Oil Prices, Tech Market, and the Economy, Part II

The Tech Bubble

The New Yorker

Asset bubbles, or the appearance of them, concern almost everyone due to their omnipresence in the media. Last year, Mark Cuban wrote a paroxysm of how the 2015 tech bubble is worse than the 2000 bubble because retail investors can't participate (Cuban's a smart guy, but this makes no sense. Isn't that a good thing if we're in a bubble and retail investors aren't participating? It would mean fewer people hurt by the popping of a bubble if companies are private instead of public). Everyone, from TechCrunch to Vanity Fair is talking about the tech bubble. I'm just waiting for Drake and Meek Mill to have diss tracks arguing about the existence of a tech bubble. 

I think it's smart to begin by defining an asset bubble, which, surprisingly, isn't easy, followed by some empirical evidence and economic theory.

Definitions: 
Some economists define an asset bubble as an upward price movement in an asset over an extended range of time that then suddenly implodes. For the most part, this definition is too ambiguous because it doesn't convey how high the prices should move and why that movement is not justified. 

A more precise interpretation would define a bubble as a "situation where an asset's price exceeds the fundamental value of the asset," according to Gady Barlevy of the Federal Reserve Bank of Chicago. He goes on to note that an asset's value ought to be the present value of its future cash flows. If the price of an asset increases significantly, perhaps in a short period of time, without any expected change of future cash flows, then there may be an asset bubble. Again, there ought to be a difference between prices when expected cash flows grow by 10% versus 1000%, Thus, this definition is also bereft of quantifying how large the movements have to be to constitute a bubble, but the idea of prices being disassociated with fundamentals is key.  

I also think it's imperative to note what a bubble is NOT: 

1. There is not necessarily a bubble just because prices in a certain asset class are higher than they used to be. Pricing must be divorced from fundamentals in order to constitute a bubble. 
2. In the same vein, higher fundamental valuations don't always point to a bubble. Many reporters cite the growing number of unicorns as a sign of a bubble. If the present value of that company's future cash flows is over $1 bil, then the valuation could be justified. That's not to say high valuations are always justified, and indeed, in many cases they are not. But, in order to proclaim a bubble, one should dig several levels deeper to figure out if the entire asset class ought to be generalized as overvalued beyond fundamentals. 
3. Lower stock prices do not necessarily mean that there was an asset bubble that is in the process of bursting. Day to day volatility in the stock market is a lot higher than day to day volatility in valuations of companies. If stock price compression is due to political reasons, over-reaction to market data, or other exogenous factors, it probably isn't a sign of a bubble popping. A correction from speculative levels of valuations to levels that more adequately reflect future cash flows, however, could be a sign of a bubble deflating. 
4. Failure of companies does not mean there was a bubble that is imploding. Ben Thompson of Stratechery made a great point about the winner-take-all market: there will be failures in industries where there's only room for one major player due to network effects. Advertising is a zero-sum game and some apps/social media sites will lose out to others. That doesn't mean there was a bubble; that just means expected cash flows from one company were transferred to another.

So what could have caused the recent downturn in tech stocks recently? We can't ignore the impact of the Chinese stock market and recent tech earnings. Ben Thompson, however, makes a great argument:

"I think the recent chill in valuations and fundraising is about coming to terms with the fact that a lot of those unicorns are in the same boat as Facebook and Google’s advertising competitors: they have already missed out to the dominant player in their field (or, that their field was never viable to begin with). In some respects it is tech’s own inequality story: the average and median company and startup will increasingly bifurcate. It’s not a bubble, it’s a rebalancing, and the winners are poised to be bigger and richer than anything we have seen before." 

Empirical Evidence:  
How can we ascertain the existence of a bubble? When valuations reach unrealistic levels, we see more and more financial capital chasing companies in a particular industry. So, first, we can look at how much money has gone into the venture market now and back in 2000. In 2000, over $100 billion had been invested in VC, compared with $59 billion in 2015, according to the PWC MoneyTree Report. So there has been a lot of money spent in VC, just not as much as there was in 2000.

Moreover, during bubble times, investors put money into companies at the "idea"or very early stage. Speculators and non-venture investors enter the market at seed or angel rounds in hopes to land the next unicorn. If investors are chasing newfangled investments in hopes for another gold rush the way they were in 2000, one would expect to see much more capital into the seed and early stages of investments.

According to the PWC MoneyTree data (graph below), there was $21 billion of capital into the seed and early stage VCs in 2015 compared with $29 billion in 2000. Approximately $8MM per venture went in at the seed or early stage  in 2000 compared with $8.6MM into the same rounds in 2015.

It's interesting to note that the average dollar size per investment during seed and early stages is higher this time around, even though total capital deployed is lower, implying that there could be more of a winner-take-all strategy that Ben Thompson alluded to earlier.

So are companies this time of higher quality than before, justifying the higher level of investments? We can look at the quality of tech companies that have raised public financing this time compared with in 2000 to help determine that. While this isn't an apples to apples comparison, it gives us an idea of how mature the companies are when they go public, and ultimately, how far the investments could fall if their valuations aren't justified.

I looked at 2002 revenues of Nasdaq companies that IPO'ed between 1998 and 2002 and compared that with last twelve month (2015/2014) revenues of Nasdaq companies that IPO'ed between 2012 and 2015. The idea was to see how much more traction today's companies have before the public, non-VC investors jump in. Intuitively, we know that since companies have been waiting longer before going public, they should have greater revenue traction, which was corroborated by the data below.

The data above confirms the suspicion that companies are in later stages and have more control over their expenses (which the revenue/employee is supposed to indicate) now than they did in the early 2000s. Which means that if there is a bubble, the speculative nature of it isn't nearly as bad as it was in the early 2000s. Perhaps, instead of acting with irrational exuberance, investors are merely unreasonably quixotic.

So it appears that there's not much of a bubble in the public markets or later stage VCs since, outside of a few companies, valuations are more or less close to fundamentals this time around with higher revenue traction and lower expenses. As in, we're seeing "real companies" at the later stage VCs and public companies than we had in 2000, when we saw more investments due to speculation.

There could be a bubble in the early stage or angel investing staged companies since there is almost as much capital invested at those stages now as in 2000. The perilous impact from the bursting of that bubble would be limited to investments in just those stages.

What would cause the implosion of high valuations in tech companies? Katie Benner of New York Times and Jason Calacanis proffered in an engaging TWIST round-table that what we might see this time around may be similar to what we saw during the 2009 crisis. That is, we may see a negative impact on the tech industry if other industries or consumers began buying less technology. As mentioned in my previous blog post, if oil companies, for example, began spending less or had massive layoffs so consumers couldn't spend on technology, we'd see lower tech revenues. Jason calls this a contagion, or a downturn caused by exogenous factors rather than the inherent overpricing and then correction of tech valuations themselves. The magnitude of the contagion affect this time would be a balance between how much more investment there is in technology now versus in 2009 and how much of an impact a downturn will have on tech revenues now than in 2009.

Economic Theory: 
For economic theory about asset bubbles, there's no better source than Carlota Perez's Technological Revolutions and Financial Capital. In it, she describes four phases of technological revolutions: Irruption, Frenzy, Synergy and Maturity.

The Irruption Phase is when "new revolutionary entrepreneurs outstrip profit making potential of all established production sectors, and there is a rush of financial capital towards them, readily deploying new appropriate instruments when necessary." In this period, there is idle money in search for profitable use, and it leans towards investing in these new entrepreneurs to obtain high yields.

The Frenzy Phase is when there is a decoupling of financial capital and production of new innovation. Financial capital becomes arrogant from the highly profitable "bets" made by investors. Financial capital becomes a powerful magnet to attract investment into new areas, which become the "new economy". The entrepreneurs are forced to do whatever is necessary to attract the investors, in this case, the  VCs.  This is also when uncontrollable inflation sets in, debt mounts at a reckless rhythm, and a vast disproportion between paper wealth and real wealth becomes apparent.

After the Frenzy Phase, there is a turning point, which brings with it a collapse and a recession. Bubbles begin at the end of the Frenzy stage and burst during the turning point.

"There are three structural tensions that make it impossible to keep the frenzy profit going for an indefinite time. There are tensions between real and paper wealth, between the profile of existing demand and that of potential supply in the core products of the revolution, and between the socially excluded and those reaping the benefits of the bubble."

The Synergy Phase is where there is a re-coupling of financial capital and production. Innovation and growth can take place across the whole productive spectrum in this phase.

In Maturity, some disappointment comes from highly profitable sectors reaching their limits in both productivity and markets. Profits begin dwindling, and we begin to see "idle money" in the financial markets again.

So which phase are we in? According to Ms. Perez, we're likely in the midst of the turning point.

While it is possible that there will be several small tech valuation bubbles followed by corrections during the Turning Point, it seems from Perez's work that the big tech crash and related recession have already occurred. And it appears, from the empirical evidence, that we're facing less of a bursting of a tech bubble and more of a contagion effect on the tech industry at the moment. So, are we in a tech bubble? Probably not.

Oil Prices, Tech Market and the Economy, Part I

IS-LM Model

Dow Jonesy enough for you?
The New Yorker

One of my colleagues and I were recently discussing the dizzying number of stimuli trying to play tug-of-war with the US economy in general and the financial markets (public and private) specifically. There's so much going on! Collapsing oil prices, prodding at the "tech bubble", the presidential elections, burgeoning threat of terrorist activities, Kim Jong-un inching towards insanity... What does all of this mean for our economy and our financial markets. 

As an economist, I like to (over)simplify the world by thinking in terms of frameworks, and the one framework that spoke to me in my macro courses was the IS-LM model, which illustrates the Investment/Savings - Liquidity Preference/Money Supply equilibrium. Behind this almost nonsensical jargon is a simple concept that interest rates and GDP are a function of how much money is sloshing around and whether people would rather invest or save that money.  

For those of you who want the details, the IS and LM curved are derived from the aggregate demand equilibrium where output (Y) = C (consumption) + I (investment) + G (government spending) + X(net exports)

The LM curve is a little harder to understand, but an easy way to think about it is that i(interest rates) is the price of holding on to money. That is, we all would rather have money in our checking accounts, readily accessible (holding money), but if i (price of money) is high enough, we'll let someone else (mutual funds, banks, etc) hold our money and pay us for it. 

The IS curve is pretty relevant today given the collapsing oil prices. Exogenous variables (not just the price) have resulted in a glut of oil supply. Conventional wisdom would tell us that lower oil prices would boost production of items where oil is an ingredient since input prices would go down. As The Economist mentions, however, that doesn't seem to be the case at the moment. 

"Cheaper fuel should stimulate global economic growth. Industries that use oil as an input are more profitable. The benefits to consuming nations typically outweigh the costs to producing ones. But so far in 2016 a 28% lurch downwards in oil prices has coincided with turmoil in global stock markets. It is as if the markets are challenging long-held assumptions about the economic benefits of low energy prices, or asserting that global economic growth is so anemic that an oil glut will do little to help."

Let's go back to our IS-LM framework: oil prices are low, so investment in oil should decline, shifting the IS part of the curve to the left (from IS to ISd). If investment in oil is lower, producers will be reluctant to produce oil (and many may not be able to produce given their much lower income). 

As The Economist says above, it could have been possible that although the I part of Y=C+I+G+X would decline, increase in production of goods could have boosted the C and X portions of the equation, hence leaving the IS curve unchanged or even higher (to the right, to ISi). That doesn't seem to be the case this time, however. It appears that C and X, for whatever reasons, need more to boost them than lower input prices. As an example, you'd like to buy a Lucite table that costs $500 last year and now costs $400 (Consumption), but you still don't think it's a good enough deal to purchase (perhaps wages haven't risen enough, prices of other goods have risen more than you had expected, your taxes have increased, etc). 

The impact of a lower IS curve is that GDP on the X axis (output, income, yield, or whichever other measure you'd like to use) is lower and the economy is producing less. What can be done to counteract that? 

Well, usually, the Fed could just shift the LM curve to the right by spurring money supply. That is, the Fed could increase the money supply by buying bonds (less bonds, more money in the market), which is the mechanism used to achieve what everyone refers to as "reducing interest rates". With lower i (interest rates, the price of money), instead of letting someone else hold your money (put it in a savings account, a mutual fund, etc), you hold it yourself as just a store of value. 

As we know, however, interest rates are pretty close to the lowest they can be. Although rates can be reduced a little more and into negative territory with quantitative easing, there's likely a limit to how low they can go before the economy becomes topsy turvey.

Paul Krugman at the New York Times says that at the rate of 0, the LM curve should be flat, like this:

When rates are at 0, people have no incentive to buy bonds or put money in a savings account; they'd rather hold cash. Changes in the money supply have no impact, which is known as a liquidity trap.

"And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all," Paul Krugman.

So if the LM curve can't be changed to counteract the lower IS curve and if lower oil prices aren't doing much to spur consumer demand, then we're left with the lower IS curve, meaning lower output and rates.

What does that mean for the rest of the economy? A lower IS curve is further away from full-employment, so we'll likely see higher unemployment, primarily from the energy sector. But rates will also remain low.

Low interest rates lead many investors to continue searching for higher yields elsewhere. That is, investors will take on riskier endeavors because risk-free investments (treasuries) or low risk investments (investment grade bonds) won't yield much. This impacts the technology market and silicon valley enterprises too. The lower the yields, the more money investors will be willing to put into startups and other technology ventures that have the possibility of an out-sized return. And we've seen this phenomenon for a while now since rates have been close to zero.

The demand side of the equation for technology and venture startups may be impacted negatively if products were meant to be sold to firms related to oil production. At this point, however, it doesn't seem likely that we'll see a major revenue slowdown for tech companies just because of lower oil prices. It also doesn't seem like lower oil prices are having a recessionary impact on the rest of the economy because it hasn't hit industrial production, the real GDP, real income or wholesale retail sales.

What about the "tech bubble" then? And do the weakness in the public markets portend an impending disaster? Should we expect a deleterious impact from a repeat of the 2000's tech crash? Or is this time different? I will address these issues in the context of a technological revolution in Part II of this post.