Thread by @LT3000Lyall

A lot of people are arguing the sell-off in tech/high flying growth names is due to the longer duration of their cash flows, & hence greater sensitivity to higher discount rates. That's not the real reason. It is instead due to their sensitivity to liquidity conditions (thread).

A huge amount of money creation has occurred of late via central bank printing, and it's flooded into certain sectors of financial markets. Desperation for any sort of return in a zero rate environment has also pushed risk averse capital into riskier assets - alts & stocks.

Wary of the impact of covid on the economy, that money has flooded into perceived lower risk stock exposure - "covid winners"/secular growth stories perceived to be immune. Performance chasing, and the high weighting of frothy growth stocks in ETFs has also contributed.

The basic issue is that if liquidity tightens (i.e. the relative availability of liquid cash/capital vs. availability of investable liquid assets), the worst impact asset prices will logically be those that were the largest beneficiaries of the recent aggressive money printing.

A lot of people argue things like "but stocks are real assets", so inflation ought not matter. Wrong. Asset pricing is a real world, practical thing, not a theoretical construct. If you shrink the availability of cash/debt relative to the availability of assets, prices will fall.

There are two ways higher inflation could seriously dent liquidity. The first is the Fed is forced into rapid tightening. The second is that inflation erodes the real value of the huge stock of nominal assets (bonds & cash), thus reducing the real supply of liquid capital.

Both scenarios would significantly alter the demand and supply balance in capital markets, increasing the market clearing cost of capital, thereby pushing down asset prices.

Bubble stocks are also bearing the brunt of a sharp sell-off this early because prices were previously being supported by rapid inflows/new buying. When prices are this extended, a mere slowdown in the pace of new inflows can be enough to trigger a sharp pricing rout.

The supply of stock is increasing. There are lots of new IPOs. Insiders are regularly selling, and there is ongoing copious stock based compensation. Secondary issues are needed to fund ongoing losses from many tech coys. This requires constant new inflows of capital to absorb.

Consequently, merely a slowdown in the availability of new liquidity (seen in past few weeks) will be enough to significantly tank prices. If we actually see a significant tightening in liquidity (outflows), the sell-off will accelerate & declines of 80-90% will be fairly common.

In short, asset pricing is a pragmatic thing, not an academic one. Prices are driven not by fundamentals, but by demand and supply (fundamentals only matter to the extent they influence demand and supply - investor perception/behaviour, and FCF-funded buybacks etc).

Academic concepts like higher discount rates impacting longer duration equity cash flows are BS/irrelevant. The fall in asset prices in tech land has absolutely nothing to do with that. It's due to the sensitivity of demand & supply to liquidity conditions.

Just as importantly, a lot of the high returns some investors have seen of late owe absolutely nothing to investment brilliance - indeed more often they are a sign of ineptitude. They and many commentators have mistaken systematic liquidity conditions for investment genius.

We could also see the impact of reflexivity emerge if prices keep falling. As asset prices fall and the cost of capital rises, cash-burning tech companies will be forced to make some tougher choices. Spending could be reigned in to slow cash burn, precipitating growth slowdowns.

This can become a nasty downward spiral. If serious dilution becomes a major risk due to lower equity prices, you can't so easily run operating losses with impunity. Reduced spending cascades across supply chains. Tech company growth slows down & earnings fall.

Growth & earnings shortfalls can then precipitate yet further equity declines, leading to growing investor fear/risk aversion that leads to equity outflows from tech funds etc, forcing more selling and leading to yet more equity price declines. This is how a bust happens.

If/when this happens, it will basically be the movie we have seen in the past few years in tech land played in reverse. It's the exact same self-perpetuating dynamics that lead to the boom in the first place, just playing out in the opposite direction.

I older & wiser investor I know has historically had an uncanny knack for calling the cycle. I asked him how he did it. He just said you know you're close to the top "when you start to see people doing really dumb things". We have been seeing a lot of really dumb things of late.