The Prof G Pod with Scott Galloway - Bonus Episode: Plunging Markets, Crypto Winters, and Elon’s Twitter Deal — with David Yermack

Episode Date: May 18, 2022

David Yermack, a professor of Finance and Business Transformation at the Stern School of Business, joins Scott for a special reports episode on how to think about the current stock market and crypto volatility. We also learn more about whether Elon can actually back out of his deal to acquire Twitter. Learn more about your ad choices. Visit podcastchoices.com/adchoices

Welcome to a special episode of the PropGPot. Today, Professor David Urmak from the Stern School of Business joins us to discuss the state of the markets, crypto, and the Twitter deal that is for now on hold. It's caused confusion amongst investors and rattled Twitter's stock price. This is the worst environment that I've seen since the dot-com crash, even worse than the great recession of 2008-2009. Okay, so I don't think there's any debate.

We are in the middle of a crypto winter. So, David is a colleague. I wouldn't call us friends. We like each other. We're very collegial. And he's someone who is just a gift. The finance department at NYU is arguably, and most academics will agree, one of the best finance departments in the world.

And at NYU, they kind of rule the roost because they get just such outstanding faculty. And David has been one of the few people that's been able to kind of tame these lions and bring the management skill required to manage all of these enormously talented and very confident and very large ego professors. Is that fair? Anyways, it's not easy to be a department chair at a university, much less the department chair of kind of an iconic group as the finance department. Anyway, the thing I really appreciate about David is that he is an optimist and even maybe a bull on the crypto space, but he doesn't bring this Taliban absolutist mentality. He's pretty sober about it. He's pretty thoughtful, but he occupies this unique space. I find that crypto is bifurcating into the Charlie Munger, Bitcoin is evil, or people just throw up their hands and say, I don't get it, to the people telling you to mortgage

your house and max out everything just to buy Bitcoin and that it's going to change everything and bring about world peace. And David comes at this from not only staggering credibility and insight. I know firsthand that some of the most influential people in the world of government and economics reach out to David regularly, but he has just a very kind of optimistic but sober view of this asset class. Anyways, here's our conversation with Professor David Yermack. David, where does this podcast find you? I'm at home in Morristown, New Jersey. All right, let's bust right into it. So I'd love to just get your take on the markets. Higher interest rates, big R, little r, transitory inflation.

What are your thoughts on what's going on out there? Well, the bill for the COVID pandemic stimulus is coming due. You had over the last two years, the government gave trillions of dollars to people. A lot of it was thrown right into the markets. And over the last year, despite the best efforts of the administration, they haven't been able to keep the stimulus coming. And, you know, as a result, we have higher consumer prices. There's going to be inflation and higher interest rates, which is always bad for the stock market. And the interesting segment of the market that's really been hit hard are the technology stocks.

They're, you know, Amazon, but others as well, that many of those, the so-called fangs were sky high, but they've come down to more realistic levels, you know, implying lower growth rates for the foreseeable future for their customers and profits and so forth. So on a very basic level, you have companies that probably just in terms of valuation got out over their skis because people having so much money that ended up in the market and everybody likes the cool stuff, the cool kids. We also have growth companies that require financing and their cash flows in the market and everybody likes the cool stuff, the cool kids. We also have growth companies that require financing and their cash flows in the future. So higher interest rates make their growth more expensive and make their future cash flows less valuable. Anything else I'm missing? Is this just a healthy correction or something bigger going on? I'm not sure healthy is the

right word, but you definitely have lower consumer demand. The stock in the news today is Target, which dropped 25%. It all speaks of less discretionary spending by consumers. We still have a very tight labor market. Unemployment is down in the threes and wages are rising. But I think we were in a very unusual setting the last two years and reality has set in that there's not going to be any more stimulus from the government and probably some concerns about the costs of the Ukrainian intervention and defense spending going forward. There may be a permanent shift in American commitments all over the world in light of the changed foreign policy of the Russians.

And this could be expensive the way it was back in the 1960s if it's not reined in and kept to a reasonable level. We'll have to see what that means. So put this, I don't know if it's technically considered a bear market yet, put this in a historical context. What does this look like in terms of past recessions or market corrections? And what can that tell us about what's going to happen here? Do you think this is going to be hard landing, soft landing, depression? What do you think is going to happen here? It reminds me of the early 1970s when the economy got overheated as a result of the spending on the Vietnam War. Employment was still strong, but once inflation crept in, the value of stocks began to fall. I think there were steps taken by the Nixon administration around 72, 73 that in hindsight, they probably would have reconsidered.

It strikes me that the markets are obviously, there's some volatility for lack of a better word. People point to the quote unquote dramatic increase in interest rates. But if I look at inflation relative to interest rates, it looks as if interest rates are going to have to go up a lot more. Much more. I think the central bank is probably hoping that inflation pops down. But if it stays up in the eights, you would basically take that as the thing that you would add the risk premium to. So the government would be paying perhaps 9% to borrow money and A-rated corporations paying 10 or 11. Interest rates are nowhere near that level yet. So one or the other is going to have to give way. Either inflation

is going to have to drop or interest rates will have to go up. Probably a little bit of both is what will happen, some combination. It feels like there's more pain coming. Do you think that's fair? It's hard to see how unemployment can stay down in the threes. That's never been a sustainable level. And certainly with the cost of financing going up, you're not going to see the formation of new businesses, the recruitment of staff and so forth. I think it's an open question whether the great resignation is going to hold. All the people who left the labor market during the COVID years, will they come back looking for work or do they really have enough

savings set aside to live on now that the market has dropped? But I think you're not going to see the kind of labor market that we're in now indefinitely. And that's going to spell trouble, you know, probably for tens of millions of people. So let's transition into crypto. Prices are collapsing, but again, it's nuanced. You know, the headline news is, you know, Bitcoin off 50%. I think when I first talked to you about it two years ago, if I bought crypto then, I'd still be up, if I bought Bitcoin, I'd still be up 40 or 60%. So it's all a bit relative, but I would love to, let's just start there. What's happening? What's your sense of what's happening in the crypto markets? Well, the markets really have been dropping since November. So you've had a very gradual slide for about six months. And most assets are down more than 50%, sometimes a great deal more. But it's not as severe as other episodes that we've seen. There was the crypto winter in 2018, where there was a much faster, sharper drop.

I think Bitcoin dropped as much as 80% peak to trough in the crypto winter. There was another correction in 2014 after the Mt. Gox bankruptcy and shorter lived ones as well. But it's always been volatile. And if you've been watching crypto for five or 10 years, you've seen this kind of price movement before. I think really there are certain projects and certain corners or nooks of the crypto world where there's probably much more concern. But the big assets of Bitcoin and Ether and so forth are standing their ground much more than a couple of the stable coins and NFTs as a category. The generative art collections and so forth seem to be very challenged, as you might have expected all along. But I think the basic infrastructure of

the crypto community, companies or coins and assets that are tied to smart contracts, to transferring between blockchains. There's still a lot of interesting projects being launched and in the long run, probably a lot of value to be preserved there. Many of the DeFi coins and tokens are probably going to sustain their value as well.

So it does feel as if there's a separation or a caste system emerging in crypto, and that is you have the big two, Bitcoin and Ethereum, that might in a volatile market be down 40 or 50 percent, and then there's everything else, which literally can lose 90 percent. Yeah, there's more than 18,000 of them out there. And I think the top 20 or 30 probably account for 90, 95% of the value. But you really have to look at what these things are designed to do. And some of them have unique issues like Ripple, we're still waiting for the conclusion of the litigation that the government's brought against it. I think that's a huge issue. Either good or bad, we'll have to see. But the value of Ripple is going to be closely tied to the outcome of that case. And you've had most of the stablecoins really locked on the $1 peg,

with one very notable exception in a couple brief uncouplings that occurred last week. But they're holding their ground as well. And it really depends on what the coin is trying to do. And if you have a bunch of cartoon characters that you're trying to sell as avatars, they're going to drop in value. They're collecting comic books, collecting digital art, especially when it's being flooded into the market in large volume, is not necessarily going to pay off for people. Let's go back to stable coins.

I kept reading that it was a big deal, that it had broken the buck. Can you explain to us the value and construct of a stablecoin and why it was such big news? I think we all read about it and knew it was supposed to be a big deal, but most of us, myself included, didn't really understand why it was a big deal. What happened? Stablecoins are very similar to money market funds in that if you own a share of a money market fund, it is always worth $1. And it's been very, very rare. There was one money market fund that fell below that in the financial crisis. And because people count on it being worth $1, it has all kinds of spillover effects that are very bad for people's ability to meet their

commitments and so forth. Now, in stablecoins, you have a majority following essentially the same business model as a money market fund in that they will have assets in reserve, hopefully high quality assets. But for every dollar circulating in the form of a stablecoin, there should be a dollar in the bank somewhere. And in principle, you can actually redeem the stablecoins and get the dollars back and so it's the redemption promise that essentially guarantees their value so there's there's collateral essentially in escrow somewhere the smaller group of stable coins and this includes the one that got into trouble are based on trading strategies and they resemble what governments

sometimes do when they run currency boards, where they announce that we're going to fix the value, in this case, fix the value of the stable coin at $1. If the value goes up for whatever reason, we'll just issue more into the market, increase the supply, which will push the price back down. And that's easy to do. Where the trouble comes in is in the other directions. If the price drops, you're supposed to buy them back and reduce the supply and push the value back up from essentially basic supply and demand. And that will work until you run out of working capital. And in the case of this Terra USD, they had a huge reserve of Bitcoin that had been set aside for emergencies, but they blew through it very, very quickly. And after that, the confidence in the project completely evaporated. So it looked really a lot like Argentina in the late 1990s, which successfully pegged itself to the U.S. dollar for several years. But once you run out of reserves, the capitulation occurs pretty

quickly. And we've had some research into stable coins. The ones that follow the reserve model have in fact been more stable over time. The ones that follow the algorithmic trading model have been more volatile. And if you had told me one of them would get into trouble and asked me which group it would come from, it's not a surprise. It was one of the algorithmic ones. And so what's happened? Is it Luna, which was the one that went down 90%? It's called TerraUSD, and it had a companion coin called Luna. They often have a coin that is used as part of the rebalancing for trading purposes. So another very big one, which has held its value just fine, is the DAI stable coin, D-A-I. And its twin, if you will, is the Maker token. These are connected to the MakerDAO DeFi platform. And what happened with Luna and TerraUSD was just a severe imbalance of supply and demand so that they blew through all their reserves that were set aside for trading protection

rather quickly. And it happened in some interesting ways. But once you drop below a dollar with any significant daylight, typically, it's very hard to recover. And, you know, there's been a few of these in the past that also ended very abruptly and very badly. I think, you know, it's a very risky model and difficult to implement no easier in the crypto world than in the real world. Tell us about what's happening in the NFT market. There's been a very significant drop in most NFTs. And it's important to confine the discussion to the families of generative art. So the best known are the crypto punks, the bored apes and so forth. But there were a ton of imitators that hit the market after some of these early entrants did very well. And essentially, the market just got over flooded.

It looked to me a lot like the comic books bubble that we saw 30 years ago, where Marvel just started turning on the printing press and issuing new comic book titles to feed the market. But after a while, the supply swamps the demand. And the real value of NFTs is not for generative art, for bored apes and so forth. It's to fix ownership of assets that can be as diverse as real estate or old master paintings or anything where the provenance and the documentation of the property right has been challenged through history. There's all kinds of ways that society has kept track of who owns what. And using a blockchain with a digital token seems to be a much more rigorous and robust way to record property ownership. So I think in the long run, you're going to see NFTs replacing things like automobile titles and real estate

titles. It's not going to be about digital art collections so much as real property where the government registries have never been as foolproof and as trustworthy as you might wish. That's super interesting. So you're saying that effectively this is sort of the innovation or the digital innovation around kind of the deed space. Exactly. That instead of having something notarized and locked away in a safe deposit box saying you own this property, that there'll be a more robust, accessible, secure, transparent deed put online using NFT technology. This was exactly why the blockchain was created back in the early 1990s.

They were looking for a way to record digital property, but it doesn't have to be just digital. You know that when you buy a car, there is a paper deed issued by the Division of Motor Vehicles. And then if you sell the car to someone else, you're supposed to sign it on the back. There's a lot of forgery and corruption in the recording of automobile ownership. And for that matter, real estate ownership, The titles to paintings are the subject of feature films and all kinds of books. In wartime and in tough economic times, art sometimes just disappears and then it reappears centuries later and there's no paper trail. NFTs offer a permanent way to record ownership of just about any asset you want. And if you think of the

systems that are in place in society right now, many of them are very vulnerable to corruption, to simply fires in the courthouse, destroying the records. In medieval times, the peasants would sack the castle and they would burn the book of obligations and land ownership as a way of getting back at the landed gentry. And essentially, the NFT technology would allow you to tokenize just about any asset. And it was developed because there was a clear need for registering digital assets. But I think it was quickly recognized that things like real property and aircraft, anything valuable where you can have identifying information, and that includes stocks and bonds, for instance, will probably be turned into an NFT and traded over these decentralized networks. So I'm trying to pretend I'm a music artist or a celebrity. And I heard about an investor group buying Chelsea FC. My kids are huge Chelsea fans. So it ends up, I know some people involved, called them and said, I want to put in, I want to own 0.0001% of this Chelsea FC. And I want to be part of the ownership group. And my value add, and no one said yes to me, by the way, my value add is that I believe that sport teams or sports franchises could develop really substantial incremental high margin forms of cashflow by thoughtfully creating NFTs from

each specific game. You know, the three, MVP, the two goals, who gets the NFT of the 10 second video of that goal? And I think not only is there an emotional reward, but there might be some speculation. It might be a store of value. Do you see the same potential for these iconic sports teams and even media companies that produce kind of these moments, if you will? There certainly are people trying to create this. The big success has been the NBA Top Shot, which essentially took the concept of baseball cards and turned it into digital tokens where you would take highlights of LeBron or even go back in history, highlights of Jerry West hitting the half-court shot 50 years ago, and then having very limited edition collectibles that would be, again, displayed for purposes of bragging and prestige. You've also had a lot of the European football clubs begin to issue NFTs as a way of essentially bonding fans to the team, creating loyalty like a frequent flyer mile.

So you put them out in limited supply, the fans compete with them, and they don't get ownership of the team, but they do get to vote on the color of the jersey. They get probably preferred access to new merchandise that comes online. There's all kinds of ways that you can use this to create loyalty and keep fans interested in the offseason and so forth. So I think this will require fairly deft marketing skills. But given the number of teams that are out there experimenting with this, we'll probably see some best practices that will be taught in business school marketing classes and widely imitated. We'll be right back. Support for this show comes from Constant Contact.

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Subscribe wherever you get your podcasts. Published by Capital Client Group, Inc. Okay, let's talk about Elon. I've never seen anything like this. I think it's actually a really interesting moment. What's your take on Elon and him trying to back out? Give us your view. When you say this, you're referring to Twitter because there's any number of things that you could... That's what I'm talking about. In this instant, that's what this is. To me, the deal looked very unusual from the start because a company of that size being taken private by one person is just no precedent for it. It would be very risky for him individually to pull off and to continue to own something in his own right worth $40 billion. And it would be very hard to get the

financing, I would think. And you look at the whole transaction, you see, I've never seen a transaction that looks at all like this. So I'm a little bit skeptical that it's going to go the distance and close. When you add to that some of the regulatory concerns about him not declaring his 5% ownership in a timely way and being on the list of bad people that the SEC keeps track of and so forth, you wonder if there won't be interventions of a regulatory nature that could also sidetrack the deal. So it strikes me, okay, that Tesla stock off 30%, the peer groups off 30%. So when he started acquiring shares, it was 32, which means its natural level right now would probably be in the low 20s. And he's signed an agreement saying it's going to show up with 54 bucks a share. And he just did the math and said, this is a stupid idea. And I'm going to just try and come

up with any excuse whatsoever to walk. And the people who I said, I called bastards, the SEC, I'm now asking them to investigate bots, of which 72% of my followers are bots. I mean, I'm going to put forward a thesis, and you tell me if this is just projection and me being hopeful. I think the worm has turned on this guy, and that is he has pissed off so many people, and the SEC is really looking for a means of taking an underfunded agency

and sending a strong signal. The Delaware courts, I think are going to have to say a signal that if you start putting out offers on big corporations and having them accepted, you can't just start walking away. I mean, if he's allowed to just walk away

without a serious exit wound here, doesn't this threaten all of corporate M&A where say Facebook could get in the way of Apple acquiring Netflix and say they're acquiring it, knowing that they could just walk in six months when the market has changed somehow? It strikes me this is a big moment for a lot of different players and the Commonwealth and the markets on a lot of different levels. So the area that you're getting into has to do with things like breakup fees that are very common in large transactions in this day and age. So typically, when two people negotiate a deal, you know, in this case, the board of Twitter and Elon Musk, there will be often mutual breakup fees. If one side or the other backs out, there's a penalty that in this case, I think is a billion

dollars. Now, you can't just walk away. You have to have a reason. And the reason typically falls under the heading of material adverse change, that you essentially learned something or an event took place that made the deal look very different. And we've actually seen this before. There was a very interesting period when the global financial crisis hit, where many leveraged buyouts had been proposed and agreed to back in 2007 and 2008. And then when the market dropped very sharply, a lot of people wanted to back out, but there really was no material adverse change. So some people just walked away and said, sue me. I'll see you in court. And the legal testing of this has never really been satisfactorily settled. These cases always end in compromises. There was one with Huntsman Chemical where it looked like Mr. Huntsman really wanted to take the buyer to the cleaners, but he compromised and settled at the 11th hour.

So it's an area where the Delaware courts have not provided nearly enough clarity to say what is and what is not possible. Now, we are, again, in a falling market. It's certainly not falling as sharply as it did in the Lehman Brothers days. But I do think that just the basic assumptions that Elon Musk was making about interest rates and the cost of capital, they look different today than they did three or four weeks ago. And if the deal was marginal then, it's probably tipped into being unattractive. And can he really use the presence of bots on Twitter as a material adverse change and claim not to have known about them and so forth? That's ultimately a question to be litigated, but it does have an air of being far-fetched because I think you and I knew that there were robots on social media and

that well over 5%, you know, and not just Twitter, but many of the platforms are populated by all sorts of nefarious bots and software agents and so forth that are doing things that the platforms weren't originally intended for. So who knows? I think, you know, all of this should be seen in the context of a negotiation that is very much still active. And maybe he's just trying to get a lower price. Maybe he's looking for other financing. It's hard to know. The price that this would make any sense for him personally and economically is so far south of the number that he, quote unquote,

signed an airtight purchase agreement around. I think the board would look incredibly stupid. They'd be like, well, what's the guarantee it's going to show up this time? I just don't see how they engage in future conversations with the guy. And what I'm curious about is, say the Delaware court says, all right, you knew about bots. You've even said you're going to clean up the bots as part of your proposal. And now you've decided that you don't like the bots Musk, you're full of shit, and you're looking to back out of this agreement. What could they do? Do you think there's, could they, I mean, I period. Because if you ordered them to pay $16 billion or $20 billion, it was simply not possible to raise that money and to close on the deal. So the court can direct that you close the deal. But if you don't have the $40 billion or whatever, it's not really clear. But could they force him? Could they say, as of today, your stock is worth $120 billion in Tesla. You're ordered to raise $45 billion and show up in 30 days. Could they do that? I don't think they can force him to liquidate other assets.

And, you know, you can issue an order. And then I guess if this played out, he would ultimately be found in contempt if he didn't apply. And you could get a judgment against him as Twitter could get damages and whether he chose to actually pay those damages. There's a huge field of finance called strategic default, where you owe someone money and decide you're better off not paying because the cost of them going after you and the odds of them recovering seems rather remote relative to the possibility of negotiating some sort of compromise. And I don't see that he would ever sell tesla just to deliver 40 billion to the board of twitter and you know there's the chance for years of litigation but almost always these things

settle in some type of con you know compromise and so forth i think you know that's far down the road we're nowhere near the point where people are starting to sue each other. And I think there's some hope on both sides of keeping the deal alive, hopefully with the markets going back up. But if the markets continue to drop, it could start to get ugly. broaden the lens again or zoom out. How do you protect yourself or can you in this type of market? Assume that inflation, I think there's a lot of investors out there that, okay, do I have an emotional reaction and sell while I'm still a little bit up? I can't stand this pain. Any thoughts around how your investment strategy shifts or or maybe it doesn't, given what looks to be a recessionary, inflationary environment? We have very clear research on this in the university, which is that you should diversify and never trade.

You know, you just, you want to do the most boring, put your money in very steadily over the course of your career. Don't pay attention to the ups and downs. And if you try to time the market with, very steadily over the course of your career. Don't pay attention to the ups and downs. And if you try to time the market with getting out at the top or rebalancing, it's a coin flip. You're going to pay taxes and transaction costs, but you have only a 50-50 chance of being correct. These variables that we're tracking, they all follow random walks, which means that they are unforecastable.

And if you look at the portfolios of finance professors, we all own index funds, and we don't think very much about them. We're thinking about the very long-term return and not trying to do anything in the short term to react to transitory news. Do you feel the same way about crypto or would you avoid the non, what I'll call the non-iconic coins? I've always thought that crypto looked a lot like technology stocks in the early to mid nineties. And we know that there were hundreds and hundreds of IPOs, 99% of them disappeared. But the ones that got through, you're talking about firms like Amazon and Google and so forth, they became the most important companies in the world. I think crypto will have a similar set of outcomes.

The 18,000 assets that are out there, probably 99% of them will go to zero in pretty short order. But it's very hard to tell which ones will pop out and do well. And it's not necessarily the big well-known ones. There's going to be a few that break out of the pack. But given the difficulty of figuring it out, again, diversification is the one and only strategy that is time-tested and has been shown to work. And any other advice? Do you think there's a good company? I don't know about you, but in my office hours, no one comes to me to talk about my domain expertise. They don't want to talk about brand or strategy.

They want to talk about careers. Assume you're coming out of undergrad or business school. You're blessed with some opportunity, the right certification. Are there specific industries or specific skills you think, all right, that's a great place to position your human capital at a young age? Well, I think studying cryptography and probability and statistics is the value-added skill for the next generation. Cryptography.

I've had all my kids, as they've gone through high school, take AP statistics. And once you get to the university level, you want to study cryptography wherever it's taught. It's often, in fact, in the engineering faculty. And the making and breaking of codes is really how property rights are being traded in the new economy. And there's a real shortage of people who understand what makes this work. The engine that's behind it, the analytics, the mathematics that secures the assets on blockchains and so forth. So learning to code and understanding probability and statistics and cryptography are skills that I think will be extraordinarily valuable for decades to come. David Yermack is a professor of finance and business transformation at the Stern School of Business, where he's taught since 1994. David also serves as the chairman of the finance

department, which by the way, let's be honest,, Stern, it's finance and the seven dwarves. I didn't say that. I said it. As someone in the marketing department, I can confirm it. Oh, I'm sorry. I'm in the middle of your bio readout. I just read that the average salary for NYU Stern graduates this year is going to be $212,000. Is that accurate? attractive jobs. And we're doing better than we ever have. And the numbers are very much

indicating that we're a major league school. And the New York location is obviously a part of this, but that's an asset that most other schools don't have. And we try to take advantage of it. And we have a lot of access to good potential opportunities for our students through the career office. Yeah, that number just blew me away. Professor Yermak's research areas include boards of directors, executive compensation, and corporate finance. David is also a faculty research associate of the National Bureau of Economic Research and has been a visiting scholar at the U.S. Federal Reserve Bank. He joins us from his home in New Jersey. David, as always, a sober yet interesting look at the markets.

We appreciate your time. Thank you very much, Scott.