E114: Markets update: whipsaw macro picture, big tech, startup mass extinction event, VC reckoning

Podcast Summary

• Factors Influencing the Current Economic Landscape and the Fed's Challenges in Labor Management: Despite positive market reactions to the Fed's rate hike and significant job growth, the slowing wage growth and uncertainty surrounding the economy remain concerns for both the labor market and venture capital/startup industry.

  The market data, the Fed rate hike, the jobs data, and labor participation all play significant roles in shaping the current economic landscape. The Fed's decision to raise rates has impacted the market positively, with job data showing significant growth. However, the Fed is facing challenges in managing the labor market. Despite an increase in labor participation, wage growth is slowing down. The conversation also highlights the uncertainty surrounding the economy, with discussions on market reactions and the Fed's actions. It is noted that the market tends to bottom out before it becomes evident, and recent systematic buying has led to a surge in the short term. The overall effect on venture capital and the startup market remains a topic of concern.

• Shifting Sentiment: From Recession Worries to Inflation Concerns: Recent economic indicators have caused a shift in sentiment, with concerns now shifting towards a potential increase in inflation rather than a looming recession. However, the delicate state of the market and uncertain future remain significant factors to consider.

  The economy is highly volatile and difficult to predict. Just a month ago, there was a negative sentiment and predictions of a recession later in the year. However, recent good inflation reports and a strong jobs report have shifted the consensus. The belief now is that the risks of inflation returning are slightly higher, but the risks of a recession are slightly lower. The employment picture has improved, indicating that people may have blown through their savings and now need to go back to work. However, there is still concern about wages going up, leading to inflation. The market is in a delicate moment, and if inflation is reignited, the Federal Reserve may have to start another hiking cycle. Overall, the future of the economy remains uncertain.

• The Complicated and Volatile Market: Strategies and Considerations: In a market driven by automated processes, investors must adapt their strategies to unpredictable market conditions and stay informed about inflation trends and interest rates.

  The market is experiencing a complicated and volatile moment. Many investors on Wall Street were caught off guard by the current situation and are now scrambling to adjust their strategies. There is a growing interest in going public for a number of companies, with big banks actively trying to secure buyers for IPOs. However, it is important to note that much of the market is driven by computers, algorithms, and ETFs, which follow a formulaic buying model. This means that market movements are often influenced by automated processes, leading to inflated prices and potentially unhealthy market conditions. Additionally, the conversation highlights the importance of monitoring inflation trends and interest rates, as they have a significant impact on market predictions and investor behavior.

• Implications of Decreasing Interest Rates on Startup Investing: With interest rates no longer at zero, investors need to consider different investment strategies as money-losing startups become less attractive due to changing trade-offs.

  The market is predicting a decrease in interest rates over the next two years, with long-term rates stabilizing at around 3.5%. This indicates that the Federal Reserve has done enough to combat inflation. As a result, the conversation suggests that we are moving away from the previous environment of zero interest rates and entering a more normal one. This has implications for startup investing, as the risk-free rate is a key factor in determining the maximum price to earnings ratio that investors are willing to pay for a stock. With interest rates no longer at zero, the trade-offs for investors are changing, making money-losing startups less attractive. This shift reinforces the need to adapt to this new regime and consider different investment strategies.

• The Intersection of Technology Trends and Periods of Austerity: A Key to Company Success: The success of companies often relies on the convergence of technology trends and periods of austerity, as seen in the PC and internet revolutions. Startups may benefit from an improved economy and advancements in technology, but cautious investment strategies could also emerge.

  The success of companies is often tied to the intersection of technology trends and periods of austerity. This was evident in the PC revolution of the 1970s and the internet revolution of the late 1990s. During these times, companies like Microsoft, Apple, and Amazon were founded and had to focus on profitability and positive cash flow. As interest rates creep back up, and if there are improvements in technology in the next few years, it could be a boon for startups and startup investing. However, there is also a counterbalancing effect caused by the record high amount of VC capital raised, which may take a few years to fully manifest. This may lead to a more selective approach by investors and a retrenchment in the VC industry.

• The shift towards efficiency and leaner organizational structures in the tech industry.: Reducing layers of middle management promotes productivity and allows the best people to actively contribute, rather than just manage.

  Companies, especially in the tech industry, can become inefficient and bloated with unnecessary layers of middle management. The abundance of available funding in recent years has led to a lack of survival pressures, allowing companies to avoid making tough decisions and addressing inefficiencies. However, we are now seeing a shift towards greater efficiency and leaner organizational structures. Examples like Facebook, which underwent layoffs and removed layers of middle management, have shown how focusing on doers and reducing bureaucracy can lead to positive results. The problem of infinite delegation, where everyone wants to be a manager and layers keep piling up, must be recognized and addressed by reducing the number of layers in the company. This promotes a culture of productivity and ensures that the best people are actively contributing rather than just managing.

• Facebook's shift to cashflow generation sparks investor excitement and potential for massive shareholder returns.: Facebook's transition into an ex-growth company presents an appealing investment opportunity with its potential for generating substantial cashflow and distributing billions of dollars to shareholders in buybacks and dividends.

  Facebook is transitioning into an ex-growth company, focusing on generating cashflow rather than pursuing growth. By cutting expenses and becoming more efficient, Facebook aims to increase its cashflow yield and generate substantial amounts of cash. This shift has excited investors as few ex-growth companies have the potential to compound massive amounts of money. With over $100 billion in revenue, Facebook is in a favorable position to achieve this. Value investors find Facebook's stock attractive, considering its modest PE ratio and potential for substantial shareholder value return. Similar to Apple's successful ex-growth transition, Facebook could potentially distribute hundreds of billions of dollars to shareholders in the form of buybacks and dividends. This presents an opportunity for investors like Warren Buffett to consider Facebook as an appealing investment option. Additionally, early and mid-stage startups may face a mass extinction event in late 2023 and 2024, with an estimated 50% of these companies going out of business.

• The Need for a Venture Capital Reckoning: Recalibrating Strategies and Partnerships: Venture capital firms must adjust their expectations and reassess partnerships in order to navigate the changing landscape and address challenges in the industry.

  There is a need for a venture capital reckoning. Over the years, excess capital has led to artificially low loss ratios, giving a false sense of success. However, it is important to revert to the historical average and expect a 50 to 60% mortality rate. Many startups, especially those in the dot-com bubble, have experienced high failure rates. The current trend of focusing on short-term gains and feature-oriented products hinders the potential for long-term success and differentiation in the market. Additionally, many companies have raised substantial capital but are struggling to meet the valuation expectations, which leads to the need for recapitalization and often entails difficult decision-making. In light of these challenges, venture capital firms need to recalibrate their strategies and reassess their partnerships to navigate this changing landscape.

• The Keys to Success as a Venture Capitalist: Successful venture capitalists prioritize companies with cash generation potential, scalability, and platformability, and prioritize long-term financial success over maintaining relationships. Understanding business fundamentals and having a commercial background are crucial for making strategic investment decisions.

  Being a successful venture capitalist requires a strong commercial background and the ability to make tough decisions. Simply investing in companies with high valuations and momentum is not enough to ensure a positive return on investment. Instead, venture capitalists should focus on companies that have real cash generation potential, scalability, and platformability. It is important to prioritize long-term financial success and prioritize limited partners over maintaining a congenial relationship with entrepreneurs. The most successful venture capitalists have a strong understanding of business fundamentals and have experience in commercial roles, such as investment analysts or journalists. In the current market, the rise of AI companies presents both opportunities and challenges that require skilled decision-making and pressure on management teams to achieve target numbers.

• The Importance of Hiring Investors with Technical Skills in the AI Startup World: To make informed investment decisions in AI startups, venture capital firms should prioritize hiring investors with technical expertise and utilizing third-party individuals for technical due diligence.

  The current trend in the startup world is for companies to rebrand themselves as AI companies, attracting significant investment from venture firms. However, there is a concern that these firms may misallocate their funds due to a lack of expertise in the AI field. It is suggested that VCs should prioritize hiring individuals who are not only experienced investors but also possess technical skills and knowledge in AI. The ideal investor would be someone who can effectively assess founders, have a curiosity to learn new areas, and identify the best companies within the AI space. Additionally, the conversation emphasizes the importance of having a team approach, utilizing third-party individuals for technical due diligence in order to make informed investment decisions.

• The Importance of Accounting and Pricing Best Practices for Startup Founders: Founders need to prioritize financial literacy and gain a strong understanding of their business's financials to avoid miscalculations, misrepresentations, and potential funding obstacles.

  There is a significant need for founders in the startup world to be educated on accounting best practices and pricing best practices. Many early-stage startup founders lack basic accounting knowledge and struggle to understand their own financials and operations. This lack of understanding can lead to miscalculations, misrepresentations, and ultimately, a disconnect between what founders think about their businesses and what accountants think. This knowledge gap not only affects the day-to-day operations but also hinders future funding rounds, as venture debt can create an overhang and make subsequent rounds less attractive to potential investors. Therefore, it is crucial for founders to prioritize financial literacy and develop a strong understanding of the bottom line and the ultimate earnings of their businesses.

• The Impending Venture Debt Crunch and its Potential Impact on Startups: Startups should brace themselves for a potential venture debt crunch in 2023 and 2024, which could lead to cash flow challenges, limited flexibility, and the need for restructuring or recapitalization. Founders and investors must be prepared.

  There is a potential venture debt crunch coming in the second half of 2023 and 2024. Many startups have been able to survive and raise funds in the past due to the easy availability of capital in a low-interest environment. However, with the predicted crunch, companies may find themselves in a difficult situation when their cash reserves run low and they need to raise additional funds. Venture debt, with its restrictive covenants and potential triggering of immediate repayment, can further limit their flexibility. The return models and assumptions made in the past may not hold true in the future, leading to potential down rounds, restructurings, and recaps. It is important for founders and investors to be prepared for these challenges ahead.

• The challenging road ahead for founders and VCs: Founders and VCs should be prepared for a tough journey ahead, with the need to cut costs, lengthen runway, and adopt a realistic mindset, as valuations may never reach pre-2021 levels.

  Founders and VCs need to prepare for a challenging road ahead. The next 18 months or more could be rough for many companies, especially those that didn't cut enough costs and lengthen their runway. It's important for founders to understand that things will never go back to the way they were in 2021. While there may be some market rallies and improvements, valuations will likely never reach the levels seen before. This means that building value and success in the tech ecosystem will require hard work and a realistic mindset, similar to the early 2000s. It's also crucial to recognize the difference between the tech ecosystem and the overall economy, as they may experience different trends and outcomes.

• The Role of Short Sellers in the Market: Accountability and Impact on Publicly Traded Companies: Short sellers can have a significant impact on stock prices with their reports, raising questions about their responsibility and the need for oversight from the SEC to ensure a fair market.

  There is a debate regarding the role of short sellers in the market and their ability to publish reports that can significantly impact the value of publicly traded companies. While some believe that short sellers play a crucial role in identifying and calling out potential accounting or capital markets fraud, others question whether they should have the same level of responsibility and accountability as insiders. This raises concerns about the potential manipulation of stock prices based on well-crafted reports, which can lead to significant financial losses for investors. It is suggested that short sellers should be held accountable for the accuracy of their claims, and the SEC should have a role in adjudicating the truthfulness of their reports to ensure a fair and well-functioning market.

• The Importance of SEC Regulation and Increased Transparency in Financial Markets: Chamath Palihapitiya believes that the SEC should take a more active role in regulating short positions, preventing the spreading of fear, uncertainty, and doubt, and increasing transparency to protect investor confidence and market stability.

  Transparency and accountability in the financial markets are crucial. Chamath Palihapitiya suggests that the SEC should play a more active role in regulating and disclosing short positions, as well as preventing the spreading of fear, uncertainty, and doubt (FUD). He emphasizes the need for anonymous accounts to prove their claims before negatively impacting the stock market. The example of Tesla and the pressure it faced due to false information spread by short sellers highlights the potential harm caused by unchecked speculation. Furthermore, the conversation touches upon the over-lending and over-leveraging of stocks, which could lead to critical fail points in the system. These issues can affect investor confidence and the stability of the market, making it necessary to address them through regulations and increased transparency.