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The Bubble Question (avc.com)
236 points by DanielRibeiro on Apr 24, 2014 | hide | past | web | favorite | 91 comments

> It’s hard to sustain a bubble for four years.

Says who? As Wilson observes, "Since the financial crisis of 2008, policy makers in the developed world have kept interest rates at or near zero. They have flooded the market with cheap money in an attempt to heal the wounds (losses) of the financial crisis and incent business owners to invest and grow their businesses." It's kind of amazing that he doesn't see how years of unprecedented coordinated central bank action could drive and sustain bubbles.

> It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.

As an investor, there is no doubt that DFTF and BTFD has been very profitable, but the implication that a weak global economy and low interest rates is essentially responsible for sustaining the good times should be disturbing to anyone with exposure to the venture capital asset class given what it is supposed to represent.

Incidentally, I think it's somewhat amusing that VCs are asked the "Are we in a bubble question?" in the first place. When you ask market participants who can only play the market in one direction using a single asset class, you tend to get the least insightful answers in my opinion.

Interestingly, he didn't answer the question with a no. He described a situation that, to some readers, may be a yes. "It's hard to sustain a bubble for four years, but here we are," in essence. He explains that the demand for stock in certain companies is artificially high, driving up valuations by a multiple.

"Markets can remain irrational longer than you can remain solvent."

Absolutely. The thing with market trends is, no one can predict them. It's a guessing game, that no one can predict. Sometimes the bubble last very long, sometimes not.

Great post; I agree with everything here.

Well, this chart focuses on tech but Robert Schiller also thinks the overall market is bubbly. I'm amazed that interest rates could have been held down so long and this is the real danger: how the heck can they ever normalize? If they do it will wreck havoc so the fed is trapped between the proverbial rock & hard thingy. Lo interest also hurts older people who rely on savings (But theyre not going to be here long anyhow...but Peter Schiff argues savings is the only real form of investment )

Bottom line is interest rates can only be held low because alternatives around the world don't exist. I'm also amazed how alot of people think the fed saved the economy & created more wealth : as Jim Rogers says they only know how to print).

Finally, I think the derivatives were around 600bill upto Lehman downfall. I was astonished to find that they're now a quadrillion! Buffet called derivatives financial weapons of mass destruction. I think this world might experience this interesting concept.


>If they do it will wreck havoc

No they won't. Rates don't magically rise in a vacuum; rising rates coincide with improved economic conditions or rising inflation. Or, most likely, both.

The Fed Board of Governors, unanimously, predicts interest rates of ~4% beyond 2016[0]. They certainly are not infallible, but they have the tools and the mandate to get there. Do you claim the market isn't pricing this in already?

>Lo interest also hurts older people who rely on savings

If anyone is to blame for the financial wrongdoings and shenanigans of the past 20 years, it's these same old people. I'm not terribly sympathetic. Besides, no one has ever said you're entitled to a magic return on your cash for glorified mattress-stuffing (savings account). This is a capitalist society, put your capital to work.

>I was astonished to find that they're now a quadrillion!

Notional value.


When the fed raised rates the last time ,stepwise & slowly it didn't work as planned and I think they're going tohave a helluva time normalizing. 2)Keeping savings is putting money to work . (sure I'd rather be a VC) I just believe Peter schiff on this.

That notional value didn't help AIG. The pt. Is that nothings changed in the financial system. 1 quad means things are riskier than ever.

"The pt. Is that nothings changed in the financial system"

Actually, a ton has changed in the financial system - some good and some bad. Banks are larger than ever (bad - more potential systemic risk), but they're being more strictly regulated (probably better). Mortgage rules now exist that didn't exist in the housing bubble (generally good) - but Fannie and Freddie are the only game in town. Our bailout of Fannie/Freddie has now paid back the invested capital. And we haven't hit the hyperinflation that Peter Schiff and other similarly ill-informed pundits said would happen. The notional value of the derivatives contracts says nothing about the risk - just total exposure.

>When the fed raised rates the last time ,stepwise & slowly it didn't work as planned

You mean how when they raised rates in part to prick the housing bubble? How did it not work "as planned"? When the economy heats up and inflation is a risk, rates will rise. This is the business cycle.

>I just believe Peter schiff on this.

Being as how he's been wrong on just about every public prediction he's made, and his hedge fund gets crushed both during the crisis (which he "predicted") and since, I think you'd do better to expand the borders of your economic prognosticators.

Well my 1st expansion was looking at the bandwagon of ( Rogers, faber, schiff,...) I was about to invest at the peak of dot com but reading them kept me out Didn't buy during house bubble- I was wary of what this group was saying - but I couldn't convince my condo flipping acquaintances - my chicken little perception faded a bit. I do notice that it's very hard for analysts to be flexible , thus titles like perma bear/bull...

One interesting thing about the high valuations of tech startups now is where the money is coming from. It's not stock markets.

At or near the bottom (or is it top?) of this "bubble" funnel a lot of high valuation investments from "private" money acquisitions & other supposedly smart money, like the recent AirBnB investment. Were $10bn valuations possible without public markets before recently? Does that make us daffier if this is a bubble? IE, is this proper risk capital that is less fragile and sensitive to death spirals?

Facebook has been aggressively scaling up (in my opinion successfully) their ad business since the IPO. Facebook has/had 2 big make-or-break risks: (1) losing popularity/users (2) failing to turn users/visits into into ad revenue. There was also some risk that in trying to fix #2, #1 would break.

Risk, reward, uncertainty. Nothing unusual here. Risk #1 is constant ambient risk. Risk #2 is/was more of a "what's under that rock" risk. The rock is being turned as we speak and so far the news has been good. FB value has roughly doubled in the last 9 months and IMO, that's the product of "information" about the viability of facebook as an advertising platform.

Here is the subtle point.^ They could have turned that rock just as eerily before IPO. They could have worked on the ad platform sooner or they could have delayed the IPO. I think that move was deliberate. Facebook chose to make that unavoidable, but timeable risky step after the IPO.

As an analogy, imagine a widget company. They get investment design & manufacture a warehouse full of widgets. Then they pause, take some more investment, don't spend it and go public before finding out if their widgets sell.

What role does this pre-IPO money play? FB didn't seem to need it to operate.

^I'm not sure about this. It's a speculation and I don't know or understand enough to be confident at all about it.

VC is private equity, so generally we do not know who invests in whom. But many of the ways that VCs receive investment are through highly diversified means.

VC is some fractional line item allocation for diversified investors. The Sultan of Brunei or whatever is not calling Fred Wilson to yell at him about how USV is performing, unless the Sultan invested directly for some reason. The Sultan has 7% of the 5% of his funds that he handed to his asset management guy at investment bank X to handle.

It's possible that the asset management guy will yell at Fred Wilson about Zynga being a turkey, but not likely, because that fraction of the Sultan's money was supposed to be high risk anyway. It is playtime fun money for him anyway.

Similarly, CALPERS bureaucrats do not actually need to show a stupendous return -- they just need to maintain the appearance that their allocations have the possibility of providing a stupendous return. They won't get fired if they tried to hit 8% and can show that some model shows that according to previous decades of performance they were on track to hit 8% until some act-of-god prevented it from occurring. Their VC allocation helps them maintain this appearance so that they can maintain their 3rd wife to the lifestyle she has become accustomed to and continue to golf.

One of the later episodes of the a16z podcast featured Marc Andreessen and Benedict Evans. They were discussing technology valuations and made some good points. Though I disagreed with their "no bubble" consensus, they were right in mentioning the classic "Russian oil money" and "new players" argument. Previously, most tech investing was done by U.S. venture capitalists. (One of the reasons why non-U.S. start-ups find it hard to fund themselves.)

However with multi-billion dollar technology floats like Facebook taking place - many, many people are taking notice and bringing lots of money with them. This, obviously, increases demand which in-turn increases prices. That's all. If, or indeed when, the bubble pops and people realise that these businesses aren't worth the price paid, I suspect it won't lead to the type of crisis that occurred in 00/08 - just lots of rich people with less money.

"just lots of rich people with less money."

My original take on the "bubble" was somewhat in line with this. However, the more I think about it, the more I am inclined to believe that this will "trickle down" in many ways. Fewer investments will lead to fewer jobs. In SV, this could lead to a cooling down (or worse) of the labor market. The established players (Google, Apple, Amazon, etc) will probably pull through alright, but the VC money will thin out. If I was a software engineer and I wanted to hedge my bets, I would probably try get a job at one of the bigger, more stable companies in the next year. If things do cool down, I imagine that programmer jobs and salaries will be the most noticeable side effect.

Of course I could be entirely wrong. It's possible that VC money makes up only a small fraction of the demand for software engineers. After all, almost every industry under the sun is shifting towards (or wants to shift towards) higher levels of automation and efficiency using computers and software.

You're absolutely right that "trickle down" occurs. Basic logic suggests that if lots of businesses have lots of funding, and that funding dries up, there will inevitably be job losses because they have to be funded from somewhere.

However, I wouldn't worry too much because technology is clearly the future and the need for technology professionals will continue to grow. These stupidly high valuations are for, I hope, decent businesses. By that virtue, they will get the funding they need - just not the scale that we have seen. Hence, I used "just lots of rich people will less money" because the people set to lose out are the huge investment vehicles who seem to be huddled around the Valley at present. The highly skilled engineers needn't worry because the likes of Mr. Wilson and Mr. Andreessen aren't going anywhere, and the average Joe Bloggs needn't worry because their pensions aren't at risk. The people who should worry are those who watched the Facebook float and said, "Shit, I need some of that action!"

As always, it's the stupid that lose out. Fortunately, the stupid ones aren't providing our mortgages or issuing our credit cards this time. (Namely, Royal Bank of Scotland, Bank of America, et al.)

But, hey - I'm just a 24 year old CS grad come IT consultant, what do I know?

> One interesting thing about the high valuations of tech startups now is where the money is coming from. It's not stock markets.

See, I think that it is coming from the stock markets. These valuations are there because the investors think that they can dump the stock onto the market for above that amount. Look at KING--investors in KING knew that the jig was up, they dumped it onto the stock market and got out.

$10bn valuations are possible because of the public markets. If the investors weren't extremely optimistic that the stock market will eventually buy their stock for more than that valuation, they wouldn't do the investing. That's the only time they'll get their money back. Make no mistake: they're (VCs) not in it to keep it private and to keep the profits to themselves. They're in it to take it public or get bought by someone even bigger. That's all it is.

The stock market is their end-game, and that's what they're targeting with these investments. The intermediate money isn't coming from it, but ultimately that's where the money comes from, in my view.

I think the £1bn+ acquisitions must be playing a role as well (obviously that's is stock money too). That is an IPO scale exist without an IPO.

Keep in mind that this generation of startups is delaying IPO as long as possible. The main reason appears to be a desire to delay public company reporting requirements, not a lack of capital needs. Since the IPO market remains strong, a set of new investors has entered the market to play this "public/private arbitrage" opportunity, buying private stock shortly before IPO for apparently* sure gains. This group of players includes hedge funds (Tiger Global), mutual funds (TROW), and private equity funds (TPG). Traditional growth-stage funds are starting to pull back as this competition is pushing up valuations. Note that the arb players are betting on near-term market reception to the stocks that they are buying, and less sensitive to absolute valuation. Without commenting on current valuations, I will say that these dynamics certainly have the potential to create significant overvaluation in the private markets.

* I call them apparently safe gains because if the IPO market collapses, these investors will be stuck with some very large, illiquid investments.

That's the straightforward reason, but it doesn't sound big enough to me.

First, AirBnB just got valued at 10bn. FB's IPO broke valuations records. Reporting requirements are a drag and I'm sure they impact IPOs on the margin, but 10bn is not marginal. Reporting for a company like AirBnB is not that hard. They have a straightforward business model with one business. It's not like they have 50 years of hair, cross ownership, JVs and zombie businesses.

Second, FBs timing indicates (to me) that something else is going on.

Third, WTF is the reason for these arbitragers. Arbitrage requires a willing seller. Why raise capital (sell shares) at a lower cap 9 months before an expected IPO?

It's not the administrative cost of reporting, it's the cost of having to run your business differently based on being measured quarterly.

I generally agree with fred that monetary policy is driving valuations. However, I think it's not quite as simple as he describes (although he may be intentionally simplifying for his audience).

It's true that financial assets compete with each other for investors. So when the Fed reduces the yield on Treasurys or MBS, the marginal investor will rotate to a riskier asset. This will create a chain reaction that eventually raises equity prices. However, it's not the case that earnings yield (Earnings/price or the inverse of P/E) is going to be equivalent to the interest rate on Treasurys (T-bills). Typically the way that investors think about it is earnings yield = Treasury rate + equity risk premium. So at an equity risk premium of 5%, even a Treasury rate of 0% would result in an earnings yield of 5% or P/E of 20, not infinity. This isn't too far from the market multiple of the S&P 500 right now. (The historical average ERP over the past century has been 4.2%.) So the market multiple implies that the overall market is not in a bubble, but that doesn't eliminate the possibility that some sectors are in a bubble.

The Fed's influence on the market goes beyond their impact on interest rates. One reason for the sharp rise in markets is that investors are fearful of inflation. Although CPI inflation has remained low, investors would rather hold scarce assets such as equities and real estate than a rapidly diminishing percentage of the money supply (i.e., cash) that results from money "printing". While money creation is nothing new, and in a sense, unconventional money creation is not that different than conventional easing, the sheer scale of our current monetary policy is unprecedented. This lack of precedent creates a high degree of uncertainty in the ultimate outcome.

The final reason for the strength of the markets is a widespread belief that the "Fed put" is back. It is almost universally believed that the Fed has taken on a third, unstated mandate of stable and rising equity markets, by easing and talking the market up when it declines. I don’t know to what extent this is true, but the mere notion has created a hidden source of instability in the market by giving investors unusual confidence. While there is no reason to believe that markets will crash, it's also not out of the question.

The Fed has announced that it will "taper" QE purchases from $75 billion / month to $55 billion / month. At the current rate of taper, QE purchases could reach zero by the end of the year. One key question for investors is whether this may reverse any of the three dynamics listed above.

>investors would rather hold scarce assets such as equities and real estate than a rapidly diminishing percentage of the money supply (i.e., cash)

Do you have any data to back this up? It is my understanding that the demand-for and holding-of cash (specifically the USD) reached epic proportions in 2008 (as happens during financial crises, hence the need to print) and remains very high.

At the same time as this tech boom, S&P 500 companies are (I'm told) busy borrowing fistfuls of money in order to pass it on to shareholders through dividends and share buybacks. That seems to suggest that investors are happy to have cash right now; it also puts the complaints about excess or wastefulness against the current SV boom into some perspective ...

Isn't that borrowing more because of US tax policy causing vast amounts of money to just sit there in foreign bank accounts for those SV companies?

Well, to be clear, an asset purchase transaction (ex the Fed) does not change the number of "dollars outstanding" (the money supply). To be more precise in my language, investors prefer holding assets to cash at a specific asset price. The evidence for this is in the rise of asset prices (even more specifically, the rise of multiples, since underlying values change over time). The specific phenomenon you are referring to during the crisis itself is a flight to safety/liquidity, which is unrelated.

The key here is the context of inflation risk. In an inflationary environment, his point holds with the rational investor. Most people would rather invest in something than effectively lose money by holding cash.

Paul Krugman argues that there's too much money chasing too few assets. Combined with low interest rates we have a bidding war for anything that isn't Zynga. Even Greece has seen money pouring in recently because, really, where are you going to put $10B?

> too much money chasing too few assets

And why are there too few assets? To put the question another way, why is it that, even though the Fed has given banks $2.8 trillion in quantitative easing, the banks can find nothing better to do with it than to leave it in their accounts at the Fed earning 0.25%? Is there really nothing more productive going on that they can loan money for?

My worry is that I don't see any "mainstream" economists asking this question.


Be wary of conflating corporate cash with the LP cash backing VC companies. Companies are holding record amounts of cash because (1) it is seen as insurance for financial shock-event; and (2) low interest rates do not penalize them for holding it.

If interest rates were 7%, shareholders would be demanding minimal cash on balance sheets. But with money @ 0.25%, the BOD is telling investors the "option value" is worth the minimal carry cost to the company in terms of FCF and/or NI.

On the other hand, the sources of VC (LP) have excess liquidity they do not want to hold as cash. If they had 7% <paid> on cash they would hold some cash as insurance; but with 0.25% (6.75% forgone) the cost of this insurancs is too high. This is exactly opposite dynamic of the corporate case.

So, you see companies hoarding cash and LPs trying to get rid of it. But for VCs and valuations, it is the LP's dynamics (excess liquidity) which are relevant. The corporate cash piles have second-order effects (via M&A), but the central source of liquidity is driven by LPs wanting to be fully invested.

(There is also the issue of spread/total rate which pushes LPs deeper into the risk spectrum to meet threshold returns. This effect drives allocation to equity vs bonds, and equity market liquidity has carry-through for VC exits both at the iPo and m&a level.)

> Don't confuse corporate cash with the cash backing VC companies.

Actually my post wasn't talking about either: it was talking about all the reserves the banks are holding at the Fed instead of lending them out. Technically those aren't cash since banks can't just hand them to you with no strings attached; they have to give them to you as a loan.

Corporate cash, OTOH, could be paid out as dividends directly, though you're correct that that's not going to happen with rates where they are now.

Banks are hoding cash for the same reason as corporates. The cash is cheaply financed by low-cost debt and it has utility as an insurance-liquidity-pool-of-last resort in the case of a policy reversal by the Fed.

For argument's sake, assume debt is mis-priced right now relative to equity. If you believe that, and you are a bank, what you do is increase ROE through increasing leverage (shor debt markets+long equity). So, if you are a bank you borrow and buy back shares. Or, you borrow and keep shares at a minimum/flat.

On the other side of your ledger, if you are a bank and you believe debt is mis-priced, the last thing you want to be doing is going long credit (to customers). So, what you should expect is increasing debt/equity ratio and flat/decreasing proportion of long-credit/total assets.

The "stingy credit" allegation is perfectly rational if you make the assumption that debt is fundamentally mis-priced as an asset class. That is the essential assuption Wilson is making to explain why money is chasing equity/pe/vc.

The only open issue is whether or not the assumption is correct.

If we look at policy, when regulators ring-fence reserve and increase the reserve level, they are forcing the banks to sell-equity. The reason they are doing this is because--assuming equity is mis-priced--they understand that banks will leverage up. The problem with banks leveraging up increasingly over time is policy hysterisis.

If the fed policy results in increasing bank leverage, the baking system will become increasing more "brittle". This tie the hands of the Fed--when they move to revert policy--they will risk creating a problem due to having added "brittleness" to the financial system.

So, even the fed is acting as if the assumption about debt pricing is true.

That being said, it is a more difficult case to explain from first principles whether or not debt is truly mis-priced as an asset class. But the analysis can be followed as far as I can tell simpley based on the binary assimpyion (yes/no). And one of those assumptinos seems to explain alot, while the other faces a harder time making sense of the data we are seeing.

From your piece:

The hope is that the lower interest rates will encourage people and businesses to take out more loans and thereby start spending again.

What we are seeing is opportunistic borrowing for financial engineering. We are not seeing 1:1 borrowing to spending on operating expenses or PPE. We are seeing borrowing that is being spent on share-buy-backs and/or cash-stockpiles that maked increasing leverage ratios more operationally risk-tolerant. (And it seems this is true for corporates and financials, at least to a first order approximation.)

That blog post is the best explanation of how the Austrian economic philosophy applies to the current situation that I've ever seen.

Am I convinced that QE is a bad thing? No; I'll have to think about it. But at least I have some idea now of what the argument against it is.

(Like most of us, I'm no more than an armchair economist, but I do find it interesting.)

Yes, there really is nothing more productive to do. Worse, we're going to end up in a situation where unless we make big investments now with negative current ROI, society will be even poorer in the future once the current capital assets have depreciated and been written off.

Example: sustainable power generation.

>>> investors would rather hold scarce assets such as equities and real estate.

Real Estate is not the investment it once was and homes have yet to recover their initial value since the crash in 2006. I doubt this is something people would be actively investing in like they used to.

This is pretty spot on. We in the SFBA don't think about rates much but in a past life it was all I did. The moment the markets price in a long term expectation of rates rising, a lot of the current behavior we are seeing (eye popping salaries/valuations/home prices/rents) will correct themselves. It won't mean the businesses are bad - just that they're priced less richly. Until then, they are making hay while the sun shines and they're probably wise to do so.

I think Fred is not telling the entire story with this bubble question/explanation. From a macro perspective I personally don't think there is a bubble, part of the rationale is explained in Fred's post.

What I think Fred is avoiding is the company-specific micro-view. In that case, I think "yes", many late stage startups seem to be over valued, just by applying Fred's yield logic (and growth-risk accounted for). Zynga was one of those companies (and obviously) we never heard how overpriced this was at IPO from Fred.

The valuation of these over valued startups seem to be driven by (i) increase in capital/competition from funds, (ii) eagerness by public markets to jump on the tech/startup bandwagon, and (iii) unrealistic "believe" that double-digit growth is sustainable for years to come.

Aren't a lot of those levels "sticky"? I could certainly see rate of increase going to zero very quickly, but actual decreases in salaries, leveraged assets like homes, etc. are a much bigger step.

I agree it's unusual that an employer will cut someone's salary - but there's another way to decrease average salaries.

If the cost of money rises, companies that are only viable while the cost of money is low go out of business, and their employees' salaries drop to zero.

Absolutely spot on

I don't know about SF, but it certainly didn't stick in London (UK) post the dotcom bubble. Many people ended up either with no work in tech or taking voluntary pay cuts, and the hourly rates for contractors dropped dramatically only to get back to previous levels in GBP terms 10 years later. Many tech workers left London because they couldn't afford to live there any more. New properly developments around certain parts of London didn't find tenants, rents dropped making it more attractive to buy a few years later.

They are sticky, but part of the rate of change is driven by people moving between companies and getting raises and such. That will just happen less and attrition over time will do the rest.

This is the most honest article that I've seen from a mainstream financial figure about why valuations are so high.

ZIRP (zero interest rate policy) means that money is near worthless to financial institutions that can run the carry trade on Treasuries, or other carry trades involving foreign exchange. VCs manage money for those guys, along with pensions and other enormous concentrations of capital.

What you want are equity stakes (control) of productive assets. The cash that you use for that is not that useful except to normal suckers like you and I who need to hand over a bunch of paper tickets every month to the landlord, the grocer, and the government. The guys who issue the tickets are generally above those concerns, but they still need to get a return on their capital.

I would rather own stock than a pile of green tickets. Stock is, again, just another kind of ticket, but they're more expensive tickets that grant you rights to a productive asset. It is a safe bet to dump your green tickets into speculation because, while the speculation may work out, you know for a fact that those tickets are going to depreciate.

You will not see interest rates go up if the Fed can help it, because to do so would provoke an immediate fiscal crisis. Bubbles result from rational allocations of funds based on a certain set of assumptions. It is a good assumption that the US government will not permit rates to rise as long as there is zero public appetite for a major reduction in government spending. Once that reality changes, the structures that rely upon that environmental state will either need to adapt or will fail.

Startup-land is a greenhouse arrangement that thrives so long as the temperature remains high. When the guy who owns the greenhouse cuts the power, most of those plants are gonna die. If you want to be resilient to that risk, you must leave the hothouse. However, the hothouse plants have a lot more access to capital in the near term, so it is rough to compete with them directly. That is the trouble with bubbles: you can't really escape their effects by being 'prudent,' because low interest rates make prudence imprudent.

In order to raise rates, the US would probably have to either confiscate a lot of assets (which would harm its international status as the cleanest dirty shirt), raise taxes, raise retirement ages, implement means testing on medicare + social security, and cut military pensions/VA expenses. There is no real solution that does not involve provoking some sort of major crisis, so it is much easier for everyone to keep the carnival going as long as possible until something snaps internationally. The federal government can't afford even a slight rise in rates without having an immediate cash flow crisis.

It is a safe bet to dump your green tickets into speculation because, while the speculation may work out, you know for a fact that those tickets are going to depreciate.

Green tickets are almost guaranteed to depreciate, but probably very slowly. Speculation can result in very fast and large losses. There is no such thing as a safe bet.

Probably? We see a lot of examples where they depreciate quite quickly, both in American history and worldwide more recently. Look at a JPYUSD chart, or ask a Japanese guy. Whoa Nelly, that's a steep drop from 2012.

I agree that there are risks in absolutely everything. What's important is to understand and manage them.

Yep, I'm sure USD hyperinflation is right around the corner. Eminent economists such as Peter Schiff and Ron Paul have been predicting it for decades. They can't always be wrong about it, can they?

I didn't say that. I compared it to other steep depreciations. I also dislike Peter Schiff for various reasons.

The fact that the yen has fallen against the dollar means that yen are worth less in countries where they use dollars, but not necessarily in places where they use yen. If yen were worth less in Japan that would reflect itself through higher yen denominated prices on stuff in Japan -- it would show up in inflation -- but inflation in Japan is somewhere south of 2%.

There are a number of gross oversimplifications here.

> What you want are equity stakes (control) of productive assets.

Productive assets are great, but valuation matters. When everyone is chasing yield and you are forced to overpay for productive assets, you are extremely vulnerable and stand to lose a lot more in the long run.

I'm not suggesting that you should have a mattress full of cash, but "I'm losing money if I leave my cash in the bank" is not a good justification for, say, chasing Momo stocks, especially at these levels. The risk of losing 1-2% a year is a different proposition than losing 10% in two weeks.

> You will not see interest rates go up if the Fed can help it, because to do so would provoke an immediate fiscal crisis.

You have to look at the yield curve. Short term rates are still incredibly low, but the 10Y has already crept up. Right now, it appears likely that short term rates will be kept at incredibly low levels, but long term rates will rise modestly.

If you don't consider the entire yield curve, you're liable to make bad investment decisions. For instance, a market in which the Fed is holding short term rates at near historic lows and allows long term rates to rise a bit would create an ideal scenario for mortgage REITs, which borrow money at short term rates and invest in long term mortgage bonds, effectively pocketing the spread.

>There are a number of gross oversimplifications here.

Yup. Dunno if I'd call them 'gross' or 'over,' but sure.

>Productive assets are great, but valuation matters. When everyone is chasing yield and you are forced to overpay for productive assets, you are extremely vulnerable and stand to lose a lot more in the long run.

Yes, I agree with this. As far as VCs care it's OPM. As far as entrepreneurs care it's the OPM of OPM. So mostly good for both classes of people until the music stops.

>I'm not suggesting that you should have a mattress full of cash, but "I'm losing money if I leave my cash in the bank" is not a good justification for, say, chasing Momo stocks, especially at these levels. The risk of losing 1-2% a year is a different proposition than losing 10% in two weeks.

Absolutely agree unless you are a professional trader, and even if you are a professional trader.

>You have to look at the yield curve. Short term rates are still incredibly low, but the 10Y has already crept up. Right now, it appears likely that short term rates will be kept at incredibly low levels, but long term rates will rise modestly.

Entirely possible. Also possible that there will be another round of intervention to respond. Further possible that that round of intervention would not work at achieving its intended goal of rate suppression.

Thanks for the insightful comment. I am curious to know whether you subscribe to the Keynesian or Austrian school of economics (or neither).

I would also be interested to get your insights on how this game might play out in the long run if other high-powered countries are afraid to make the move to raise interest rates for fear of upsetting the local/global economy.

A good explanation!

I made a rather long (2 hours) YouTube video that explains the fundamentals of our current economic system - perhaps it is helpful to someone who wants to get a better understanding of the issue:


"In order to raise rates, the US would probably have to either confiscate a lot of assets (which would harm its international status as the cleanest dirty shirt), raise taxes, raise retirement ages, implement means testing on medicare + social security, and cut military pensions/VA expenses. There is no real solution that does not involve provoking some sort of major crisis, so it is much easier for everyone to keep the carnival going as long as possible until something snaps internationally. The federal government can't afford even a slight rise in rates without having an immediate cash flow crisis."

They could demand immediate taxes(30 years retroactive) on all those offshore banks that slick corporations and rich boys like to hide money. If the banks hesitate; send in the the Boys. It might be the first honest war we have had in awhile? Oh yea, and immediately default on the Chinese debt. Wow--I sound like my father? I am ashamed of wealthy Americans who skip out on taxes though. They like to blame the poor, but it's the guy's who don't get a regular check who hide money. I remember this Harris dude who bragged about his Caymen Island trips in the 80's.

You can't legally selectively default on debt; see the ongoing Argentinian "pari passu" saga as documented by FT blogs. Doing it illegally is basically hanging out a "we're now a rogue state lol" banner in New York to welcome businesses.

Having said that, I'm in favour of politely but firmly squashing the tax haven states. There is some work in this area but it's very slow.

Can you offer a good book on that coherently explains US federal monetary policy? You have a good handle on what's going on. I still don't quite understand it.

No, you have to read maybe 10+ books at a minimum plus a lot of other stuff.

I would start from federalreserve.gov and go from there. There's also an educational site set up by the Fed here: www.federalreserveeducation.org/about-the-fed/structure-and-functions/

Once you get it straight from the horse, you can go out from there. When people ask me this question I start there, because it has official authority and is usually more direct than other more opinionated sources. If you talk about it from sources other than the Fed most of the time you'll get a lot of incredulity because the system is counter-intuitive.

If you want to duel perspectives, you can read both 'A Monetary History of the United States' by Milton Friedman and Anna Schwartz (http://www.amazon.com/Monetary-History-United-States-1867-19...) and 'A History of Money and Banking in the United States' by Murray Rothbard (http://en.wikipedia.org/wiki/History_of_Money_and_Banking_in...), which draw nearly opposite conclusions, although both agree that the pre-Fed eras were rife with major crises caused by poorly managed banking schemes.

Paul Volcker shines in secrets of the temple

Seconded. Secrets of the Temple by Greider is pretty accessible (if biased, as they all are).


Also, the EconTalk podcasts are awesome: http://www.econtalk.org/archives/money/


- David Laidler on Money (http://www.econtalk.org/archives/2013/09/david_laidler_o.htm...)

- Sumner on Money, Business Cycles, and Monetary Policy (http://www.econtalk.org/archives/2013/03/sumner_on_money_1.h...)

- White on Hayek and Money (http://www.econtalk.org/archives/2010/02/larry_white_on.html)

- etc.

I second the EconTalk podcasts. I've been listening to them for over 5 years. They are hour long interviews on a wide variety of subjects. The host, Russ Roberts, does a great job of letting the guest get his or her point across even when you suspect he disagrees. The tone is polite and non-confrontational. It is more about accurately presenting a position than debating, although there is some point/counter-point.

I cannot exaggerate how much I've learned from EconTalk. Plus, there's even an episode with Paul Graham about ycombinator and startups:


While it is certainly true that valuing a business with an ongoing (and somewhat predictable) revenue stream, the typical yield approach is earnings / purchase price, this is not as applicable in situations where there is either no revenue (such as in the case of Oculus Rift) or little predictable revenue (WhatsApp). What exactly is the yield rate on the Oculus Rift acquisition when earnings are near zero?

Much of the acquisition activity that is driving exits, which is in turn driving VC activity (exits motivate investment), is coming from land grabs in expectation of FUTURE potential significant markets. Facebook grabs OR because it believes that the $2B purchase price now will be far outweighed by the potential for VR in the future, same for WhatsApp.

It would be simplistic to say that valuations that drive acquisition activity comes simply from comparing yield levels.

That being said, where does Facebook get the money to make the acquisitions they do? From the public market. The public market is mostly driven not by individual investors, but by major market movers, which are few in number compared to the "retail" investor market, but significant in influence. And Goldman Sachs and the like might be motivated to keep pushing money into Facebook because the alternatives are weak, given the current low yield environment.

If yields improve, then GS and the other market movers might shift from equities to other asset classes (fixed income, equities, maybe even CDOs again), and then as the money stream starts to taper for folks like Facebook, their acquisition activity will slow, and then valuations will start to decrease, and then Venture Capital activities in those sectors will also dampen, because the exits will be seen as less lucrative.

It would seem to me that exit activity drives valuation more so than current yields, but current yields might impact the money flow that drives those acquisitions.

> It’s hard to sustain a bubble for four years.

I don't think so. The housing bubble that popped in 2008 lasted a lot longer than 4 years.

It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.

The discounting is what's propping up the market. It's a strange phenomenon in that the market is betting that earnings will hold or grow, but the economy will be weak enough to discount future cashflows at a low rate. This is why signs up recovery that suggest tightening cause the market to tank.

Cheap money (or, low rates with "safe" bond markets) + high growth tech = sky high valuations - got it, Fred.

Just, one more thing... how did he go from the 10% yield ($100M / 10M = 10% yield) to "if interest rates are 5% instead of 10%, then you would pay $200mm for the business ($10mm/$200mm = 5%)." Is he simply interchanging the word "yield" with "interest rates" or actually talking about the central bank?

(s/b 10M / 100M = 10%). He is interchanging the terms and he should have written things differently to avoid confusion. It s/b "yield = annual earnings/purchase price", not "interest rates = annual earnings/purchase price". (He does correct himself later in the paragraph.)

Thanks for the clarification!

>They have flooded the market with cheap money in an attempt to heal the wounds (losses) of the financial crisis and incent business owners to invest and grow their businesses. That has not worked particularly well but it has worked a bit.

I would argue that it hasn't worked at all, given all the bad things that are yet to come from it.

"Bad things that are yet to come" aren't a given...

Well, yes they are. The can has been kicked down the road. Few things have actually been repaired. Printing and borrowing money only temporarily solves a current problem, and pushes other problems down the track.

The _really_ scary thing is that as rates are moved close to 0, inflation seems to slow down. This is true both in the US (almost 0 rates, low inflation) and in the EU (a bit higher rates, but almost 0 inflation in the last few months). If deflation kicks in, then this flood of free money will evaporate very quickly.

I think we should be more worried about high inflation in the future, not deflation:

The lack of inflation despite the Fed's printing can be explained in the massive increase in excess reserves (and also the slowdown in the velocity of money.): https://research.stlouisfed.org/fred2/series/EXCSRESNS

This jump is a result of the Fed getting authorization from congress to pay interest on said reserves. By controlling this rate, the Fed can effectively control how much excess reserves they have, thus having a large impact on the rate of inflation. Having said that, it is a massive and unprecedented amount of excess reserves. If something goes terribly wrong in their exit strategy (and/or the velocity of money picks up unexpectedly) then the worry would be high inflation, not deflation.

EDIT: I believe you meant if inflation kicked in then the flood of free money would discontinue. That would be accurate as interest rates would rise and QE would most certainly be off the table. Deflation fears is what set QE into high-gear in the first place ;)

Economics aren't discontinuous around zero. All this evaporation would either happen approaching zero or not happen.

Deflation does not mean spending money is a bad idea. If I have $100 and there's 10% deflation, in a year, it's worth $110 of today's dollars(or some other number because I can't math, but in that general direction). But if a company is experiencing 100% growth and is worth $100 today, it's still a good investment (if you can sell it in a year).

The Eurozone is looking at mild deflation, and it will do a lot of damage. Deflation in the US is nearly impossible, because the FED will just purchase assets until the problem of low inflation goes away.

Deflation in the Eurozone will be bad mainly because it will make the personal and public debts of the debtor nations unbearable. Not because "money will evaporate very quickly".

Deflation will be bad because nobody will by something today when they think it will be cheaper tomorrow.

This is standard excuse trotted out. Of course it is incomplete at best and grossly misleading at worst.

Deflation is the opposite of inflation. One is an increasing value of currency, and the other is a decreasing value of currency.

People deal with deflation every day - both in their own national economies and internationally - when your currency is rising (gaining value) why would you purchase something today when it is going to be worth more tomorrow? The answer is because the value of having the thing today is worth more than having the money tomorrow - which is how we base all our purchasing decisions.

It's true that deflation will have effects that are not good - but mild deflation is no horrific thing. Most people have been told deflation is a scary monster in the same way that they have been told marijuana is a scary drug. There are circumstances and reasons when that is true, but it's not generally true and generally overblown. Both high deflation and high inflation are runinous to an economy, but mild deflation and mild inflation just produce different classes of winners - savers vs creditors.

What people actually mean when they say "buy something" is "invest in something".

When an investor chooses whether to invest in something, the question they ask themselves is "will this make more money than the best alternative investment on offer to me?"

When the value of currency is falling, it becomes relatively more appealing to invest in things that are not currency. For example, new machines for the local factory - those machines make widgets, and with 2% inflation those widgets are worth 2% more every year.

When the value of currency is rising, it becomes relatively more appealing to invest in things that are currency, like keeping my money in the bank. Glad I'm not one of those suckers who invested in the widget factory, because of the 2% deflation those widgets are worth 2% less every year.

Me, I think our economy would be better off with more invested in manufacturing and less in financial services.

>because of the 2% deflation those widgets are worth 2% less every year.

Also, the value of your loan increases in real terms, as does the labour-share of input costs (because the workers aren't going to give back wage gains in times of deflation). Your return is hampered.

These are some of the problems with deflation.

>savers vs creditors.

Savers and creditors are the same people.

True. Creditors vs Debtors. Creditors are advantaged by deflation, debtors advantaged by inflation. Except where effects of one or the other affect the amount of bad debts.

That's a bit of an overstatement. Many purchases are time-sensitive to the extent that expected deflation would have to be very high.

That effect isn't very strong in an already depressed economy (where people only buy the bare necessities anyway).

This is why I try not to buy computers with my own money :)

Other EU countries with their independent currencies/central banks have gone the same way as the Eurozone: Sweden just went into deflation and UK seen inflation go below their 2% target (designed for normal times, arguably should now be higher) as well.

If deflation kicked in, why wouldn't the fed fight with increased QE?

This may sound subjective but at least in my opinion when the rate of IPOs starts to rapidly increase and the companies behind those IPOs don't really seem promising, then you begin to worry about a bubble. Back in the 90s it seemed like if your company wasn't going IPO something was wrong.

> It is the combination of these two factors, which are really just one factor (cheap money/low rates), that is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime.

> I have no idea when and if that will happen.

Apparently, neither does anyone else, including the Fed itself who's been predicting a rise since 2010 or so: http://www.zerohedge.com/sites/default/files/images/user5/im...

This sounds like a perfectly reasonable take on the situation. As a general rule of thumb, expansionary monetary policies benefit smaller companies. Now that the fed will likely start tapering back some, I think we'll start seeing larger companies (Apple, Google, maybe Facebook) having good years.

There's one thing I can guarantee though: we are almost certainly in some kind of bubble. It may not be a tech bubble, but bubbles are just a fact of economic life.

Nothing like some well argued logic with supporting numbers and formulas to ease the anxiety. Ahhhhh.

"This is not the bubble you're looking for..."

"Move along..."

The VC can have a strong influence on the weak minded.

VCs don't understand markets, and market guys don't understand VC. It's foolish for either to opine in the other's territory.

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