Above the Crowd

On Bubbles …

January 24, 2014:
bubbles-water-transparent-design

Over the past few months, many journalists have begun to ask the question that no one really wants to hear; “Is Silicon Valley in another technology bubble?” It’s a dangerous question to ponder – especially out loud and especially here at ground zero. Silicon Valley thrives on optimism, and anyone waving the bubble flag is auditioning for the title of nonbeliever or party pooper.

There is another reason it is dangerous to predict the arrival of a bubble. It was 1996 when Federal Reserve Board Chairman Alan Greenspan first uttered the now historic phrase “irrational exuberance.” Even though things were frothy enough that the head of the federal reserve felt the need to talk down the market, the top was in fact many, many years away. And the venture capital firms that pulled back in 1996 missed the best three years of return in the history of venture capital industry. All of which makes predicting market tops a delicately tricky business.

Warren Buffet has a famous quote, “Be fearful when others are greedy and greedy when others are fearful.” Using this traditionally contrarian investment mindset, one would certainly tread with trepidation in today’s market. Although we may have not reached the level of observing obvious greediness, there is most certainly an absence of fear. Those that managed companies in 2008 or thirteen years ago in 2001 know exactly how fear feels. And this is not it.

There is another way to think about identifying bubbles. Occasionally you will hear sophisticated investors talk about the notion of “discounting risk.” They might suggest that certain investors in a certain sector are discounting risk. The implication is that they are not properly accounting for the risk of the given situation. Investors are not the only ones that can discount risk; executives and employees can discount risk as well. This happens anytime someone is operating in a situation where their assessment of risk is far lower than the actual risk to which they may be exposed.

All of which leads to my “discounted risk of employer profitability” theory. Ask yourself this question. What is the percentage of employees in Silicon Valley that are working at profitless companies (i.e. companies that are losing money or have negative cash flow)? And how has that trended over time? What was that percentage in 1999? What was it in 2003? And what is it today? An employee’s decision to work for a company that is losing money is an implicit decision to discount risk. If the macro environment changes, that company is under much greater stress than one that is profitable. Yet many individuals are making just such a decision today.

Through this lens you can also see why markets are cyclical, precisely because the willingness for people to take on such risks happens gradually over time. Like the boiled frog, the employee base as a whole does not perceive that anything is changing. Yet, at a micro level, one person’s decision to get comfortable with this risk is based on the fact that someone else did it earlier, which was based on someone else even before him or her. And as more and more people make that decision, the risk is constantly increasing. No one makes the implicit decision, “I am going to go to work for a money losing company!” However, slowly over time, a large portion of the employees in the area inherently are. And then, when the bubble bursts, the consequences are far greater.

Its not just employees that take on this incremental risk. I am just highlighting that looking at this particular detail is one way of measuring the discounting of risk. Obviously, venture capitalists, investment bankers, public market investors, founders, and executives are all part of the game, and they all play a role in the acceptance of more and more risk over time. There is value to knowing where you are, even if you play the game on the field.

12 Comments

  1. William Mougayar January 25, 2014

    How about a bubble on the VC funds side? I’m seeing a lot of new funds being raised by new/less experienced VC firms. What will the effects or after-effects be?

    Reply
    • bgurley January 30, 2014

      Absolutely.

  2. fred wilson January 26, 2014

    hi bill
    i’ve been thinking a lot about this stuff too.
    but i think the period we are in right now may turn out to be the best three years in VC history.
    certainly your portfolio makes me think that way
    Fred

    Reply
  3. Brad Gerstner January 27, 2014

    Bill,

    Like the post – I too am getting all the same “bubble” questions. Rather than binary – “bubble” or “no bubble” – we should really think of as a continuum – where 1 is the depths of dispair (Nov 2008) and 10 is the height of euphoric, undisciplined risk taking (1999). In Nov 2008 there was no future return that could attract investment – and in 1999 very little evidence of future return was demanded. Using this lens, I think we can all agree that we are somewhere north of 5 but definitely not a 10. We can have debates about where we are between 6 and 9 – but no doubt that investors and employees (who are investing their human capital into a single stock portfolio) would be well served to pay attention to where we are on this continuum.

    Reply
    • John Power February 21, 2014

      @Brad – agreed – definitely not binary – more like the expanding/contracting/expanding Universe theory.

  4. Matt Covington January 28, 2014

    Bill,
    It is very rare that a start-up is profitable day 1, so you have to offset the risk by asking yourself, if I take this job can it benefit me in the future. I’m betting on me in that case, not the company, and if that company is the next “X”, I’ve got a tremendous return and if it’s part of the 95% that fail, I better have some marketable skills and a network at the end of the day.

    Reply
  5. Valerie Weise January 28, 2014

    That’s the nature of the beast with VC — they’re always looking for the next big fad, and fads are cyclical. They’re inherently prone to market bubbles. Investment in some tried and true industries (like mine, a transportation concept) helps balance a VC’s risk. Keep an eye on trends, and take advantage when possible. But a portfolio can be balanced by considering un-trendy opportunities as long as those entrepreneurs’ markets and profit projections are solid.

    Reply
  6. Sramana Mitra January 28, 2014

    I think the reason the market feels frothy right now is that we’ve seen a bunch of valuation-without-revenue exits at very large valuations. This is impacting both investors’ and entrepreneurs’ thinking, especially the younger ones in the latter category who have not seen cycles such as the dotcom bust.

    Working for a company that is not profitable is one thing. Working for a company that has no business model is quite another. Currently, employees are willing to do the latter, which says, the risk tolerance is really high!

    Reply
  7. Neil Hutson January 28, 2014

    I think that we are in a very different spot this time around. Many of the startup’s have real business models behind them and they are growing. There will always be a process of natural selection, and the cream will remain.

    In the late 90’s, people were putting money into anything and everything, without any real business model and chance to drive revenue.

    Reply
  8. Chris Calder January 29, 2014

    Interesting take Bill – I hadn’t considered the role employees play in indicating (or helping to create!) a bubble.

    I’ve heard that the best strategy when markets become frothy is to stay aware of rising valuations and invest in companies with (hopefully) staying power – whether that’s through profitability or the ability to raise more money. What are your thoughts?

    Reply
  9. Matt Blodgett February 2, 2014

    Another perspective: a bubble’s collapse creates great opportunities as well.

    Bubbles are evidence of great progress: automobiles, electricity, Internet. Collective exuberance is more often right (Internet) than wrong (tulips).

    This is much more thoughtfully stated by Bill Janeway in a recent piece, linked below.

    http://www.foreignaffairs.com/articles/139871/william-h-janeway/the-next-economic-bubble

    Reply
  10. Chris February 6, 2014

    Fear drives people to make irrational decisions as does greed. However, people tend to get scared more quickly than they get excited. The markets tend to reflect this as well. Look at Twitter’s stock today so far as an example. I am not saying the drop is or isn’t justified, I am just saying the price moves quicker to the downside on scary news vs. to the upside on good news. I think the bottom line in the end will be contingent upon whether or not the Venture Capitalists are allocating capital in a an efficient manner. As a whole are these investments going to have an IRR greater than the risk free rate? I think currently yes, however if too much money flows into the system the returns might not work out.

    One caveat, there is however the risk of the irrational price swings hurting everyone…Soros’s reflexivity principles apply here. I guess we’ll just have to wait and see.

    Reply

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