The decline in the US stock market, and the resulting aftertaste of price volatility over three days last week has been attributed in large measure to technical issues in a derivative market. Specifically, volatility in the VIX--ironically, a volatility index--spilled over into equities. And not just in the US, but world-wide. 

But we saw little effect in the bond market or other asset classes, such as gold

The equity guys have been quick to point out that the decline in the stock market had little or nothing to do with the real economy, other than perhaps a whiff of inflation from last week's 2.9% year-over-year wage increase. Point taken, although if the economy is overheating as a result of increased deficit spending, inflation is definitely expected. (And, where were these cats when we had the long, slow recovery from 10 per cent unemployment over the last 7 years? Coulda used a little stimulus then, no?)

Anyway, let's stipulate that other than possible inflation, the real economy is not too bothersome to the market. That means no one was hurt, right?

As they say in about a dozen of your favorite movies, Not-so-fast!

The economy may not have truly hurt the stock market, but the building pressures in the stock market may be hurting the prospects for one of the economy's most vibrant sectors.

Nothing Ventured?

I am speaking of the ever important investments in the venture capital sector.  Venture capitalists are firms, corporations and even individuals who invest in the earliest-stage companies in the hope that they can either sell the company to a larger acquirer, or take the company public in an IPO.

Some of the country's most valuable and influential companies, such as Facebook and Uber, came out of the VC world. These days, venture funding comes in all sorts of flavors.  There are large deals, small deals. Late-stage, medium stage, early stage and inception stage.

To some communities, the inception stage is important as a point of local pride and as a potential source of new jobs or industries. Many have organized programs, called accelerators, which take in a class or cohort of entrepreneurs and graduate them to the wider world of investors and continued growth.

What each of these stages have in common is the need for the next funding round.  Meaning that the early investor wants fresh money at a increasingly higher valuations. So, seed funding needs an A round of funding and A rounds need their B rounds. Bs need Cs and Cs have to start thinking about exiting to either a merger or an IPO.

O Capital, My Capital

This is a very well-studied segment of the economy, courtesy of the venture associations, private service and the academic world.  And what the data shows is continued growth through mid 2018.

What do we think was happening? That's pretty clear:

  1. We had plenty of investors, courtesy of the rising stock market. Part of this is psychological, in the so-called wealth effect. Rising wealth makes people want to spend and invest.
  2. Part of this was also from the lousy alternatives. CD's with virtually no income?  You figure, better to throw some dice in a startup.
  3. And lastly, a vibrant stock market gives early investors the hope that as the venture-backed company gets closer to exit, a fat IPO valuation awaits.

And what happens when the stock market dives?  Technically, it means that the cost of capital might be rising. And the higher the cost of capital, the more strict the would-be investor must be when considering potential companies as target investments.

As a practical matter, it means that items 1-3 could start to reverse:  A psychology of scarcity instead of plenty; cash and other interest bearing investments start to reflect more-competitive rates; and fear of a closing IPO window scare the would be investor.

Nobel Prize winning economist Robert J. Shiller says that a stock market correction has the characteristics of an avalanche; cracks appear, signaling real danger. But no one knows when it will be deadly.

And this week the VC community--the most vigilant of avalanche watchers--well, they saw the first cracks.  

Published on: Feb 8, 2018