Wednesday, September 19, 2007

Beware the Banks and Brokers!

After reading a post by Fred Wilson yesterday, I started to get a little concerned about an impending economic downturn. While it's always been in the back of my head - considering we've been in a bull market for the last 4 years - I haven't paid it much mind in a while.

Now Fred was talking about a downturn specific to the web - I mean, that's where he makes his bread and butter so it's something that is near and dear to his heart - but my concern is more broad based. I think we can see a major downturn hit the stock market and that will have a reverberating effect throughout the economy, and especially in the fragile tech space.

Here's my take:

After working on Wall Street for a few years you learn a couple of tricks. One of which is, if you want to know which way the market is headed six months in advance, keep an eye on the banks and brokerages.

Once you see the banks and brokerages start to take a dive, you know that the rest of Wall Street isn't too far off - we'll call them a "leading indicator". Every major bear market was preceded by sub-par results in the banks and brokerages.

Now, much of this is going to have to do with the recent mortgage crisis the country has plunged into. A lot of these banks are going to take a monster hit on all of these defaults we're seeing.

In fact, the Wall Street Journal just reported that Morgan Stanley (NYSE: MS) took a 17% hit to Net Income this quarter. Lehman Brothers (NYSE: LEH) showed an increase in profits but took a hit in fixed income due to the mortgage issues.

I also think that many of the banks and brokerages have been reaping the benefits of an unsustainable bull market - the market has been up almost 20% a year for the last 4 years - that means that when this market heads south (or stops rocketing higher) these companies can no longer use their trading and investment banking fees to compensate for losses in other divisions. And that my friends means the brokerages will be headed south for the winter.

When that happens many of the IPO dreams and lofty valuations for many of today's web startups will go into hibernation for the winter as well. But in all fairness this "dot-com renaissance" we've been seeing isn't solely predicated on the public equity markets. But at the very least I think we'll see VC's and other private equity firms tighten the purse strings a bit.

Like I said in my comment to Fred's post, I don't think we're headed for an all out crash in the Internet space, but with the market looking like it might take a bath, investors and entrepreneurs alike need to be cautious now and prepare for a potentially tough winter.

Some steps to take:

1. Batten down the hatches and lower your burn rate: If you're currently supporting high fixed costs figure out ways that you can right-size your Income statement if revenue suddenly takes a hit (i.e. if revenue drops 25%, how can you cut costs by 25%?).

2. Stockpile your supplies: For investors and entrepreneurs this means you need to get capitalized! If you've got enough cash on hand and this downturn isn't "too" bad, you'll be just fine. But for those operating on a shoe string budget already, you might be in for even tougher times if this downturn hits.

3. Focus on the Fundamentals: At the end of the day most of this stuff is beyond any of our control, so there's not much we can do by worrying. So focus on your business - continue to execute on all fronts and proceed with your plan. Don't take your eye off the ball for a single second.

I think James Dean said it best - "Dream as if you'll live forever; live as if you'll die tomorrow."

I prefer, "Act like your company will be around forever; but plan like it could be gone tomorrow."

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