Unpleasant Facts and Other Musings

Bitcoin is an online crypto currency that has grown significantly from its introduction in January 2009. While tech enthusiasts like using it for its own sake, it is mainly used in black and grey market transactions. If you want to get money out of Cyprus or if you want to switch your money into Argentinian pesos without going through official channels then bitcoin is the right tool.

Thanks in large part to the internet connecting the world like never before, the first decade of the third millennium saw unconditional convergence. The poorer countries didn't have to become significantly less corrupt in order to approach the technological frontier, they just had to let their citizens get online and connect with the world.  This naturally resulted in an increase in outsourcing and trade as global coordination was made possible. 

We are a couple of days into the government shutdown. The GOP doesn't want to pass a continuing resolution without a concession from the Democrats, while the Democrats don't want to grant any concessions to the GOP after they gave away what they felt to be too much in previous negotiations over the federal budget and debt ceiling.

During this standoff, Obama apparently attempted to scare the markets.

Obama dismissed talk on Wall Street that Washington will solve its problems, warning that the fight this time is putting not only government operations at risk, but the debt ceiling as well.

“I think this time it’s different,” Obama said in the interview. “I think they should be concerned.”

Tyler Cowen's analysis of the situation is broadly accurate - a market panic which would result in a solution won't occur because there would be no reason for the market to panic in the first place if a solution would result from that panic. Assuming he understands the nature of markets, Obama is probably more concerned with getting Wall Street donors talking to congressmen than he is with helping cause a market panic in order to force everyone to act.  When thinking about what would cause markets to panic, a conclusion we should draw from this is that the markets won't panic about the situation until and unless even a market panic has some chance of not resolving the situation. The market crash after the first TARP vote failed falls into this category. In our current situation, it means that if the political institutions require a market panic in order to act then things will probably occur on a very last minute basis, perhaps just as the Treasury is running out of ways to borrow money despite almost hitting the debt ceiling. 

Right now the political situation looks like a zero sum game. Either the GOP lose by not even getting a small concession to show for their trouble or the Democrats lose by going back on their word about not negotiating until a continuing resolution is passed. Unless both sides figure out a solution they can rhetorically pass off as a victory there isn't an obvious compromise on the table.

So Warren Buffett is probably right when he says that the US will approach but not cross the point of extreme idiocy. 

Which way is global inequality going? 

This should be a question with a simple answer. First, the question must be clarified. Usually answers to this question refer to the Gini coefficient, where a number close to 1 implies all of the wealth is owned by a few and a number close to 0 indicates that income is distributed more evenly.  If the question is asking about the direction of income inequality in various countries around the world, the answer is obvious: It is going up.

The above chart from a 2011 OECD report on income inequality highlights that income inequality has been rising in most countries around the world. It may be that national inequality is more important than global inequality, as electoral (or revolutionary) politics have a history of working more on a national basis than a global basis.

Still, the direction of global income inequality is still interesting for its own sake. A World Bank working paper, Global Income Inequality by the Numbers: In History and Now by Branko Milanovic looks at three different ways of measuring global inequality.

Concept 1. Inequality between countries.

Concept 2. Inequality between countries weighted by population.

Concept 3. Inequality between individuals of the world.

The first two are easy to measure while the third metric is much harder to get data for until the 1980's. Concept 2 is clearly superior to concept 1, as smaller countries should not be weighted the same as significantly larger countries. By the same measure, concept 3 is superior to concept 2, as wealth in developing countries is less significant if it is wholly in the hands of a few. The only downside to concept 3 is the inherent data problems as surveys of the very poor and the very rich will often be skewed.

Looking at concept 2 and concept 3, it appears that worldwide inequality has actually been falling during the 2000's. It may be a little unintuitive that inequality can go up everywhere but down in total. But those in the bottom third of the income distribution have seen their real incomes rise between 40% and 70% over the past 20 years. This has created a new middle class and the income distribution has become somewhat more equal overall even if countries where people are coming out of poverty are also creating many new US dollar billionaires.

Whether or not this trend will hold is another question entirely. The internet gave a boost to the economic institutions of almost every country in the world, so from the mid 2000's up until the financial crisis we had unconditional convergence between developing and developed countries. Going forward, institutional quality might again begin to cap the growth of developed countries around the world. And if that happens, world inequality may start to increase yet again. 

In the wake of the Twitter IPO announcement, Tyler Cowen asks if the return to public equities is now lower. His theory, about a wealthier world that causes successful companies to stay private for longer seems flawed but he brings up an interesting question.

More recently, Linked-in went public in 2011 for $4.5 billion and Facebook went public in 2012 for $90 billion. With Facebook now comfortably above its IPO price, Twitter is planning on going public with analysts estimating its IPO market capitalization between $10 and $20 billion dollars.

There are many differences between the world that spawned the Microsoft IPO and today’s markets, but the below might be the most important:

1. Sarbanes Oxley raises the cost of going public. When Sarbanes Oxley costs average over a million dollars the cost benefit analysis of going public doesn't make sense until a company has a significantly higher valuation/revenue stream than it would have needed in the past.

2. With many companies putting off going public a new financial ecosystem developed to fund these companies. Late stage VC firms like Andreessen Horowitz entered into the market. Not only do they have billions of dollars they need to deploy but they actively help the companies they invest in. This further raises the opportunity cost for companies thinking about going to the public markets.

3. A growing secondary market in shares of startups lets many founders and early employees diversify a significant amount of their new worth out of the company. When these employers feel financially secure this reduces the incentive for an immediate IPO.

4. With the internet and globalization, network effects are much more important and markets are much more likely to be winner take all. Once the winners are established their market capitalization will be significantly higher than companies in the past. This doesn't stop companies from going public sooner by itself, but it does mean that by the time the company feels that it is stable enough to be traded on the public markets its market capitalization will be much higher.

Given all of these factors, the higher market capitalization of IPOs makes a lot of sense. What this means for public equity returns is more complicated. 

The first factor prevents many companies from going public until they are much more successful. This includes companies that go on to be successes but there are also companies that end up as failures or frauds that would be detected by tougher accounting laws that public market investors are never exposed to. Small companies will also often sell themselves to larger companies rather than enter the public markets. Overall it is difficult to calculate the direct effect of this factor on public market returns. 

The factor that really penalizes public market investors is that a healthy secondary market means there are not as many situations where a company will go to market merely for the sake of allowing its management team to cash out. When there is demand for liquidity, the people on the side of the trade giving liquidity will on average make a higher return. The reduction of this factor could lower returns for public market investors in general. At the very least it should cause a reduction in the size premium. And from the chart below, we see that size was never a particularly attractive risk premium to be long in the first place.  Momentum, market return, value and even the risk free rate have outperformed the classical size risk premium factor.

The winner takes all (most) nature of many of markets today is both a blessing and a curse for public equity investors.  It isn’t always private companies like Facebook or Twitter who create new markets, as Apple investors from the early 2000s know very well. At the same time, other public companies, Microsoft is an example that comes to mind, will often spend billions of dollars trying to be the winner in a new market but fail miserably.  And if companies really are sustainable pseudo-monopolies, then public market investors have a chance of benefiting from investing in them even after IPOs.

When thinking about what impacts public market returns it is fun to think about things like the impact of mega IPOs will be but it is better to double check theory again the basic fundamentals. We currently have an equity market that is yielding over 6% while investment grade debt yields, depressed by quantitative easing and low rate expectations, are below 4%. Until the past few years, investors in bonds have been paid a premium over earnings yield because they are taking on inflation risk and their earnings will not go up. The last time this happened we have to go back to a time period when equities were viewed as a realm for uncouth gamblers and everyone knew that railroad bonds were the key way to keep their money safe.

Given the current valuation dynamics, it isn’t likely that the average return on publicly-held companies has moved lower. 

When talking about an event between 1980 and 1989 we call it the eighties. When talking about an event between 1990 and 1999 it is the nineties. But the one from 2000 to 2009 is confusing. Wikipedia was somewhat helpful.

Orthographically, the decade can be written as the "2000s" or the "'00s". Some people read "2000s" as "two-thousands", and thus simply refer to the decade as the "Two-Thousands", the "Twenty Hundreds", or the "Twenty-ohs". Some read it as the "00s" (pronounced "Ohs", "Oh Ohs", "Double Ohs" or "Ooze"), while others referred to it as the "Zeros". The single years within the decade are usually referred to as starting with an "Oh", such as "Oh-Seven" to refer to the year 2007. On January 1, 2000, the BBC listed the noughties (derived from "nought" a word used for zero in many English-speaking countries), as a potential moniker for the new decade. This has become a common name for the decade in the UK and Australia, as well as other Anglospheric countries.

Others have advocated the term "the aughts", a term widely used at the beginning of the 20th century for its first decade.

The "two-thousands" might have seemed good at first, but those using it probably forgot that it refers to the whole millennium and not just the first decade of that millennium. Two contenders make sense - the "Twenty-ohs" and the "aughts".  The first is accurate, if three syllables, and the second has historically been used, even if it sounds like you are being told what to do when someone brings up the decade. But one thing is clear - we can't let it be called "the noughties". That would just be awkward. 

At least this confusion won't happen in the teens.