Businomics Blog

Facebook IPO Not a Flop

Is the Facebook IPO a flop? Not on your life. It’s a sign that Silicon Valley has gotten as smart about finance as it has been about technology. I like it.

The smackdown of Facebook comes from the lack of a price pop on the first day of trading, compounded by declines in the company’s stock price in succeeding days. This is not a flop from Facebook’s perspective, it’s a success.

(A separate issue is NASDAQ order execution, which I’m not discussing here.)

What’s bad is not Facebook’s initial public offering, but the old Initial Public Offering model: the stock is sold at some price, let’s say $20. On the first day it jumps to, say, $35. Further upward movement follows on succeeding days, leaving the stock price at $40 a week after the IPO. What’s bad is that the company sold stock for $20 that it could have sold for $40, or at least $35. It’s a violation of fiduciary duty for the officers and directors to knowingly participate in such a scheme, though usually everyone is so happy to have the IPO completed, and to be so rich, that they don’t really care too much.

A company is not helped by the “pop” on the first day of trading, but others are greatly benefited. Those investors who got in at $20 and could get out the next day at $35 were obviously better off. How do you get to be such an investor? You do business with the investment house that underwrote the deal. The sad part of the story is that the corporation going public pays the underwriter a fee that’s usually seven percent of the proceeds for small issues and averages 3 ½ percent for large issues. Imagine paying a fee for the underwriter to favor its investment clients over the company going public. (The Facebook underwriting fee was reported to be 1.1 percent of the money raised.)

Here’s what good about the Facebook deal: the company worked for its own best interest and was not intimidated into favoring the investment banks. It negotiated a low fee and pushed for as high a price as the market would bear. Was it a flop? Not for Facebook. This is one deal to like.

Thomas Jefferson on Investment Bubbles

My friend Patrick Lee at Thomas Jefferson Leadership quotes Mr. Jefferson:

 

The American mind is now in that state of fever which the world has so often seen in the history of other nations. We are under the bank bubble [of financial speculation], as England was under the South Sea bubble, France under the Mississippi bubble, and as every nation is liable to be, under whatever bubble, design, or delusion may puff up in moments when off their guard.

Patrick has a brief commentary about Jefferson on bubbles.

On this topic, I use the works of Kindleberger, MacKay and Bagehot on financial crises.

 

 

U.S. Treasury Bonds Split Rated: The Song

When a bond is rated differently by two ratings agencies, it is said to be "split rated." Thus the title of the song performed by Curtis Threadneedle, written by him and Marcy Shaffer and our old friend Merle Hazard:

 

Can Industry Survive the Stock Market Crash?

Manufacturing and related wholesale businesses are mostly enjoying better sales than last year, but Wall Street gyrations have thrown a scare into many executives of heavy industry. The key questions for manufacturing and distribution are whether the stock market means anything for this business. If it does mean something, then what is that? More importantly, which sectors of manufacturing and distribution will thrive, and which are most vulnerable to economic turmoil?

The connection between the stock market and the economy is often confusing, because either one can affect the other. That said, most often causation goes from the economy to the stock market. Investors are concerned about the future earnings of companies whose stock they are following. When the economic forecast looks poor, analysts will lower their estimates of future earnings, resulting in selling of stocks, lowering the overall stock market averages.

The analysts don’t even have to forecast a recession for the stock market to decline. If they change their forecast from corporate profits growing by ten percent a year to a less-optimistic figure of five percent growth, that by itself will trigger a decline in stock prices. The problem is not that the economy is headed down, but that stock values were previously based on too optimistic a projection of the economy.

Causation can also run the other way, such as when a fall in the stock market makes capital spending too expensive. Reduced expenditures on plant and equipment will hurt the economy. Generally, though, causation runs from the economy to the stock market.

So what is the stock market saying today about the future path of the economy? Volatility seems to have been triggered by Standard & Poor’s downgrade of United States Treasury bonds. The downgrade by itself isn’t a disaster—the interest rates on government bonds has actually declined, so investors obviously are not worried about a government default. Rather, the S&P bond downgrade was a wake-up call. The federal government will have to adjust to the reality that its current fiscal path is unsustainable.

A sustainable path requires spending cuts or tax increases or some combination of the two. Neither is good for the economy in the short run, according to the models that most of us economists use. A program to put the nation’s fiscal house in order is obviously good in the long run, but it’s hard to imagine a reasonable program that does not involve some short-run pain. That has the stock market in the doldrums.

Investors are also nervous about Europe. Greece is a relatively small country, but Italy is large. An Italian debt crisis could well plunge the Continent into recession. A European recession would probably spread to the United States.  Probably, though not certainly.

Between the American budget and European debt, there are good reasons for stock market investors to be nervous.

What does this turmoil mean to industrial manufacturers and wholesalers? There are some who will be hurt more, and some less, and it depends on both geography and product type.

Businesses selling to Europe are at the greatest risk. I strong recommend contingency planning for the possibility of a recession, especially one centered on Europe. It’s too early to pull the trigger on the recession plan, but it’s not too early to sketch out the plan.

Asia, on the other side of the planet, is the safest market to be in right now. There will someday come a Chinese recession, but right now China, India and their neighbors are strong.

In the middle are companies selling in North America. There is certainly risk, but another recession in the near-term is far from a certainty. I recommend planning for moderate growth, with contingency plans for a downturn.

Different industries have different outlooks. Mining and transportation equipment are strong right now. Some companies tell me that their constraint is from vendor supplies rather than a weak order book. Businesses selling equipment that help other companies lower their operating costs are enjoying growth right now. That’s part of the reason that technology companies are doing well. On the other hand, corporations that sell machinery to expand productive capacity are generally seeing weak growth. Most industries are not using all the capacity that they developed before the recession and thus see little need to add more machinery.

Consumer discretionary spending will be weakly positive. Households actually have money to spend, at least in limited amounts. Nerves are frayed, though, not only because of the weak job market but now by stock market gyrations. The Dow Jones averages don’t directly affect most families, but news headlines are frightening to many. Finally, construction is weak, limiting growth of those businesses selling products into that industry.

What should top management of a manufacturing or wholesale company do right now? First, ignore most of the headlines and drill down to specific markets. Second, every business should develop contingency plans for a recession. (That advice applies to non-profits and government agencies, too.) Third, every business needs to take advantage of the growth that is occurring now—and the economy is actually growing, albeit slowly. Conditions may not be booming, but a successful business leader works with the economy he or she has. After a career watching companies weather various economic storms, I have concluded that I’d rather see good management in a weak economy than poor management in a boom.

Interview on Investor Radio

I was interviewed this past weekend on InvestoRadio, about the stock market volatility, the S&P downgrade of U.S. Treasury debt, and the risk of another recession. Listen here. (My interview starts about one-fourth of the way into the show.)

The guys on InvestoRadio are really good. There's a lot of snake oil in the investment community, but Tom and Don deliver sound advice. I recommend them highly.

Is Gold a Bubble (2011 edition)

You think?

Here's some perspective: history, demand and supply.

Brief history of gold price: Gold had sold for $35 an ounce, then shot up to $675 during the last bubble, peaking in January 1980. (I'm using monthly averages throughout this article.) That's cool, buying at $25 and selling at $675. However, as gold was shooting up, plenty of new "investors" were buying, and there were plenty of people who got in on the boom at above $600.

Within two and a half years, gold had lost half its value. It finally hit its trough in 1999, 19 years after the peak, at $257 an ounce. That would have been a good time to buy, but who would have thought? Gold had slumped for nearly two decades. It appeared to be a stupid time to buy.

Now we're up over $1500 an ounce (I'm writing on April 28, 2011). Isn't that great? Let's stay with the history for a bit. Let's go back and adjust that 1980 peak for inflation. In terms of dollars with 2010 purchasing power, that peak was $1,892 per ounce. Another 23 percent upward and those old investors will have recovered all their purchasing power. Whoop de do. Just for comparison, if you had bought stocks in January 1980, you would have a total inflation-adjusted return of 316 percent. But we were headed into a recession in 1980, with fed funds at 13.8 percent, mortgages at 12.8 percent, and everyone knew it was an awful time to buy stock.

Demand for Gold: The big surge in gold demand recently has been speculative, but first let's cover usage. Jewelry is a major use, and the expanding economy in the emerging world is stimulating demand. There's plenty of industrial use of gold. Your computer has gold connections, but not enough to melt down your box and turn a profit. However, we have a lot more electronic stuff than every before, and industrial usage is rising. Gold is also used in dentistry, and I would expect rising incomes in the third world to stimulate demand for gold fillings. There are other industrial uses which should rise with the world economy.

The speculative demand for gold has historically been fueled by inflation fears. The tremendous monetary stimulus of the Federal Reserve warrants some concern. However, here in the United States we have so much unused productive capacity that I can't see inflation emerging anytime soon. Further, one would want to look at worldwide monetary policy, which is not nearly as stimulative as U.S. policy.

Certainly some prices are rising rapidly, but they are primarily commodities (such as oil). No one seems to notice that plenty of other prices are falling. Anyone buy a computer lately? The price changes are predominantly changes in relative prices, meaning the price of one good relative to other goods. They get translated into general inflation only if the central banks of the world print more money. (Here in the United States, the money supply has risen less than five percent in the past 12 months.)

The bottom line is that I think the speculative demand for gold is fickle, and could quickly turn to selling. But that depends on ...

Supply of Gold: In the short-run, it's hard to increase gold production. Mines are capital intensive businesses. The existing mines may be able to run double shifts and increase output, but adding capacity takes time. However, high prices for gold motivate mining companies to ramp up production. The first key thought is that we have a large number of gold mines out there. A typical mine has a variety of mineral combinations in different locations. The mining geologists know that the high-concentration (equal low cost production) ore is over here, while the low-concentration ore (high production cost) is over there. They will sometimes shift production back and forth to keep their workers fully employed. At times like these, though, look for every operating mine to produce at maximum capacity.

In addition to the mines currently operating, there are plenty of mines that shut down in past years when prices were too low for profitability. Nothing like a huge run-up in price to get old mines back in operation.  Old mines being reopened was pointed out in this New York Times article.

In addition, prospectors are staking out claims to new fields, as the Wall Street Journal reported today. Supply will increase substantially, but with a long time lag. What happened after that 1980 price spike? It took several years for production to increase, and then it zoomed. And stayed high even as prices were plummeting. (Statistics here.) That's what happens in a capital intensive business. A company says, "At $600 an ounce we can make a lot of money. We invest a bazillion dollars upfront, and then we can mine gold for only $200 an ounce." By the time the mine is operating, gold is down to $300 an ounce. It turns out the bazillion dollars of upfront expense are not justified by the production economics, but the mine continues to operate because it's covering its variable costs. (This might be a good time to review the microeconomics of fixed costs and variable costs.) The bottom line: once production increases, it stays high for years to come.

Forecast of Gold Prices: It's hard to predict exactly when the price of gold will start to decline, but it will come down. And when it turns, it is likely to turn very sharply down, then remain depressed for at least a decade.

 

Economic and Financial Impact of Tokyo Earthquake and Stock Market Sell-off

I rarely invite guest authors in, but the following piece is worth an exception. The author is Phil Diamond, CFA, Chief Investment Officer of Focus Point Solutions:

Before you all get the idea to ask the question, we thought we’d go ahead and answer it. What does this mean for our portfolios? The short answer is probably very little. Obviously, the outlook in Japan has changed in the last week. Much of Japan’s focus is going to shift from economic recovery and growth to helping their fellow Japanese ease their crisis.

The world’s reaction to this series of disasters has been overblown. Japan will have a time when they won’t be able to produce as much as they had produced. Part of this will be due to direct damage to facilities in the north where the earthquake and tsunami were focused. Part of this will be due to power shortages as most of Japan’s 55 nuclear power generators were taken off-line to check for damage. This second issue should right itself in days, the first may take months. But, Japan did not stop just because of the earthquake and tsunami. Most Japanese were not directly impacted by this disaster and will largely go about their business, perhaps even work a little harder if that can ease the suffering of their countrymen in the north.

Getting food, shelter and medical supplies to the stricken area is the first priority, but soon thoughts will turn to repairing and rebuilding this shattered area. That will create jobs and growth for the affected area.

Japan will need steel, cement, machinery and other materials to rebuild. These will largely be produced in Japan. There may be a slowing of exports as supply chains get interrupted, but that will get fixed and Japan will come back.

The gross overreaction of world markets and Japan’s market for that matter will soon be seen as just that, an overreaction. We did not value Japan’s stock market based on the assumption that there would be no earthquake and no tsunami. The idea is that looking forward, Japan’s stocks are worth their discounted future cash flows. Those cash flows have not been reduced by 20% in the last several days as Japan’s market has been. The market was probably a little pessimistic about Japan even before the disaster. Now, we are just too low in valuing many of Japan’s stocks.

The reaction of other world markets to Japan’s financial panic is just silly. What has made French consumer goods companies and English manufacturers worth less? Nothing. This is a reaction to perceived higher risk premiums by investors worldwide. We’ve been buffeted by the shock that disasters of this magnitude can happen in civilized places like Japan. If it can happen to them, it can happen to us. Well duh! Nothing is guaranteed, but the probability is that nothing like this will happen again for many, many years. This was a once in a century occurrence. We can’t live our lives and plan our futures and invest our money based on once in a century events.

The closest parallel to our mind was the reaction of the markets to the 9/11 attacks. The loss of life, the property damage, the impact on the broad economy were all far smaller from that event than from Japan’s current disaster. But, people reacted the same way. They panicked. What good did it do them? None. Within a couple of months the market had recovered all its losses from immediately after 9/11. Then we went on and completed our bear market, but the ultimate lows of the bear weren’t all that far below the lows hit the week after 9/11. If people stick with their plans and look at these types of events as opportunities rather than crises, they are better prepared to react correctly.

 As we have said before and will likely say again, “no one brags about selling on Black Monday.” But that is exactly what nearly everybody did. No one will be proud of selling Japan today. Few will look back at this moment and say they did the right thing.

Investment Information: Good Advice in Easy Format

In my free time I am chief-economist and co-founder of abcInvesting.com.  We have just launched version 2.0 of our investment information website. Here are the cool things we're proud of:

1. Our lessons, the "ABCs of Your 401k", are available in text, audio or video, and they use "drill-downs" so you only get the details as you need it; the rest of the time you get a high-level overview of nine key topics.
2. Our personal financial assessment gives you recommended goals. Why take a quiz and get a letter grade or percentage score when what you really need is an action plan?
3. MyPage helps you keep your goal and next action step at the top of mind, as well as links to your account information, investment performance, handy calculators. (You need to sign up, because we'll be keeping track of some of your information.)

Let me know what you think of abcinvesting.com

 

Stock Market Forecast from Last Year

In preparing this month's newsletter, I glanced at the issue of one year ago, May 2009.  Here's my chart on the stock market:

That turned out to be prescient.  Here's the picture carried through last month:

It's not all wonderful forecasting, though.  A year ago I thought this would be the time that the Fed started to tighten.  Looks like we're still a few months away from that.

High Frequency Trading and the Stock Market Crash: Trust the Computers?

Last week's short sharp shock to the stock market had the usual poorly informed people speculating that the computers had gone berserk.  HAL was doing to investors what it had done to astronauts in 2001.  Although there may have been a computer involved in driving the stock market down, here's an interesting observation:  the highly computerized "high frequency trading" companies pulled the plugs on their computers when the stock market took it's steepest dive.

CNN/Money quotes Rishi Narang of Telesis Capital:  "I do know for sure that high-frequency traders backed off ...."

The Wall Street Journal reported: 

A number of high-frequency firms stopped trading Thursday in the midst of the market plunge, possibly adding to the market's selloff.

Tradebot Systems Inc., a large high-frequency firm based in Kansas City, Mo., closed down its computer trading systems when the Dow Jones Industrial Average had dropped about 500 points, said Dave Cummings, founder and chairman of the firm.

Tradeworx Inc., a N.J. firm that operates a high-frequency fund, also stopped trading during the market turmoil, according to a person familiar with the firm.

One person connected with a high frequency trading company says that when the market was down sharply, his computers were screaming, "Buy Buy Buy!"  The company didn't buy, however, because the humans didn't want to trade in such a volatile market.  They left many millions of dollars on the table because they did not buy when the market was crashing.

Maybe computerized trading is not the problem, but rather the solution.