Two Fresh Signs of Receding Froth

One long-running bear market truism is that these grueling, grinding downturns serve to squeeze accumulated excess out of the economy and markets, setting the stage for the next expansion and bull market. That process is obvious enough when bear markets precede recessions. But what about when they don’t, as was the case (so far) with 2022’s? We saw some evidence of a shakeout in Tech layoffs and weak business investment, but it was mostly a trickle. Now, two stories in Wednesday’s Wall Street Journal hint at the process continuing alongside stocks’ 2023 rebound, which we think underscores this young bull market’s firm foundation.

Usually, you can see a bear market’s impact in the big cost cuts it generates as businesses, battered by panicky declines, fear for their survival. This often parallels economically sensitive value stocks’ getting battered, setting up their early rebound. Since all-clear signals don’t exist, cuts usually continue well into an early bull market.

This has been harder to see this time, and we think there are a few reasons why. One, inflation hit all points of the supply chain, boosting nominal costs even as some companies trimmed fat. Two, value didn’t take its usual pounding this time. Three, credit didn’t contract, which is one of the main motivators to enter bloat-cutting survival mode. Yet that doesn’t mean there was no excess. It was just stealthy, and companies’ battle against it was equally hard to see outside the aforementioned layoffs, office closures and scrapped investment plans.

Now the shakeout is becoming more apparent in other areas that previously looked a bit frothy. One such area: niche exchange-traded funds (ETFs). Not broad market-wide, sector or regional funds, but small thematic ones, like meme stock funds and even funds consisting of leveraged plays on single stocks. According to the Journal, 929 funds have closed globally year to date, light years ahead of the 373 closures at the same point last year.^[i] This includes 178 shuttered US exchange-traded products, well above 2022’s full-year total of 142. Many of these were upstarts trying to capitalize on heat chasing and enthusiasm for hot new trends including the metaverse and Gen Z’s values and consumption habits. Pretty frothy creations, in our view. And now, in the wake of last year’s bear market, the enthusiasm is gone.

The other headline-grabbing squeeze centers on the widely hyped AI startup space. Less than a year ago, when ChatGPT launched in November, AI startups were hot and buzzy, with venture capitalist backers cheerleading nonstop. Money poured in as investors eyed quick riches from light-speed mass adoption. And now? Users are losing interest, startups are navigating layoffs, and—as we thought likely—the spoils are mostly accruing to the large Tech companies that had the clout and economies of scale to absorb the high up-front costs of training generative AI models. In the startup space, people are getting more judicious. As the Journal reports: “Venture investors say they are still unsure what a winning business model looks like for a startup building new products around the technology. Many young businesses have yet to prove they can retain users and develop products that existing tech companies couldn’t easily mimic. Training cutting-edge models can cost companies billions of dollars, thanks to the large volumes of data they need to ingest and analyze. Investors have become hesitant to bankroll such businesses, given the uncertain path to profitability and heavy competition from well-funded rivals.”^[ii]

At the risk of sounding callous, pain in niche ETFs and AI startups is a good sign for broader markets. The more froth gets squeezed out, the more it frees up capital for more productive investments, ultimately fueling more growth and returns. It also is a very strong indication the new bull market isn’t rising on a bunch of hot air. Rather, it looks like the standard case of stocks digesting a panoply of fears and dreary economic expectations last year, then bouncing high and fast once that pre-pricing process finished and markets could look further ahead to the future earnings recovery. It may not be the most exciting story, but stocks don’t need exciting narratives and hot themes. Reality plodding along better than expectations is enough, and we have that in spades now.