The 2022-2023 Regime Change

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Dear fellow investors, 

The events that began with Thursday’s tumult in financial stocks and precipitated the FDIC takeover of Silicon Valley Bank and Signature Bank were swift. The only thing that ran through my mind was the regime change that we are continuing to see. This didn’t remind me of something I’ve seen personally before, but instead one of the best movies of the last 20 years, Argo.

Argo was a Ben Affleck-produced movie about the events that unfolded in late 1979. The movie begins on November 4th of that year. The opening scene shows a crowd of people outside the US embassy walls in Tehran, with state department workers watching the crowds outside. There are Iranians waiting in the embassy for services. A couple people break over the wall, followed by the gate being breached. All hell begins to break loose. The state department and the marines present are watching chaos ensue in front of them.

The state department workers begin to burn files to protect the information. The crowds begin to break windows to penetrate the building. One marine decides to go outside to talk with them. He is blindfolded and held at gunpoint. Soon everyone is being taken hostage or fleeing the US embassy. This scene begats what we know as the Iran hostage crisis.

This event was what took place during a regime change. It was the brutal trials that come from a passing of leadership from one group to another. In this case, from the Shah of Iran, Mohammad Reza Pahlavi, to the Ayatollah Khomeini. The Shah died in exile. Iran never left the regime that began to take over in late 1979. Many Persians left Iran and have never returned to their land of ancestry.

This style of regime change is what investors are feeling now. The years 2020 and 2021 were typified by low rates, technology stock dominance, unicorn sightings, SPAC/IPO nirvana, Munger’s crypto crap and overall excitement for stock and bonds markets. Ultimately, these were allowed by easy money. You can take that to the bank.

The years 2022 and 2023 feel nothing like that period. They have seen higher interest rates, tech stock weakness, tough to raise capital, IPOs shelved, crypto hell and losses in stock and bonds markets. It’s a new regime.

The events of Silicon Valley Bank this weekend struck at the heart of this regime change. Silicon Valley Bank was a darling in the banking industry. It was the pinnacle of American capitalism in a tech-dominate, nouveau riche kind of a way. The bank was not young, but its success and history followed the arc of technology’s growth in the Santa Clara Valley over the last 40 years. Its booms marked the local business booms and its busts followed suit as well.

If you look at the companies who had uninsured deposits with the firm, it’s again reflective of the tech ecosystem of Silicon Valley. The peril they felt is a far cry from the money that flowed around them in the prior regime. Below is a picture.

There have been three major booms in venture capital (VC) prior to this present episode: 1969, 1987 and 2000. I was reminded of this by Gary Morgenthaler of Morgenthaler Ventures who I ran into on a ski chair four years ago. Gary gave great perspective to me on the prior regime changes. Gary’s father, David, was a pioneer of the venture capital industry. Margaret O’Mara’s book, The Code, opens with Gary’s dad and is an incredible primer on the history of Silicon Valley.

These prior regime changes were not fun. The 1970’s were a pullback in military spending and a climb in capital gains tax rates. The second regime change was the crash of 1987 and the slump from the SNL debacle in 1990 that affected the financial markets. The year 2000, was the drying up of capital from the tech bust followed by a downturn in the San Francisco-area economy. By 2001, it was the slowest growing area of the US economy.

This regime change has some elements of the dot-com bubble and the savings and loans debacle, but don’t confuse Silicon Valley for America.

We look at this as a ‘rich-cession’. Who are the unsecured depositors of Silicon Valley Bank? Rich people and cash-flush tech companies burning cash in their operation. In other words, the people and the investors that can afford to lose money. The secured depositors are middle America. No sleep should be lost.

Other evidence of a regime change

Bernie Sanders and other class warfare marketers did such a great job of explaining to us that the rich were getting richer and the inequality was growing. What they haven’t said is the regime change has caused this inequality to begin to reverse. Who lost money in the stock and bond markets 2022-2023? Not lower income America, as they have few assets outside of their primary residence. It was the rich. The market’s gyrations taking place are something that wealthy people are glued to, but much of America drinks coffee and goes to work.

This regime change is providing huge benefits to those left behind in the prior regimes as shown by the chart below. Since the end of 2019, the lowest income quintile has produced the largest amount of wage gains. “What a great benefit this regime change has provided!” You won’t hear rich people say that.

We deal in a complex network as investors. All complex networks have a vast number of connections and nodes. Some nodes are stronger than others. The complexity of the network is understood by the way it adapts. If you remove or weaken connections to a node, how does it reorient itself to pass information along the network? This is exactly what these regime changes do. The network adapts to nodes that gain strength and move away from the ones that lose strength.

Much like the events that followed the Iran hostage crisis, there is a permanence that comes with these regime changes. Many Persians never went back to their ancestral lands. The US has never been comfortable with Iran. The symptoms of regime change in the venture capital business vary by the exogenous forces that are thrust upon it. It looks unquestionable that this will have permanent repercussions for major players. One thing also looks certain to us based on the periods when prior regime changes happened: funding in VC markets may dry up.

Fear stock market failure,

Cole Smead, CFA

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, CEO and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

©2023 Smead Capital Management, Inc. All rights reserved.

This Missive and others are available at www.smeadcap.com.

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