From Techcrunch: It’s Going To Be A Grinch Christmas: Slowdown Forecast For Online Holiday Sales

There’s been discussion about consumers spending less this winter shopping season, and how the credit crisis is the culprit.  I would like to introduce a thought here, and one that extends a little further down the rabbit hole.  Consider for a moment that demand destruction has in fact occurred.  Consumers are scared and are holding back purchases - everyone understands that concept.  However, the new construct I would like to introduce is the notion that demand destruction will not exceed supply destruction.

What did that mean exactly?  Most retailers, specifically consumer focused retailers, tend to turn profitable around Thanksgiving.  That’s one of the reasons why the day after Thanksgiving is called Black Friday.  This is directly tied to demand coming in the front door (actual or virtual) of the business.  It’s possible that the exogeneous factor of the credit crisis may delay Black Friday, and in fact keep the year in the red.  However, if one also considers the reduced ability to borrow, things get even more challenging for the retailers to turn profitable.

Retailers need to stock up inventory ahead of their selling season.  Inventory is taken on credit terms.  Whether it’s a “net X day” payable, with the ability to return the goods if unsold, or borrowing against the value of the inventory is irrelevant.  Someone, somewhere, needs to borrow funds to make the stuff.  If the ability to borrow is impacted, whether by higher interest rates (pushing down margins and borrowing power), or borrowing is negated all together, the retailer themselves will be harmed because they will have reduced inventories to sell.  With reduced inventories, retailers will be challenged to hit their “black” date.

This puzzle becomes ever more challenging when you consider psychological factors on pricing.  To wit, if retailers fear reduced demand, they may start jumping the gun and offering sales, at reduced prices (and thus reduced margins), to spur demand.  This will have the perverse effect of pushing out even furhter the date at which they would turn black.  An even bleaker picture could envision inventories running out, and credit not being there to keep up with even a reduced demand, at reduced margins.

I can say this - I would not want to be long any retailers for the next two quarters.

It should go without saying that the current financial crisis is going to loom large over the business plans of young and new software companies.  In fact, there is an article out that suggests that the removal of Lehman and Merrill from the buyer pool has reduced the IT budget of the financial services sector by 6%.  Let’s let that marinate for a moment.

It’s one thing to have a cyclical contraction in spending.  It’s another thing entirely to compound that problem with demand destruction.  Worse still, the demand destruction is not due to a symptomatic pricing issue, but rather the abject removal of key buyers from the market.

Even more complicating is the difficulties in financing businesses operations.  I’m not talking about raising venture money, but good old commercial credit.  Many companies use debt for expansion, and many times that expansion includes computer systems.  Companies are now having their hands forced to not just pay lip service to lowering their CapEx associated with IT, and moving it to OpEx.  They have no CapEx dollars left.  They need (must) find a way to fund software and services.  Enter SaaS business models, and the Cloud more broadly.  I would expect a knee jerk and rapid migration of buyers in the market to seek out SaaS solutions for line of business applications, and a reduction in spending on CapEx associated with IT.

Here’s the sad irony of the current financial debacle.  IT is what got us here.  IT has been wielded as an offensive asset for many of these firms.  The calculations required to price and model out many of the derivative products they were buying in insane.  I almost took a job at Merrill working on their Fixed Income Derivatives desk back in 1995.  Scary.  Here’s what’s more scary: my Fixed Income homework from my FNC235 class (*there’s a nod to all Wharton peeps who ever had Prof. Basak) is what got me the job.  The MD actually said “hire this guy.  I can’t make heads or tails of his homework and he got them all right.”

People worry about Google being the current incarnation of Skynet, but I would look more to the systems which have been handed the ability to make trades for humans based on human created models which very few people understand, much less can maintain in such manner as to adapt to what are being called 10 sigma events.

I was in NYC when 9/11 happened.  I remember a quote that still hangs with me: that we suffered a failure of imagination in our ability to stop the terrorist attacks.  There’s a similar sentiment to be had here.  The failure of imagination in the building of these models has led to many models essentially acting (reacting?) the same way, causing herd like behavior in a flight to or from assets.  The combination of programmed trading, naked shorts and no uptick rule has led to some serious unintended consequences.

I was sent an email by a family member about how to impact gas prices.  It started off with quite a come on:

THIS IS NOT THE ‘DON’T BUY’ GAS FOR ONE DAY, BUT IT WILL SHOW YOU HOW WE CAN GET GAS BACK DOWN TO $1.30 PER GALLON.

This was sent by a retired Coca Cola executive. It came from one of his engineer buddies who retired from Halliburton. If you are tired of the gas prices going up AND they will continue to rise this summer, take time to read this PLEASE.

I should have known we were in trouble when I saw that engineers were involved with this economics shenanigan.  I say that in jest since one of my undergraduate degrees was in engineering.  I was curious about this one since most of the ideas revolved around not buying gas for a day.  Bill O’Reilly certainly had this plan a while back, and it seems to come up every now and again.  Of course, it has proven completely ineffective as no one signed up for the plan.  People need gas in their cars.  However, this plan promised to have a new twist on the problem, so I read on:

With the price of gasoline going up more each day, we consumers need to take action.
The only way we are going to see the price of gas come down is if we hit someone in the pocketbook by not purchasing their gas! And, we can do that WITHOUT hurting ourselves.
How?

How indeed?  The premise here is that the consumers are in control of the market, and that we can act in some manner to effect maybe one player, and not all, in an effort to impact the price of gas.  Hmmm, I’m not sold, but I want to hear more.

Here’s the idea: For the rest of this year, DON’T purchase ANY gasoline from the two biggest companies (which now are one),EXXON and MOBIL.  If they are not selling any gas, they will be inclined to reduce their prices. If they reduce their prices, the other companies will have to follow suit.

I suggest that we not buy from EXXON/MOBIL UNTIL THEY LOWER THEIR PRICES TO THE $2.00 RANGE AND KEEP THEM DOWN. THIS CAN REALLY WORK. 

So, this is where the plan completely falls apart.  On the surface, this plan feels like it should work, right?  Unfortunately, a study in basic economics will prove that not only will this plan not work, but due to unintended consequences, the exact opposite could occur.

The first problem is that this plan doesn’t actually have a net impact on demand in the marketplace.  By not buying from Exxon/Mobil, they will certainly see demand for their product go down, but the demand will go elsewhere.  Logic would dictate that Exxon/Mobil would have to lower their prices, right?  Wrong.  The issue now becomes that gas, which is a limited resource, will now have it’s net market supply impacted by having Exxon/Mobil removed from the marketplace.  As such, the increased demand to the other stations, for their now more scarce supply, would cause their prices to go up.  Assuming that there are rational buyers in the market, the pricing at Exxon/Mobil, without any changes, would now appear to be cheap, and the demand would flow back to them.

Now, assuming the demand could permanently be removed from Exxon/Mobil, their supply is completely out of the market and the price of gas would have to go up.  You see, Exxon/Mobil can’t simply lower their prices to what the “market” defines as fair.  The current price is what the “market” defines as fair.  If we are to assume that a lower price, say $2.00, is OK to allow people to return to buying from Exxon/Mobil, they will see a run on their stations, which will cause their supply to disappear, again causing the supply demand imbalance with the other stations.  Exxon/Mobil will have to raise their prices.

Rationality in the marketplace is all fine and good, but there is another dynamic which further complicates this issue.  Exxon/Mobil, as refiners and marketers of gasoline, sell their gas from their terminals to the highest bidder.  Sure, they sell gas to stations which they have branded (some owned by them, many are not), but they are happy to sell that gas to a distributor or jobber at a higher price if the market will allow.  The station owners really only make a penny or two on gas, so the people getting hurt by this plan are the station owners, who are not Exxon/Mobil employees.  This narrow margin on gas is why the pumps at the stations are so slow.  Those mini-marts make far more in terms of profit for the station owner than the gas.

To sum up, supply/demand is really simple.  For a given supply, there is demand, and that determines price.  Without removing demand, but actually removing supply, the price will go up for the resource, not down.