4 Ways Stock-Market Volatility Affects Every Business
A lot of folks, on mornings when they wake up to find the Dow Jones Industrial Average off 1,000 points, breathe a sigh of relief that their fortunes, or prospects for a fortune, aren't tied to the whims of the stock market.
But they are tied. Bound, even. In fact, if you're breathing a sigh of relief now, you're likely going to be among the first to have the life choked out of your business.
Here's why: the stock market matters. A lot. We tend to make the mistake of viewing business as a local affair. We know our customers. We know our competitors. We know our employees. But we often forget that the financial sphere -- and the "Wall Street" too many people demonize nowadays actually binds them all together into a business ecosystem, that, like the very air we breathe, is both vital and invisible to us.
And it doesn't matter if the averages closes higher on a day when they open down 1,000 points. It just matters that there was violence in the movement, volatility, uncertainty, mayhem.
Those swings affect you and your business in four key ways, and you probably don't even know it.
Ours is a consumer economy, built on spending. Wages are down, the labor-force participation rate is at historic lows, and immigration policies are making it difficult for the unskilled or semi-skilled worker to have job mobility. So how have we been able to show ecomomic growth? Credit. Americans take on debt to spend money. We finance houses. We finance cars. We finance education. Hell, we even pay for groceries with credit cards. Using credit means you are borrowing money, transferring the entity to whom you owe the money. When you buy a car, the dealer gets paid from the bank, not from you. You, in turn, owe the bank, and pay over time, with interest.
It actually happens all throughout the buying process. Let's look backward, with the same car example. You borrowed to buy the car. You owe a bank money, but the dealer got paid. The dealer bought from the manufacturer, often with a finance arrangement where the manufacturer was paid, but the dealer now owes the bank money. The manufacturer made that car likely with products it used bank financing to acquire the underlying parts, and the manufacturer owes the bank money. Even at the grocery store, the supermarket generally gets short-term financing in acquiring the products on the shelves, the food producers get financing for the equipment used to process what's on your table and the farmers get financing (and government subsidies) to keep them operational for planting and harvesting. Our entire economy runs off borrowed money, with the banks in the middle of almost every transaction, whether for a 30-year home mortgage, a 5-year car loan or a 30-day line of credit.
That makes interest rates so important -- and what makes the current market swoon so unsettling. Traditionally, the Federal Reserve lowers interest rates to stimulate the economy. That means it lowers what it charges banks to borrow to have access to the capital to lend out to folks. Rates are at zero. The Fed isn't going to go lower. If anything, it wants to start raising rates.
But looking at the Fed Funds rate doesn't matter to you that much because banks charge you an interest rate, whether you're a business or an individual, based on what the banks believe is your ability to pay in full. Just because a bank borrows at zero doesn't mean you won't pay 18 percent on a credit card, or 6 percent on a house, or 9 percent on an unsecured small-business loan.
It's this flexibility that banks have in setting rates that is directly affected by the market's fall. Your ability to pay, as assessed by the bank, is based partially on your past performance but also your market conditions. Falling markets create uncertainty. Uncertainty increases risk. Risk raises what you're charged for interest. Suddenly, borrowing has become more expensive, raising the costs to manufacture and sell your product and lowering the attractiveness of the consumer to borrow to buy. All because the banks are watching the markets and dabbing sweat off their brows. What they worry about, you need to worry about.
But what if you don't borrow? And what if all of your consumers pay cash? Or in Bitcoin? Or trade raccoon pelts?
Well, it is true that, if you have created a credit-free Elysium in your life, interest rates won't matter. But you still need to sell products, and that's where consumer confidence comes in. People spend first on what they need, second on what they think they need but really just want, and lastly on the stuff they want but know they don't need. The last category is first to go at times in market uncertainty because people tend to cut back their spending. Then comes the second category. Both are where most businesses make their money.
Why would people hold back spending when the market is volatile? Because most people are invested in the stock market. We may not trade through online brokers everyday, but our futures are tied to the markets. If we have an IRA, a 401(k) or even a pension, those underlying assets float on the whims of the financial markets. Swings there affect our personal wealth. What we found during the financial crisis of 2008 was that our personal "worth" was too closely tied to home values and those were largely illiquid, unless of course we borrowed against that value (see Credit, above), which some of us couldn't do because we had borrowed way more than we should have in the first place.
While the response to our overreliance on home-mortgage credit was to lower interest rates to stimulate more borrowing (ibid.), the wisest of us began to save more and focus on areas in our personal lives like savings and cash management. We kept larger parts of our portfolios in cash, and only within the last few years dipped our toes in to the rising equities markets again. After all, anyone can sell a stock quickly. It's a fairly liquid security, provided you like the price and it isn't thinly traded.
True, retirement-savings investments are managed by mutual funds, but those funds invest in the stock market, mostly. Sure, there are different allocations, but the money is made in stocks.
What's more, the drop in the indexes belies the bloodbath many consumers' personal portfolios will suffer. In a fairly good market in 2014, 86 percent of active large-cap fund managers underperformed their benchmark indexes. And that wasn't a fluke. Almost 89 percent posted underperformance over the previous five years, with 82 percent underperforming over 10 years.
So, when consumers look at their portfolios, they see losses and translate that into less available money down the line. That means more saving, less spending and fewer people buying your products.
If you're in the middle of a funding round, expect it to be delayed, lowered or cancelled. That goes for friends and family, who, like all consumers, are nervous about their cash, to seed and other rounds, where venture capitalists might be worried about where they are coming up with their own money. VCs like to act like Perseus before every market Kraken, but, in truth, they get just as nervous as you do. After all, with the exception of some angels, they're more often investing other people's money rather than their own. They have to go out and raise money from wealthy individuals and fund managers who are just as nervous about parting with a buck in an uncertain environment. Many a VC might have Fortuna favet fortibus plastered on their office walls, but they got to where they are by following Durate et vosmet rebus servate secundis.
Even the deals that do come will be smaller. Private-company valuations generally follow public-company ones. It's the easiest -- and most realistic -- comparison to follow. If tech companies on the Nasdaq suffer a Black Monday, it will be a Grey Tuesday for private companies seeking venture money. The markets are demanding a valuation re-evaluation (and most smart VCs will welcome that, since it raises their potential returns at exit).
If you think it's bad for an early-stage company to raise money, pity the later-stage one looking for an exit. In any period of high volatility for the stock markets, the first body bags are reserved for the IPO market. Uncertainty kills initial public offerings because they are, by definition, the riskiest equity play an investor can make, since they don't have a track record as a stock. When the Nasdaq Composite suffered its first major fall back in 2000, the IPO calendar went from being the most potent in history to drying up to nothing in a matter of weeks.
And those looking to exit through mergers and acquisitions shouldn't sit by their phones waiting for a suitor either. For a public company, a stock is a currency instrument. You buy companies with cash or stock, or a combination of both. A drop in stock valuation is a devaluation in its most important currency with which to make an acquisition. You might still get a deal, but it will come at a lower price because of the buyer's lack of flexibility in paying more.
Smart business owners and CEOs are probably saying to their staffs that they believe their companies aren't affected by this volatility and the best approach is to stay the course. Stiff upper lip, and all that. Privately, one hopes they are terrified -- not in panic, but just scared enough to move from prudence to anxiety. Why? Because how competitors act in these environments matters. If borrowing raises costs and lowers revenue, if consumers shy away from spending and if the ability to tap outside resources to keep the bills paid squeezes you, it squeezes just about everyone in your industry and you're fighting over a much smaller piece of cheese. It will get nasty. You might have to cut prices and margins, which will attract customers but might make you lose money in the short term. You might end up in price wars with competitors, battles neither of you can afford. Better-capitalized competitors might lure you into these margin traps, knowing they can weather a war of attrition a lot better than you can. Remember, you aren't just competing for customers. You're also competing for lenders and business partners.
And, as you fight for that smaller pie, you might find yourself getting squeezed by competition you hadn't even noticed before. The great irony of entrepreneurship is that it flourishes in bad markets and bad economic environments. Despite all the feel-good rhetoric about how everyone should be an entrepreneur, long-term rates of business creation have been down for a few decades now. The reason? Well, part of it is that fewer businesses have failed, mostly because of government programs to keep bad ideas in circulation. That lack of business dynamism hurts new-business creation.
Also, we forget that most businesses are created not just out of opportunity, but necessity. In times of high unemployment, people are more likely to be their own bosses, so they start companies to make money. It's the free market's safety net. As a result, the expansion of entitlement programs is one of the areas blamed for a slowdown in entrepreneurship. Still, when companies are squeezed by competition and squeezed on margins, they often jettison staff. Those ex-workers, driven by entrepreneurial impulse and the necessity of maintaining a life for themselves, could take their knowledge, woo your customers and beat you at your own game. If you don't believe that, you don't know your history (and Steve Wozniak and Steve Jobs would still be designing games for Atari).
Ray Hennessey is the former editorial director of Entrepreneur.