We are at the NYC Green Festival this weekend, talking to visitors about Socially Responsible Investing. Stop by and visit up at booth 321, Javits North.
One of the more notable financial news stories of the year so far is the decision of social media heavyweight Facebook to go public (an event we alluded to in our top 10 themes for 2012). The question on everyone’s mind is whether a potential $100 billion market valuation is appropriate for a company that had roughly $1 billion in net income last year. It wouldn’t be the first tech company to trade at a three digit P/E (we’re looking at you salesforce.com), but it would be the largest. We are going to leave the valuation question aside for a moment and think in broader terms.
In our view, there are a few factors to keep in mind when considering the lofty growth expectations that surround Facebook.
Fewer, poorer, new users: At 845 million relatively regular users, Facebook already has the cream of the crop when it comes to potential consumers. The economic elite — by far the most attractive consumers — are, for the most part, already on Facebook. The next billion users will have less spending power, and will not consume as many of the digital goods Facebook wants to sell them, nor will advertisers pay as much for access to them.
With the exception of China (where Facebook is banned), the network has no other large upper-middle class markets it can tap into. Since the next billion Facebook users will have more modest means and this could be a tricky cultural and business shift. Facebook initially set itself apart by limiting usage to select colleges. Over time it has successfully expanded availability to new demographics (older users and international users) . But its user base has always been the more affluent segment of each market.
By highlighting this, we’re not trying to diminish the broader value of an open social network and its ability to connect people and create opportunities for them. We hope Facebook continues to be another powerful Internet tool available to a person of modest means to foster deeper connections, expand their horizons and develop themselves. But we do recognize that social networks by definition will mirror divisions in societies, and certain virtual spaces will be more attractive than others to specific groups.
User disengagement: There’s a chance Facebook jumps the shark and usage drops. Despite its meteoric rise in recent years, Facebook operates in the notoriously fickle world of social media, where users may tire of a particular platform and seek out the next hottest thing (let’s not forget Friendster or Myspace, once robust social networking communities before Facebook came along). While Facebook has done a phenomenal job building its user base and cornering the social media market, there are other platforms out there waiting to swoop in should there be a misstep (Google+), or capitalize if users ultimately decide they prefer to segregate their status updates (Twitter) from their picture sharing (Instagram) and location data (Foursquare).
In addition to the possibility of competitors poaching away market share, there is also a question as to how users will interact with the platform going forward. We already see a divergence in the frequency with which men and women use Facebook. Women use Facebook much more regularly than men do. Over time, we could see photo-sharing and instant updates lose their novelty value for certain users who then disengage from Facebook.
Advertising could be ineffective on Facebook: It’s tough for an advertiser to grab a Facebook user’s attention when they are competing with photos and updates from their nearest and dearest. Ads on Google search are powerful revenue generators primarily because the user is searching for something and the ad is related to the search. A Facebook user, on the other hand, is visiting the site because they wish to see photos or updates of their family and friends. An ad on Facebook generally disrupts the user-experience.
Of course, Facebook could use the reams of data it has on each user to suggest a gift for your wife or girlfriend based on browsing or comment history; but this could easily mis-fire and be considered intrusive. Similarly, word of mouth recommendations are very powerful drivers of product sales, and Facebook is an effective medium for friends to share these; but advertisers tamper with word of mouth at their own risk. Our sense is that Facebook has become a virtual family gathering or a dinner party, and overt advertising or sponsorship will always feel slightly out of place at such an event.
On Facebook everyone knows who you really are, even if you’re a dog. All that said, there is one aspect of Facebook that sets it apart from virtually every other website and could end up being extremely valuable. From the very beginning, Facebook has insisted on “real names” and worked to keep anonymous or fraudulent identities off the platform. The result is that Facebook can tie virtually each of its 845 million users to a real-world identity. They have also built an authentication framework on their platform which other sites can use in lieu of asking users to pick new passwords or user ids. Since Facebook has photographs of all your friends, they can be used as a challenge if unauthorized activity is detected. Your ability to recognize your friends, along with Facebook’s knowledge of who they are, combined with a large photo database, makes it very difficult for an unknown attacker to try to hijack your profile. This has meant an enormous shift in the previously anonymous world that the Internet was, and it remains a rare and valuable commodity. It is a service Facebook could charge other sites for down the road. For Facebook, it may be the next big thing. Perhaps bigger than targeted ads.
The genesis for this post came as a result of a wide-ranging conversation we had recently, and which led us to think about two of our favorite books…
The first is Neal Stephenson’s Snowcrash, a 20 year old book that predicted much of the impact the Internet would have on human society. No one who has ever read that book can underestimate what anonymity can lead to and what power accrues to an entity that can definitively identify 20% of humanity.
The second book is Asimov’s Foundation series, which is what got one of us interested in Economics and reinforced the constancy of human behavior. Some of the conversation about 3-D printing and replicators also brought to mind Asimov’s gem, The Last Question.
Photo credit: Flohuels
Since we’ve now closed the chapter on 2011, we’d like to review our “11 Economic Themes For 2011” from last January, to see how well our ideas performed.
1. No. Raise ‘em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members. We were flat out wrong on this one. The Fed kept rates steady at the lowest possible level of 0-0.25% throughout the year. A blip in US economic data mid-year and continuing concerns about Europe held back even the most hawkish voting board-members from recommending a raise.
2. Not exactly. Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25 , prices are at the upper end of historical range. We were right to think that 2011 would be a year where market participants would lower risk, but we focused on US Equities. In fact, US Equities became a relative safe-haven as investors fled the Emerging Markets and Europe.
3. Yes. United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe. We have been discussing this theme for years, but it did come into its own in 2011. If anything, the conversation about potential outcomes has moved much faster than we would have expected. A year ago, who would have thought the markets (and even some in European political circles) would be discussing Greek default, and the break-up of the European currency union. The conclusion of the extraordinary events in Europe is still unclear and this will be a theme for 2012 as well.
4. Yes. Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion. We expect certain weaker revenue and real-estate projects linked bonds to default… large scale defaults by major issuers (state GOs, water/sewer) are very unlikely. Municipal and State finances have continued to be in the news all year. We saw a very high-profile bankruptcy in Jefferson County, Alabama. We expect the role that financial intermediaries played in that case, and others, to receive attention over the course of 2012. As we anticipated, defaults in the municipal space were limited and the muni-market did quite well in 2011. However, the longer-term challenges remain in place. State revenues improved in 2011, but the fate of state-guaranteed pension funds and health benefits is still uncertain and remains a huge future liability for most US state and local government.
5. Yes. Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011. It is now clear to most participants that China is at an inflection point. The Chinese equity market has been in an unbroken bear market since reaching an all-time high in 2007. We believe other asset bubbles in China are at the point of bursting as well, and that this could well lead to large-scale social and political change in China.
6. Yes. Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages. Deleveraging continued as US consumers reduced debt wherever possible. Debt service and financial obligation ratios fell over the course of the year as rates remained at all time lows. Total outstanding consumer credit rose by 2%. Consumer sentiment returned to where it was at the tail end of 2010, after spending much of the year at depressed levels.
7. Yes. Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year. We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%. Though headline unemployment took a large drop towards 8.5% in December, it had spent most of the year around or above 9%. And if the political discussion is an accurate measure, the country as a whole remains concerned about jobs. As we anticipated, U-6 stayed over 15%, suggesting almost one in every seven workers is under-employed in some way.
8. Yes. Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course. Though the full-year numbers are not available as yet, growth in the first three quarters in the US was estimated at an annualized rate of 0.4%, 1.3% and 1.8%. Unless the fourth quarter growth rates were truly remarkable, we will be well under 2% for the year. The story in Europe was, if anything, worse, with full year growth rates for the 27 member EU estimated at 1.6% and growth-forecasts for 2012 at 0.6%.
9. Yes. Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent. We started 2012 with the news that a number of companies expect to offer solutions to sequence a person’s entire genome for about $1,000. We believe the rapid commercialization of this technology will change health-care and many other realms of human activity.
10. Not exactly. Feast and Famine: We expect 2011 to be a very volatile year for commodity prices. We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well. We were partially right here. Commodities remained volatile in 2011, with the DJ-UBS commodities indices down over 13%. However, the two commodities we highlighted, gold and oil, remained relatively strong though gold did see a selloff during the second half of the year.
11. Yes. Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform. The Congressional debt ceiling crisis and the subsequent downgrade of US treasuries by S&P this past summer brought this topic to the fore. As with everyone else, we wait to see what reform proposals the tax discussion will bring to the 2012 political season.
The final score is 8 out of 11, which is not bad.
The third quarter saw equity markets trade substantially lower from where they began—the S&P 500 index started the quarter at 1,320.64 and ended at 1,131.42, a loss of nearly 15%. On October 4th, the S&P 500 saw an intraday low of 1,074.77, which marked a decline of more than 20% from the 2011 high of 1,370.58 reached on May 2. This level was important both from a technical and psychological standpoint since a 20% major index decline is the metric used to determine whether or not we have entered a bear market. Equity markets have bounced back over the past several days, but it remains to be seen whether we are entering a longer term bear market in stocks or if we are merely experiencing a “soft patch”.
So what has caused this decline in stocks? There are several factors at play:
US Economic Data
The US economic picture, which we have long viewed as being fragile and artificially supported by government stimulus, is showing substantial cracks in its façade. In early August, the US GDP for Q1 was revised down from an initial estimate of 1.9% to .4%, a huge 1.5% move down. Second quarter GDP came in at 1.3%, well below analyst estimates of 1.9%.
While many market commentators at the time pointed to the Congressional budget standoff and the S&P’s lowering of the US credit rating to AA+ as the reasons for the stock selloff, it’s now apparent that the problems run much deeper. Over the course of the quarter, as employment, housing, manufacturing and consumer sentiment data rolled in, it became clear that the selloff was a response to a US economy losing its footing rather than a gridlocked Congress (although that certainly didn’t help matters).
Federal Reserve policy
From our perspective, the stock market rally of the past two plus years can largely be attributed to the stimulus policies of the Federal Government and the monetary policies of the Federal Reserve rather than an organic economic recovery.
While government stimulus has largely dried up after Republicans regained control of Congress in the 2010 mid-terms, the Federal Reserve has continued to implement a monetary easing policy with ever more inventive sequels to the original QE.
These measures include: ZIRP (zero interest rate policy), quantitative easing (versions QE1 and QE2) and POMO (permanent open market operations). While the economy and unemployment rate has seen little in the way of tangible benefits as a result of these strategies (although it could be argued that the Fed’s policies helped stave off a Depression), interest rates remain at rock bottom levels and the stock market has roared back to life. The question on every investor’s mind is whether this is a sustainable burst of energy, or a sugar high that will soon wear off.
If the latter is the case (which we believe) then it appears the stock market has gotten ahead of itself and its bullish trajectory does not accurately reflect the fragility of the economy. Instead of an organic recovery driving the markets, it seems stocks are being buoyed by the Fed’s policies and can only continue moving upwards if the Fed keeps refilling the punch bowl of liquidity. But what happens if the Fed decides to end the party and cease its easy monetary policy—will the economy be able to expand on its own?
Increasingly, it looks like this decisive moment has arrived. When the QE2 program expired at the end of June, the Fed elected not to renew it. Instead of entering into another round of buying bonds with cash, as many investors hoped/expected, the Fed went in a different direction. On August 9th the Fed announced its expectation that it would extend the ZIRP policy through 2013 in an effort to keep interest rates low and encourage lending. On September 22nd, they also announced Operation Twist, an action in bond markets designed to push down long term interest rates on everything from mortgages to business loans, giving consumers an additional incentive to borrow and spend money. This approach was first used in the 1960’s (originally named after the dance craze that swept the nation).
While both of these measures are intended to help support the economy, they failed to elicit the same level of excitement in stock investors as the first two rounds of quantitative easing. We remain skeptical of these policies since, in our mind, the problem is not high interest rates, but rather the desire and ability of businesses and consumers to borrow. If businesses do not believe expanding their operations will be profitable, they will not borrow to do it. If households do not believe they will earn more in the future, they will not borrow to finance home-purchases and consumption today. And if loan and credit officers across the country do not believe the economy and employment will grow in the next few years, they will not extend credit. The problem is not the supply or price of credit (the interest rate), rather it’s the demand for it.
European Sovereign Debt Crisis
Ah, our dear old friend, the problem that just won’t go away, no matter how many summits are organized to exorcize it. It seems we always devote some space to this topic every quarter and this letter will be no different.
The problems in Greece and in other European debt-ridden nations, reared its ugly head again this quarter. However, the focus shifted a bit from the nations themselves to the European banks which hold much of this bad debt on their balance sheets.
The major concern many economists and market participants have is that several of these banks would not survive a Greek default. So, if Greece were to go down, it could create a cascading, domino-like event, similar to what was narrowly averted during the 2008 credit crisis. The prevailing view is that the countries and banks are so interconnected that one failure – a European country or a bank – could potentially bring down the entire system. Of course, nobody knows for sure whether or not this is really the case, but elected officials do not seem interested in testing this hypothesis after witnessing firsthand the economic carnage that was unleashed when Lehman Brothers failed. The trouble, however, is that their constituents do not want to pay for the cost of rescuing Greece or even large pan-European banks.
In our view, this train-wreck will continue to play out in slow-motion for the next several months. The solution has to involve some restructuring of Greek debt, and some mechanism to conclusively stop the damage from spreading to Spain and Italy. We do not hold out high hopes for a speedy resolution though. The outlines of the solution have been known for quite some time, but the relevant political and regulatory actors do not appear to have the will or courage to take decisive action and implement it.
So where does this leave investors?
We think the status quo will continue for the near future: structural headwinds in the US economy will persist and the debt problems in Europe are still a long ways from being resolved. Barring another massive monetary intervention by the Federal Reserve (QE3), we believe stocks will continue their slide lower. If there is a QE3 announcement too soon, we think there’s a pretty substantial chance it will be seen by the markets as a sign of desperation on the part of the Fed. We believe the chance that Congress manages to enact meaningful tax or budget reform, or additional fiscal stimulus, is negligible as we enter the presidential election cycle.
We have seen a few weeks of remarkable volatility within financial markets. Stock indexes have moved hundreds of points in both directions with some regularity. Interest rates, bonds and the FX markets have also seen very sharp moves in each direction. We believe this period of volatility will continue for the next few months as the European crisis grinds towards its inevitable conclusion and signs of stress in China make themselves apparent.
As a result, we continue to recommend a defensive portfolio for clients, with high quality, short term/intermediate bonds and cash making up the bulk of client holdings.
We think there will be an opportunity to buy high quality stocks on the cheap in the coming weeks/months and have targeted a list of companies using the following criteria:
- Large cap, US-based companies that have significant exposure overseas, particularly in developing markets
- Companies that have sustainable, attractive businesses and a history of paying dividends to investors through tough market cycles
- Preference for defensive/non-cyclical industries like consumer goods and utilities rather than banks or financials
We believe that, longer term, investments in these types of companies will perform well. In the short term, they will provide cash flow through dividends, so investors will benefit by being paid to hold these stocks in the event the stock market trades in a flat or negative trajectory.
“It’s like deja vu all over again.” — Yogi Berra
Let’s take a look at some economic bullet points, shall we?
* The stock market, after peaking in April, is in the midst of a summer swoon.
* The sovereign debt crisis in Europe is getting progressively worse.
* Unemployment remains stubbornly high and the housing market remains stagnant.
* Gold continues to climb as investors speculate that safe haven currencies like the USD, Euro and Yen will see continued pressure as debt levels mount.
*Quantitative easing from the Federal Reserve has recently expired and Government Stimulus money has run dry.
*Investors wait with baited breath as Fed chairman Ben Bernanke is due to give a highly anticipated speech at the annual Jackson Hole economic summit.
Sound like a good encapsulation of where the financial markets are today? Perhaps, but I’m actually describing where things stood last summer on the eve of the Jackson Hole summit. While a lot has certainly changed in the past twelve months, many of the problems facing the global economy remain the same.
And so here we are, almost exactly a year later, and the markets are waiting/hoping/praying that tomorrow Ben Bernanke can pull a rabbit out of his hat in his Jackson Hole address like he did last August, when it looked as if the stock market rally was sure to falter.
So how did things play out last summer?
As we wrote in our last quarterly letter:
“When Ben Bernanke announced the QE2 plan on August 27th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.”
Many stock market bulls believe that a third round of quantitative easing will deliver similar results. While we concede that another round of QE will likely give the stock market a short term boost, we don’t believe it will cure any of the underlying ills that the economy suffers from (high unemployment, anemic housing market, low consumer confidence etc).
But never mind all that negativity, a stock enthusiast might say, will there be a QE3?
It’s hard to predict. The Fed’s dual mandate is to provide economic growth and boost employment. While it can be argued that the last two rounds of quantitative easing helped the US economy avert a depression, the main beneficiaries of these market interventions, particularly the last round, seems to have been stock holders — not exactly the constituency most in need of the Fed’s support. And to compound the problem, two byproducts of these policies have been rising commodity prices and a weakening dollar, which creates a whole host of other issues for consumers.
Given that the Fed’s fiscal policies have come under increasing criticism from all corners of the financial and political world, including from some of the Fed’s own Board of Governors, it seems to us that another QE round would be enacted only as a policy last resort. It’s also entirely possible that the next fiscal action from the Fed would not be a QE package, per se, but rather something resembling Operation Twist, which was an approach used in the 1960′s.
But if the financial markets continue their move further south, the question becomes: what other entity could possibly intervene to provide support? Congress has demonstrated, through the debt ceiling fiasco and the rise of Tea Party influence over the Republican party, that a stimulus bill would almost certainly be dead in the water. And as we get closer to the 2012 elections, it becomes increasingly difficult for our elected leaders (namely Obama) to institute major economic policy decisions without being accused of playing politics, particularly in the toxic partisan environment of Washington.
So, really, that leaves the Fed as perhaps the only game in town when it comes to market intervention. If things get worse, then there may be increased pressure on the Fed to act since they have the mandate and resources to step in — whether that means tomorrow or at a future date remains to be seen (and regardless what your views are on the Fed’s policies, at least they can reach a decision and act on it in a timely manner — unlike our distinguished members of Congress).
So, has this summer sell-off and rampant speculation of potential Fed action hanged our investments thesis? Not really. We remain cautious and reiterate what we said in our last quarterly letter, in July, before the stock sell-off began:
“We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.”