Mark Neuman, CIO and Founder of Constrained Capital, discusses the bursting of the bubbles seen in 2022 including NFTs, SPACs, and Cryptocurrencies and how the next one up could be ESG. He discusses how investors can prepare and protect themselves for this potential further bubble unwind.

Full Article

The crypto and ESG bubbles are bursting. The Fed’s quantitative easing (QE) and zero interest rate policy (ZIRP) paved the way for cryptocurrencies and ESG to create one of the largest causes for investor concern in modern history. Unprecedented Fed policy ushered in by the Global Financial Crisis (GFC) and perpetuated by the pandemic, opened the monetary floodgates that enabled these bubbles to form in the first place.

How did this all happen? With near-zero interest rates until 2022 arrived, easy money fueled the too-good-to-be-true scenarios of ESG and crypto. The tech bubble of 2000 and the real estate/credit bubble of 2007 were also the result of similarly easy money. Rising rate periods burst bubbles and we’ve just witnessed the potential fall of crypto with ESG continuing to struggle. Easy money in the crypto space led to speculation, malinvestment, and misallocation of capital. Then inflation sprung and rates went higher. That was the catalyst to this latest market cycle spiraling out of control.

Bernie Madoff proved to be the poster child for the Ponzi scheme a decade ago. His successor, Sam Bankman-Fried, aced the crypto fraud with the help of an ESG stamp of approval. So, what is the difference this time?

While the value of investor assets that both Madoff and SBF lost is in the billions, SBF’s scheme may ultimately be just as disturbing because it shows that investors haven’t learned from past Ponzi schemes. They continue to be gullible, dazzled by popular and trendy investments and by the drying-up flow of low-interest, easy money.

SBF capitalized on the ESG ruse of sounding good but not doing good–he got an ESG stamp and investors lapped it up. Most were convinced of an “Everyone wins, nobody loses,” scenario.

But as all great Ponzi schemes go, when the money stops flowing, so does the run. What happened to Madoff is now happening in crypto, and the next bubble to burst is in the ESG field, as inflows dry up.

Easy Money Fueled Misallocation of Capital; Crypto Was Fast, ESG Is Slower 

QE/ZIRP caused misallocation of capital. ESG’s capital constraints epitomize malinvestment as investment decisions are largely based on rating agency opinion, and less on true facts. The same is true in the crypto space. Cryptocurrency is misallocation and malinvestment on steroids. Bankman Fried called crypto “a magic box to put money in.” SBF cleverly married crypto and ESG by erroneously getting a high ESG governance rating, thanks to Factset’s Truvalue Labs, despite FTX’s Board having just three members. SBF rode the ESG gravy train, flouting it in a tweet, “ESG has been perverted beyond recognition…[It’s a] dumb, contentless, ‘good actor’ framework,” and, “[ESG] is this dumb game woke westerners play where we say all the right shibboleths, so everyone likes us.”

The ESG ratings distortion impacted crypto and might result in damage elsewhere as rating agencies further confuse the matter. In early 2022, Russian companies had higher ESG scores than EU companies. In the US, Amazon is the world’s biggest non-energy carbon footprint, yet it appears in 75% of ESG funds, including the #3 slot in Blackrock’s flagship ESG fund. It’s becoming clearer that ESG ratings are opinions proposed as fact. Amazon down 50% in 2022.

showed everyone just how misguided and misled investors were in Amazon’s fake “ESG” cache. The first wave of risk unwinds came as a result in 2022.

Additionally, ESG peer pressure has villainized traditional energy while projecting alternative energy as the hero. When ESG politics shut down Germany’s nuclear plants and Russia took advantage of ESG capital constraints, the world suffered with energy insecurity. We all felt the inflation pinch. This is ongoing. Rates ratcheted higher. Easy money ended. Now the Ponzi-like structures are collapsing. Bad investments are costly and ESG pitchforks are coming out as risks surface and PnL suffers. Larry Fink is on the hot seat. His “ESG backlash is personal,” crocodile tears should not fool anyone.

The bubble collapse is underway. It grew massively for more than a decade yet is rapidly collapsing. Despite the warning signs, there’s still too much money chasing misguided dreams in the worlds of crypto and ESG. 2023 has begun with old habits dying hard in ESG and crypto alike.

At the end of 2017, the Fed’s balance sheet exceeded $4 trillion and M1 was $3.6 trillion. After the pandemic and another round of easy money stimulus, the Fed balance sheet was $9 trillion and M1 was a mind-boggling $20 trillion. There’s no analog like this in monetary history. The new higher rates’ paradigm has become a fly-in-the-ointment.

What Should Investors Do Now? 

Investors need to be prepared and disciplined. Diversifying holdings, conducting meaningful due diligence, and ignoring popular, get-rich-quick investments like crypto and false pretense-laden ESG are good starting points.

To that end, find less crowded investments, such as favoring those left out of crypto and ESG funds. Stick to the areas that were ignored and cast aside from the recent bubble. Find stocks and sectors that were excluded from the crowds in all the same “fad” investments. And own real assets. With rates going higher, the costs of bad investments and bad capital expenditure will be magnified going forward. This “high cost unwinds” began in 2022 and hardly looks complete.

Those expecting help from lower rates (which I don’t think is coming that fast anyway) should understand those rate cuts would be defensive, not offensive. From 2000-2002, the 2-year yield fell from 6.5% to 2% as the SPX FELL from 1500 to 800.

Know what you own. Know what the companies do. Verify the themes and concepts others are selling. Don’t be misled by things that sound good but don’t really do good. If it sounds too good to be true, it probably is.