The Long and the Short of Investing in 2022

As we enter the second half of 2022, many investors feel like they’re on a rudderless ship, wondering if they’re headed for a bigger squall or finally approaching safe harbor. They face this uncertainty after being rocked by the first two quarters of 2022, which were among the worst for equity markets in over 50 years. Things were even bleaker in the fixed-income ocean, with the six months ended June 30 the worst on record.

The current environment makes it difficult for traditional buy-and-hold investors to make money or even find a place to keep the profits of the longest bull market. So what happens in the second half of 2022? Some market strategists are predicting a recovery, believing that after such a big loss, a rebound is likely. I’m not in that camp at this point because. Although many investments have sold off materially, there are several reasons behind market declines. While we may not be in a recession yet, equity markets are expecting one, which is understandable given the Fed’s path to tightening monetary policy. Fed policy and inflation concerns are also causing significant turmoil in fixed-income markets, including everything from investment-grade debt to junk-rated issuers and even mortgage markets. These trends are now also starting to affect confidence among consumers and companies, which are therefore reducing risk-taking.

The market turmoil has similarly affected the cryptocurrency markets, where many investors, including a few notable ones, thought there was easy money to be made. In November, Bitcoin was trading at ~$60,000/token, and the entire crypto market was valued at ~$3 trillion. By July 1st, it was only trading at ~$19,000, and its total market cap had plummeted to under $1 trillion. We’ve already seen some major bankruptcies in the crypto space, such as Celsius Network LLC and Voyager Digital Ltd., and there are signs of more stress on the way. Perhaps most alarming for crypto speculators is the revelation that so-called “stable coins” that are allegedly backed by hard currency are not so stable.

In Q2, the largest stablecoin, TerraUSD, which was always supposed to be worth $1 USD, dropped to under $0.01! Others have also struggled to maintain their pegs, to the point where some speculators are now shorting Tether, another stablecoin pegged to the US dollar.

Around the same time as the stablecoin collapse, Coinbase CEO Brian Armstrong, in response to a new SEC disclosure requirement, indicated that in the event of a bankruptcy, crypto assets held for third parties could be considered assets of the company, sent out a tweet saying, “We are not at risk of bankruptcy.” But telling investors that you no in danger of bankruptcy is not the kind of statement that inspires confidence. It just makes counterparties wonder if this is a risk they may have overlooked.

Since crypto firms are less regulated than most other financial institutions, their success depends almost entirely on sentiment, and sentiment looked fantastic when Bitcoin moved from $5,000 to $60,000. Now that momentum has reversed and we are facing a situation where in which the emperor has no clothes. Thus, we are seeing significant new difficulties in crypto and we should expect more bankruptcies. Typically, wise distressed securities analysts look for things like hard assets and collateral to support the valuation. However, valuation is elusive in the crypto arena as traditional analysis does not apply. For example, if a coin loses support among users, the liquidation value of its issuer’s assets may be poor at best when the dust settles.

What next?

For the rest of 2022, investors will be trying to figure out where the chips have fallen and, depending on the asset, whether there is more room to fall. In many cases, it’s probably because we don’t seem to have hit rock bottom. Usually to get to this point you need a capitulation when there is proverbial blood in the streets and investors are just looking to sell at any price. We have yet to see this type of panic selling in 2022.

We are looking at an uncertain market for the second half for sure, but it seems to be working in an organized way. Still, it has been difficult for investors to make money anywhere unless they have the knowledge and ability to invest both long and short. As markets fell, losing money on the short side was difficult, which is unusual. Not too long ago, short sellers had a hard time staying in business, but now things have turned around.

One company that looks like a prime short-selling target is Bed Bath & Beyond ( BBBY ). It started the year trading above $30/share and recently traded below $5. Like most brick-and-mortar retailers, it has struggled with online competition and COVID over the past few years, but has also suffered from a revolving door of executive turnover. In its latest earnings call, BBBY management announced that CEO Mark Tritton has been let go. He had to turn the business around and invested heavily in private label inventory. However, it turned out that the chain’s customers preferred brand-name goods after BBBY had already spent hundreds of millions of dollars buying inventory that no one wanted. Until a new chief executive is appointed, the top job is held by board member Sue Grove, who has extensive retail experience but also experience working at an insolvency consultancy. BBBY has about 700 stores in the U.S., but does not own any of those locations. Instead, its landlords are owed a present value of $1.9 billion in rent for those locations over the term of their leases. This liability, in addition to the company’s regular trade loans, makes BBBY look hopelessly insolvent. Furthermore, it spends the money it still has, and revenue continues to decline each period. All of this makes restructuring through bankruptcy an increasingly likely outcome for BBBY.

As mentioned earlier, the key for investors in an environment like the current one is the ability to invest both long and short, up and down the capital structure. However, long options are harder to find right now. For the rest of 2022, the best advice for investors is to keep your head down, eyes open and always do your homework before committing to any investment.

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