We are living in times of unprecedented instability, change and opportunity. Those quick to adapt will prosper. Those that follow the herd will likely see the same fate as more traditional industries that procrastinated and failed to adapt like print and broadcast media. In today’s world would you rather be Netflix or Rogers?
I had originally blogged about these global shifts prior to the Great Recession of 2008 in a series of posts called “Forces of Change”. Albert Wenger of Union Square Ventures has a slightly different perspective, but very insightful take on the shift of economies from industrial to information here: Video of the Week: Albert Wenger at DLD NYC on the topic of “World in Transition II” on the AVC blog. The economy is a changing.
While the economic shift from the industrial to the knowledge era forms the base of economic change, which is broad based and global, there are also a number of irrational instigators that are further stressing the economy. The two principle irrational instigators are opportunity scarcity and availability of capital.
Demographics and an aging population are primary contributors to the availability of capital in North America. With the boomers quickly approaching retirement age more and more capital is being put away. An aging population is one factor contributing to the availability of capital. Basil Peters has a great video on the topic “Why exits are so hard to learn”.
Another driver of the availability of capital are a number of recent IPOs and transactions in the social networking space. For example, LinkedIn went IPO in 2011 for $352M, Facebook’s 2012 IPO generated $16B and Facebook's acquisition of WhatsApp injected another $19B of capital into the startup ecosystem. The combinations of IPOs and acquisition activity inject a significant amount of capital into a market already flush with cash and looking for opportunities.
The lack of good investment opportunities is further compounded by something I like to call “Valuation Inflation”. The key driver of valuation inflation is precedent setting prolonged low interest rates that are also limiting the number of investment options. Fred Wilson has a great post (The Bubble Question) on his blog AVC that describes the effect of prolonged low interest rates on valuations. While there is a significant amount of capital available there is a general scarcity of good investment opportunities and a significant valuation multiplier for the prospect of return on investment.
In summary the key irrational instigators are large amounts of capital looking for investment opportunities, a general scarcity of good quality investments and valuation inflation that is fueling some irrational exuberance in the market place.
Signs of Exuberance
An important consideration for the current economy is that business runs in cycles. IMHO, we are at or near the high water mark for the current business cycle. The stock market has more than recovered since the Great Reset of 2008. The US economy is growing at a rate of 4.2% in the second quarter of 2014 according to the US Department of Commerce, Bureau of Economic Analysis. The US unemployment rate is edging down to 6.1% so there are a number of very encouraging economic indicators.
However, if you scratch beneath the surface there are also a number of troubling leading indicators of exuberance. There are three key leading signs of exuberance: rapid increase in VC investments, runaway P/E ratios, and stratospheric acquisition prices. The last time VC investment increased at the rate it is today was 1999 and 2000. VC investments doubled each of those years and we are on a similar trajectory for 2014 and 2015.
Robert Shiller, the Nobel Prize-winning Yale economist, recently issued a cautionary note about the economic indicators being similar in many respects to those in: 1929, 1999 and 2007. One of the factors Shiller referred to was:
“The CAPE ratio’s long-term average is about 15. But as he pointed out in his New York Times article, the ratio has risen above 25 following this summer’s market surge, a level surpassed only three times since 1881.”
The CAPE or Price to Earnings ratios (P/E) is a leading indicator of an economic correction and one of the strongest indicators of irrational exuberance. I have done a bit of my own research here and came up with the following Exuberant Basket of Stocks in Google Finance.
You can see that TD Bank (a Top 5 Canadian Bank and steady performer) provides the base with a P/E ratio of 14. SAP is a traditional software company and has a P/E of 21 and Google a high growth company has a P/E of 29 all of these are within a rational domain. These three comparative companies are in the more traditional P/E range.
Exuberant Stocks (in the red circle on chart 1)
Facebook is in the irrational area with a P/E of 84 and Amazon is in the Exuberant stratosphere with a P/E of 870 ... BTW, someone recently told me that Amazon is one of the most shorted stocks on NASDAQ. The last time aggregate P/E ratios were above 25 was in 1999 and 2000. Facebook's acquisition of WhatsApp for $19B also defies business common sense and is difficult to justify in rational terms. There are definite signs of exuberance in the market today.
Déjà vu all over again …
I distinctly remember this 2011 post by Jeff Bussgang of the blog seeing both sides … “What if it is 1996 and not 1999.” Well first of all I think Jeff was spot on. 2011 was the equivalent of 1996, however, if it was like 1996 three years ago then it is 1999 today. The signs of exuberance are solid indicators of a business cycle that is at or near the high water mark. The doubling of VC investment each year, the runaway P/E ratios and lofty acquisition prices are very reminiscent of 1999 and 2000. IMHO this business cycle is much more like 1999 than 2008.
Reference Check … What is Warren Buffet Doing?
Berkshire Hathaway has a long term market strategy and is generally a buy and hold company. Berkshire Hathaway recently shed $2.86B in equity for a gain of $1.96B. That is close to $5B in buying power and Berkshire Hathaway is a buy and hold investor. What we do know for sure is that it is a good time to sell. However, what could be implied is that there will soon be some opportunities where having access to significant buying power will come in handy.
This time it is different …
The set of economic circumstances we find ourselves in today are unprecedented. The business cycle correction will be the first reset in the new knowledge based economic epoch and while there are many similarities to dot com bubble it is a new game. The key bubble driver is prolonged low interest rates coupled with the transition to a new economic epoch. Availability of capital, opportunity scarcity and valuation inflation are irrational instigators. If you believe that business runs in cycles and I do, then there are quite a few indicators that we are at or near the high water mark of the current cycle.
The Next Reset will likely be niche rather than broad based affecting specific overheated sectors like medical marijuana, wearables, social networks and other areas of exuberance. If 2008 is a reference point in terms of speed of correction, the improvements to trading technology in the financial sector will make for a bumpy ride. Ladies and gentlemen please fasten your seatbelts we are expecting turbulence ahead...
Turbulent times create new and disruptive opportunities for those that embrace change and there is little doubt in my mind that times will be getting more interesting.
- Ian Graham