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The new tech bubble takes us to a new world. A mad world.

23 February 2014

Summary: As we enjoy the third bubble in 15 years, watching America’s investment capital burn away, let’s break loose from the crowd and seek a more accurate perspective. However bleak the vision, never ask for the blindfold.

Bubble-shutterstock_82544554

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Contents

  1. Our odd third bubble
  2. Peter Schiff asks “WhatsApp With That?”
  3. About the author
  4. For More Information

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(1)   Our odd non-investment bubble

“Hegel says somewhere that all great historic facts and personages occur twice, so to speak. He forgot to add: ‘Once as tragedy, and again as farce.’”
— Opening line to Karl Marx’s The Eighteenth Brumaire of Louis Bonaparte (1869)

Investment bubbles are an inherent aspect of free market economic systems. They predate central banks, fiat currency and modern fractional reserve banking systems (despite conservative mythology). They leave both losers and the infrastructure they built (e.g., canals, railroads, the Internet).

The two previous bubbles are oddly recent, but otherwise typical. The current one is not. First, three bubbles in 15 years suggest either amnesia drugs in the water or a people with a dysfunctionally-serious inability to learn. Second, despite the claims, this is not a tech bubble. The technology involved is only slightly advanced, the resulting companies mostly unprofitable, and the key products are stock certificates. The massive customer growth results from underpricing (there are always takers when selling dimes for a nickel), the funds come from the venture capital – investment bank – investment management industry. They, and the senior managers of these companies, will keep their profits when the investors’ money vanishes with last year’s snow.

This is half of America’s seed corn. Poured into what are little more than ponzi schemes, whose collapse will leave little behind. (The other half of our seed capital feed our military and intelligence machinery. The resulting flames are pretty, but accomplish little).

Let’s correctly assign responsibility for this. All cons require suckers. Our amnesia makes us perfect for that role in this game.

“You can’t cheat an honest man.”
— W. C. Fields movie (1940)

(2)  A look at the latest chapter in our mad adventures

WhatsApp

WhatsApp With That?
By Peter Schiff
From EuroPacific Capital, 22 February 2014
Reposted here under their Creative Commons license

Two pieces of business news announced this week provide a convenient frame through which to view our dysfunctional and distorted economy.

  1. The first (which has attracted tremendous attention), is Facebook’s blockbuster $19 billion acquisition of instant messaging provider WhatsApp.
  2. The second (which few have noticed) is the horrific earnings report issued by Texas-based retail chain Conn’s {see Reuters}.

While these two developments don’t seem to have much in common, together they shed some very unflattering light on where we stand economically.

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Bubbles-In-Bubbles

America: bubbles within bubbles

Given the size and extravagance of the Facebook deal, it may go down as one of those transactions that define an era (think AOL and Time Warner). Facebook paid $19 billion for a company with just 55 employees, little name recognition, negligible revenues, and little prospects to earn much in the future.

For the same money the company could have bought American Airlines and Dunkin’ Donuts, and still have had $2 billion left over for R&D. Alternatively they could have used the money to lock in more than $1 billion in annual revenue through an acquisition of any one of the numerous large cap oil producing partnerships. Instead they chose a company that is in the business of giving away a valuable service for free. Come again?

Mark Zuckerberg, the owner of Facebook, is not your typical corporate CEO. Through a combination of technological smarts, timing, luck, and questionable business ethics, he became a billionaire before most of us bought our first cars. And in the years since social media became the buzzword of the business world, Wall Street has been falling over backward to funnel money into the hot sector. As a result, it may be that Zuckerberg looks at real money the way the rest of us look at Monopoly money. It also helps that a large portion of the acquisition is made with Facebook stock, which is also of dubious value.

But even given this highly distorted perspective, it’s still hard to figure out why Facebook would pay the highest price ever paid for a company per employee — $345 million (more than four  times the old record of $77 million per employee, set last year when Facebook bought Instagram). The popular talking point is that the WhatsApp has gained users (450 million) faster than any other social media site in history, faster even than Facebook itself. Based on its rate of growth, the $42 per user acquisition cost does not seem so outrageous. But WhatsApp gained its users by giving away a service (text messaging) for which cellular carriers charge up to $10 or $20 per month. It’s very easy to get customers when you don’t charge them, it’s much harder to keep them when you do.

Boosters of the deal expect that WhatsApp will be able to charge customers after the initial 12-month free trial period ends (it now charges 99 cents per year after the first year). Based on this model, the firm had revenues of $20 million last year. But what happens if another provider comes in and offers it for free? After all, the technology does not seem to be that hard to replicate. Google has developed a similar application. More importantly, no one seems to be projecting what the cellular carriers may do to protect their texting cash cows.

Investment banker at work

Investment banker at work

WhatsApp gives away what AT&T and Verizon offer as an a la carte texting service. As these carriers continue to lose this business we can expect they will simply no longer offer texting as an a la carte option. Instead it will likely be bundled with voice and data at a price that recoups their lost profits. If texting comes free with cell service, a company giving it away will no longer have value. People will still need cellular service to send mobile texts, so unless Facebook acquires its own telecom provider, it can easily be sidelined from any revenue the service may generate.

Some say that texting revenue is unimportant, and that the real value comes from the new user base.  But how many of the 450 million users it just acquired don’t already have Facebook accounts? And besides, Facebook itself hasn’t really figured out how to fully monetize the users it already has. In other words, it is very difficult to see how this mammoth investment will be profitable.

From my perspective, the transaction reflects the inflated nature of our financial bubble. The Fed has been pumping money into the financial sector through its continuous QE programs. The money has pushed up the value of speculative stocks, even while the real economy has stagnated. With few real investments to fund, the money is plowed right back into the speculative mill. We are simply witnessing a replay of the dot com bubble of the late 1990′s. But this time it isn’t different.

In another replay of that spectacular crash fourteen years ago, the appliance and furniture retailer Conn’s has just showed the limits of a business built on vendor financing. In the late 1990′s telecom equipment companies almost went bankrupt after selling gear to dot com start-ups on credit. For a while, these “sales” made growth and profits look great, but when the dot coms went bust, the equipment makers bled. Conn’s makes its money by selling TVs and couches on credit to Americans who have difficulty scraping up funds for cash purchases. For a while, this approach can juice sales. Not surprisingly, Conn’s stock soared more than 1500% between the beginning of 2011 and the end of 2013. These financing options are part of the reason why Conn’s was able to keep up the appearance of health even while rivals like Best Buy faltered in 2013.

But if people stop paying, the losses mount. This is what is happening to Conn’s. The low and middle-income American consumers that form the company’s customer base just don’t have the ability to pay off their debt. The disappointing repayment data in the earnings report sent the stock down 43% in one day.

In essence, Conn’s customers are just stand-ins for the country at large. In just about every way imaginable, America has borrowed beyond its ability to repay. Meanwhile our foreign creditors continue to provide vendor financing so that we can buy what we can’t really afford.

So thanks for the metaphors Wall Street. Too bad most economists can’t read the tea-leaves.

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Peter Schiff

(3)  About the author

Peter Schiff is the founder, CEO, and Chief Global Strategist of Euro Pacific Capital. He is known for his vocal and unpopular bearish views of the U.S. economy, voiced prior to the 2008 financial crisis, many of which were outlined in his 5 bestselling books.

He is the host of the syndicated “Peter Schiff Show”.  His weekly commentaries appear here. See Wikipedia for more information.

His books:

  1. Crash Proof: How to Profit From the Coming Economic Collapse (February 2007)
  2. The Little Book of Bull Moves in Bear Markets: How to Keep your Portfolio Up When the Market is Down (2008)
  3. Crash Proof 2.0: How to Profit From the Economic Collapse (2nd Edition, September 2009)
  4. The Little Book of Bull Moves, Updated and Expanded: How to Keep Your Portfolio Up When the Market Is Up, Down, Or Sideways (2010)
  5. How an Economy Grows and Why it Crashes (2010)
  6. The Real Crash: America’s Coming Bankruptcy — How to Save Yourself and Your Country (2012)
Bubbles

This is America

(4)  For More Information

(a)  Other articles about Facebook’s mad acquisition of WhatsApp:

  1. ‘Serious Dysfunctionality’ On Wall Street: Facebook-WhatsApp And The Deals That ‘Marked The Top’” Of The Last Two Bubbles”, Wolf Richter, Testosterone Pit, 2 February 2014

(b)  Posts about investment bubbles

  1. Will 21st Century USA have a surprise boom, as did the 19th Century UK?, 23 October 2013
  2. Four graphs showing a nation in decline. An unnecessary and easily fixed decline., 1 November 2013
  3. Larry Summers gives us the bad news. Worse, the only solution is more of the same., 20 November 2013
  4. Has the Fed blown another housing bubble?, 30 January 2014

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11 Comments leave one →
  1. Jordan permalink
    23 February 2014 9:19 am

    That was a nice description of business practice and retailers becoming banks.
    That bubbles are reapering, over and over is not sign of investors not learning anything, but it is a sign of savings glut in the world. There are savings that are looking for investments and go where the past showed profits. Past trends do not ensure the future.
    But there is saving glut tied in with debt around our neck.

    Besides good businnes descriptions, Peter Schiff again goes with gold bug dogma and claims that it is savings from foreign investors and that QE has something to do with those bubbles.
    It is true that QE pumps money in finacial sector, but it goes nowhere from there. It is locked in finacial sector. It’s enough just to look at excess reserves and see that it still there and it was not used for more credit issuance, othervise it would not show such excess reserve almost equal to the amount of QE.

    There is overwhelming debt and at the same time there are enormous savings in the world.
    Accounting practice point that they should be of similar size. The fact that such saving glut is producing repeated bubbles is a sign that distribution of wealth is fundamentaly bad and the same will keep happening untill corrected.
    There are two ways to correct this inflation in one sector with deflated other sector that this bad distribution created; either deflate investment sector (which will hapen over and over on its own) or inflate wages sector to catch up with investment (capital) sector.

    Like

    • 23 February 2014 11:21 pm

      “The fact that such saving glut is producing repeated bubbles is a sign that distribution of wealth is fundamentaly bad and the same will keep happening untill corrected.”

      I have very much the same intuition. Something that bothers me, though, is that I’ve yet to read of anyone with enough knowledge of economics to put that into a quantitative model having done so.

      Is there anything like that?

      It seems like there should be some proposition of the form that when some measure of concentration of wealth exceeds some measure of the capacity of the real economy to supply reality-based returns without eroding aggregate demand then things become unstable.

      I know that’s not quite right; the instability began (in the 80s? I think) when we took to using ever-increasing levels of private debt to maintain aggregate demand.

      Could it be as simple as capital vs. growth? That is, when there is a lot of wealth seeking returns, there has to be a lot of growth to provide those returns; when there is little growth, only a relatively small amount of wealth seeking returns can be supported; otherwise, mad scrambling (soaring debt, casino finance) necessarily follows, because that wealth will not rest without its returns, yet there is no adequate and sustainable real source for them.

      Like

    • 23 February 2014 11:48 pm

      Coises,

      ” Something that bothers me, though, is that I’ve yet to read of anyone with enough knowledge of economics to put that into a quantitative model having done so.”

      Because there is no obvious relationship between a higher-than-normal frequency of bubbles and increasing inequality of wealth. Past periods of such inequality did not have unusually frequent bubbles. Nor is there any obvious linkage in theory.

      Intuition is an unreliable guide to economics.

      Like

    • 23 February 2014 11:45 pm

      Jordan,

      “That bubbles are reapering, over and over is not sign of investors not learning anything, but it is a sign of savings glut in the world. ”

      The invisible hand holds an invisible gun to investors’ heads. “Buy internet stocks at fantastic insane valuations, although they have no profits” it says in a deep voice.

      Really, that’s silly.

      “There is overwhelming debt and at the same time there are enormous savings in the world. Accounting practice point that they should be of similar size.”

      Totally false.

      “the fact that such saving glut is producing repeated bubbles is a sign that distribution of wealth is fundamentaly bad and the same will keep happening untill corrected.”

      There is no clear link between the two phenomena: bubbles and distribution of wealth.

      Congrats, a hat trick: silly, false, made-up.

      Like

    • 24 February 2014 7:42 am

      “[T]here is no obvious relationship between a higher-than-normal frequency of bubbles and increasing inequality of wealth. Past periods of such inequality did not have unusually frequent bubbles. Nor is there any obvious linkage in theory.”

      Is there any macro indicator which does presage (in theory or in practice) the frequency and depth of bubbles? Or do they appear to be just a random feature of modern market capitalist economies?

      Like

    • 24 February 2014 3:10 pm

      Coises,

      See the first post listed in the For More Info Section, esp the links in it to the papers by Prof Odlyzko.

      In brief, bubbles are an inherent part of free-market systems. But bubbles so large as to affect the economy are rare. Once-a-generation rare, which makes detailed analysis of them difficult. What’s so odd is that we have had 3 in 15 years. That suggests something dysfunctional at work. Lots of candidates (e.g., Fed policy, global savings glut). It will take time for economic theory to gain from the experience of the past two decades.

      Note that “bubble”, like “inflation”, have become grossly overused terms — almost without fixed or useful meaning. Both used in similar senses, as “something increasing that I don’t like or agree with”. Sloppy speech => sloppy thinking.

      Like

    • Jordan permalink
      24 February 2014 4:30 pm

      Editor
      As i understand bubble, it is the exuberant inflow of money into the limited number of products (finacial papers).
      As i understand inflation, it is the exuberant inflow of money into the limited number of products (comodity).
      Material products inflate just as finacial papers inflate, it is the separate use of terminology in order to separate subject of effect. Bubble is inflation of finacial assets while word inflation is used for material assets. Used as a verb and reduced to the logic of it.

      “Both used in similar senses, as “something increasing that I don’t like or agree with””
      As you can see that i used “deflated” wages, which should point that it is not about liking or disliking. I only used such terminology in order to explain a process.
      I did not use it with intention to produce dislike or like as you accuse me off.
      I am just pointing out money distribution tendencies.
      Yes, i have a clear dislike of highly random distribution.

      “Accounting practice point that they should be of similar size.”

      Totally false.”

      How is that accounting points to similar size of saving glut and debt in world?
      It comes from well accepted macro theory that cost of production in one cycle has to be equal to income in order for sale to complete, all else equal.
      There comes credit to replace income in order to complete the sale. Credit comes from savings, unused savings. Without using those savings there would be less sales and therefore less employment, but credit can use savings and add more to income then hidden in savings.
      That is where growth comes from; credit can be much bigger then savings taken out of cycle.
      So the growth completly depends on new money from credit. Reduce the growth of credit and sales would not close the cycle, hence unemployment.

      As credits use savings as base for more credit, and credit creates more savings available, it is a feedback loop of reinforcement, and savings equal credits/ debt by the end of a cycle. Hence the accounting points to saving glut equals debt.

      Cost of production have to equal income in order for sales to close in a cycle. My spending equals someone’s income, but not other way around.
      It is a fundamental equasion and it is accounting. Develop from it and you will come to the same conclusion as i did. How do you get growth from it if amount of money is fixed? Well, it is not fixed. Where money comes from and where is interjected?

      Steve Keen spent decades to develop these formulas and apply them for Minsky program.

      Like

    • 24 February 2014 6:35 pm

      Jordan,

      You do not understand bubbles, and are just making stuff up. As usual.

      There is a large literature on things. Even reading Wikipedia would teach you much.

      Like

Trackbacks

  1. The new tech bubble takes us to a new world. A mad world. – Fabius Maximus (blog) ‹ Squawk Trader
  2. Latest Open A Free Bank Account Online News
  3. Is Facebook crazy? – Observer Online ‹ Squawk Trader

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