Why Tech Just Collapsed

The tech industry is crashing, and unfortunately there isn't a simple answer as to why. This has happened before in the year 2000, during the dot com bubble. But everything is different this time around. This downturn is affecting nearly everyone. Tech stocks are way down, but so are traditional retailers. And even though Bitcoin was supposed to be protected against inflation, it's fallen over 50%. But there are a few people who have spent years preparing for this. And I'm not just talking about Warren Buffett, who's been focused on value stocks for his entire career. A small segment of the market is doing just fine. But the question is why? What do this year's high performers see that we're all missing? And how did today's billionaires get through previous financial downturns? In order to answer these questions, we have to analyze how we got here. The last two years have led to absolutely insane growth for tech stocks. The NASDAQ more than doubled. Venture capital investment also doubled. And the number of unicorn startups worth more than a billion dollars increased to over 1000. Tech was already growing really quickly over the last decade. But 2020 and 2021 accelerated things to an absolute frenzy. There were four key drivers of this recent growth. First, we saw a real technological shift over the past decade as cloud computing became ubiquitous and software worked its way into every aspect of personal and business life. Ten years ago, most companies used technology in some capacity to manage their businesses. But recently it's become clear that any company without a solid technology strategy is dead in the water. This shift has led to hundreds of large technology companies going public. And everyone was predicting that this trend would continue. But in previous business cycles, successful tech companies would go public much earlier in their growth. That's changed, and for the last few years, we've seen tech companies stay private for much longer. This trend has led to more venture capital dollars flowing into these late stage tech startups. Without the public markets to act as a check on company financials, valuations have soared. These high valuations were driven in part by low interest rates. Since the US Government has kept interest rates so low, investors have gone hunting for new ways to earn decent returns. They can't just park a billion dollars in bonds and make reasonable money, so they have to take more risk on tech startups. The low interest rate environment created a glut of capital that worked its way into tech companies. But now interest rates are rising and every company is getting repriced. The last driver of the recent tech surge was the COVID effect. When the pandemic first hit venture capitalists worried that there would be a severe recession and startups would have trouble raising more money. Sequoia Capital even published a memo saying that this was a black swan event and things were going to be incredibly difficult for the foreseeable future. But then something unexpected happened. The US government stepped in with the largest stimulus package in history and and ended the recession incredibly quickly. At the same time, tech products like Zoom started to look indispensable. So investors started piling money into anything that could be used remotely. Travel companies still took a hit, as did anything related to in person events. But overall things looked really good for tech. People were shopping online more, which led to massive growth for Shopify. Working out at home became extremely popular. So Peloton took off and with movie theaters closed indefinitely, Netflix became the go to place for at home entertainment. There was a problem though. See, after a few months of adjustment, everyone thought these changes would be permanent. The pandemic had led to massive adoption of all these tech products and there was no sign that it would slow down. But it did. Just look at this graph of E commerce shopping. The percentage of shopping activity that happens online had been growing steadily for decades. From 2000 all the way to 2020. The graph is incredibly smooth. But then all of a sudden the pandemic hit and E commerce adoption spiked from 11% to nearly 16%. But as things opened back up, people went back to their old habits and started shopping in person. More this phenomenon is called reversion to the mean and it's an incredibly powerful force when looking at long term trends. Whenever there is a big market move, people rush to point to one single reason to explain everything. But that's a trap. The real story here is much more complicated and it's better to think about this as a sequence of events. Covid hits in 2020. Everyone thinks there will be a massive recession. But then the government steps in with a huge stimulus and low interest rates that puts dollars in everyone's pockets. Consumers go out and buy things and investors pour money into companies. But that creates a problem. See, manufacturing capacity got hit really hard during COVID People were sick and couldn't show up to factories to make things. So supply dropped. And what happens when supply drops while the money supply increases demand? That's right, inflation. So now the government has a new problem on their hands. Inflation hurts everyone. And you don't need to look further than your local gas station to see that prices are rising. And long term inflation can create reinforcing spirals that erode the value of the US Dollar. The government doesn't want that, so they have to fight back. The answer is rising interest rates. But this hurts tech stocks the most. Stocks are typically valued based on their future cash flows. And most tech companies aren't generating a lot of cash flow right now. They're in growth mode, working hard to develop new products and scale their businesses. This is fine when interest rates are low, but as rates rise, they get hurt the most. And that's what we're seeing in the market. Currently, the Nasdaq is down nearly 30%. But we need to dig in deeper to understand what's really going on. See, not all companies on the Nasdaq are created equal. Some are profitable and some aren't. And it's the unprofitable companies that have been hit the hardest. At the end of last year, unprofitable tech companies were trading at 25 times revenue. But now they trade at just 6 times revenue. This collapse has already hurt tech investors a ton. But the real question is, what happens next? In order to answer that, it's useful to look at what happened during previous market sell offs. See, it's easy to watch a bunch of high flying tech companies fall in value and immediately say, oh, this is just like the dot com bubble all over again. But that's not quite right. In the year 2000, basically any tech company could go public on pure hype alone. They didn't need profits, they didn't need revenue, and sometimes they didn't even need a successful product. That's what happened with a company called mp3.com, that was one of the first attempts at online music streaming. In July of 1999, mp3.com went public at a valuation of $4 billion. The Internet was extremely trendy, and online music streaming seemed like an inevitability. The only problem was that the company was still extremely small by all accounts. At the peak of mp3.com, the company had less than 1 million daily active users and was only making a few million dollars in revenue per year. Now, let's compare that to Spotify. Spotify has over 422 million active users and brings in nearly $10 billion in revenue per year. And yet, while MP3.com was valued at $4 billion, Spotify is worth only $20 billion today. So Spotify has 400 times the amount of users and over 1000 times as much revenue, but they're only worth five times as much. You can clearly see how overvalued.com stocks were back in 2000. So what's the point of this comparison? Well, it's meant to illustrate that the tech companies we have today are a lot more established than two decades ago. Most of them make billions of dollars and are actually used by hundreds of millions of people. Music streaming is clearly a valuable service. So even though the market may be re evaluating the appropriate price for the company, they clearly have built a real business, unlike what we saw during the dot com boom. There's a good reason why people are calling this the Great Revaluation. The current crop of tech companies are real businesses. They just might be overvalued, which is leading to this massive sell off. Now there's another interesting lesson from the dot com crash. We should dig into Amazon.com? as the name implies, the Great Revaluation is all about how the market values companies. Revenue multiples are a big part of that for every dollar a business generates in revenue. And how much should that be worth to an investor? Remember, mp3.com was trading at more than 1000 times revenue during the dot com bubble, whereas Spotify trades at 2 times revenue today. Well, Jeff Bezos went through his own frothy period during the dot com boom. At its peak right before the turn of the millennium, Amazon was trading at more than 55 times revenue. Then the market tanked. And even though Amazon has grown significantly, the revenue multiple has stayed constant around three times revenue. It's almost as if investors went through a period of price discovery where they really had no idea how to value Amazon. But then all of a sudden it clicked and the multiple has been stable for the past two decades. Now today we're seeing something very similar happen with Shopify. The revenue multiple has been all over the place. In 2016, Shopify was trading for around 10 times revenue. Then it spiked to over 60 times revenue during the pandemic, and now it's back down to around 10 times revenue. Looking at the graph, you can see that investors still don't know how to properly value Shopify's stock. And that's a big part of the reason why Shopify's CEO Tobi Luetke took to Twitter to ask if financial analysts are being held accountable for their predictions. For another interesting historical example, let's look at the online pet food industry. Back in 1999, there were not one, but four online pet food companies that raised significant Pettopia.com, petsmart.com, Pets.com, and and Petstore.com all raised tens of millions of dollars. In 1999, then in February of 2000, Pets.com raised $82 million more in an IPO. By the end of the year, they had managed to spend over $100 million, including $2 million for a super bowl ad, and wind up bankrupt. None of those four companies generated significant revenues. But today we're seeing something different. Chewy.com seems to have figured out how to sell pet food online because they sell a lot of it. $9 billion just in 2021. But even though their revenues have been growing pretty steadily, Chewy's valuation has been all over the place. During the pandemic, they traded at almost five times revenue. Now they're back to just over one times revenue. The high expectations that Covid would permanently change consumer behavior are coming crashing down to earth. And with it, so are the valuations of these companies. A big part of why tech companies could fetch sky high valuations historically has been the fact that they capitalize on either Moore's Law, Metcalfe's Law, or both. Moore's Law essentially says that computers double in power every two years, while Metcalfe's Law says that networks get exponentially more valuable as they grow. In the early days of Facebook, they were kind of riding both of these trends. Computers were getting faster and cheaper, so people were spending more and more time online. And at the same time, Facebook was a network that perfectly benefited from Metcalfe's Law. Every time someone signed up for Facebook, the whole site got more valuable because there was more content on it. But Moore's Law has been slowing down for years now, and many new tech companies just simply don't have network effects. So these companies are grappling with the painful realization that they might not be able to justify as high of revenue multiples as they have in the past. In 2008, the global financial crisis caused a deep recession and a massive market sell off, driven primarily by a housing bubble and and an intertwined derivatives market. The crisis didn't affect tech all that much, but it can still be useful to look at as a guide. Today, just as the market was collapsing, Sequoia Capital released the now famous RIP Good Times memo. In the 56 slide deck, they covered dozens of different macroeconomic indicators that help explain what's going on. Things like personal savings rates, unemployment and inflation were all key factors in driving the last recession. So the question is, how do we stack up today? Well, there's some good news and there's some bad news. First, the good unemployment is currently lower than it was before the 2008 recession. And personal saving rates are also higher. Before the housing Crisis, the average U.S. household was spending 13% of their income servicing debt. Today that number has fallen to 9%. So overall, more people have jobs and households have less debt. Good stuff. The bad news is that inflation is currently much higher than it was going into the 2008 recession, and that means that the government will have fewer ways to respond to the downturn. The US government also has way more debt than it did back in 2008. Actually, it's twice as much on a debt to GDP basis. That means that big bailout packages will probably be harder to justify this time around. But there is some cause for optimism. As rough as the 2008 downturn was, innovation didn't slow down. Great companies still get built regardless of market conditions. And that's what we see time and time. Time again in 2008, small startups like Airbnb, Square and Stripe all got going and made it through. And in the dot com bubble, Google, PayPal and Amazon.com all found a way to persevere even while the stock market was down 80% or more. Warren Buffet is famous for saying, only when the tide goes out do you discover who's been swimming naked. And I suspect we will see a lot of that over the next few years. Startups that haven't really found a way to deliver a clear value to a a customer will wash out, but the best companies will survive. And that's cause for optimism. Anyone who's been in the startup world for more than a few years can tell you how crazy 2020 and 2021 have been. Money has been flying around like crazy, and it was pretty clear that it couldn't keep accelerating forever. But the question remains, where will the venture capital industry land in a year or two after the dust settles? Will it look like 2008 where VC investing decreased by 30%, or will it look more like the dot com bubble where VC investing dropped by 87%? Well, clearly a dot com crash style pullback would be terrible. But if that did happen, the VC industry would only reset to 2012 levels. And that's actually when I got my start in Silicon Valley. It wasn't easy to raise money for a startup back in 2012, but it wasn't impossible. My first funding round was just $17,000 and I had to live in a single bedroom in a rundown house that I shared with my co founder to stretch that cash. But I still got to work on interesting problems and it ultimately led me to where I am today. Even though startups weren't able to raise millions of dollars with nothing more than a pitch deck back then, it really wasn't that bad. I had enough money to pay rent and it gave me all the time I needed to learn to program. Some people who are only interested in startups or technology for the money will wash out and go get other jobs. But for the truly dedicated builders, nothing can stop them. So if you want an inspiring story of an entrepreneur who stuck it out for decades during good times and bad, just go watch my video on Epic Games next.