Bursting of speculative bubbles leaves path of financial destruction

Warren Buffett famously said, “Only when the tide goes out do you discover who’s been swimming naked.” To slow rampant, persistent inflation, the Federal Reserve (“Fed”) has slammed on the monetary brakes by rapidly increasing short-term interest rates and reversing its program of “quantitative easing,” emergency relief measures implemented at the start of the pandemic.

The narrative of abundant, ultra-cheap credit was a tide that lifted asset classes of all types. With that “accommodative” stance now reversing to “restrictive,” that tide is rolling out. This has created tremendous pressure on assets that had benefitted the most from “free money” (i.e. cheap credit and three rounds of stimulus checks); highly speculative, minimally (if at all) profitable, astronomically-priced technology stocks, “meme” stocks, SPACs and cryptocurrencies.

In other words, we’re discovering who’s been swimming naked. Since the pandemic started, I’ve written about the critical importance of knowing the difference between investing and speculating and railed against the industry built around convincing you investing is as easy as child’s play and you can trade your way to instant prosperity, all for free. It’s not and you can’t.

It would be fascinating to study how a pandemic-induced shutdown of the economy helped birth speculative bubbles that have been bursting in spectacular fashion.

According to a recent paper by professors Robin Greenwood (Harvard), Toomas Laarits and Jeffrey Wurgler (both NYU) , shares of “meme” stocks-speculative stocks generating frenzied interest whipped-up by newly-minted investment gurus like The Roaring Kitty on online forums like Reddit’s WallStreetBets-soared soon after individual investors received their first ($1,200) and second ($600) rounds of federal stimulus checks (“stimmies”), performing up to 19% better than “non-meme” stocks.

Free money magically appearing in your bank account is awesome, but you still need a Robinhood (HOOD) or other “zero commissions” broker to “invest”/place your bets.

Robinhood’s schtick is “We’re All Investors” and implies everyone is getting rich — but you. Robinhood is able to offer “free” trades because it gets paid by “market makers” like Citadel Securities to route customer orders to them for execution, a controversial practice called “payment for order flow (PFOF)” that accounted for as much as 80% of its revenue. The more “free” customer trades Robinhood routed, the more it got paid. Follow the money.

The U.S. Securities and Exchange Commission (SEC) recently announced it’s considering banning PFOF arrangements. Perhaps the SEC doesn’t think encouraging excessive trading by offering “free” trades is a good idea? HOOD’s IPO was priced at $38 in late July 2021, quickly surged to $85 and was recently below $8.

Special-purpose acquisition companies (SPACs) are “blank check,” non-operating companies that seek to merge with a private company. Voila, the private company is transformed into a public company without the hassle and expense of an initial public offering (IPO) and everyone gets rich, especially the SPAC’s “sponsor.” SPACs exploded in popularity during the pandemic as they offered both a low dollar price of $10/share and chance to get in on the ground floor of the “next Facebook.”

The “pied piper” of the SPAC craze and self-proclaimed “King of SPACs” to his legion of social media followers is Chamath Palihaptiya, a former Facebook executive whose schtick was he was going to build a better Berkshire-Hathaway, saying “nobody’s going to listen to Buffett, but there has to be other folks to take that mantle, take the baton and do it as well to this younger generation in the language they understand.”

Due to a combination of increased SEC scrutiny, abysmal post-merger operating performance and hundreds of SPACs chasing a dwindling number of businesses that have suddenly determined being privately-owned isn’t so bad, SPACs have collapsed. According to Bloomberg, 78 of the roughly 371 firms that merged with a SPAC are trading under $2/share. The King of SPACs’ post-merger Clover Health (CLOV) crashed from $22 to $2, Virgin Galactic (SPCE) $56 to $5, Sofi Technologies (SOFI) $24 to $5 and Open Door (OPNDF) $27 to $12. That’s language anyone can understand.

Hard to believe it’s only been four months since the Super Bowl, with commercials featuring investment gurus LeBron James, Larry David and Matt Damon touting cryptocurrencies, with Damon imploring “fortune favors the brave” for Crypto.com (implying you’re a coward if you don’t crypto?). The market capitalization of cryptocurrencies has plummeted from a peak of almost $3 trillion in late November to about $1.3 trillion. Beware Super Bowl commercials!

Unfortunately, it’s human nature to chase past performance and the ARK Innovation ETF (ARKK) is a prime example. ARK’s Cathie Wood is an “ideas-driven, big picture” investor who invests based on technology, future growth prospects and momentum, not current profitability or stock valuation. According to ARKK’s Prospectus, “‘disruptive innovation’ is the introduction to a technologically enabled new product or service that potentially changes the way the world works.”

About 90% of the dollars invested in ARKK since its inception in 2014 came in 2020 and 2021. Further, the majority of 2020 inflows didn’t occur until late in the year (particularly December), so most investors who bought that year didn’t fully benefit from its 152.8% return (vs. 18.4% for the S&P 500). Unfortunately, these same investors who bought at the peak are participating fully in ARKK’s subsequent collapse, with a return of -23.4% in 2021 (vs. 28.7%) and -53.4% year-to-date through the end of May (vs. -12.8%).

Two of the primary duties of the SEC are to protect the integrity of the financial markets and protect investors from fraud. Unfortunately, there’s little the SEC can do to protect investors from themselves.

During the post-pandemic speculative frenzy, the SEC issued bulletins with information and warnings at www.investor.gov.

The SEC recently launched a game show-themed public service campaign (investomania