Last year, I ended my Outlook 2008 with the following sentences: “As we head into 2008 my best advice to entrepreneurs is to be flexible and creative. This is going to be a very interesting and probably volatile year.” Talk about understatement. Well, as 2008 draws to a close, I can safely say that one thing is certain: if you scare the stuffing out of consumers and businesses, they will stop spending money. That’s pretty much where the certainty appears to end. As we head into 2009, uncertainty is the order of the day. That being said, there are some data points out there which I will try to connect to provide some guideposts for the coming year.
The US Economy Will Improve Throughout 2009
Those who regularly read this blog know that for most of 2008 I have had a contrarian view of the US economy, at least in comparison to how it has been portrayed by the mainstream media. At the risk of continuing to appear to rail against conventional wisdom, I believe that a large portion of the continuing economic dislocation has been caused by emotional reactions to a large and frightening financial credit crunch that most people do not understand but has now passed. At its most basic, the original financial crisis was caused in large part by fear amongst bankers (a group that should have known better) which was amplified through subsequent reactions and media coverage. Unfortunately, understanding the nuances of the current financial markets and their effect on the economy requires specialized knowledge and an appreciation of interdependencies that few people really understand and fewer can easily explain.
What is easier for the media to report and people to internalize has been the emotion surrounding the “crisis” and the economic data reported in the aftermath, which demonstrates, not surprisingly, that when people are scared within an inch of their lives they tend not to spend money. That is the only thing the data really shows, but it has created a reinforcing news cycle, where bad news creates fear, which creates scary data, which creates bad news… and so forth.
I do not mean to suggest that the economy is currently uniformly strong – it is not — but rather to make two large points:
- The most dire news predictions regarding the next steps in the current financial crisis have not been accurate – notwithstanding almost a uniform portrayal in the media of its inevitability, the financial world has not ended, and the US has not slid into a Great Depression (or anything close to it).
- Because a large portion of the current economic downturn has been caused by a large and sudden shift from consumption to savings (fed by a cycle of fear), there is a strong possibility that a significant portion of the down turn will be reversed quickly as consumers and businesses stop being frightened and start to spend money again.
This suggests the following developments that will play out over 2009 and result over all in economic growth and opportunities for investors and entrepreneurs.
Swan Hunting Will Become Less Uniform
If I had a dollar for every news article or blog entry over the last six months that stated “yes, it’s bad, but it’s not as bad as the Great Depression – yet”, I would be able to reverse my stock market losses. Well, the economy isn’t even close to “as bad as the Great Depression” for many reasons. Moreover, it’s not going to get that bad, largely because of the many positive and significant differences in the financial world today when compared to the 1930s; some of which have been put in place in the last six months, and some of which have been in place for decades. However, the larger point is that it’s a meaningless comparison to look backwards for what is going to happen next when you are making predictions in the aftermath of a large systemic shock.
Here’s why. People tend to give disproportionate weight to past events when predicting the future. Nick Taleb, in his book “The Black Swan”, provides a good analysis of this phenomenon. The example he uses is that if you had never seen a black swan, you would assume with 100% certainty that every swan you will ever see will be white. But if you see a black swan, your expectation of the next swan being black will be dramatically changed – even if the black swan you saw was truly the only black swan that ever lived. You would expect to see a black swan, or many black swans, sooner rather than later. And, although your expectation for seeing a black swan in the future would lessen over time if you never saw another one, it would lessen only gradually. Further, if the shock of seeing the black swan was great – and accordingly it left a deep emotional impression on you — you would expect to see many, many more black swans, quite literally, a black swan around every corner.
One way to think about an economy is that it is a multitude of concurrent predictions of future circumstances, based upon individuals making assumptions as to the probability of future events. Examples of these predictions are the investment decisions we make, the job opportunities we seek, the money we spend at the Mall and the companies we decide to start. Businesses make similar predictions, as they decide to expand, hire employees, look for credit and seek investors. For many people and businesses, the credit crunch and stock market swoon in 2008 was a black swan, and they are acting predictably – expecting to see a black swan around every corner. If you have heard a friend say to you, “what’s going to go wrong next?” they are telling you that they are swan hunting. More than anything else, 2009 is going to be shaped by the moment when individuals and businesses stop swan hunting and start to concentrate on the more mundane aspects of their individual circumstances.
Many Asset Values Will Continue to Decline, but Not Uniformly
One of the hallmarks of the current economy is the re-pricing that is occurring in the value of assets that were purchased by easy credit. As that credit has been removed from the economy, the assets that were acquired by this credit are becoming less valuable. Think of it as a balloon that depends upon a constant influx of air to maintain its shape and you get the idea – without new air, the balloon shrinks. Over the last six months, asset values across the entire economy, whether it is holiday homes in Palm Springs, leveraged buyouts in Texas or stock holdings on NASDAQ, have declined in large part because people and businesses have assumed that the lessening of credit will affect all assets uniformly.
What will become clear as people stop swan hunting is that certain assets have more intrinsic value, particularly when compared to other assets. For instance, the rate of decrease in the value of houses in Georgetown will likely slow, when compared to condominiums in Las Vegas, Nevada, because the intrinsic value of these properties – their utility to owners — will diverge. In other words, the value of an asset will again be determined not just by the ease upon which it can be acquired, but its ultimate utility to the user. Call it a return to fundamentals. Not surprisingly, people assign more value to things that they need. Or, put another way, when resources are finite, people tend to choose to obtain and consume the things that they want most. The inherent value of assets that people need will decline less in value, on both a relative and absolute basis, and may in fact increase as the year progresses.
Debt Capacity is Going to be the Major Differentiator
For many years what mattered in the US economy was how much you “owned,” with the “much” being an accumulation of assets, whether physical or financial. The more someone owned, the wealthier she felt. This calculation didn’t really include a calculation of the overall indebtedness required to obtain these assets, since credit was inexpensive and plentiful. This is no longer the case: for 2009 and beyond, a much greater differentiator between the haves and have nots will be debt capacity and creditworthiness. True wealth, or the ability to maintain or expand a current standard of living, will be determined for many by their ability to obtain and service their indebtedness.
The same way that the excessive availability of credit over the last few years allowed consumers, investors and businesses to live beyond their current level of wealth, the current absence of easy credit will disproportionately punish those who incurred that “easy” debt. Debt is unforgiving – you have to pay it back whether or not the asset you purchased has devalued. Putting aside glib media portrayals to the contrary – jingle mail is not an option for most home owners – debt is going to weigh down the spending of many households and businesses for 2009 and beyond. Their consumption and investment spending will be constrained by their debt service requirements. Additionally, they will in many cases seek, or be forced, to dispose of assets to reduce their debt load. The decrease in consumption and investment by the debt-encumbered has been widely reported. Without question these unfortunate households and businesses will not spend and invest as they had been and their debt challenges will be a drag on overall economic performance.
However, what is not appreciated is that many other consumers and businesses are not overwhelmed by indebtedness, and they will be able to service their obligations. Additionally, in many cases they will have the capacity to take on new indebtedness. To those that are not over-indebted, 2009 will seem like the world is “on sale” as those with excessive debt dispose of assets to satisfy their financial obligations.
You can see this trend playing out in the accelerating percentage of homes being purchased in foreclosure and in capital finding its way into banks and US government securities. Money and wealth is still out there, and many of the “losses” that have been suffered in the financial markets are unrealized paper losses. As the search for the economic black swans fades, and as individuals realize that their own particular economic circumstances are not as bad as the general media coverage had made them presume, you will see increasing consumption and economic activity among the “have no debt” class. They will initially be quiet about it, but they will consume and invest in larger numbers and at higher levels as the year progresses.
The federal government will provide a large financial stimulus to the economy in the form of infrastructure investment. There is little debate about this. The debate is around the size of the stimulus and the other aspects to be included. Whatever the result of the debate between Congress and the Administration, the US government’s fiscal activities over the next two years are going to be very supportive of economic growth.
As a response to the financial crisis, governments and central banks have injected a large amount of liquidity (money) into the economy. A large amount of this liquidity is being held by non-governmental financial institutions, and they are currently being very conservative in how it its deployed. However, it should be remembered these institutions are profit making enterprises, and they only generate profits for their shareholders by lending and investing their capital. The manner in which the liquidity has been provided will not provide sufficient return opportunities in the absence of lending and investing activities. The pressure to lend and invest will become significantly greater as 2009 progresses, particularly as it becomes clearer that there will be money to be made by doing business with creditworthy consumers and businesses.
Making Money the Old Fashioned Way – Here Comes More Regulation
There is a generally held view that the financial crisis’ primary cause was financial engineering – creating illusory wealth though the sale of complex financial instruments rather than by providing a product or service. Whether it is the investment bankers that created mortgage backed securities, the suspected manipulation of oil prices by hedge funds, or the massive fraud of Bernie Madoff, there is now a prevailing general sentiment against “making money from money.”
Investment bankers, hedge fund managers, private equity investors and venture capital fund managers are going to find their operations more regulated and their compensation practices more closely scrutinized. Additionally, skepticism will cause investors to look more closely at the financial performance of their financial advisors and to demand greater transparency and accountability. Some financial managers will not survive this scrutiny and will go out of business. As this trend plays out over the coming year, and beyond, the process of aggregating capital for private company investment will be much more difficult. This will likely result in fewer pools of managed capital for private company investment.
I expect that a disproportionate portion of this backlash will be felt by hedge funds, since they are the least transparent. And the Bernie Madoff scandal has put a number of large hedge funds in a very bad light. However, it is very possible that venture capital funds, which are also aggregations of capital under financial management will face some scrutiny, or be subjected to at least some of the new regulations that will be directed towards the financial services industry.
Venture Capital will be Hard to Find
In addition to the foregoing trend which may adversely affect the amount of available venture capital, the venture capital industry is also wrestling with difficulties of its own. As I have mentioned in recent blog entries, venture capital is in many cases not now properly configured for emerging company investing. These trends – lack of large exit opportunities, greater capital efficiency of emerging companies and maturity of currently targeted investment sectors – were exacerbated, but not created by, 2008’s financial crisis. Accordingly, venture capital as an industry will continue to go through change, even as the overall economy improves. New models for technology investing will undoubtedly emerge, but in the meantime, venture capital is going to be harder to find for emerging businesses, particularly cash flow negative emerging businesses.
Emerging Company Investing Will Become More Attractive
Interestingly enough, while the availability of venture capital may decrease, the opportunities from emerging company investing will improve. In a world where wealth will have to be created by satisfying compelling needs, rather than by merely applying easy credit, businesses that can create new markets or satisfy a need become more valuable. Entrepreneur established businesses are a primary means for new value creation and technology businesses have the additional attribute of creating rapidly growing businesses by satisfying previously unmet needs or satisfying existing needs much more efficiently. In a world where a premium will be placed on businesses that establish a direct connection between the creation of a product or service and value creation, rather than financial alchemy, technology investing, with its almost direct correlation between capital investment and idea promulgation, will become more desirable.
Government Policy Will Favor Small Business
The Obama Administration will face a large amount of pressure to adopt government economic policies that provide for lasting changes in employment and industrial development. Statistically, the majority of new high technology jobs and innovations come from small and emerging businesses. Additionally, there is strong support in Washington for applying technology in areas such as energy conservation and creation, health care, and defense. Coupled with a shortfall in private capital to finance innovation, the Obama Administration is very likely to adopt policies to foster small business creation and technology development. What is less clear is whether it will adopt policies to encourage capital investment in emerging technology businesses to make up for the likely short fall in venture capital. More likely are changes in tax laws or eligibility for SBA loans or SBIRs for venture backed companies, since these changes will not require specific dollar authorizations at a time of large Federal budget deficits.
The upcoming year is going to provide tangible opportunities for entrepreneurs who create businesses that create something valuable, and for investors and other financial sources that are interested in benefitting from their activities. Entrepreneurs that are willing to start or expand businesses during the year ahead will be rewarded if their businesses create value. Moreover, by being willing and able to act as entrepreneurs during a time when many will go with conventional wisdom and stay on the sidelines, the value creating entrepreneur will be disproportionately rewarded. It is often suggested that starting a business during an economic down turn is the best time to start a business – because of the depth of negative emotion and confusion that currently surrounds the economy entrepreneurs that act now will be making a particularly strong statement – to customers, investors and other stakeholders.
The environment for emerging company entrepreneurship will also benefit from governmental activity. Although media focus has been on the likely size and scope of upcoming economic stimulus packages, the Obama Administration has quietly been preparing initiatives to support emerging businesses, including health care reform. It is also going to have a more favorable bias towards scientific funding, and the government being a consumer of a wider range of emerging technologies.
The largest message to take away by all is that the upcoming year will reward those that look at the world as it is and not those that spend their time swan hunting. The economic story is more complex and more promising than currently portrayed, and for those that put away their swan hunting guns and get to work 2009 will be surprisingly rewarding.