Of Bubbles, Synapses & Slime Molds

I’m fond of analogies that come from other disciplines outside of investing and VC because they help lower my own ignorance and may have universal principles useful in many facets of life. To the man with only a hammer, every problem looks like a nail. It’s fun and worthwhile to keep adding new tools and mental models to your own toolkit.

I have always been insatiably curious and drawn to other curious people, but really took to this kind of multidisciplinary thinking once I read, listened to and then met Charlie Munger, the brilliant billionaire curmudgeon counterpart to Warren Buffett at Berkshire Hathaway. This inquisitiveness was then reinforced when I befriended and started lifelong learning from Michael Mauboussin, and has continued as I’ve gotten closely involved (after years of sopping up everything I could) with the Sante Fe Institute, a rare place dedicated to this kind of thinking.

Here are two interesting examples in nature of phenomena that may hold relevant: the first is interesting to know and remember, and the second may be useful to see what is happening in investing markets right now.

I read an obituary recently and quickly (and maybe a bit too excitedly) reached out to the late man’s son to profess my admiration. The son was my friend Dan Huttenlocher, the founding Dean and Vice Provost of Cornell Tech. His father, Peter Huttenlocher, was a pioneer in neuroscience whose charts I had previously studied. From the time you are born until age 3 or 4 there is a rapid and exponential increase in the number of synapses in your brain and then what follows is, as Michael Mauboussin has noted, a precipitous pruning. The chart looks like this:

Who cares?

Anyone entering an industry or betting on early entrants to win.

Why?

Because this pattern has played out time and time again in the business world, as evidenced by the following charts from Mauboussin’s “More Than You Know”:

The incessant birth and death of synapses, messy and inefficient, seems to hold a universal lesson for entrants in new industries. And then there were but a few.

The second analogy is that of the slime mold. As long as food is abundant, it exists as a single cellular organism and can venture out looking for more food. But when food gets scarce, warning signals in the form of chemicals ripple through, sending the single cells congregating into a single mega body.

So what?

Right now, every one is acting like the slime mold. If you have friends that are or were bankers, lawyers, accountants or consultants…there are quite a few I’d bet that are now trying their hands at startups or even VC or angel investing.

If you had friends that weren’t the smartest or hardest working who just raised a lot of money at what you hear is a pretty high valuation, it has motivated not just you, but others to go and try the same thing. “If that guy just raised money, I can do it!”

In this process, lots of startups are forming and hiring. The main and obvious beneficiaries right now are real estate owners. They are turning crappy Class C and Class B space into sought after incubators and co-working startup spaces. Vacancies are down. Rents (or memberships) are up. WeWork is valued at $5B. If and when VC and angel money dries up, the operating leverage the landlords and owners get on the way up will hurt on the way down as startups without funding lay off people, downsize and can’t pay rent. Shockingly, this scenario took place 15 years ago and landlords went from taking equity in their startup tenants to demanding 6 months cash up front in case they weren’t good for it. Things got messy quickly.

Today we are in the dispersion phase. Every experiment is being tried. Many will do amazing things. Most will fail. But the byproduct of their detritus will be the fodder for the next wave to recombine into more useful things.

At some point, many will abandon their adventures and head back to the safety, security and predictability of motherships like McKinsey, Goldman Sachs, JP Morgan and Deloitte. Sadly the pressure of significant others and in-laws often demand it.

The real question is when?

The real answer is nobody knows. But everyone has a feeling something is awry.

Here is my best measure of “when”. It is based, in a Keynesian beauty contest way, on an expectation of other people’s expectations. I have been polling people over the last few years as to when they think that this boisterous environment ends.

The answers vary widely.

Some incorporate anecdotes and references to macro economic forces. Some invoke Mohammed El-Erian, reference a “New Normal” and tout those timeless and dangerous words “this time is different”, referring to the virtue of better capital efficiency, being able to do more with less (while conveniently forgetting the corresponding vice: lower barriers and many more entrants make it harder for investors to see all, let alone pick winners).

Some point to excesses and note that if history doesn’t repeat, it sure rhymes, and headlines seem like rhyming couplets to 15 years ago. Some refute that very notion. Some point to the benevolence of central bankers printing money to stave off deflation, to induce inflation, to reduce unemployment, to devalue currency in the face of mounting sovereign debt (and interest payments due). Some point to the low, zero or negative yields available for government bonds, rising equity prices and declining earnings yields–in short the absence of yield in otherwise safe places that have “forced” investors to make riskier investments (as defined by my partnership as having a higher probability of permanent capital loss).

Some on the other side see issues with liquidity, and instead of many millions of retail investors buying dot-com stocks on margin accounts at E-Trade, TDAmeritrade and Schwab, they instead see many millions of retail investors allocated to Fidelity, T.Rowe Price and BlackRock, who are making large block illiquid investments into private, pre-IPO companies. If the pace slows or market volatility from some unexpected event narrows the IPO window, these late stage investors may pull back, and down rounds may follow. Though these late stage mutual funds may have terms that protect them, earlier investors may get crushed.

Whatever the input to each person’s thinking, some see logical reasons why things will continue or accelerate positively, while others see reasons why things will come to abrupt halt.

Around this time last year, while sitting with Yahoo founder (and a co-investor in some of Lux Capital’s investments) Jerry Yang, he told me he thought the market had jumped the shark with the huge head-scratching headlines of Snapchat, Oculus and WhatsApp. But he said the most important thing I heard: he capitulated. Now, he said, he thought it could go on for two more years or maybe more. And at that moment, I started tracking what percentage of people I polled and spoke with on a given week said “two years”. Around that time, from a pretty diverse sample set ranging from cynical short sellers and deep value equity investors to CEOs, VCs and bullish entrepreneurs, 10% of people imperfectly (and not very empirically) polled, said “2 years”. About six months ago, the number crept up to 25%.

Today, in April 2015, it stands at 1 in 2, 50%. My speculation is that when 80% of my imperfect sample size measure answers “two years”, then that day, it’s over. Markets discount expectations. So, take all the anecdotes, weak signals and empirical evidence of your own experience and vantage point and let us know: what is your best guess?