Thursday, October 30, 2008

10 year outlook for investors: U.S. dollar Inflation, Devaluation, and Structural economic changes

It's notoriously difficult to predict the future of complex systems like human societies, and betting hard-earned money on predictions is not my idea of investing. Nonetheless, long term investing requires us to have a long term view of the economy, to allow us to think through investing possibilities and to test our investment ideas. As Eisenhower is reputed to have said, "the plan is useless, but planning is essential".

So here's my thought exercise on the outlook for the future:

Outlook for 2008 to 2010
(Immediate future)

In the immediate future (2008-2010) or so, we will likely see a severe recession as the misallocation of savings invested into unproductive assets starts to work itself out. The misallocation of resources brought about by excessively cheap credit was extreme. The excessive growth in credit (reflected as M3 money supply growth) relative to GDP growth over the last decade strongly suggests this.

The fact that core inflation was low during this period of M3 growth suggests that most of this credit was used for capital asset formation (e.g. housing, machinery and equipment) and/or channeled into financial assets. Cheap imports from China may have had some impact on keeping inflation low, but imports are actually a relatively small component of the US economy, and cannot completely explain the lack of inflation in consumption goods (products and services). 

It is beginning to look like that the recent U.S. fixed capital formation was mostly in housing, and not productive assets like machinery. This could make the recession a longer and deeper one, as the U.S. economy may not have a whole lot of spare productive capacity (capital assets such as machinery) to form the foundation for economic growth. There isn't a lot of spare machinery lying around that we can just turn on when demand sentiment picks up. This can slow the recovery process because businesses will need to invest in new machinery before they can increase economic output. And they will only do if they see sustained customer demand or a general improvement in the mood of the country. This means there is an "energy barrier/step-function" to cross before the overall economy will start growing again. Without an uptick in consumer demand, businesses won't invest in capital assets. And without investments in capital assets, there is one less mechanism to get people back to work and earning income.

On the other hand, if businesses had spare machinery, it would be an easier decision to reactivate one of the idle machines and cater to minor increases in demand. The economy wouldn't have a step-function barrier to economic growth, but rather would be able to inch its way forward and slowly increase overall economic activity. While this chicken-and-egg catch-22 is an unfortunate hurdle to economic recovery, it also means that once the step-function is crossed, the economy will likely experience strong and sustained growth as economic activity lurches forward to produce both capital and consumption goods.

The sheer quantum of the misallocation of resources (manifested as credit losses) in the boom leading up to 2007 also suggest that it will take a prolonged period of time for the economy to untangle the web of work wasted on building white elephants. A large amount of claims on future work will not be honored, because the economy did not build enough productive capacity to honor these future claims. The work was wasted on creating white elephants instead, and it will take some time for economic participants to get over this and move forward. The sheer size of the problem also makes it likely that consumer demand will drop a lot in the short term, which may lead to deflation as businesses cutprices to cover their fixed costs.

Outlook for 2010 - 2020
(Long term)

In the longer term, over the next decade (2010-2020) or so, I believe there is a significant probability that we will see (1) monetary (forex and pricing) instability, (2) the general reduction (reversion to mean) in corporate profits as a % of GDP, and (3) structural changes in the factors of production.

(1) Monetary instability may come about because:
  • To combat the current credit crisis, central bankers around the world are injecting money into the banking system to counteract the destruction of money caused by the massive debt writeoffs. While some economists might argue that this merely delays the reallocation of credit to productive resources, I agree with the current approach because a reduction in money supply would cause the flow of money to freeze as banks try to bring themselves back into solvency. This would push the real economy into a depression, which could bring about a change in social and political outlook that would steer us away from free market capitalism.

    But over the longer term, this massive injection of money into the money supply base will cause a strong inflationary bias in the economy. While the Treasury was sterilizing some of the money supply injections earlier, I believe it will ultimately stop doing so, or sterilize less than the amount of money injected, to allow for a net quantitative increase in money supply. In other words, the Fed will turn on its printing press and print out money.

  • The U.S. government has huge, unfunded social security and medicare obligations to the baby boomer generation who will be retiring over the next 15 years. By some accounts, the unfunded obligations total up to 35 trillion dollars, which more than twice the GDP of the United States. The government can issue Treasury debt to fund these obligations, but the size of the government existing debt ($10 trillion) combined with the sheer size of the unfunded obligations, suggests that there simply won't be enough people to buy the debt that the Treasury will need to issue. Given the short-term focus of the political process, political expediency would likely pressure the Federal Reserve into buying this debt from the Treasury, in effect printing money for the government. This will cause further money-supply inflation, and effectively short change the beneficiaries of Social Security and Medicare.
Both these factors will cause the money supply to grow in excess of the underlying productive capacity of the U.S. economy. This will in turn, lead to a sustained depreciation of the US dollar against many other currencies. While Asian central banks will try to stem this depreciation to support their economies, which are structured to rely on exports to keep running, it is probable that they will eventually reduce their buying of US dollars as (1) it becomes politically difficult to keep buying US dollars as US inflation destroys the value of their dollar holdings, (2) this attempt to fix currency exchange rates starts importing inflation into the local economy, and (3) the continued monetary sterilization carried out to balance the sale of local currency (through selling government bonds or increasing banking reserve requirements) leads to rising local interest rates that distort the domestic economy. If central banks do not manage this process well, there is a potential for currency and monetary instability as currencies see-saw and whiplash repeatedly. 

Unfortunately, the odds are that central bankers will not be able to manage this process as they would like, because as long as political systems reward short-term results, governments in export-oriented economies will favor the central banks' continued currency intervention because it supports jobs in their export-oriented economies. The depreciation of the US dollar will be a long term trend, but there is a high probability is that it will take place in a lurching, see-saw fashion, with bursts of rapid devaluation offset by periods of appreciation or sideways movement.

The US dollar will only stop its long term depreciation when the U.S. economy's productive capacity allows it to produce excess goods, and its depreciated currency makes its goods attractive in international markets. The turning point will be reached when the US export machine starts firing up on all cylinders. Such a period of changing expectations and changes in the direction of capital flows will probably also cause volatile currency movements.

(2) Reversion to mean of Corporate Profits as % of GDP

This will happen because of the continuing economic growth of China and India. As their workforces become fully employed and linked up to the global economy, the source of cheap labor will gradually dry up. The labor surplus over the last 2 decades which depressed wages and allowed companies to earn outsized profits will go away. The result is that more of the US GDP income will accrue to labor as opposed to corporate profits.

(3) Structural Changes in the Factors of Production

The Earth's increasingly affluent consumers will put strains on the planet's capacity to supply these basic resources. If this is simply a problem of increasing supply capacity, then any jump in commodity prices will be temporary since it will induce additional investments in commodity extraction capacity.

However, if we are hitting the planet's resource limits (e.g. peak oil), then it means that each unit of resource may require more capital intensity to produce (e.g. difficult-to-extract oil located in geographically challenging areas). This would mean that higher real commodity prices may be here to stay, and it implies that we will face structural shifts in the economy as more of GDP income needs to be diverted to pay for basic resources which require more effort / technology to extract. For example, each hour of work we put in now buys less products, because more of that effort has to put into pumping hard-to-reach oil out of the ground instead of making the products we want.

This could make a whole host of products that we currently enjoy economically unfeasible to produce. This could radically alter the economic landscape. Companies which have existed since the dawn of the automotive age could go out of business as their economic models become impractical. For example, will big box stores be practical in a world where oil is ultra-expensive? For that matter, the concept of suburbia itself could be threatened as the cost of living in spread out spaces becomes prohibitive. We could return to an era of living in high-density living, like in Victorian England.

Saturday, October 25, 2008

Are U.S. stocks cheap? (October 2008, S&P 500 at 860)

The Natural Cadence of the U.S. Economy:

Between 1950 and 2000, corporate after tax profits have averaged 5% of GDP (historically they have hovered between 4% and 6% of GDP source1, source2 ), out of which approximately 40% of the profits have been paid out as dividends (net dividends) and 60% retained for reinvestment (source: using data from the BEA for nominal GDP and Corporate Profits).

The historical risk-free interest rates (1 year treasury bill) between 1950 and 2000 have averaged approximately 5%. (This also seems to be the case going back to 1900 in the modern industrial economies of Europe, the U.S. and Japan)

Nominal GDP growth during this time has averaged 7.3% per annum. As a rough approximation, corporate profits after tax should also have increased at this rate. Given that corporations retain 60% of their profits, this implies that the historical ROE is about 12% on average.

In other words, the structure and cadence of the modern U.S. economy suggests that over the long run, the natural order of things is for the economy to grow at 7.3% per annum in nominal terms and have a risk-free interest rate of 4.8%. Looking at each year's GDP by income, the corporate sector's post-tax profits account for 6% of GDP, of which it distributes 2.4% of GDP to its owners, and reinvests 3.6% of GDP for corporate sector fixed capital formation. The natural cadence of interest rates, risk premium and economic activity has allowed the corporate sector to this with an average ROE of 12%.

With this natural cadence, stocks are fairly priced when
the Market Capitalization to GDP ratio is around 80%

If we believe this economic cadence will continue into the future, then we can calculate the NPV of the U.S. corporate sector using the nominal growth, ROE, and profit as a % of GDP figures we have observed.

(a) Estimate 1: Given a required discount rate of 8%, the NPV of Book Value of all corporations after 40 years + NPV of all dividends received over 40 years is approximately = 18.64 times the current corporate profits, which = 93.2% of GDP (the average corporate profits is about 5% of GDP, this means that the NPV of the corporate sector is 5 x 18.64 = 93.2 % of GDP)

(b) Estimate 2: Given a required discount rate of 8%, half the NPV of Book Value of all corporations after 40 years + NPV of all dividends received over 40 years is approximately = 15.75 times the current corporate profits = 78.75% of GDP (the average corporate profits is about 5% of GDP, this means that the NPV of the corporate sector is 5 x 15.75 = 78.75 % of GDP)

Stocks are now fairly priced
(Oct 2008, S&P 500 at 860)

As of Oct 25, 2008, the Market Capitalization of the US stock market (based on the Wilshire 5000 index) is about 74% of 2007 GDP.

It looks like it is fairly valued (it's not overpriced, but neither is it a fire-sale price), but only if:

(a) you are a long term 20-30 year investor willing to accept 5-6% per annum returns (you should conservatively estimate expect returns to be less than the discount rate or economic growth rate, because your purchase price and selling price may be at different valuation multiples), and

(b) the cadence of US economy over the next 40 years will be similar to the period since 1950, so that the historical averages we are using in the valuation will remain valid over the next 40 years. This assumption would require that economic cadence is determined by the legal and capitalistic free-market structure of the U.S. economy, combined with the socio-political norms in the U.S. and universal human/psychological factors (all of which look likely not to change) and not by technology (which is improving at an accelerating pace as futurists such as Ray Kurzweil suggest).

(c) you think a 8% discount rate is sensible.

Will stock prices go down further?
(Historically, what is the cheapest that stocks have gotten?)

Yes, it's certainly possible. Investor psychology can cause markets to be severely undervalued or overvalued for prolonged periods of time. In the 1940s, the US stock market has at times had a capitalization as low as 40% of GDP. In the 1980s, during the high interest rates of the Volcker era, it was trading at about 50% of GDP (see Nick Nejad's blog post). So if history is a guide, investor psychology could make the markets could go down another 33%. (Historically, those two periods were also times when equities were out of favor with the public at large. The period between the 60s and 1974, and the period between the late 80s and 2000, were periods when equities were extremely popular.)

If we are moving into a period when equities are out of fashion in the zeitgeist, then it is conceivable that the market could fall till its value is only 50% of GDP (i.e. S&P 500 at around 580; or it could just stay stagnant as GDP grows until the ratio is about 50% (GDP would have to increase by 50%, ie. grow at 7% for another 6 years for this to happen).

The Wall Street Journal also has a neat table showing historical PE ratios of the market. Though PE ratios of the market in any one-two year period are not indicative of historical averages (because corporate profits as a % of GDP swing from year to year), they do suggest the possibility of the market going down by 35% if we return to the market PE ratios common in the 1980s. (2008 market PE ratio: approx 12; 1974 market PE ratio: approx 7)

Can we use this market capitalization to GDP ratio to assess the value of other equity markets?

This approach works for the U.S. equity market, because (a) the U.S. economy is extremely broad, robust, and resilient, and (b) the U.S. equity market is well developed and the publicly listed companies are representative of the overall U.S. corporate sector.

This is not true for all countries. For example, Brazil has a broad and deep economy, but a disproportionate amount of its market capitalization is for natural resource companies. Buying the index tracking fund there would not give you exposure to the underlying economy. As another example, Singapore has a small niche economy and a stock market that hosts many companies with businesses outside of the Singaporean economy. The market capitalization to GDP ratio in Singapore would tell you nothing about whether Singapore listed equities are overpriced or underpriced.

Buying stocks (or an index tracking fund) is a bet on the U.S. economy.
So should investors be concerned about the huge (and growing) U.S. current account deficits?

The 2007 current account deficit was about USD 731 billion, or about 5% of GDP. The impact of this to investors is that as the U.S. imports more stuff every year, the U.S. dollar will be under constant devaluation pressure.

(Side Note 1: The 2007 U.S. Net International Investment Position was about negative USD 2.4 trillion dollars, or about 15% of GDP. The NIIP has been deteriorating at a slower rate than the growth in cumulative current account deficits, suggesting that foreign holders of US dollars have been buying US assets whose prices generally decline over time, and/or that US investors have generally been buying overseas assets which generally appreciate in price over time. [see the BEA's "changes in selected major components of the international investment position" for details] But the U.S. NIIP is deteriorating nonetheless.)

(Side Note 2: As a comparison, Australia has a negative net international investment position of about 68% of GDP. This could theoretically be due to Australia borrowing more to fund its gross fixed capital formation which is about 25% of GDP, as compared to the gross fixed capital formation of about 18% of GDP in the U.S.)

If you are U.S. based investor who uses USD for day-to-day living, then this won't matter as long as the U.S. economy is able to start domestic manufacturing of items that were previously imported. My bet is that it will be able to do so. The resourcefulness and ingenuity of the capitalistic U.S. economy will rise to the occasion. You US dollar investments will return you US dollar dividends which will maintain their real value.

If you are a overseas based investor who used another currency for day-to-day living, then you would be concerned that even if you own all the companies the US, the US dollar dividends would be worth less and less, in real terms, in your local currency. However, my bet is that if the US dollar depreciates excessively, US companies will begin manufacturing things that used to be imported, and also export their wares as the depreciating dollar makes them more price competitive. This should limit the decline in the real value of your US dollar investments. But the quantum of the decline in real value of your US investments is hard to determine.

Tuesday, October 21, 2008

Analyzing eBay - How wide is eBay's moat?

eBay is often thought of as a business with a wide moat, because its core eBay site has a strong network effect and it has the largest number of users among its competitors. As with most network effect businesses or technologies, once a dominant player emerges, it is practically impossible to dislodge because of the value the network has to its users (the value created for its users grows polynomially as the number of users increases linearly). eBay was seen as the dominant franchise.

eBay started as a giant swap meet for people to buy and sell to each other. eBay was a venue for traders to meet and trade, much like a stock exchange. Such exchanges are economic entities that enjoy a tremendous network effect, and they are able to command economic rent. (The stock exchange analogy is conceptual only. In real life, there are large market makers participating in the U.S. stock exchanges each of which accounts for a large proportion of trading volume. This erodes the ability of the exchange to command economic rent, because the market makers can just link up among themselves to create a parallel exchange)

Because each participant in an exchange can potentially engage in two-way trade with all other participants, each additional participant increases the number of trading possibilities polynomially (think of it as a complete graph - such a graph has n(n-1)/2 edges). Traders, who value the number of trading possibilities available in an exchange, the value of the exchange grows tremendously as the number of participants increases. In practice, once a critical mass of participants is reached, the value of the exchange to all its participants probably grows at a rate far greater than the polynomial growth that the number of trading possibilities would suggest. In real life once a critical mass of traders is reached, benefits like economies of scale in trading volume and market liquidity kick in once a critical mass has been reached.

This economic characteristic makes it extremely difficult for smaller exchanges to compete with a larger dominant exchange. In fact, like all network effect entities, once a large exchange achieves a size beyond its competitor(s) by some amount, a tipping point is reached and competing exchanges will shrink rapidly as participants migrate to the dominant exchange. eBay was thought to be the dominant exchange and hence unassailable.

However it is probable that this assertion that eBay's site has a network effect is wrong. This is because eBay may actually be a marketplace and not an exchange. Exchanges have a network effect, while marketplaces do not.

There difference between the two lies in the trading patterns and behavior of its participants. In an exchange, all participants are traders that buy and sell from each other. In a marketplace, participants generally perform only one role: they are either buyers or sellers. Marketplaces are venues for two groups of people to meet, and for each group to derive benefit from the other group. The value of a marketplace to a participant is proportional to the number of participants that belong to the other group. For example, the value of a market to a seller is proportional to the number of buyers present, and the value of the market to a buyer is proportional to the number of sellers present.

Marketplaces do not have strong network effects because the value of the market only increases proportionally to increases in the number of participants. (Unlike an exchange, whose value increases disproportionately). However marketplaces do exhibit a self-reinforcing feedback loop effect. The more buyers there are, the more valuable the market venue is to sellers. This causes more sellers to come on board. The increased number of sellers in turn makes the market venue even more valuable to buyers, which causes more buyers to come on board. This in turn makes the market venue even more valuable to sellers, enticing more sellers to come on board, and so on. Examples of marketplaces are newspapers, shopping malls, and supermarkets/department stores that sell on consignment.

Newspapers (especially the classifieds section) are essentially a market venue for advertisers and readers. The more readers there are for a classifieds section, the more important it is for advertisers to advertise there. With more advertisers, readers will find the classifieds more valuable because of the increased ranges of products and services available. This brings in more readers, which in turn brings in more advertisers. (In a sense, the "news" in a newspaper is just a sideshow used to bring readers in - the real business of a newspaper is in being a market venue for readers and advertisers.)

Shopping malls operate on the same principle. The more people there are who visit a mall, the more valuable the mall is to shop owners. And the more shops there are, the more useful a mall is to customers.

Like exchanges, marketplaces tend to be "winner takes all" types of businesses. If an marketplace becomes much larger than its competitors, the business will eventually drain away from the smaller markeplaces and migrate to the larger marketplace. However, unlike in an exchange where it is practically impossible to dislodge a dominant player, it is relatively easier for a competitor to dislodge a dominant marketplace. How so?

For a small exchange to dislodge a larger exchange, it essentially has to convince a large number of participants to move from the large exchange to its smaller exchange. In fact, to beat the larger exchange, it literally has get enough people to move over so that it becomes the larger exchange. In other words, the strategy for a smaller exchange to beat a larger exchange is to become the larger exchange. This is going to be difficult, because participants of the larger exchange derive higher value simply because it is the larger exchange. It is difficult to come up with a proposition to get them to switch over.

However, for a small marketplace to dislodge a larger marketplace, it only needs to convince one group of participants to move over. Once it has done this, it can count on the self-reinforcing feedback loop to draw in the other group of participants. The participants know this too, and they may be willing to bet that the market owner will be able to convince their group peers to move over. For example. they may believe that the market owner has the clout/salesman ship to bring over lots of their group peers. The hurdle to overtaking a large competitor is lower than in the case of exchanges.

Signs suggest that eBay is a marketplace, not an exchange.

Although I have no figures to back this up, it looks probable to me that the bulk of today's eBay users are not traders. Rather they are divided into two groups of users: buyers and sellers. It appears that more and more of the trading on eBay is between people who specialize in selling (such as the eBay Power Sellers) and people who visit eBay only to buy/hunt for bargains (i.e. buyers).

If this is true, it would explain why eBay is trying to move away from its "flea market, swap-meet auctions" format to a more commercial "buy it now" format with fixed prices and store fronts. This look-and-feel transition, if true, signals that the underlying economics of eBay have changed. This change of format is not simply a cosmetic matter, or a matter of catering to the changing zeitgeist (which is what retail and fashion businesses have to do to stay relevant to their customers). (Even if the underlying economics are exchange in nature, eBay's current moves towards a marketplace business model means that the underlying economics will eventually become marketplace economics)

The competitive landscape - Amazon Marketplace.

If indeed eBay is being used as a marketplace, then it susceptible to competition from Amazon, in particular the Amazon Marketplace which was launched in 2001.

While eBay does seem to be orders of magnitude larger than Amazon (2007: eBay Gross Merchandise Volume of USD 59.3b, compared to Amazon Revenue of USD 14.8b), Amazon does have very strong mindshare with buyers as the "defacto place to buy things online". Amazon's mindshare with the general public will make it possible for them to convince large numbers of buyers to move over. Likewise, their fulfillment capability could also convince large numbers of sellers onboard. This could then precipitate the self-reinforcing feedback loop which could grow their marketplace significantly and threaten eBay's position.

Strategically, the only two Amazon capabilities that eBay cannot counter, is (1) the fulfillment feature for sellers, which can attract sellers on board, and (2) Amazon's mainline store, which can be used to offer loss leaders and coordinated merchandising to bring in buyers. These are two very strong competitive tools that Amazon has in its fight against eBay. eBay's competitive advantage over Amazon (as of now) is its larger size.

This competition is shaping up as a contest between a large bazaar of vendors selling to customers (eBay) and a huge shopping mall with an anchor tenant (Amazon).

The two may be able to co-exist, but only if (a) the e-commerce market is large enough and both players to maintain size parity with each other; otherwise tipping point economics will take over and only one will survive, or (b) each specializes in a different product range, or (c) each specializes in a different type of buyer/seller; for example eBay goes for traders/swap-meet, while Amazon goes for conventional buyers and sellers. Because the online ecommerce market is still growing and its ultimate size and form is unknown, the growth and competitive parameters of both Amazon and eBay is tricky to quantify.

eBay's other businesses - PayPal, Skype and online Classifieds (Gumtree, Kijiji)

While eBay's other businesses are strong, they are still small relative to eBay's overall business.

Nonetheless, they have strong competitive positions, and eBay may end up as a conglomerate with a collection of strong online businesses. Betting on them is a venture capitalist's game, not the game of an investor looking to invest in a running business. I'll take a look at eBay's other businesses sometime, possibly in another post.