Profitless Prosperity
avc.com
avc.com
It's amazing to me that folks in the Silicon Valley/VC world continue to look at the performance of publicly-traded tech companies and for some reason never seem to consider that, as deserving of premium valuations as some of these companies may be, much of the crazy price action of the past several years has been driven by the Fed.
You can't seriously look at the charts of companies like Netflix and Tesla and believe that this is the result of DCF analysis.
> If you believe, as Amazon management does, that the future growth is going to be there for Amazon, then you ignore the current P&L and think about what a future P&L might look like.
> If you think that Salesforce and Workday can continue to grow their revenues at or near their current growth rates, then you ignore the current P&L and think about what a future P&L might look like.
How about this: if the Fed balance sheet continues to go up and to the right, ignore fundamentals, pick momentum stocks and think about what their future charts might look like. It doesn't take a lot of imagination: up and to the right.
Of course, when the fun ends, "profitless prosperity" will indeed be profitless for the folks who didn't cash out in time.
But- if one did a sensitivity analysis for changing discount rates & valuation - it wouldn't be the key driver for high growth companies like Facebook & Tesla.
Damodaran has done a somewhat detailed analysis on TSLA & FB & changing discount rates don't seem to be a big factor in valuation. http://aswathdamodaran.blogspot.com/2013/09/valuation-of-wee...
Every time there has been even the mere talk of tapering or an end to QE coming - no actual tapering has ever occurred - the stock market tanks.
Wall Street parties every time they get confirmation QE is going to continue. Every headline on CNBC et al. tends to track specifically what the Fed is going to do regarding their debt monetization and housing inflation programs. Immediately after it's confirmed the Fed will continue to devalue the dollar and inflate assets with low interest rates and QE, the stock market spikes higher. This has been the pattern for years now.
"Dont run small fishs, they dont know what they are saying, they are lunatics, stay with us and put your money here, we know better"
When money is cheap, it pursues high risk investments for outsized returns. Institutional investors in fact push for such, in a race to keep up with the returns their peers are seeing during periods of very large stock market gains. Investment funds pursue ever higher risk investments for higher returns, in a competition for capital. For the most part, all money and all investments compete in a global market place. Very few investors have the will power to sit on the sidelines while others are making fortunes riding bubbles (eg the late 1990s, 2004 > 2007).
The Fed's policies are specifically aimed at making money cheap right now (and they've succeeded; see corporations issuing debt at almost zero cost, such as AAPL and MSFT). Whether we're talking the cost of a mortgage, or the POMO shots boosting the stock market, or the indirect asset bubble effect from money chasing risk to compensate for the lack of interest yielded from cash, and on and on it goes.
Providing easy money should give a boost to all stock prices, and in fact the Feds actions should give the biggest boost to low risk investments since they are the closest substitutes for what the Fed is buying.
The Fed's policies encourage money to chase risk. When money is 'free' it becomes wildly risk seeking. People that acquire free money do not do the responsible thing and seek safe investments (ask most lottery winners). That's why you see massive asset bubbles develop with low interest rates. The Fed has in fact said it wants to create an artificial wealth effect by leveraging asset bubbles, they wanted to re-inflate the housing bubble for example with toxic mortgage purchases and low mortgage rates.
Don't take my word for it. The US Treasury has stepped forward to admit as much.
http://www.zerohedge.com/news/2013-08-13/us-treasury-finally...
Or take a look at the S&P without the Fed:
http://www.zerohedge.com/news/chart-year-fed-has-doubled-sp-...
Or overlay the S&P with the Fed securities:
http://i.imgur.com/QFHnbBv.jpg
There is now an endless parade of evidence available as to exactly how the Fed creates asset bubbles (we're on our third bubble period right now in just 15 years), and how their programs directly inflate the value of the stock market. The Fed has even taken direct credit for being responsible for as much as 40% of the stock market's value.
On the evidence you are presenting: This doesn't prove that the Fed is causing a stock bubble. The stock market, if anything, is forward looking. Even if the fed was causing a bubble, the kind of patterns you are showing wouldn't be expected. Take the second link, for example. The article clearly states that the stock price gains are made before the FOMC announcements. So somehow the act of making any announcement is causing the market to react in anticipation.
I don't know how to explain these patterns, but they are certainly not good evidence for the Fed causing a bubble.
Monetary policy is very simple and in accordance with the best macro theory we have. The Fed lowers interest rates in recessions, in the hope that it will cause people to consume/invest more and "save" less where saving might include holding hard currency, or safe physical investments. Put in more conventional language, the Fed lowers interest rates to stimulate economic activity.
But this should not be interpreted as trying to cause a bubble. The aim of the Fed is to stimulate economic activity so that both the current efficiency of the economy improves, and beliefs about the future efficiency of the economy are more optimistic. In doing so, it hopes to cause the economy to move from the "unnatural" state in which people are fearful about the future, expect high interest rates, and are unwilling to invest or consume, to the "natural" state in which people are optimistic about the future and expect low (short and medium term) interest rates.
Personally, I don't need more empirical evidence than that.
Fortunately we have a mountain of direct evidence to support my position.
Monetary policy being simple has nothing to do with its results. Cheap money doesn't stay put, it chases returns.
Our supposed best macro policy is a disaster. It has neither contained price inflation, nor produced jobs. Quite the opposite in fact over the last two decades of high level Fed tampering with the economy. Said macro policy is not the best at all, it's standard issue failed Keynesian policy (Japan has been enjoying a similar program for decades as their economy has rotted and accumulated hyper debt).
Not only has the Fed admitted it can create asset bubbles with low rate policies (both Greenspan and Bernanke have acknowledged such); not only has the Fed said that they want to spur asset inflation, to generate a wealth effect (they directly said their goal was to re-inflate housing for example); but the US Treasury and the Fed's own governance board has also stepped forward to say that the Fed's policies directly drive asset bubbles, including in the stock market. The Fed's governance board recently warned that the Fed's policies were creating potentially dangerous imbalances in asset prices; that was a year ago.
Then all the direct correlation data:
"between January 2009 and April 2013, on days in which the Fed POMO was more than $5 billion, the stock market rose a total of 570 points, on days in which the POMO was less than $5 billion, the cumulative stock market gain was "only" 141 points, and when there was no POMO, the S&P gained... -51 points."
OR:
"We show that since 1994, more than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year)—a phenomenon we call the pre-FOMC announcement 'drift.'"
The data points are extraordinarily overwhelming in supporting the fact that the Fed's policies directly drive the stock market. We have the logical (get rid of yield on cash, money has to chase risk), the empirical (the charts and data), and all of the players admitting it. We also have the perverse: watch CNBC on Fed announcement days.
If that doesn't convince you, there's nothing that can.
(What I said was, "On the evidence you are presenting: This doesn't prove that the Fed is causing a stock bubble. The stock market, if anything, is forward looking. Even if the fed was causing a bubble, the kind of patterns you are showing wouldn't be expected. Take the second link, for example. The article clearly states that the stock price gains are made before the FOMC announcements. So somehow the act of making any announcement is causing the market to react in anticipation.
I don't know how to explain these patterns, but they are certainly not good evidence for the Fed causing a bubble.")
These are not the only stocks benefiting, but they're great examples.
> Providing easy money should give a boost to all stock prices...
I don't know when you last checked, but the S&P just hit a new all-time high this past week, and the Dow achieved a new all-time high last month. The NASDAQ is within striking distance of 4,000, a level last seen in 2000. So yes, easy money has boosted all stock prices.
> ...in fact the Feds actions should give the biggest boost to low risk investments since they are the closest substitutes for what the Fed is buying.
No, that is not how this works. The Fed's actions encourage (if "force" is too strong a word for your liking) investors to bid up riskier assets because it's damn near impossible to find returns anywhere else.
Furthermore, it's very hard to separate the direct effect of low interest rates, from improvements in the economy in general. You cite the current price of stocks as an example, but the Fed has had low interest rates since the financial crisis, so you to explain why now in particular is a bubble caused by low interest rates.
On the final point, I am correct about the mechanics of which stocks benefit the most. Suppose instead of high risk stocks, low risk stocks, and bonds, we had apples, oranges and mandarins.
When the Fed buys lots of mandarins, it creates excessive demand for mandarins, and so the price increases. This causes people who were buying mandarins to buy oranges and apples, instead but the total demand for mandarins has still risen. We would expected the biggest price increases to be in mandarins, then oranges, and then apples.
Similarly the biggest price change is in the bond market (which the Fed effectively has complete control over), and then in low risk stocks, and then high risk stocks.
The effect you observe - people being driven from the low-risk to high risk markets by low interest rates - is ignoring the initial price increase that caused this shift.
You are wrong on this. That's your problem. A dollar today does not equal a dollar tomorrow. Those promising more dollars the day after tomorrow, and those promising a dollar tomorrow will see differential pricing.
The general consensus just a few short months ago was that the Fed would start tapering in September. It did not happen. There are credible observers and market participants who not only believe that tapering is not coming any time soon but that the Fed's asset purchases will actually increase.
I don't necessarily agree, but I do believe that the Fed has positioned itself between a rock and a hard place, so I personally wouldn't make too many assumptions about timing and magnitude of increases or decreases in asset purchases.
> So yes, the market will discount investments that pay off in 1-2 years at a low interest rate. But since the low interest rates aren't expected to last, we shouldn't expect huge price increases for stocks whose investments will pay off in 5-10 years.
You make the mistake of assuming that investors are entirely rational. The empirical evidence clearly demonstrates that this is not the case. You should also consider that many (and perhaps the majority) of the participants in a good number of markets aren't really "investors" as most people define the term.
John Williams, the President of the SF Fed, recently addressed asset price bubbles in a presentation[1]. It is well worth a read, and I would point you to the following:
"For monetary policy, one implication of theories with endogenous asset price bubbles is that the time horizon over which policy affects the economy may be longer than typically thought. In particular, the policy response to cyclical movements in economic activity and inflation may have effects on investor beliefs and the behavior of asset prices that reach well into the future."
[1] http://www.frbsf.org/our-district/press/presidents-speeches/...
Or at least, so the theory goes.
You are applying a model with fixed r, which is wrong because the current low interest rates are temporary.
Forget the interaction between interest rates and risk preference for the moment. Isn't it the case that if interest rates are certain to return to normal in 2 years, then the values of an investment that returns in 5 years, and an investment that returns in 2 years, will be equally affected by current low interest rates?
No, this is not true. The whole point is that R=R(r). Its just that the relationship is ~chaotic, not linear. And it gets messy as either r or R --> 0. The fact that preferences are recursive on (r) should not be a surpirse, but I don't think mainstream Economists generally go there.
On the topic of "temporary" vs Uncertain changes in (r), they are not the same. One is risk, the other is uncertainty. In general risk is priced a certain way (reasonably efficient), uncertainty is something you have preferences for (ie, you dont "price" it in the normal sense) and can only model indirectly in the first instance.[1]
[1] eg, http://economistsview.typepad.com/economistsview/2010/06/ris...
It's not a very far reach to believe that investors have become spoiled by the Fed and accustomed to a hyper low rate policy.
Every time there's talk of tapering or letting off the QE party, the stock market tanks. That's not a coincidence.
The 1999 stock market bubble was spurred on by Greenspan's errors of leaving interest rates too low for too long.
To try to artificially stimulate the economy and dodge a recession temporarily, the Fed did it again in the early 2000's, which led to the house bubble and the stock market bubble of the mid 2000's.
It is relevant because your claim is that investors are over-valuing the future cash flow of companies like Amazon, because they are using the current 0% interest rate to compute the NPV of these companies.
However, a smart investor would, like you, predict that the current interest rates will not last forever, and so will not use a formula for NPV that implicitly assumes the current interest rate will last forever.
You can't just point to the "standard" definition of NPV and somehow claim that this automatically leads to wrong valuations by investors.
please give future comments as arguments, not links. While my PhD is in economics, not finance, I'm familiar with the mainstream literature. I'm not saying I'm 100% right all the time, but if there is disagreement between us, it isn't because I lack basic education in the field.
Investors are using a <directonally lower> discount rate.[1,2]
_________
[1] The purpose of fed policy is to effect such marginal change. The rest is simple, no need to overthink it.
[2] The term structure of interest rates discussion linked above will only reinforce this point.
The original comment said "You can't seriously look at the charts of companies like Netflix and Tesla and believe that this is the result of DCF analysis"
While your claim is that low interest rates automatically raise the value of companies, when computed with DCF analysis.
So I agree with you that low interest rates do increase stock prices, but it's not relevant to the discussion at hand, since the original post was clearly referring to mis-pricing of stocks. That also explains why I and, perhaps others, didn't understand your meaning. You were applying your own notion of how the Fed drives stock prices, not the one in the original post.
All it would take is raising prices across the board by just a little bit. Amazon has more than $70 billion in annual sales, so a 1% average increase in prices would bring in more than $700 million in annual pretax profits. A 10% average increase would bring in over $7 billion more a year.
In fact, if Bezos were to ask his executives to go through Amazon's entire portfolio of products and services to figure out how, when, and where they could raise prices the most to maximize present profits, the company would quickly become one of the world's most profitable businesses. Customers -- particularly Amazon Prime members who've gotten used to clicking a button and ordering for free delivery almost everything they need -- will not suddenly change their buying habits if, say, the price of light bulbs on Amazon.com goes from $0.79 to $0.89 per unit.
So I agree with Wilson: Amazon's lack of profits today could be a very good thing. It all depends on WHY Bezos is holding back from taking all those easy profits already available to the company.
A key question is whether that 10% price increase would be absorbed by customers with no change in sales. There's an argument it goes the other way: customers trade the immediacy of brick-and-mortar for Amazon's low prices. But if the online prices are no better, then Amazon provides no benefit, and a 10% price increase could result in a much larger drop in sales. This played out in my own household: we used to buy diapers exclusively through Amazon, but completely stopped following their diaper price increase.
Speaking only for myself, the vast selection and stock is a huge factor for why I often prefer to buy things from Amazon.
For instance, there's a particular mustard that I like that is hard to find in stores nearby. I don't like it enough to justify going from store to store to find it, but I do like it enough to buy it from Amazon for the same price that I would pay by doing that, and just wait a day or two. Often stores are out of stock of the things that I want. Amazon tells me that without leaving the house. I live in a city where a trip to a store that isn't in walking distance can be a couple of hours or more to haul myself around on transit, but Amazon delivers to my office. I imagine that there are people in more rural areas that if the local store just doesn't have what you're after, you're out of luck. And so on.
My point is, there are plenty of reasons besides price to give up immediacy
You spend lots of time in shopping + gas + car. Delivery is a nice thing.
There are countless examples of giant companies that haven't realized the enormous future cashflows embedded in their stock prices. It is obvious that Amazon generates lots and lots of revenue, no one disagrees with that. What remains an open question is will they be able to ease off of massive infrastructure investment and actually harness the future profitability that everyone seems certain of at this point.
These straw man arguments that profit-less companies have huge market caps so they will turn hugely profitable ignores the actual argument of whether they can actually achieve that. Can profit does not equal will profit.
These Fed driven asset bubble waves are a huge wealth give-away to the biggest companies. They tend to be able to ride out the ups and downs, while their smaller competitors who get caught up in it as well, do not tend to survive the extreme down-turn (take Sun Microsystems for example: they modified their business to ride the exaggerated dotcom boom, their stock was worth $200+ billion at the peak, and their sales grew massively, and then it all imploded and nearly destroy Sun on the way down, and some would argue it did in fact; meanwhile Microsoft rode it all out just fine).
Lesson being, some companies get caught up in the exuberance, and they roughly speaking get destroyed, while their competitors thrive in the post-bubble period when the stock market & private markets aren't willing to fund competition any longer.
I can hardly believe how much this sounds like the same voodoo justifications I was reading in 1998. Saying it's deja vu wouldn't do it justice.
Arguing for making long term investments, has nothing to do with whether $14 billion for a company that has never made money (has lost a ton of money) and only has $273m in sales - is a reasonable valuation. 51 times sales?
Well what you don't do, is buy Amazon in 1999 for $85 / share, you wait for the inevitable crash and buy it for $6 or $8. And you don't buy Amazon for $363 after a parabolic run, you buy it for $40 or $50 after the 2008 crash.
Workday and all the others will follow this pattern, some will live, some will die. If you think a company has long term value to offer, you buy it cheap when a lot less people want it; you don't buy it when everybody wants it during an epic stock market run; and you don't assume a bubble valuation has any correlation to its future prosperity (or lack thereof). The last two bubbles should have demonstrated that in spectacular fashion.
Just co-incidently, TWTR is going through its IPO. This is just a little nudge to remeber that profits don't matter, and you should just go buy some stock. =D
I was surprised to read your analysis of the situation. I must say that you're just flatly wrong.
Amazon is not a good place to work if you value your life outside of its value for your employer. Everyone from warehouse employees to the knowledge workers are sweated for everything they are worth. Recall that Amazon runs their warehouses like prisons and they have the lawsuits to show for it[1].
[1] http://www.mcall.com/news/breaking/mc-amazon-integrity-wage-...
In other words, the specific mechanism of how a company uses profit (or more specifically, free cash flow) does not have any inherent value to shareholders (dividends, buybacks, paying down debt, or re-investment.) It's only in the context of the opportunity cost of how that capital could have been used elsewhere that you can measure the value for shareholders.