In early August, startup investor George Zachary gave a presentation to his partners at Charles River Ventures, with data pointing to one conclusion: We’re in a bubble.
Only his data had nothing to do with inflated valuations among venture-backed companies, the number of 20-year-old college dropouts raising millions of dollars or sky-high real estate prices in Silicon Valley. It was all about the public markets, specifically the price of U.S. equities.
For example, he showed a ratio favored by investor Warren Buffett, which gives the value of U.S. stocks relative to gross domestic product. Looking at the Wilshire 5000, the broadest measure of U.S. equities, versus economic growth, the market is more expensive than it was at the 2007 peak but still cheaper than the top in 2000. The average price-to-earnings ratio of the market over the past 10 years, meanwhile, has rarely been higher.
Even after the past month’s stock market drop, the S&P 500 is up 33 percent in the last two years.
“We’re in an inflating bubble, not a bursting bubble,” Zachary said in an interview recently at his office in Menlo Park, California.
One slide he presented in August had a trend line that showed that the stock market was rising at almost the exact rate as the government’s purchase of mortgage-backed securities. So, if the Federal Reserve takes away the punch bowl, look out below. Other problematic indicators include record low rates on junk bonds (there’s since been a selloff, lifting rates), high margin debt and big time bank consolidation, making the “too big to fail problem worse,” he said.
Why does Zachary, whose early investments include Twitter, Yammer and watchmaker Pebble, care so much about public stocks, when he’s often backing companies that have hardly started generating revenue? Because if the value of big, public tech companies drops, they’re less inclined to pay premium prices for emerging start-ups, and it becomes much harder for more mature but still money-losing companies to hold initial public offerings. Everything trickles down.
“Most people in Silicon Valley don’t want to talk about it,” Zachary said.
The venture capitalist had a strategic reason for invoking bubble talk with his partners while at the off-site event in Aspen, Colorado, this summer. With companies like Uber, Airbnb and Snapchat valued in the $10 billion stratosphere and with many more start-ups choosing to raise private rounds at billion-dollar-plus valuations, there’s a temptation among venture capitalists to go big.
A month before the meeting, CRV raised its 16th fund, bringing in close to $400 million. As the firm starts investing that money, “Let’s not do later-stage deals while everyone else is,” Zachary said. Instead, he was urging his partners to stick to early-stage rounds, where even though valuations are high, the check sizes are manageable.
Zachary is careful not to predict a crash. At the time, he called for a near-term market correction of 5 to 20 percent, but said he isn’t seeing clear indications of a market top. Rather, the data just suggests that there’s a lot of froth, and history tells us that rallies don’t last forever.
“We’re at the back end of one of the longest-running bull markets in history,” he said.
Image Credit: CC by Jay Morgan