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Monthly Archives: January 2014

Facebook stock had a good day today (1/30/2014), as it shot up $7.55 based on what was deemed to be a good quarterly earnings report.  Suspicious that all the hype was airy-fairy, I decided to conduct some further investigation of my own.   I began by looking at the two biggies—Twitter and Facebook.  Yahoo Finance reported no P/E for Twitter as of 1/30/2014 as a consequence of the negative “E” in the denominator.  Despite the negative earnings per share, Twitter’s market capitalization was reported as being over $34 billion.  Turning to Facebook, it did have a small but positive “E,” and based on its trailing earnings per share the P/E stood at about 156 with a total market capitalization of around $150 billion.   

 Outlandishly high P/E multiples exist for the lesser known social media stocks as well.  Zynga’s service allows a person to socialize by playing online games with friends.  That doesn’t sound like a business model that would make a fortune, but I guess young people like it.  (When I was in college fun was had by skiing on Friday and having a kegger afterwards.  Now the college gang gets together virtually on Friday night for an evening of raucous online gaming.)   Zynga’s market cap is  $2.9 billion, with no reported P/E as a result of a negative “E”.  LinkedIn has a market cap of about $25 billion, with a lofty P/E of 956.  

 Being one of those aging dinosaurs that rarely use any of the services the social media companies offer, I may not be in the best position to comment on whether such sky-high P/E multiples are reasonable.  A short time ago I visited LinkedIn’s website in an attempt to better understand what LinkedIn does, and why it is so popular with folks.  On the company’s website I read what the LinkedIn service helps you to do: “Connect. Find.  Be found.”  For those of us who don’t want to “connect, find, and be found” it is difficult to comprehend how a company that dishes out such punishment can be worth $25 billion.    

 cloudsIn general, what little income the aforementioned social media companies generate is from advertising.  An old marketing maxim says that “half of a company’s advertising budget is wasted—the problem is nobody knows which half.”  Today Yahoo Finance conducted an online poll asking readers whether Facebook will continue to benefit from increased mobile ads in the future. As of the time when I checked the results, here is how the answers were stacking up:  Of the respondents, 26 percent answered yes, Facebook will continue to benefit from mobile ads.  The remaining 74 percent thought the mobile ads were either ineffective (31 percent), a passing fad (22 percent), or soon to be replaced with a different technology (21 percent).  Obviously, the demise of the social media stocks will occur if advertisers come to the conclusion that they are throwing away a great deal of their shareholders wealth by marketing extensively through mobile ads.

 Another canary in the coal mine for the social media stocks is the language the so-called analysts are now using to talk about the firms’ net income.  Rather than focusing on “earnings per share,” the conversation now often centers on EBITDA per share, or even revenue per share.  Now that’s going way up the income statement in order find a positive number.  Flashback to 1999.

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fish and netFor years I have been expecting a surge in inflation.  After all, how is it possible that the Fed can be creating so much new high-powered money without a jump in prices?  Surely those who are familiar with the quantity theory of money share my puzzlement over the relatively stable Consumer Price Index (CPI). 

In trying to understand the absence of rising prices I have thought a lot about fiat money and the process by which it enters into circulation.  After a lot of searching and racking my brain I think I’ve found the inflation.

Low CPI inflation is in part a consequence of our broken banking system, as detailed in the January 22 blog.  Because banks are reluctant to make loans, the rate of growth in high-powered money has greatly exceeded the growth rate in M-1. 

But despite our broken banking system, M-1 is still growing pretty darn fast.  For the six months ended December 31 M-1 has been growing at an annual rate of 10 percent, which compares to an annual CPI inflation rate of only about 1.5 percent.  So, where is the money going?  Where is the inflation?

 Recall that the CPI measures inflation in the prices of consumer goods—capital goods are not included.  If the price of an existing factory doubles, that doesn’t show up anywhere in the CPI.  Nor do rising stock and bond prices. And that is where the inflation has occurred, as will be described below.

Perhaps it is useful to visualize an island economy where there are two goods, a consumption good (fish) and a capital good (fishing net).  In the absence of fiat money there would arise some equilibrium price of a net in terms of fish—it might be 20 fish per net.  If a net is expected to catch, say, 30 fish during its five-year economic life, an investor might reasonably be willing to give up 20 fish today in exchange for one.  Of course, no rational investor would  be willing to give up 32 fish now in exchange for a net that is only going to harvest 30 fish in the future—in that case the price of capital is simply too high.      

Continuing with the illustration, let’s now suppose that fiat currency and a central bank emerge on the island.  The central bank prints up money at a rate it deems to be appropriate.  In order to get the new money into circulation the island’s central bank needs to buy something—it can buy fish and/or nets.  Obviously, the terms of trade between fish and nets will be affected by the central bank’s decision as to which it buys.  If the central bank is determined to rapidly print new money and introduce it into the economy entirely by purchasing nets, then initially the price of nets (capital goods) will soar relative to fish (consumption goods).  Depending upon how feverishly the central bank is printing the money and buying up nets it becomes entirely possible that the fiat-currency price of a net will be 40 times the fiat currency price of a fish, even when the net is only capable of catching 30 fish over its economic life.   The central bank in this example is not particularly worried about making a smart investment—its only goal is to get money out there, and fast!

Presently the Federal Reserve is introducing new money at a rate of $75 billion per month.  The money enters the economy through open market operations where the Fed purchases government bonds and mortgage backed securities from hedge funds, mutual funds, investment banks and so forth.  Obviously an initial impact may be to enrich the sellers of the securities the Fed is buying up. But more significantly for the economy as a whole the affect is to drive up bond prices well beyond what would otherwise make sense. 

So that’s why bond prices are so high and interest rates are so low. However, the story doesn’t end there.  The Fed’s intrusion into the market with a flood of fiat money has also impacted the stock market.  Of course, the Fed doesn’t print up money to buy common stocks.  So why have stock prices inflated?  I believe this is easily understood when we consider who is selling all those bonds to the Fed.

Large financial institutions, hedge funds, and well-heeled investors who own bonds are rewarded when the Fed prints up new fiat money and buys some of their bonds for ballooned-up prices.  But upon selling their bonds to the Fed the financial institution now finds itself invested in cash—an undesirable investment in a world where cash is being enthusiastically created by the central bank.  Where do large investors then go in search for a better return?   The answer is to stocks, and thus we see inflation appear in stock prices as well. 

Have we reached the point where the price of capital goods exceeds the value of the future earnings the capital will be able to produce?  (Is the fishing net now selling for 40 fish when it is only capable of catching 30 over its useful life?)  Certainly the operation of the central bank the past several years has pushed us in that direction.  To cite one piece of evidence, The Wall Street Journal reported a P/E ratio of 86 for the Russell 2000  as of January 17, 2014 (http://online.wsj.com/mdc/public/page/2_3021-peyield.html). So, this is where all the money is going, and where the inflation has first surfaced.

Ultimately markets converge towards rationality, and the relative prices of consumer goods and capital goods will make sense. This might happen with falling security prices or with rising prices for consumer goods.  With all the new money sloshing around, I’m still expecting the latter.

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A recent glance at U.S. monetary data is astounding.  The money base (that is high-powered currency issued by the Fed and held by individuals and banks) stood, at year’s end, at approximately $3.6 trillion.  The M1 money supply (currency held by the public plus checking accounts – the normal “transactions” of money) by comparison was much smaller, standing at $2.6 trillion.  This strange twist is not new, it has persisted since the 2008 credit collapse and it shows how badly broken our traditional banking system was and how hobbled it remains.  The world has moved on, but apparently our anachronistic money and banking system has not.  When the monetary system is “normal,” M1 is usually much larger than the money base.  That is the case when the banks are lending out all or most of their excess reserves as a growing pyramid of loans, creating new money balances in the process through the expansion of checking accounts.  This is what has traditionally been referred to as the “banking multiplier” portion of the stock of money.   It is this old, nasty characteristic of the “fractional-reserve” banking system that has historically resulted in a large injection of uncertainty and instability into our financial system.  It is the reason that past Federal Reserve chairmen have bemoaned the uncertainty and difficulty of controlling the overall money supply and hitting monetary targets.  It is destabilizing because it joins bank lending and monetary expansion at the hip, resulting in the central bank’s lack of control over the total money supply.  This “fractional reserve” banking characteristic is responsible for a sad history of credit booms and busts, of periods of inflation and deflation.

13106574_mThus a minor and unheralded blessing of our current situation is that the “normal” bank expansion of the money supply is not working now.  Why?  Because private banks are in the aggregate either too scared or too tightly regulated to lend—or both.  They are appear to be huddled down and cautiously accumulating all the excess reserves they can get.  This has been the case now for a number of years as the Fed has been desperately throwing high-powered money at the banking system without much effect on aggregate bank lending, “quantitative easings” 1, 2, 3, and so on.  Be thankful the traditional bank multiplier is not working.  If it was, inflation would now be roaring.   To the observer, the Fed is reminiscent of a peculiarly dull child who is flooding a campfire with more and more gasoline, evidently unaware that the embers are totally dead.  Nonetheless splashing about in gasoline is a dismaying behavior to behold.  Clearly it is fraught with danger, as any small spark could and would trigger a real conflagration with all the puddles of gas lying about.

Yet there is hope even for the very slow-witted.  In the back of the child’s mind there is somewhere the vague realization that more and more gas might not be a good thing.  The Fed has the same realization.  Somewhere in the recesses of their minds even central bankers are uneasily aware that flooding the economy with liquidity can somehow raise the risk of future inflation.  Didn’t they read it somewhere?  Thus, they embark on the “taper.”

Since bank lending has failed the strongest attempts by the Federal Reserve to re-ignite it for a number of years, why don’t we congratulate ourselves and just live without it.  The economy is evidently functioning and lending is occurring through other mechanisms—it is just that private banks and their lending are evidently playing a far reduced role.  A market economy evolves and moves on as new lending mechanisms arise as old ones diminish or fail.   The idea of linking bank lending activity to the growth of the overall money supply was always a crazy, de-stabilizing Ponzi scheme in any case—attractive mainly to bankers.  Good riddance to it.  The Fed should take this opportunity to quietly enact several new years’ resolutions for its one hundred and first year.  First and most importantly, set the bank minimum reserve requirement at 100%.  Given where the money and banking system is right now it would be a moot point with little aggregate effect.  For the future it would help make the monetary system more rational and stable.  For the first time in its history, the Fed would actually have a chance to precisely target and control the supply of money.

What should the central bank do next?  We could think of a couple of suggestions.  Follow a “rule of one.”  What do we mean by that?  To simplify the money supply process that Fed should get out of the role of manipulating monetary policy and simply issue “one” of something.  For example, one dollar (in other words divide all wages, prices, and monetary quantities by approximately 1/H or 1/$3.6trillion).  This could be a monetary policy that is understandable to all and possible to implement.  Even the most intellectually challenged central banker should be able to get their arms around the idea that the size of the U.S. money supply is pegged at just one dollar.  After all, with a fiat money units don’t matter, but keeping the supply stable and predictable does.

After the Fed realized that, with its “rule of one,” it really wasn’t doing anything in terms of monetary policy, it could logically move to the final step.  At that point, the Fed could realize that it had evolved into an unnecessary appendix.  It could give the nation a wonderful present after presiding over 100 years of bad policy and chaos since its creation and simply disband itself.   In a technologically advanced, instantaneous exchange, debit-card economy, it is high-time to move on from fiat money to a private, market based unit of exchange and valuation.  What could or should that be.  It could be something with engineered, hypothetical scarcity, such as Bitcoins.  We would suggest an exchange and valuation good, a money, based upon the real fundamental value of broad index units of productive capital.

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