There is significant interest among retail investors in digital assets such as NFTs, cryptos of all types, and any firms in the crypto and NFT space. We’ve all seen stories in the Wall Street Journal and Bloomberg about animated pictures of monkeys and wolves selling for five, six, or seven-figure amounts, while cryptos ranging from Bitcoin to Solana sport total returns to investors in excess of 1000% over just the last two or three years. Against this backdrop, it’s probably no surprise that advisors and financial professionals at all levels are fielding calls and emails from retail investors and traditional fund managers alike who are looking to dip their toes in the space.
Given this context, it’s important to remember a few key points in the current economic environment:
1. We’ve been here before
Many of us who have been in the business a while will remember the irrationality of the late 1990s. Firms like Pets.com, Ask Jeeves, and even well-known companies still around today from AOL to Cisco all traded at extremely excess multiples. There was a sense at the time that the world was about to be fundamentally transformed overnight and as a result, traditional valuation metrics like P/E ratios and KPIs like margins did not matter. Instead, it was all about eyeballs and web traffic. We all know how that went. And while it’s in vogue these days to compare any mania to the 1990s, it’s important to remember this is a recurring theme throughout investment history—the 1970s saw the rise of conglomerates and the Nifty 50, while earlier on, railroads and the airplane inspired similar excitement. Far enough back one could even point to the tulip bulb mania in the 17th century. It’s probably not a stretch to conclude humans are enthusiastic by their nature. Thus the wild exuberance about cartoon chimps seems only slightly stranger than firms like Kozmo that promised to deliver products to customers for free, and a loss rivaling the ~$2 trillion dot-com bubble is still certainly a possibility (see https://money.cnn.com/2000/11/09/technology/overview/).
2. Asset price delta in a rising rate environment is a direct function of duration
As the Fed raises rates, it is important to remember Finance 101—yield and price of assets are inversely related, and long duration assets are hurt more by rising rates/yields than short-duration assets. Essentially a high P/E stock is a long-duration asset—just like a zero-coupon bond, the investor is betting on the terminal value of the asset. NFTs and cryptos, which produce no cash flows today, are all the equivalent of extreme long-duration assets—we can and should therefore expect to see their value decline more than shorter-duration assets as rates rise. When borrowing costs nothing, it’s easy to bet on a long-term prospect, but as the debt service costs rise, the Internal Rate of Return (IRR) on that long-term prospective payout shrinks dramatically. None of this is to say that cryptos are going away—they have already survived more than a decade at this point—but a prudent portfolio manager should understand where they fit in a rising rate environment. This brings us to the final point.
3. The market can stay irrational longer than you can stay solvent
As the saying goes, markets can remain out of balance for much longer than many expect—again, the 1990s might be exhibit A for this. A clear-headed observer in 1998 could have pointed out that 600% first-day gains in internet IPOs seemed overly optimistic, yet anyone shorting the market would have had to wait another two years and endure a significant upside before the NASDAQ finally started to collapse after quintupling its value over the preceding five years. More recently, GME short-sellers found out to their chagrin that when fundamentals meet herd behavior, herd behavior wins without question—at least for the short term.
All of this points to the importance of a sound and balanced approach to managing risk across asset classes, and certainly, that is true with newer investment categories like digital assets.
Join the SS&C Learning Institute May 11, 2022, as we delve further into the investment management opportunities digital assets and NFTs present. Register and view the webinar agenda.
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Asset Management, Wealth Management