed them. But programmatic trading was merely the spark — the conflagration was ultimately fuelled by market excess and an extended retreat from fundamentals (sound familiar, anyone?). In the five years before the crash, the DJIA tripled in value. At one point the market’s overall price/earnings ratio rose to over 20. It took two years before markets recovered their pre-crash levels.

That seems like a sprint compared to the dot-com crash. In that event it took NASDAQ two years to reach rock bottom, eventually marking a 78 per cent drop from its peak, and nearly 15 years to recover. The dot-com boom and bust marked the rise and decline of the Greenspan era of irrational exuberance. 

That the market crashed was not unexpected. That outcome had been predicted for at least a year prior, but the expectation was that it would largely affect the valuations of the dot-com businesses (pets.com and Webvan were among the more notable failures). However, the wider tech sector was also contaminated by the fall in valuations. For example, how does a large equipment manufacturer sell its products for full value when they are available on eBay, in liquidation sales, at peppercorn prices? Why write Cisco a cheque for $100,000 when you could buy the same switch, still in its shrink wrap, for just a few hundred bucks? Cisco lost 80 per cent of its value.

Finally, in 2001, just when the sharks thought it was safe to go back into the water, Enron collapsed in America’s largest corporate bankruptcy up to that time. It was the final punctuation mark of the era.  By 2004, a fresh-faced kid from Harvard had launched The Facebook, and the cycle started anew. LinkedIn (2002) Twitter (2006), Uber (2009), iPhones (2007) and Android (2008) all emerged from the wreckage and defined the next two decades of technology innovation.

The GFC in 2007 meanwhile proved that the smartest guys in the room had no more idea about how to unwind collateralised debt obligations than the taxi drivers who at the time were routinely offering investment advice to their customers. (They probably should have advised them to invest in ride-sharing.)

It began as a property problem. Property valuations fell and borrowers couldn’t meet their debts. The problem might have been contained to the US, except those debts had been repackaged and resold with derivatives all over the world. As things went south rapidly it became clear that even the sharpest suits on Wall Street had little idea about their true positions. Too big to fail? Tell that to the owners of Lehman Brothers and Bear Stearns. 

All of that is the context for current circumstances.

With markets once again in retreat, this month’s Tech Roundup taps the collective experience (and scars!) of the North Ridge Partners team, who have lived and traded through market corrections, reversals, crashes, and meltdowns.

Unlike the examples above, for now, we are experiencing a slow-motion train wreck. Since November the NASDAQ is down 23 per cent, with many second and third tier stocks down 70-80%. The March recovery was quickly snuffed out, and the latest round of big tech earnings results have confirmed investor fears of slowing growth. Inflation worries, rising interest rates, ongoing pandemic-induced supply chain issues, a brutal war in Ukraine and persistent energy shortages are all weighing on the economy, and hence the equity markets. On top of that, evidence suggests that valuations in the private markets are being impacted quite significantly.

Given how long the bull market has run, there are likely to be many successful entrepreneurs who have never experienced conditions such as these.  

With this in mind, we have identified five key lessons to help navigate the next few months (and years).

Rule One: Don’t panic

Clearly, with a war on the edges of Europe, there is a risk that something unthinkable happens. In reality, that risk has plagued the world for over 75 years and business can’t stop for that reason.  

We know that markets will recover and that liquidity will return. Revenue multiples, however, may or may not return to previous levels. One thing seems certain: the new paradigm — melding high-speed internet, seemingly limitless storage and computing from cloud computing, smart mobility, data analytics and more recently AI — is unstoppable. And that is before the transformative impacts of Web3 technologies emerge over the next few years. Entrepreneurs will keep building businesses and investors will look to generate returns by supporting them.

But, while you shouldn’t panic, you should plan. Which leads to …

Rule Two: Make sure you understand everything about your business

You need to know what levers you can pull, and what happens when you do? Do you have a downside management plan? What can you cut, and what happens if you do? 

Retrenchments are painful for everyone, but sometimes they’re necessary. What are the impacts of reducing marketing spend? Companies that need to preserve cash also need to understand the implications of the choices they will need to make. For instance, growing more slowly than your cashed-up competitor.  

There is no universal playbook, and what you do with the knowledge will vary according to the impact of our next two rules.

Rule Three: The importance of liquidity

By definition, a crash sees values decline. But the other common and essential characteristic of such times is that liquidity dries up (see article two). Indeed, most of these events have led to reduced liquidity in markets (and by extension private markets too) for a couple of years (sometimes more, sometimes less).  

You need to plan in order to survive and grow over that period. Companies with access to capital should look to call on it — even if that means accepting the reality of …

Rule Four: Adjust your valuation expectations quickly

Tech companies that get on with raising capital (even at lower prices), and use that capital to weather the storm can keep growing and come out the other side with more market share. Amazon, eBay, Google and Netflix all predate the dot-com crash. All thrived in the years afterwards.

Those are the examples to follow, as opposed to others who reduce investment in product development and marketing, lose ground, and are worth less at the other end.

Rule Five: Stay nimble and look out for opportunities

There is obviously no “one size fits all” answer, and there’s certainly no single plan at the start of a crisis that will get any business through. You’ll find that 80 per cent of the journey is course corrections as you navigate towards an outcome.

You should keep an eye out for opportunities in bad times — which is difficult if you are in survival mode. Are there roll-up opportunities? Mergers and acquisitions? This may not necessarily require spending precious cash, but there could be business combinations which benefit both sides — cost synergies, marketing synergies, products which work together. All of these are reasons to look.

Any crisis can be a trigger for good things to happen. Beauty is in the eye of the beholder!