Vicious Circle?
Nasdaq, IPOs and The Real Economy
Almost two centuries ago, Alexis de Tocqueville observed that “ [America’s] commercial affairs are affected by such various and complex causes that it is impossible to foresee what difficulties may arise.” He also noted that “commercial panics are an endemic disease...it cannot be cured, because it does not originate in accidental circumstances, but in the temperament of democratic nations.” De Tocqueville knew back then two basic facts about economics that remain true today: that economic forecasting is at best hazardous and that all good times eventually come to an end.
Consensus: No
Panic
While the U.S. economy is not in a panic and may not be for quite some time, it seems poised for a period of slower economic growth in the months ahead. After nine years of record economic expansion, the economic signals calling for a slowdown in growth, even a recession, are increasing. The confluence of a rise in energy prices, the lagged effects of monetary tightening by the Federal Reserve Board, and the strong foreign exchange value of the dollar, particularly against the Euro, are causing many economists to revise their forecasts downward.
A recent report by the U.S. Commerce Department on the gross domestic product, the nation’s total output of goods and services, underscored the effects of the Federal Reserve Board’s policy of higher interest rates designed to slow the economy. In the third quarter of 2000, the U.S. economy grew at an annual rate of 2.4 percent, the slowest pace in nearly four years. The good news was that the slower economic growth was having a dampening effect on inflation. An inflation gauge tied to the gross domestic product showed prices rising at an annual rate of just 1.9 percent in the third quarter, the year’s best showing. The bad news was that income and job growth are likely to slow in the near future. The slowdown in economic growth stemmed from several factors, but particularly was apparent in such interest rate-sensitive sectors such as housing, construction, and business investment. Consumer spending, which accounts for two-thirds of total U.S. economic activity still increased, but at a markedly slower rate than at the beginning of the year. Although holiday shopping is strong, there are a growing number of reports that consumers are becoming more skittish in their purchases. Some economists have begun to wonder whether the Federal Reserve has overdone its credit tightening and could unwittingly push the nation into a recession.
The Blue Chip Economic Indicators, a consensus of top economists in the U.S., still forecasts economic growth to be 5.2 percent in 2000 and 3.5 percent in 2001. Privately, however, many economists are revisiting their assumptions. Furthermore, depending on two hard-to-quantify links between the economy and the stock market, the slowdown could well turn out to be sharper than is now anticipated.
The Wealth Effect
There is little doubt that the growth in the economy has been fueled, at least partly, by America’s soaring stock market. The Standard and Poors 500 Composite Index has enjoyed five consecutive years of double-digit gains, boosting many Americans’ net worth to unprecedented levels. NASDAQ has risen even faster. The soaring equity market provided cash to fledging dot.com and other high-technology companies. Many of these new companies, with no track record, went public and young millionaires literally were minted overnight. The number of initial public offerings (IPOs) in the U.S. rocketed upward.
By far, the biggest story in 1999 was the rise of the Internet. Of 510 IPOs completed in that year, half were Internet-related companies, whose stock prices soared to unbelievable heights. The NASDAQ index was taken to record highs by the web-fueled economy. The ways that institutions and the public valued these high-priced new issues left some people skeptical, but many ignored the warning signs. The standard metrics of stock valuation, earnings per share and cash flow were thrown out the window. The rise of the day trader and the emergence in popularity of on-line trading created a frenetic demand for the IPO market. Stories were heard about housewives, barbers, plumbers, and high-school students playing with the new high-tech stocks, trading them on-line and making lots of money. We never heard about the losers. The danger, of course, is that frenzies never last very long.
Buoyed by an over zealousness that often accompanies speculative surges, America’s love affair with the stock market grew. Almost 50 percent of all U.S. households became stockowners, either in the form of mutual funds, pension plans, or by individual holdings. During the fourth quarter of 1999, for example, the real net worth of U.S. households rose by $3.6 trillion, an increase of almost 9 percent from the previous quarter, resulting almost entirely from surging stock prices during that time. By mid-April, however, the plunge in NASDAQ erased nearly $2 trillion of American’s net worth. Since then, the NASDAQ has continued to fall, erasing even more. The market capitalization of Internet stocks went from almost nothing in 1995 to $1.4 trillion earlier in 2000 and is now less than half that amount.
The wealth effect generated by the stock market has been unprecedented. Historical comparisons are useful. Between 1960 and 1990, real U.S. household net worth rose at an average annual rate of 3.5 percent, which is very good by historical and international standards. From 1990 to 1998, the annual rate of increase of U.S. wealth rose an astounding 6 percent a year. In the 1970s, the increase in household wealth was $2 trillion. In 1999 alone, by comparison, the increase in household net worth was $5.2 trillion! Unfortunately, the extraordinary pace of rapid wealth accumulation, fueled by IPOs and the bull market over the past several years, will not continue. Indeed, some of it has already been reversed and economists calculate that the typical household portfolio has fallen approximately 10 percent from their recent highs.
The question now is whether the increased share of equities on household balance sheets have made U.S. households more vulnerable to movements in the financial markets and consumer spending more responsive to financial events. Traditional models of the relationship between wealth and spending assume that consumers increase their annual spending by about 4 cents for every dollar of additional equity wealth. More recent studies, which factor in the technology sector, suggest that the same percentage change in stock prices now have a bigger impact. The studies find that a sustained 10 percent increase in the stock market caused a 0.3 percent increase in consumer spending in the late 1980s, a 0.5 percent hike in the mid-1990s, and a 1.1 percent change today. The remarkable factor for the U.S. economy has been the leap in stock ownership. The 1998 Federal Reserve Board’s Survey of Consumer Finances found that the ownership rate of stocks has grown over 17 percentage points since 1989. In 1998, almost 49 percent of U.S. families owned some form of stock equity, and the median value of their stock holdings had risen over 62 percent from 1989.
An intriguing theory, advanced by Stephen Roach, of Morgan Stanley Dean Witter, is that the wealth effect might become more asymmetrical, with the stock market hurting the economy more when it drops than it helps it when it rose. The reason would be that, with baby boomers increasingly close to retirement, “a large portion of the US population is more dependent than ever on wealth preservation to support lifestyles in the not-so-distant future.” In addition, the spectacular growth of pension schemes funded on a defined contribution, rather than on a defined benefit basis, implies active management of household portfolios and the need to cushion investment shocks through tactical adjustments of saving and spending. “A sharp correction in the stock market in this context could hurt the economy a lot more than a traditional wealth-effect calculation might otherwise imply.”
Clearly, the turmoil in the equity markets will affect most Americans. Because higher levels of consumer spending raise stock prices even further, which stimulates the wealth effect even more, softer consumer confidence and spending are bound to trigger a negative wealth effect. Consumer expectations, measured by the Conference Board, have dropped to their lowest in two years. Furthermore, the sharp value in the rise of assets over the past several years hides another lurking danger. Household borrowing and debt are up. In 1999, household interest payments stood at 13.5 percent of disposable income, the highest level in a decade. High levels of debt, the proliferation of easy credit, and the willingness of households to spend to their limit are ominous signs. Data from previous downturns show that the first items to be hit in an economic slowdown are the discretionary spending items, such as purchases of luxury cars and expensive jewelry. Economists clearly will be watching spending in these areas. Next to be affected usually is the real estate market, where demand for high-priced condos and coops slows down. Already some Manhattan real estate brokers are reporting some softness in this market.
A Tech Effect?
The hallmark of the U.S. economy over the last decade has been strong economic growth without serious inflation. The inflationary demon has been held at bay because of the rise of the so-called “new economy.” The new economy, built around personal computers, the Internet, smart software, and the booming telecommunications industry, has delivered economic growth characterized by new ways of doing business revolving around high levels of productivity. Older, more established companies soon have been forced to jump on board the Internet revolution or risk being left behind. The economic gains produced by the new economy are no illusion. Gross domestic product grew for nine straight years and the U.S. economy, adjusted for inflation, reached an astounding $9.4 trillion by the third quarter of 2000.
There is little doubt that the contribution of the high-tech economy to this recent growth has been considerable. A group at the University of Texas reports that e-commerce companies saw revenues surge 72 percent to $171.5 billion in 1999, while total net-related revenues increased 62 percent to $524 billion. The Internet economy supported 2.5 million jobs in that same year – an increase of 650,000 over 1998. These activities were almost nonexistent only a few years ago. By the ISI Group’s estimate, the high-tech economy has been contributing 70 percent of the increase in overall industrial production, over the past year. The Commerce Department estimates that the information technology industry (computers, software and telecommunication equipment) has fueled 30 percent of the economy’s recent growth and a significant portion of the overall job growth in the United States.
The $45 billion raised by venture capital funds in 1999 represent almost five times the amount raised as recently as 1995 – four years earlier. And IPOs provided even more financing capital, by allowing venture capitalists to re-liquefy their portfolios by selling shares on the stock market – freeing more capital for new investments. The year 1999 was a record year for IPOs , with 510 new offerings raising $69.9 billion. The previous year, 1998, experienced 363 deals, amounting to $37.5 billion. Thanks to the access to easy capital at an earlier stage than ever before – and well before the prospect of profitability appeared on the horizon – many fledgling technology companies were able to spend huge sums on infrastructure, staffing and marketing/advertising expenses. In the process, of course, they provided a sudden, huge boost to employment and spending in the economy.
The hype that once surrounded Internet ventures is fading fast, however. In its place is increased investor scrutiny of profit potential, business plans, and timeliness. Former new-economy companies now are laying off workers and trying to find capital in an increasingly hostile environment. Outplacement company Challenger and Gray recently reported that dot.com companies cut staff by almost 8,800 jobs last November, up 55 percent from the previous month. This represented the sixth consecutive month of layoffs for the industry. Since December 1999, when Challenger and Gray began tracking dot.com companies, over 31,000 job cuts have been announced across the nation. Hardest hit by the layoffs have been the service sector of the industry, including consulting and financial companies, which accounted for 40 percent of the layoffs. John Challenger, the firm’s chief executive officer, clearly blamed NASDAQ\'s correction for the ongoing shakeout in the industry. More than one-third of the companies affected by the layoffs were in California, with 11 percent in New York.
Problems have been growing for those companies that can no longer get public funding. In the last several months, the backlog of IPOs in all sectors has dropped substantially. Many companies have been forced to take a lower offering price, sell themselves to the highest bidder, or close. At this time, the primary trend weakening the IPO market is investor cynicism regarding future profits and dot.com business plans. Many startups that have postponed their offerings for an extended amount of time are in danger of further jeopardizing already waning investor interest. Meanwhile, concerns have surfaced about the financial condition of large telecommunication companies that have embarked onto huge capital spending programs on the strength of Internet-related demand. This may soon create serious problems for the multitude of equipment suppliers to that industry, most of which have also spent and hired lavishly in the last few years. The day of the “millionaire before 25” may be long gone, and the economy may soon feel withdrawal symptoms from the disappearance of a significant stimulus that boosted it in the heydays of the Internet/Telecom boom.
While we are clearly seeing a pause in the momentum of the new economy, it would be far fetched to believe that we are seeing the death of the Internet or new-technology companies in general. The Internet is here to stay; it is a new medium and one that promises huge rewards to those who learn how to use it correctly. Nonetheless, the overly optimistic entrepreneurial spirit and the easy cash culture that recently have been part of the world of IPOs and dot.com startups are being curtailed. So, too, will America’s love affair with high-technology growth companies be scaled back -- at least in the short term. Information technology companies on the Web are not going to produce the profits that were once expected of them and investors are no longer deluded into believing that they will.
In the next business cycle, the economy will emerge stronger, governed, hopefully, less by the laws of rampant speculation and more by the traditional laws of supply and demand. To that degree, the economy and society will be better off. As de Tocqueville observed: “In the United States, the greatest undertakings and speculations are executed without difficulty, because the whole population are engaged in productive industry, and because the poor as well as the most opulent members of the commonwealth are ready to combine their efforts to these purposes.”
Norman Gertner
December 2000
Note about the author:
The information contained herein has been obtained from sources believed reliable, but is not necessarily complete and cannot be guaranteed. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. Affiliates of Tocqueville Asset Management L.P. may, in the last three years, have been manager or co-manager in a public offering of securities of issuers discussed in this publication.
New York, NY 10019