Boom economics

In a Facebook discussion of my previous post comparing the current web boom with the last one, I observed that one difference between the two was that the current boom takes place in a generally weak economy, contrary to the last one. Which creates troubling incentives: a lot of rich people have a lot of cash and very few places to put it. Dumb money is an attractive nuisance.

A friend with proper economics training had a striking reply.

You’ve hit the nail on the head, JK. There’s a lot of big, but dumb money out there. Thanks to the global “easy money” policy that's currently in effect, investors can’t get interest income, so they’ve thrown caution to the wind in order to chase equity returns. Clearly, the markets reflect that, but a lot of the big, dumb money is also going to VCs, private equity and hedge funds, and the investors have no idea where that money ends up. A lot of it is chasing presumed IPO candidates, even if their business propositions are flimsy. (To be considered an IPO candidate, no one really wants to mess around with a company unless it can get to a ^$1 billion market cap, even if there’s only a 5% chance of that happening, with the other 95% chance being failure. So, it’s an all or nothing proposition.) This is very similar to the dot-com era, and the business models are getting more flimsy all the time. In contrast, the businesses that are having trouble getting new or increased funding are traditional businesses that have more solid prospects, but which will never reach the size necessary to IPO. Their odds of actually providing sustained employment to, say, 100-500 people are much better than the typical VC-backed firm, but that’s not what the agents of the big, dumb money care about, as such companies do debt financing, which yields pitiful returns these days compared to what people think they can get in equity investments. The trouble is, the current equity returns are illusory, as we have the greater fool theory in full effect right now.

Conventional metrics indicate that we're in a frothy market. One that I like to keep an eye on is the (Robert) Schiller PE10. It calculates the P/E ratio of the S&P 500 using the average of long-term (10-year), inflation-adjusted earnings as the denominator. This helps to see what’s going on more clearly, as short-term noise is smoothed out. The current PE10 is over 25, which is well above a more desirable level of about 15. Sure, we can continue to go up from here, as we did in 1999-2000, be things have never gone well longer term when we’ve reached this level.