Janet Yellen, the head of the Federal Reserve, has warned that social-media firms are overvalued. Her words of caution have been largely ignored, just as her predecessor Alan Greenspan was disregarded when he urged caution over telecom investments in 1999. Greenspan said, “But how do we know when irrational exuberance has unduly escalated asset values . . .?”
It seems that we don’t know until some market crash arrives. Overinvestment, in social media today, as it occurred in telecommunications in the late 1990s, however, eventually has the effect of depressing prices and profits for everyone participating in their sector of the industry. As Lisa Endlich wrote in Optical Illusions, “This is a particularly insidious and dangerous condition, and one that is immune to the Fed’s traditional medicines. The usual mechanisms of stimulating growth do not work under these conditions. No reduction in interest rates, no matter how substantial, will induce investors to return to an industry already drowning in excess capacity, and by extensions, insufficient demand.”
During these exuberant times when capital is being thrown at an industry the Federal Reserve is usually forced into making a decision. Either such investment leads to a sustainable rise in the rate of productivity growth, thus altering the long-term growth rate of the economy, which is a good thing, or it leads to over-investment and over-capacity as the telecom industry experienced in early 2000 with millions of miles of unused optical fiber (dark fiber) in the ground, which is a bad thing.
Today, the Federal Reserve is wrestling with the same issue around emergent young companies where good corporate governance is not a priority. The Economist wrote, “Shares in Alibaba, a Chinese [I]nternet giant that listed in New York in September using a Byzantine legal structure, have risen by 58%. Executives at startups, such as Uber, a taxi-hailing service, exhibit a mighty hubris.”
But maybe this is not such a big problem today . . . Observations of financial excess are generally invisible for two reasons. First, big tech firms such as Amazon and Google, which are spending massive sums on warehouses, offices, people, machinery and buying other firms, are using their own cash flow to do so. Second, it is the booming private markets where venture capital firms and other interested parties assume positions in young technology companies. If a firm fails, the shareholders or VCs lose out, not the general public so much.
By the end of 1999, Allan Greenspan and the Fed’s policy decisions supported an overinvestment boom unparalleled in history. If history is repeating itself today, then Janet Yellen and the Fed’s current policies may be shielded by the concentrated wealth of the firms and investors that finance any potential failing startups or mismanaged larger public companies. Any downturn, as The Economist reports, “. . . would be confined to private markets and a few large firms with strong balance-sheets.”
For the average small investor in the stock market, there seems little to worry about. Today’s startups and tech giants, just as they did in the late 1990s, create jobs and invest in new technologies and infrastructure that boost long-term economic growth. And with little fear of another “bust” affecting the average investor, Silicon Valley can keep its reputation for “vanity, bubbles, genius and excess” unscathed.
Could this be a more benevolent Silicon Valley in 2015? Time will tell. In the meantime, under-utilized dark fiber assets are becoming more valuable.
Cheap capital is fueling much spending in order for startups to capture market share growth. It’s a déjà vu moment as this situation existed in 1999 and early 2000, right before the dot.com bust . . .
“Right now money is certainly chasing growth. It’s not totally blind growth. [Startups] do care about unit math and retention, but growth is certainly the most important factor.”
--Brian O’Malley, partner at VC firm Accel, WSJ, December 2014
"Are we creating a generation of companies whose behavior has been poisoned by easy capital?"
--Peter Fenton, partner at Benchmark, WSJ, December 2014
Record heights were achieved in 2014 for tech startup valuations. The worth of startups grew at incredible rates last year, even when compared with the “irrational exuberance” of the late 1990s.
Venture capitalists, big banks, and mutual funds assigned valuations of at least $1 billion on more than 40 startups around the world in 2014, a metric more than double that of 2013.
The Wall Street Journal reported on December 30, 2014, “Adjusted for inflation, the current roster of 70 'billion dollar' startups globally is nearly twice as large as the number during the boom years 1999 and 2000."
It is the participation of big banks and mutual funds that are bidding up startup valuations. Venture capitalists raised more than $32 billion in 2014, a total well below the inflation-adjusted $121 billion raised in 2000, according to Venture-Source. The concern expressed by many investment observers is that money is being thrown at startups “based on momentum instead of fundamentals.”