What Goes Down Must Go Up?

What we might get wrong when investing in equities, tokens, and liquid assets across multiple cycles

I try my best to attend the annual meetings of a variety of our hedge fund LPs (as well as other GPs) when they’ll have me. After a bloodbath of a year in public equities, one of the consistent themes over the past 6-12 months has been that while the markets have taken out a variety of overvalued companies, there is another cohort of great companies that have been “babies thrown out with the bathwater”¹. These solid businesses that have been caught in broader market sell-offs represent buying opportunities and investors that step in to buy those assets during market uncertainty are, in my mind, creating alpha.

Similarly within crypto, markets have sold off across the board. This has led to a variety of managers discussing “generational buying opportunities” for liquid tokens that have seen 70-95%+ drawdowns. Managers are using this as an opportunity to try to accumulate capital, a narrative shift from 2021 liquid token fundraises² that talked about how drastically undervalued these assets were as total crypto market cap was only ~$2T.

Markets are inherently long-biased and tend to trend upwards so yes, it is very easy to see assets down materially as “generational buying opportunities”.

Michael Dempsey @mhdempsey

A few SPAC'd deep tech companies reporting earnings this week after already having been beat up bad by market in past few months. Feels like very little any of these companies can do to cause a material pop in their stock price, and likely a whole bunch of negative catalysts.

To me, it is just as easy (perhaps easier for a lot of late 2021 and 2022) to see the reversal of risk capital as the death-knell for overcapitalized organizations with little traction, as it is to see this as a time to scattershot long a variety of assets.

I have put my proverbial money where my mouth is here and shorted specific companies that I feel/felt were far ahead of valuation, bleeding cash, and/or will be forced to be acquired, taken private, raise further dilutive capital as public companies, or just die. In some cases, these companies are merely overvalued and shouldn’t be viewed as bad assets, just overpriced assets, however in more cases these are businesses that overpromised materially and are fundamentally misunderstood by public markets.

So yes, they could come back, but in the same way that a down round in private markets can lead to an exodus of talent, a sharp sell-off ultimately creates the same effect; a loss of confidence in the team (often resulting in new management brought in to attempt to right the ship, or land the plane into some cash in an exit.)

Now back to crypto.

I’m generally of the belief that public assets within crypto are a very inefficient market, so yes, there is certainly material alpha to be created by being “native” and paying attention to these assets in an effort to capture venture-scale returns on liquid assets.

A bunch of managers describe this buying opportunity by looking at the top 25 or 50 market cap tokens and view those as established assets, along with perhaps some long-tail punts on other liquid assets that are more esoteric to justify a premium carry structure.³

There is a major problem with this thinking: Crypto tokens have not been around long enough to take advantage of the Lindy Effect.

Put more directly, when public equities like META or AMZN sell off, there are material moats and business flywheels that are spinning that mean the amount of effort and change required in the world to kill or materially damage these businesses is quite high. That isn’t to say that apple ramping up privacy won’t kill Meta, or other competition or factors won’t decay large public company businesses, but there are fundamentals to these assets that take time to erode.

In crypto, a market where the primitives of value creation and moats are still very obscure and non-consensus, erosion and death can happen with far less energy and innovation.

Alt-L1s have little sustainably positive fundamentals thus far besides increase in transactions which are dubious at best. DeFi protocols have few moats besides perceived security, perhaps some liquidity (i’m repeatedly dubious of this as long-term moat), and newer approaches to licensing on open-source for a period of time⁴, and GameFi plays are…well they are awful and deserve to be shorted.⁵

Until long-term moats and clear fundamentals are established, the Lindy Effect is irrelevant in most cases sans BTC/ETH as tokens from prior generations struggle to bounce back and likely underperform ETH.

As we see below, while looking at a random selection of prior cycle “blue-chip” altcoins (ZRX, ZEC, XMR, REP, MKR, XLM, LTC, XRP) from the depths of the bear market (arbitrarily setting as 1/1/2019) to just after the bull run (defined as 1/1/2022), all the alts materially underperformed the newer top tier blue chips, with only heavily incentivized, vc-backed tokens underperforming (GRT, COMP, AR) due to tokenomics that I believe will play out favorably over the longer-term.⁶

While there’s a lot of different arguments that can be made about why this time is different in crypto (and why first mover advantages are real in category creating protocols), I believe investors need to take a step back and realize something important:

The prior decade of investing has taught us lessons for investing in liquid assets including indexing + “time in market not timing the market” is dominant if your time horizon is long. We also have learned that there is enduring, material value to be created by doing what good venture investors are used to doing; finding and helping builders early.

So while everyone is staring at their stocks, tokens, and who knows what else and “diamond-handing” all the way down as we pontificate where in the bear market we are, we shouldn’t forget that if you’re not holding an index built around fundamental value creation (i.e. the S&P 500) it’s possible that this generational buying opportunity isn’t here yet or may never materialize for your assets.

Put another way, what goes down, does not always go up.

1. Sidenote, this is a psychotic expression but this exact phrasing was used across multiple traders/investors at annual meetings.

2. Some of these funds have been absolute disasters.

3. In reality this is just custodian arbitrage in many cases along with a “i need to allocate to crypto” and “i can’t get fired by investing in a fund vs. being the person investing in BTC/ETH/SOL/AVAX/etc.” hedging by the LP.

4. Some are beginning to analyze tokens on cash flow basis or fundamentals as has been reflected by SNX positioning as well as a variety of Arthur Hayes posts on why he loves tokens like GMX.

5. I swear this is partially a joke.

6. It’s likely that newer tokens will have far better understanding of tokenomics to not have this overhang happen that destroyed token price in a short period of time for these assets.