POP! or KABOOM!
How will the Southland Fare if the Economy Turns Sour?
by Matt Welch
The Zone News
People who live in Southern California’s foothills, enjoying the views from such fresh-air communities as Glendora, Sierra Madre and La Canada Flintridge, are known for not being too concerned that the mountains might fall on their houses. Yet the San Gabriel range is one of the highest, steepest, youngest and driest on the planet, and when brushfires rip through the hillsides, and then heavy rain pounds the bald slopes, two-story walls of boulders and muck dislodge and hurtle downhill, crushing cars like cockroaches and tossing houses around like cardboard boxes. Not a decade goes by without hundreds of homes being destroyed by mudslides, fires or earthquakes, yet local residents will tell you with a straight face that there is no danger. “I have no intention of leaving the foothills,” Caltech history professor Peter Fay told writer John McPhee, in his 1989 book The Control of Nature. “The views are so marvelous. The level of concern is quite low.... Part of my house was destroyed in 1969, but I am confident it won’t happen again.”
What might be called “Foothill Mentality” has spread from the northeast San Fernando Valley to the far corners of the United States economy like a big, goofy virus. After 108 consecutive months of growth, during which the Dow Jones industrial average has tripled, NASDAQ grew tenfold, unemployment fell from 7 percent to 4 percent and the Internet has gone from an obscure academic tool to revolutionary global wonder, Americans have forgotten the recessionary brushfires of seasons past and are borrowing, spending and investing as if market mudslides had been outlawed.
Government planners have let the good times rosy their projections so much that Social Security and Medicare are now considered flush (just three years after being declared unsustainable) and Los Angeles County has not fixed the structural problems in its social service systems that necessitated a nearly $1 billion federal bailout in 1995. Even the purportedly rational-minded economists and research analysts who usually counsel safety and sobriety have instead thrown more dead grass on the flames by suggesting that economic nature itself, with its cycles, booms and busts, has at long last been brought under man’s control.
Of course, as Hollywood and the venture capital industry have shown, Los Angeles-style optimism does have its benefits. Worry-free American consumers almost singlehandedly staved off a global recession after the 1997-98 Asian currency crisis by buying record numbers of cheap foreign goods, and the robust American stock market has unleashed terrific energy, innovation and productivity gains throughout the economy. Cautious and “prudent” consumers in Japan, on the other hand, can’t even be bribed with free money from their government to spend instead of save, dampening their prospects of clawing out of a long recession.
Still, history is littered with the bones of booming “new” economies whose go-go populaces thought they had managed to “beat the business cycle”—especially Wall Street in 1928 and Japan in 1989, the two time capsules that most resemble our own in terms of market expansion, social change and hubris. When those price bubbles finally burst, entire national economies deflated along with them, turning virtuous circles into vicious cycles and throwing millions into numbing despair. After each comedown, fin-de-boom behavior was condemned as frivolous and delusional, and events that seemed funny at the time were recast as dire warning signs that went unheeded.
Those signals are now everywhere you look: 30-year-olds talking seriously about retirement; new books called “Dow 100,000”; yacht sales up 143 percent since 1993; real estate prices inching above their 1989 pre-collapse highs (for more arguments pro and con about a possible stock crash, see side boxes). Even the most enthusiastic New Paradigm proponent would acknowledge that prices of Internet-related companies have now entered into a speculative phase—meaning investors can only “speculate” how much anything is worth, since all previous measures (such as price/earnings ratios) have been tossed out the window. For at least four years now, institutions have been openly investing based on the “Greater Fool” theory that even if a stock is ridiculously overpriced, some poor fool will gladly pay more for it later. Without true faith in the underlying businesses, nervous day traders and fund managers have darted in and out of tech stocks like kids trying to get one last cookie out of the jar while Mom pulls into the driveway. Volatility has been wild (the NASDAQ has veered this year from 3711 in January, to 5132 in February, to 4717 by mid-March), creating the strong impression that any serious correction will hit the dot.com crowd first, and hardest.
This is the cloud that looms over Southern California’s emergent Internet sector, even as it just now begins to take flight. Listen close, and you’ll hear the sound of teeth chattering.
“I don’t think it’s a matter of if something like that’s going to happen, it’s a matter of when it’s going to happen,” said Jonathan Funk, general partner of Media Technology Ventures, whose investments have included Sandpiper Networks and BizRate.com. “We’ve been expecting a major correction for the last two years, and along with many other people continue to be amazed at how buoyant the market has actually been.... There’s a lot of money that’s going to be lost, a lot of money that has been raised that will not be invested.”
“I think people have forgotten all the hard lessons we learned after 1989,” said Jack Kyser, chief economist of the Los Angeles County Economic Development Corp. “Right now these are pretty heady days; everybody’s going to work for dot.coms, they’re getting a lot of stock options, good salaries. Well I’d say put it away for a rainy day.”
“We haven’t repealed the business cycle,” said Brad Jones, managing director of the $1.3 billion VC fund Redpoint Ventures. “Especially up in the Silicon Valley, you see things getting excessive all over the place. Not just in the real estate market, but the cars people buy and the things they do reflect the view that things will never tighten up and that it’s easy to make money. That’s clearly not true. There’s going to be pullback.”
Guessing right about the next slump may mean the difference between survival and sudden death, and not just for short-sellers of tech stocks. So The Zone News asked dozens of local business leaders, professors and New Economy footsoldiers to assess which sectors and companies would be hit hardest, and what a post-mudslide Southland would look like. While the pessimism of some tech players may surprise, there remain plenty of others who say the view from the foothills looks just fine.
“I plan for success,” said Alan Gerson, president of Manhattan Beach-based Interactive Marketing Inc. “Not failure.”
Follow the (Free) Money
The first logical victims of a stock collapse would be any companies counting on the capital markets to keep their businesses afloat.
“If the stock market crashed today the biggest immediate hit would be companies in the IPO and the pre-IPO phase,” said Adam Shandrow, senior technical recruiter at the Orange County offices of temp-worker firm Manpower.
Last year, the U.S. launched 527 initial public offerings, raising $69 billion, up from 357 and $36 billion in 1998. A full 70 percent were Internet-related companies, and contrary to all precedence 73 percent had zero earnings, while 57 percent were younger than five years old. After seeing companies like Amazon.com turn early believers into millionaires, investors have proved willing to gamble on digital companies with no foreseeable profit. This historical anomaly is not likely to last, even without a big market downturn, said Kevin Davis, president of Arc: eConsultancy, a Santa Monica/New York-based New Media strategist.
“At the end of the day, we are of the firm belief that first-to-market is no longer a sustainable and defendable position, and that the focus must instead be placed on defining sustainable revenue-focused business models,” Davis said.
That sentiment could be terrible news for money-spurting publicly traded online retailers like local favorites Buy.com and eToys, and any other new Web company that hasn’t figured out how it will operate in the black.
Buy.com, an Internet superstore from Aliso Viejo that competes with Amazon, builds traffic by selling goods at a loss, and then covers the difference by slim ad revenue and generous dips at the public trough. The company lost $80 million in the first three quarters of 1999, and chewed through an eye-popping $65 million more in Q4, according to CBS Marketwatch. Considering that part of its $182 million IPO was used to pay off old debts, the company will likely require more cash within two years at the most, but it’s hard to imagine investors—even during the boom—giving more rope to a stock that has lost more than half its value in just its first five weeks (from an aftermarket Feb. 7 open of $27.50 to a March 16 close of $13.25).
Santa Monica’s eToys has burned investors even worse. After raising $191 million at $20 a share last May 19, the Toys R Us competitor began aftermarket trading at $78 ... and then experienced a dizzying free-fall to a historic low of $11.625 on March 16. With its 1999 losses at $2.5 million a month and growing, the company may soon need a new mountain of money. That would be hard enough in current conditions; a major market drop could end eToys as we know it.
“The companies that get harder to finance are the concept-type deals, because concept-deals usually require a lot of public cash,” said Redpoint’s Jones. “I think people will look for the safety of a company that’s got real revenues and clear market momentum.”
A NASDAQ contraction and IPO dry-out would put an immediate squeeze as well on the angel investors and venture capitalists who have bet on quick paydays, but that may be a good thing, according to MT Ventures’ Funk.
“People would realize there’s not a two-year window to a 50-times return on your money,” he said. “We think this is irrational...and the return of a more normal environment would be beneficial to everybody, not just us. All the money that’s being invested now will not make the rates of return that people who put in that money expect...and by natural selection they will be weeded out.”
But not everyone is looking forward to that Day of Reckoning.
Last year was the first that Southern California’s vaunted Hollywood-nurtured creative advantage was finally converted into hard venture capital. The region raked in $4.2 billion of the country’s $48.2 billion take in 1999, ranking it third among metropolitan areas behind the Silicon Valley and New England, according to Venture Economics. Closing the funding spigot now would strangle the baby in its crib, many fear.
“Certainly that scenario would not be good for Los Angeles,” Jones said. “We’ve got a good cadre of fairly young companies that look very good...and taking away the equity capital market from them would be really bad.”
If Digital Coast valuations fall to earth, the hotshot Internet/entertainment firms that are springing up everywhere may be snapped up by the same Hollywood behemoths they have been haunting.
“I think that there will be a move by traditional companies, especially in the media sector, to buy up or buy out many of the up-start online content plays that are now currently flourishing all over town,” Davis said. “In other words, instead of seeing the AOLs of the world buying the Time Warners, I think we will see the reverse.”
There is a sense even among pessimists that the cutting edge has moved decisively from Silicon Valley-style hardware, to Los Angeles’ more sexy software/content focus. Even if the bubble bursts, the thinking goes, the Internet will continue to grow, traditional companies such as Wal-Mart will continue ramping up their Web strategy, and high-speed connectivity will explode, creating strong incentive for Hollywood to digitize and repackage its mammoth copyright archive.
“Things will continue full-steam ahead as all of our parents start to get wired,” said Giles Goodhead, CEO of LA411.com, a Hollywood-based clearinghouse for film and video production vendors. “SoCal’s new VC pools will continue investing in local startups, and our area’s strong ties to entertainment brands will insulate us from bubble-pops anyway.”
“The Digital Revolution will continue to change the way we work and live,” Davis concurred. “Even if there is a massive correction and the IPO and stock options bubble burst, I believe e-commerce will continue to move full steam ahead, and we will simply see the wealth being distributed away from the speculative dot.com environment and move back towards traditional ‘bricks’ companies and institutions instead.”
This implies a fluid and flexible labor force. Nationwide, the number of workers placed through temporary firms has increased since the 1980s from 0.5 percent to 2.2 percent of the toal workforce (see side box), and the local entertainment industry has long fostered a culture of freelancers and independent contracting. Those with Web design and programming skills should be all right, said Sean Suhl, chief content officer for Los Angeles-based youth content site Thirsty.com.
“The kids out there working, you’re going to need them everywhere,” said Suhl, a 25-year-old veteran of three Internet startups. “There’s only so many CFOs you need that can bring a company to IPO.... The Web’s not going away, and it’s not getting any smaller.”
Still the tech labor market may soon find itself overextended. Since designers can expect $30,000 to $40,000 plus stock options fresh out of school, and programmers upwards of $70,000, students are rushing toward computer science degrees.
“It can’t last forever,” Suhl said. “When I went to college there were no classes in anything related to the Web, really.... Nowadays those classes are hugely subscribed, they’re very prominent, and just the sheer volumes of numbers five or six years from now theoretically will level out, you won’t have to pay people crazy salaries to get good technology talent.... As someone who hires people working the Web, I can’t wait; as someone who works in the Web, I really don’t ever want it to happen.”
People under age 28 who have only known economic bliss will likely have their buzzes harshed, Manpower’s Shandrow said, especially if large and liquid local public tech firms like Hughes, Raytheon and TRW have to trim their workforces to counteract declining share prices.
“It would be a wake-up call if that happens,” he said. “You have all these IT people coming out an exponential rate...an incredibly large working force that has just learned a new skill that it won’t be able to apply, which will be a major source of frustration.... It would obviously have a major social and economic impact.”
If the Internet startup space contracts, employees won’t be the only ones left holding the bag. Any service company that relies too heavily on dot.com billings is vulnerable. In the past two years especially, some public relations agencies, law firms and real estate companies have seen startups come to account for more than half of their business. That’s a sobering thought, considering that over-reliance on the federal government’s appetite for aerospace led to the loss of 142,000 local high-end jobs in the early 1990s, bursting California’s real estate bubble, deepening its version of the national recession and depleting the tax base.
“If you’re worrying, you’d have to worry about office building owners, especially on the West side, that have seen a lot of dot.coms moving in,” Kyser said.
The real estate gamble is so grave, in fact, that the head of the country’s largest real estate investment trust (REIT) believes it will contribute directly to a nasty recession.
“The economy is being buoyed by artificial means—IPO proceeds and dot.com craziness that I’m concerned will stop and stop sharply. And when it does, the impact on the economy will be much greater than everybody envisions,” Sam Zell, chairman of the board of Equity Office Properties Trust’s told the Los Angeles Business Journal earlier this year. “Intelligent real estate players are keenly aware of this risk and hopefully mixing their tenant bases so that they don’t have extreme exposure to dot.com world.... But it only takes one idiot to overbuild the market.”
In fact, real estate may be the million-pound gorilla that brings the entire economy down if the tech sector collapses.
The economy is being driven by consumer spending, which is being triggered by the “Wealth Effect” of the stock market, which in turn is being financed by exploding personal debt, much of which is being taken out using houses as collateral. Household debt has risen from 85 percent of personal income in 1992 to 103 percent last year, and “margin debt”—money borrowed (usually against a mortgage) to buy stocks—tripled over the past five years. On the corporate side, debts are growing at the fastest rate since the 1980s, largely to finance share buy-backs which artificially inflate stock prices. Even after eight years of boom, personal and business bankruptcies are at an all-time high, as are non-performing loans from banks; trends that mirror Japan’s behavior just before its economy tanked in 1989. As the famously gloomy Economist pointed out this January, “Debts can only be serviced from income; assets can pay the interest bill only if they are sold, and if lots of debtors are forced to sell at the same time, asset prices will plummet.”
Two-thirds of America’s $185 billion contribution to equity mutual funds last year went to two tech sector-loving firms, Vanguard and Janus. Meanwhile, the savings rate has hit all-time lows. If Internet stocks tank, investors and funds alike could be wiped out, forcing margin loans to be paid back overnight, probably through a firesale of assets. When real estate prices go up for 40 consecutive years, as they did here from 1949-1989 (as well as the last five years), home owners begin believing that increases are inevitable, and freely take loans out on an asset that could lose a third of its value in a heartbeat.
“I think people have forgotten. I think there’s a lot of memory loss, there’s a lot of shortsightedness. People plan one week ahead, maybe, and even corporations are thinking from quarter to quarter,” said Loyola Marymount Economics Professor James Devine. “Housing prices are up, and though all my neighbors are happy about that, I think in large part that’s a cyclical thing...and unfortunately some people have been using home equity loans to play on the stock market.”
If stocks and real estate prices fell, “it would be the Wealth Effect in reverse—people would probably start spending less, which would push the entire economy into recession,” Devine said. “That would be a shock to everyone. You’d see people really getting scared, and cutting back.”
Tiny savings rates in a boom tend to increase during a bust, deepening recessions a la modern Japan. Because more than 80 percent of America’s economy depends on domestic spending, reticence could be deadly. One obvious casualty would be the wealthy, and those who sell them goods.
“You’d see hits in high-end retail, people who sell BMWs and Mercedes...and in upper-end housing, especially in beachfront communities,” Kyser said.
“There will be some very rich people who will lose it because they were over-leveraged,” Devine said. “That’s why people jump out of buildings.”
But the true victims—as ever—would be the poor, especially those whose welfare payments are being cut off to kick them into the labor market. Lower-income wages only started recovering in 1996, which is when minority unemployment rates began tumbling down into the single digits. Joblessness is still higher than 10 percent in South Central Los Angeles communities such as Compton and Huntington Park, but they’ve been slashed from around 13.5 percent just five years ago. Many worry that these new workers will be the first ones to go.
“Usually the blame gets passed downwards, as long as the power is distributed the way it is,” Devine said.
A hit in consumer confidence would take a big bite out of mundane sectors like retail, said Joe Aro, executive director of the South Bay Economic Development Partnership. Supermarket and food sales soak up 21 percent of discretionary spending in the South Bay, while eating and drinking take 7 percent.
“If the economy goes south, one of the first things that would be hit would be restaurants,” Aro said. “The biggest effect, though, would be on supermarkets.”
If low-income jobs get cut, while immigration continues apace and welfare reform pushes more people into the labor market, the demand for social services such as health care is certain to go up. It wasn’t that long ago that these burdens triggered municipal bankruptcies and led in part to a wave of anti-immigration sentiment that culminated in Proposition 187.
“The county budget is still a little bit tight,” Kyser said. “People are acting like they think the good times are going to continue forever.”
The Clinton era has seen a return, on the federal, state and local levels, to balanced government budgets, creating a virtuous circle of reduced debt service and (in theory) interest rates. This has been made easier by ballooning tax receipts, but a slump will likely cut revenues while increasing entitlements, and suddenly the above-inflation cost increases of health care, education and Social Security
could look like a tremendous chance squandered in an irresponsible era.
Devine, for one, thinks the coming age could put an end to modest and incremental fiscal prudence of the 1990s.
“If the market collapses, I think it’s likely that we may see a shift toward New Deal-type policies. More Franklin Roosevelt, less Hooverism,” he said. “The view of the government right now is very similar to before the 1930s. During the Roosevelt years there was a shift toward Keynesianism...they may decide that ‘Hey it’s worth building a bunch of useless pyramids and bridges.’”
The last decade has also seen an amazing drop in crime, attributed to a combination of tough policing, better economic times and a smaller generation of young people (Gen X). Take the good economy away, add a bit of social unrest to the largest post-boomer generation (Gen Y), and that’s a recipe for a return to the bad old days.
Walter Russell Mead, the respected financial journalist, once laid out this scenario for the U.S. economy:
“Stock prices could easily fall by two thirds—that’s 6,000 points on the Dow—and it could take stocks a decade or more to recover. Many investors could be destroyed; mass liquidation of mutual funds in a panic could wipe out some funds entirely. The carnage among growth funds and such high-flying sectors as Internet and technology companies would be appalling.... Housing prices would plummet, leaving millions of highly leveraged home and apartment owners sitting on mortgages that are worth far more than their homes. Millions of people would lose their jobs, and tens of millions more would watch their wages drop as employers frantically tried to cut back their payrolls. Many cities would face bankruptcy as their revenues collapsed.”
That was in October 1998. Since then, the Dow is up 36 percent, and NASDAQ has doubled. Alan Greenspan warned about the market’s “irrational exuberance” as far back as December 1996, and tradition-bound The Economist has been wrong on nearly every dire prediction of the last five years. Conventional wisdom is in disarray. Chaos theorists, whether discussing stocks, the economy or tech sector strategy, have won the day.
In the past two years alone, ideas about what works online have changed nearly every quarter.
“We’ve already seen a kind of cycle-through in content companies from the ad-supporting model, to e-tailing, to B2B services and now to wireless broadband models,” said the MT Ventures’ Funk. “Who knows whether we’re all just reacting badly.”
If the New Paradigm people are right, the historic inflow of mutual fund money and the transformative effects of the Internet will provide business and investment opportunities, even during a bust cycle.
“The positive thing about a market pullback,” said Redpoint’s Jones, “is that after it happens it’s always a good time to be a buyer.”
Whether it’s the sunny weather, the Hollywood influence or proximity to the foothills, the Southland for now is looking on the bright side of what may be the most fearsome crash in decades.
“Everybody will be hindered, everybody will be hurt,” said Aro. “But it’s not going to put us back in the Dark Ages.... Our smart people are always going to make it. Our smart companies are always gonna make it.”
Then again, though Mead’s prognosis turned out to be wrong, he did accurately predict the one way he thought the market would avoid a crash in 1998:
“The Asian crisis could give the old bull one more run if Japanese capital flees that country’s troubled banks and stock markets to seek refuge in the United States,” he wrote. “Japanese investors are perhaps the only people in the world today who would be willing to bring massive amounts of new capital into America’s stock market. When that happens, watch out: Once the greatest fool of all has taken over the market, it’s time to get out. Mass Japanese movement toward the U.S. market could be the trigger that first pushes the Dow up to genuinely insane levels and then causes a long-overdue—and long-term—crash.”
In the meantime, investors and entrepreneurs may do well to follow the example of LA411.com’s Giles Goodhead:
“We’re prepared for downside,” Goodhead said, “by knowing we can always meet payroll.” z