Life after Bitcoin?

Edward GeretyWhile Bitcoin grabs headlines, a little-noted rival promises to supercharge all currencies old and new, fiat and cyber. An open-source programming system called the Ripple protocol could transform commerce and banking by making dollars, yen, euros, bitcoins, and even loyalty points virtually interchangeable.

The Ripple protocol, based in part on the system behind Bitcoin, is a payment and currency exchange system that erases the barriers between fiat currencies while also embracing digital currencies and other representations of value, ranging from gold to frequent flyer miles. It goes beyond Bitcoin by providing a code system that leaves no currency—including bitcoins—out.

Right now anyone can make limited use of the Ripple system by signing up with financial gateways such as SnapSwap and Bitstamp for quick cross-currency exchanges between dollars, euros, bitcoin, and more. The greatest value for most people will come if banks and other institutions implement the protocol to streamline their operations. Then all sorts of transactions would become simpler, quicker, and more secure. Many people would not even know Ripple was involved; they’d simply notice that their banks got better.

The system is being developed as open-source code by Ripple Labs, a Silicon Valley startup backed by Google Ventures, Andreessen Horowitz, and other leading funders. Like TCP/IP, the protocol that powers the World Wide Web, the Ripple protocol enables developers to create cheaper, speedier and more secure ways to perform transactions that are more laboriously executed by existing technology based on fiat currencies and pre-internet methods.

The key to Ripple is its distributed, decentralized nature. “It offers a way to confirm financial transactions without requiring a central operator,” says Chris Larsen, Ripple’s CEO. That saves both money and up to days’ worth of time. While the Bitcoin system also bypasses a central operator, its transactions take minutes rather than seconds to process, according to Larsen.

Financial organizations have already begun adopting the Ripple protocol. In May 2014, Germany’s Fidor Bank became the first bank to use the Ripple protocol. Its customers can now send money in any currency instantly and at a cost lower than typical bank rates through Fidor’s money transfer products.

Some larger financial institutions have also taken baby steps to help their customers learn about or participate in Ripple. For example, Bank of America (BAC) and Wells Fargo (WFC) offer easy ways for customers to send money to SnapSwap, the Ripple gateway that lets people buy digital currencies and performs exchanges in more than a dozen fiat currencies including the dollar, euro and pound. Such initiatives, now in their infancy, may pave the way for more active participation by major institutions.

Meanwhile, eleven financial gateways are now implementing the Ripple technology to facilitate transactions within the network. They are SnapSwap, Bitstamp, rippleCN, The Rock Trading, RippleChina, Justcoin, rippleSingapore, btc2ripple, Coinex, Bitso, and Ripple LatAm.

The latest gateway, Ripple LatAm, was launched on June 12 by AstroPay. The United Kingdom-based regional service, which covers Brazil, Chile, Colombia, Mexico, Argentina and Uruguay, will connect Latin American businesses with their counterparts in Asia, Europe and North America for faster and more affordable remittances, merchant payments and other transactions.

The longer-term prospects for leveraging Ripple are enormous. Perhaps the biggest first step any large financial organization could take would be to use it to offer faster, cheaper currency exchange services. According to the Bank for International Settlements, the global foreign exchange volume reached $5.3 trillion a day in 2013. This growing market is ripe for the taking.

The window of opportunity is open wide, but it could start to narrow. Already a London start-up, TransferWise, has raised $25 million to implement a peer-to-peer technology enabling people around the world to swap currencies at much lower rates than current bank transfer fees.

Beyond currency exchange, banks might also use Ripple to develop next-generation payment vehicles to replace obsolescent credit cards or to expand into cloud storage by offering virtual safety deposit boxes. Banks could also use Ripple to create innovative new smartphone apps and forge alliances with tech-savvy organizations that live by transactions, such as Walmart and IBM.  Such developments could facilitate a renaissance in community growth by greasing the wheels of services such as microloans, helping to create jobs. And if Ripple becomes widely adopted, the result could be a whole new medium of exchange—“money 2.0” or “supermoney.”

Traveling with just Bitcoin isn’t possible just yet but …


We haven’t yet reached the point where you can seamlessly book an entire vacation using Bitcoin, but it is getting easier and easier for consumers to use the virtual currency to pay for various bits and pieces of their travel and even to keep track of their rewards points.

Last month the online travel agency started accepting bitcoins to make reservations at more than 200,000 hotels around the world. Shortly afterward, CheapAir announced that their customers could also book their Amtrak train travel using Bitcoins.

For luxury hotels, back-end revenue management engine Revpar Guru has built anentire booking widget around Bitcoin in preparation of its adoption by globetrotters. Their tech platform not only allows for hotel payments at locations like D Casino Hotel and Golden Gate Hotel & Casino, but it allows international customers to deposit bitcoins into accounts that can be used for sundry items so that they never need to exchange currency.

“Bitcoin is very attractive to merchants of all kinds because it is cheaper and faster,” said Jerry Brito, Senior Research Fellow, George Mason University

The rewards site PointsHound, which aggregates your points and miles when you book travel, is now offering Bitcoin as a reward redemption option.

This was all pretty small potatoes in the travel world until very recently.

Traveling on Bitcoin’s virtual dime got an added air of legitimacy last  week when one of the major players in the travel market finally began accepting the currency. now accepts the virtual currency for payments for hotel rooms on their website.

“We’re continually looking at ways consumers want to pay for their travel; Bitcoin is a great example of how Expedia is investing early in an array of payment options to give our customers and partners more choice in the ways they interact with us,” said Michael Gulmann, Vice President, Expedia Global Product.

Companies accepting Bitcoin typically contract a third-party payment processor to integrate a bitcoin support system into the customer experience and to mitigate their risks.

Expedia partnered with Coinbase as their third-party bitcoin payment processor.

Customers who want to use bitcoins as a form of payment can select it as an option along with the other traditional methods including Visa, MasterCard, American Express, Discover, JCB, Diners Club and PayPal.

“Bitcoin is very attractive to merchants of all kinds because it is cheaper and faster,” said Jerry Brito, a Senior Research Fellow at the Mercatus Center at George Mason University. “With Bitcoin, the fees are also much smaller.”

Brito noted that Bitcoin also opens up a travel merchant’s market to countries that may not have extensive credit card industries or the use of PayPal.

“Bitcoin is international,” Brito said. “There is no limit. Wherever there is internet connection there is the ability to send payments and that is attractive to a lot a lot of folks.”

We still have a ways to go before you can book an entire trip on Bitcoin. Major airlines and car rental companies have yet to hop on board, but we could see movement in those areas by the end of the year.

China has a growing interest in Eastern Europe in order to make inroads into Western Europe

EU and ChinaChina is a magnet for European companies. With a trade volume of almost $600 billion, and a trade deficit with China at about $150 billion, the European Union is China’s largest trading partner.

The EU and China are seeking to bring trade to $1 trillion by the end of this decade, in line with the EU-China 2020 Strategic Agenda for Cooperation. However, the benefits of this trade relationship are unevenly distributed in Europe, with more advantages for countries in the continent’s North.

China is seen as using Europe as a hedge against the United States. That is one reason why China already stepped up purchases of eurozone sovereign bonds. China has also invested across strategic industries in Europe and infused a lot of capital into property markets.

What about China and the countries of Central and Eastern Europe? While China’s interests in the region are manifold, Chinese companies so far have only invested in the low billions there.

To bolster financial cooperation, a credit line stretching up to €10 billion was one of the proposals put forward at last year’sChina-CEE leaders’ summit. It also allowed for the establishment of branches of Chinese financial institutions in Eastern Europe.

China searches for new markets

China looks at the CEE countries primarily as a market for its own strategic industries, exports, and as a large window into Western European markets.

As Beijing continued to look for new markets, it made a pledge to double trade, although increasing imports of Central and Eastern European products to China seems relatively challenging.

Central and Eastern Europe-made products cannot compete on price with the lower-cost products made in China, nor do the region’s companies innovate enough to compete on quality in the Chinese market.

China also offered to satisfy the urgent needs for infrastructure in CEE (such as in high-speed and freight railways, nuclear and other forms of power, roads, ports and telecommunications).

Through investments in central Europe’s infrastructure, Beijing wants to accelerate the creation of a network of ports, logistics centers and railways to distribute Chinese products and bolster East-West trade.

Finding more energy abroad

Another important pillar of China’s expansion policy concerns securing its present and future demand for commodities, mainly by investing in countries rich in natural resources.

Especially attractive is the Balkan energy sector. Major western utility companies are unwilling to make risky investments, which gives China some options. Countries such as Albania, Montenegro and Bosnia-Herzegovina are attractive for their hydropower capacities. Macedonia, Serbia and Croatia attract investment for their wind energy potentials.

More generally, China is keen to proceed with projects in nuclear, wind power, telecommunications and high-speed railway sectors. It has agreed to build a high-speed rail line linking Hungary to Serbia and pledged to help Romania connect with Hungary.

Where to from here?

For Beijing, trade relations with Southeast Europe mainly focus on exchanges with the largest and newest EU countries. The still transitional economies of the Southeast Europe allow China to circumvent some of the EU’s anti-dumping regulations and export products directly to a market of 800 million people thanks to FTAs with EU.

In November 2013, during his meetings in Bucharest with 16 prime ministers from the Central and Eastern European countries, Chinese Premier Li Keqiang called for wide-ranging, multi-tier cooperation aimed at doubling trade and investment in five years.

However, China is not exactly an easy partner for the EU. Controversial issues include intellectual property rights, price distortions due to subsidize dumping, unequal conditions for market access, as well as discrimination against EU companies in Chinese government tenders.

And within Europe, although China and the EU signed a strategic partnership in 2004, there is a lack of common understanding in Europe about strategic policies towards China.

Fusing Chinese industry and European technology

One of the most significant strategic objectives of China’s investment in Europe is to engage more closely with the continent’s research and development networks.

To some extent, China continues to depend on technology from Europe and the United States. China is not yet an innovation powerhouse, although its spending on R&D is rising very rapidly.

China still spends less than half as much as the EU as a whole and only one-third of what the United States spends on R&D. Chinese companies are good at incremental innovation, but they lag behind advanced countries when it comes to disruptive innovation.

Less than 6% of Chinese patents are protected by global patents, compared to 49% of U.S. patents. Fifty percent of total exports and more than 90% of China’s high-tech exports are produced by foreign companies operating there.

For Europe, China represents a huge economic opportunity. Chinese labor and capital working alongside European rules and technology — carefully managed — could create significant opportunities for both economies going forward.

DISH Network joining the Bitcoin revolution

bitcoin-value-thousand-dollars-.siDish Network Corp. (DISH) said it would begin accepting bitcoin as payment starting in the third quarter.

The satellite TV service said it would be the biggest company to accept the virtual currency.

“We always want to deliver choice and convenience for our customers and that includes the method they use to pay their bills,” Dish operating chief Bernie Han said in a release. “Bitcoin is becoming a preferred way for some people to transact, and we want to accommodate those individuals.”

Dish said it would use Coinbase as its processor for the payments, specifically through the platform’s Instant Exchange feature, which exchanges bitcoin payments to U.S. dollars. Dish’s fiscal third quarter begins on July 1.

The option will be available for customers who choose to make one-time payments through the company’s Customers will still be able to make online payments through credit and debit cards, as well as through their bank accounts, Dish said.

The move comes amid a time of drastic change and consolidation in the pay-TV and telecommunications industries, while Dish, run by Charlie Ergen, has largely remained on the sidelines. Rival satellite TV service DirecTV agreed earlier this month to be acquired by AT&T Inc. for $49 billion, effectively eliminating two options for Dish: acquisition by AT&T and a merger with DirecTV.

Dish earlier this month posted an 18% decline in first-quarter profit amid higher expenses and tepid subscriber growth.

Meanwhile, bitcoin has faced increased scrutiny over its security risks and volatility.

A number of online retailers, including Inc. (OSTK) have previously unveiled plans to accept bitcoin as a form of payment on their sites. In March, the retailer said bitcoin holders had spent more than $1 million at in less than two months, surpassing the company’s expectations.

I have bought and continue to buy Alpha Natural Resources

us-flag-crayon8-521x400Coal producer Alpha Natural Resources (ANR) is having a terrible time in 2014. The company’s shares have been beaten down badly on the stock market, down almost 35% so far this year. The drop in coal prices and an uncertain demand for metallurgical coal have weighed on Alpha Natural’s performance this year. However, there could be some relief in sight for the company as its recent first-quarter results tell us.

A turnaround in progress

On the back of aggressive cost cutting, Alpha Natural managed to lower its loss in the first quarter as compared to the prior-year period. In fact, the company halved its loss to $55.7 million, or $0.25 per share, in the first quarter from a loss of $110.8 million, or $0.50 per share, in the same quarter last year. This was a tremendous performance considering its revenue was down almost 17% from last year. Alpha Natural reduced costs by almost 11% year over year and managed to turn in estimate-beating results.

Looking ahead, Alpha Natural’s aggressive cost-cutting moves should help the company improve its business further. The company is trying to build a new platform that would enable it to be more flexible and agile, allowing it to quickly respond to changing market conditions.

Positive signs for the future

Alpha Natural has been proactively managing its balance sheet as the company has extended the maturity profile of its debt obligations. It issued $690 million of senior convertible notes, with $355 million due late in 2017 and $345 million due in 2020. By using a significant portion of these proceeds to repurchase existing convertible notes, Alpha Natural has reduced its outstanding convertible notes maturing in 2015 from $824 million to $194 million.

In addition, Alpha Natural termed out its bank debt, which lowered its near-term repayment obligations significantly. In addition to successful convertible note offerings, Alpha Natural monetized a portion of its Marcellus gas acreage for a total consideration of $300 million, consisting of $100 million in cash and $200 million in shares of Rice Energy (RICE) at the IPO price, or approximately 9.5 million shares.

Also, the company is selling off its non-core assets. Late last year, Alpha Natural was engaged in four transactions to dispose certain non-strategic idle assets, according to management. The cash proceeds from these dispositions were modest. However, the transactions allowed the company to reduce liabilities, primarily asset retirement obligations, which will reduce future cash outflows from its idle properties.

Demand could pick up

However, cost cutting can take you some distance, but after that Alpha Natural will need to find ways to grow its top line. There are some positives for investors in this area as well. On the demand side, the World Steel Association is forecasting a 3.3% increase in 2014 global steel demand, a slight improvement over last year’s growth rate. More importantly, for Alpha Natural, the European Union steel demand is expected grow in 2014 with a forecasted growth rate of 2.1% versus an estimated decline of 3.8% in 2013.

On the supply side, limited growth is seen for 2014 as only a few mines are scheduled to come online. According to estimates, total exports in 2014 are estimated to increase by only about 10 million metric tons of which 6 million tons are from Australia. So, with favorable demand and supply signs, Alpha Natural can expect to see further improvements in its performance going forward.

In addition, the domestic thermal coal market is showing some promising signs. The continual coal spills experienced late last year have resulted in increased demand and interest in coal-fired electrical generation. This demand, in turn, is expected to accelerate the drawdown in utility stockpiles across the various regions.

Also, electrical generators and grid operators are focusing on the role of coal fire generation and are looking to maintain a reliable energy supply. Moreover, many utilities have not only been bringing coal generation back online, but are running it at full capacity.

According to Alpha Natural, the domestic market has strengthened and the company expects to get its share of any additional domestic demand in the markets it serves. It also continues to focus on thermal exports, recognizing the price sensitivity in these markets and the need to be opportunistic with the ability to clearly respond to opportunities available.


Alpha Natural does hold a weak balance sheet. Its cash position is just $970 million while it has a huge debt of $3.43 billion. However, as I saw above, the company has extended maturities, selling off non-core assets, and aggressively reducing costs. In addition, there’s a slight improvement expected in the end markets. So, investors could consider an investment in Alpha Natural as the stock is trading at depressed levels and it could see a turnaround going forward.

Bitcoin is Going Nowhere — A Quick Guide to Cryptocurrency

bitcoinatmBitcoin continues to gain greater traction in the media as a potential investment vehicle. Proponents praise their decentralization, convenience, and transparency. Over the past year, they have transformed from black market currencies to viable alternatives for traditional investments and existing currencies.

Bitcoin has soared from 10 cents in its early days to more than $1,200 by December 2013 as its exploding demand fascinated the media. Most people still have limited knowledge of how to use Bitcoin, let alone invest in it. Given its dual potential as both an investment and an electronic currency, it is important to understand the risks of this largely unregulated marketplace.

Growing Up is Hard to Do

Originally used as a way to barter on the black market site Silk Road, Bitcoin has now grown to cover several sectors and a variety of uses. It has spawned a multitude of imitations since its origins in 2009 and helped pave the way for cryptocurrency’s rapid growth as its market cap now exceeds $6 billion.

In February 2014, Mt. Gox, a major exchange that once handled over 70% of Bitcoin transactions, announced its loss of around 850,000 Bitcoins, valued at over $500 million. The collapse of this platform called into question the security of cryptocurrency and its ability to emerge into a mainstream currency.  The value of Bitcoins crashed overnight causing China to ban it as a currency, likely scaring off many potential investors.

Mining sacrifices your computer’s computational processes to solve complex problems that keep the respective cryptocurrency’s peer-to-peer infrastructure secure. “Miners” essentially validate every transaction in history, preventing double-spending and counterfeiting. For their contributions, miners are rewarded pieces of Bitcoins for transactions they have validated.

Because mining requires a substantial investment in computer hardware, energy, and time, many people prefer to obtain cryptocurrencies through exchange platforms. Currently, only the top ranking cryptocurrencies, such as Bitcoin, Peercoin, Dogecoin, or Litecoin, can be purchased through fiat currencies on major exchanges like VaultofSatoshi, Kraken, Coinex, and BTC-e. Not surprisingly, there are only a handful of platforms such as GoCoin that can efficiently process cryptocurrency transactions in what is still a fairly limited market.

Investment Alternative or the New PayPal?

Bitcoin is unique in the sense that it can be both an investment tool and a transactional platform. There are an estimated two to three million users of Bitcoin, many of whom hold the currency as an investment. There are real risks involved with investing in Bitcoin, as its value can fluctuate wildly. Many consumers and tech startups have supported the growth of Bitcoin as a transactional platform. The endorsement and consumption of Bitcoin spans across a multitude of categories including Virgin Galactic,, car dealerships, restaurants, and boutique shops. Spend Bitcoins, a currency directory, has nearly 6,000 companies on its database of retailers that accept Bitcoin.

Bitcoin transactions are like cash payments and do not require the customer to hand over substantial personal information, eliminating identity theft and chargeback issues. Some institutions claim Bitcoin is the new and superior PayPal and praise it for its low transaction costs. Recent IRS regulations denoting Bitcoin as “property” rather than currency for tax purposes will bring more transparency and security into the system. Some financial experts view this regulation as a move that puts Bitcoin on the path to becoming a true financial asset.

A Limitless Future

Overall, cryptocurrencies have a long way to go before they eclipse credit cards and traditional currencies as a tool for global commerce. They have displayed potential as an investment alternative, but are still not a must have asset class in your portfolio. In the next several years, cryptocurrencies are likely to evolve into a niche electronic currency that could become a realistic alternative to other electronic payment processing platforms.

VCs need to fund an official Exchange for Bitcoin

De_Waag_BitcoinOver the years, I have argued that venture capitalists should fund a regulated, US-based, preferable New York or San Francisco, Bitcoin exchange. Not necessarily for direct ROI, but to solidify the footing underneath their many Bitcoin-related portfolio companies. I also wrote that “one VC-backed company is in serious talks to move forward this something like this, likely via a ‘seat’ model.”

That VC-backed company is SecondMarket, whose investors include FirstMark Capital and The Social+Capital Partnership. The New York-based company, which once was known primarily as a middleman for pre-IPO Facebook trades, plans to spin its existing Bitcoin business out into a stand-alone company that eventually will include a New York-based exchange for the cryptocurrency. The current assets include an 11-person trading desk, the Bitcoin Investment Trust (kind of like a currency ETF) and $20 million of cash and Bitcoin.

The exchange’s goal would be to reduce Bitcoin price volatility, by using spot pricing once or twice per day (like gold spot pricing) and serving as a clearing company in which member firms would clear all transactions by day’s end. Members also would keep enough cash in Bitcoin to maintain exchange liquidity.

SecondMarket CEO Barry Silbert says that he’s modeling it after the early days of The IntercontinentalExchange, and that he hopes to have a set of founding members in place by the end of March. Expect them to include Wall Street banks and well-funded Bitcoin startups (but not, interesting, VC firms). Non-member firms or individuals would not be allowed to trade — at least at the outset — but likely could do business indirectly via the member firms.

All of this comes amid reports that one of the world’s most popular Bitcoin exchanges, Mount Gox, is shutting down after a hack that has cost its users more than $400 million. Silbert declined to comment on the developing situation at Mount Gox, except to say that SecondMarket employees were prohibited from buying/selling Bitcoin once the company learned of what was happening at Gox (a discovery that seems to have occurred hours before it became public knowledge).

From my perspective, Gox’s collapse is both a challenge and opportunity for SecondMarket’s spin-out; a challenge because Gox’s collapse could cause even the most ardent Bitcoin enthusiasts to distrust the cryptocurrency. And opportunity because there is now a market void that could a trusted entrepreneur like Silbert may be well-poised to fill. The exchange, which does not yet have a name, would launch as a self-regulated organization. But Silbert recognizes that its ultimate future is likely to be under the auspices of the New York Department of Financial Services, which recently held a Bitcoin hearing at which Silbert testified.

How America is dividing itself between Wall Street, Main Street and DC

Wall-Street-vs.-Main-StreetJulius Caesar’s treatise on the war that the Roman Empire fought against the Gauls famously starts with the words: “All Gaul is divided into three parts.” The same is true for the United States of America today.

In contrast to Caesar’s division of what is today known as France, which went along ethnic lines (Belgians, Celts and Gauls), America’s division today splits the country into the disjointed politics in DC, the real economy on Main Street and the return to old glory on Wall Street.

Trouble in Washington

The dysfunction on the inside of the Washington Beltway by now has gone from the ridiculous to the absurd. Elected federal politicians that get paid with taxpayers’ dollars continue to ignore the business of governing while nobody holds them to account for anything. They are mainly busy with raising campaign funds for re-election.

Meanwhile, President Obama’s White House is stumbling from one scandal to the next. Admissions of excessive NSA surveillance of U.S. citizens and foreign leaders are chased by the disastrous launch of “Obamacare”. What will be the next fumble?

Last month, Mr. Obama’s approval rating in year five of his presidency fell to below 40% and to the same level as George W. Bush’s was at the equivalent point in his tenure (in November 2005). The President’s only solace in this could possibly come from the fact that 39% is still a whole lot better than the 9% that Congress is getting these days.

Slow recovery and a nation of tenants

As Washington is stuck in a high stakes poker game between elephants and donkeys, the real U.S. economy displays difficulties of its own. Statistically, the Wall Street-induced Great Recession has been over for four years, but the economy is still recovering.

This most sluggish of recoveries also comes with a U.S. labor participation rate that sits at less than 63%, the lowest level since 1978. More than a third of the U.S. population that could technically be working is not. They either dropped out of the workforce permanently, or they haven’t started entering it because there are no jobs and would rather stay in school.

The drop in labor market participation marks the flip side of the relatively stable official unemployment rate at or above 7.0%. As the participation rate shows us, the unemployment rate dropping from the record highs of 2009 is not an indication of more jobs, but of more folks staying out of the workforce. That is troublesome.

Job creation in America is not just slower than expected. The jobs that are being created often come with fewer hours and a lesser wage. The recovery is agonizingly slow, both quantitatively and qualitatively.

 Today, people with poorer quality jobs are spending their hard earned money to reduce their credit card balances which is good for their credit rating but bad for an economy where consumer spending accounts for over 70% of output.

Less easily available credit is also one of the root causes why the United States is slowly turning from a society where the majority of families own their homes to one where the majority are tenants.

At near record-low prices for single and multi-family residences, this situation benefits a new generation of landlords that are picking up deals of the century to rent apartments at rates dictated by limited supply and growing demand.

Wall Street is back!

The contrast to a broken political system and a struggling real economy can be found on Wall Street these days. Mega-IPOs and mergers are back and with them the bonuses for those investment bankers that survived the recession purge.

U.S. corporations have cleaned up their balance sheets and used the recovery to improve corporate earnings. This is the stuff that markets like.

While the economy overall is still struggling with job creation and solid growth, the Federal Reserve’s generous quantitative easing and asset purchasing program made sure that there is enough liquidity around to make sure Wall Street could enjoy an almost magical recovery before anybody else.

The idea was that a fast recovery on Wall Street would eventually trickle down into the real economy, create new jobs and get GDP growth back to the 3-4% that everybody wants to see.

The reality is that the few with the means to invest in the markets are enjoying incremental wealth from the Dow Jones at record levels. Meanwhile, the many stuck in their daily struggles of getting by are still waiting for better jobs and more opportunity.

We are also likely to see a continuation of the erosion of the American middle class. The silver lining for those that still have money left in their 401k plans will be that the bulls keep roaming on Wall Street and whatever their retirement plans are invested in will help growing their nest egg.

Bubble in the Market, I think not just yet BUT…

Edward Tj Gerety BubbleOver the last few weeks, I’ve been chatting with friends about the potential formation of a bubble in the US equity market as represented by major indices and index ETFs such as the S&P 500 (SPY) and Dow Jones Industrial Average (DIA), driven by the conjunction of both record quantities of excess liquidity and declining liquidity preferences.

Starting two or three weeks ago, a flood of analysts have been falling over themselves trying to characterize the current stock market as a “bubble,” or variously as “bubbly.” So has the bubble that I have presaged aging already started?

I believe that this talk of a current bubble in the stock market is exaggerated and mostly unfounded.

This Market Ain’t A Bubble

Current consensus 12 Month Forward operating EPS for the S&P 500 is around 113. A reasonably conservative estimate would be 110. This implies a forward PE of 15.9. While this forward operating P/E is rich on a historical basis, it is not indicative of a bubble.

The analysis of historical P/E valuation does not change much if we base the P/E on trailing GAAP EPS. Assuming a trailing GAAP EPS of 94.00 at the end of the third quarter, this implies a trailing P/E of 18.6 versus a historical average of 15.5 since 1871 and a median of 17.4 since 1960. I believe that the latter figure is a more relevant basis for comparison. Either way, the current trailing P/E is not representative of bubble conditions.

Anecdotal approaches to characterizing the current market as a bubble does not work either. Let’s assume for a moment that Tesla (TSLA), Facebook (FB) and Twitter (TWTR) are bubbles. So what? There are always a few bubbly stocks in any market.

Cherry picking high P/Es as a method of “analysis” does not work either. One article I read a few weeks ago claimed that US large caps were a bubble based on citing three or four stocks with P/Es in the high teens and the low 20s. But if you objectively survey the largest 50 US stocks by market capitalization, less than 25% have forward P/Es of over 15. And less than 10% have P/Es of over 20.

Here are just a few examples of the top stocks in the US by market cap and their forward P/Es: Apple (AAPL) 11.1, Exxon (XOM) 10.8, General Electric (GE) 13.5, Chevron (CVX) 9.9, IBM (IBM) 10.3, Microsoft (MSFT) 12.1, AT&T (T) 12.9, Pfizer (PFE) 12.7, JPMorgan (JPM) 8.6, Oracle (ORCL) 11.1, Wal-Mart (WMT) 13.3. There is no bubble going on here.

In fact, the overall forward P/E for the 50 largest US large caps is less than 14. This compares to the forward P/E of the Nifty Fifty in 1972 which peaked at around 35. The top 50 US stocks by market cap also traded at a forward P/E of around 35 in 2000. Clearly, by any reasonable absolute or historical measure, there is currently no bubble in US large cap stocks.

And there is no generalized bubble in the US equity market as a whole.

Will Talk of Bubbles Prevent Them?

One potential consequence of all of this bubble talk is that it could actually serve to prevent one by placing investors on guard and getting them defensive.

However, if historical experience is a guide, I would not bet on this loose talk about bubbles actually preventing one from ultimately forming. People were loudly proclaiming bubbles in 1997, a full two years before the real bubble took off in 1999.

An important step in bubble formation is capitulation by various bears that were previously proclaiming a bubble and the simultaneous development of a narrative about a “new era” that justifies higher-than-normal valuations. Valuations are not much higher than normal now, so that sort of hyper-bullish argument would not even make any sense at present.

Bubble-Like Speculation About Profit Margins

If anything, the predominant narrative today is one of skepticism about the economic fundamentals and corporate earnings that underlie current P/E ratios.

To illustrate just one example of such skepticism, analysts such as John Hussman and James Montier have been arguing loudly that profit margins are currently in a bubble and will revert to their means of the last 30 years as soon as the US budget deficit as a percent of GDP declines. Unfortunately, while appearing theoretically plausible, this line of argumentation has virtually no empirical basis and is based on flawed theoretical constructs that were first developed in the mid 20th century by an obscure Marxist economist from Poland by the name of Michal Kalecki, and which have largely been discredited.

Contrary to Kalecki’s theoretical speculations, and general popular belief, there is no consistent history of mean reverting profit margins for corporations. To the contrary, the available empirical evidence directly contradicts the theory. For example, profit margins remained very high throughout the 1950s despite rapidly declining budget deficits as a percent of GDP. Similarly, profit margins did not exhibit any mean reverting behavior in the 1960s and 1970s. In fact, contrary to the Kalecki theory, profit margins experienced a secular decline in the 1960s and 1970s through periods of both rising and falling deficits, but mainly through rising deficits. During the ’80s, profit margins did not show any great mean-reverting behavior nor any tight relationship to budget deficits. During the 1990s, budget deficits plummeted throughout the decade while profit margins soared, in total contradiction to the Kalecki theorem. In fact, profit margins have not mean reverted at all in the past three decades regardless of budget deficits!

Profit margins have been in a secular uptrend for over 30 years through periods of both rising and declining budget deficits (as a percent of GDP). Furthermore, these increases in profit margins are based on empirically identifiable and likely sustainable developments such as globalization (capital and labor arbitrage), lower effective corporate taxation, lowered capital intensity of modern industry, cost-saving technologies, barriers to entry via intellectual property, oligopolistic industry concentration global branding and a host of other factors that have been empirically quantified in various detailed reports published by analyst such as James Bianco at Deutsche Bank, Tobias Levkovich at Citi and Dan Suzuki at Merrill Lynch.

Indeed, it may seem ironic to say so, but Hussman’s and Montier’s theories about declining budget deficits driving profit margins down, or even more simplistic mean-reversion arguments by commentators such as Doug Kass, are far more speculative and empirically unfounded than the much-maligned consensus forward EPS estimates that currently underpin the market value of stocks in the US equity market.

Speculation about a profit margin bubble in US stocks has become almost a bubble onto itself.


US stocks are currently not in any sort of generalized bubble. There are some signs of “frothy” behavior in a few isolated segments of the market. However, the stock market as a whole is still within 1 standard deviation of its historical mean in terms of forward and trailing P/Es.

When we stop hearing all the talk about bubbles and start to hear widespread talk about how much-higher-than-average P/E multiples are justified, then we can start to seriously suspect that a bubble might be in the works.

Before then, the possibility of a bubble forming in the US stock market is just that: A possibility. While I think the probabilities of the formation of a future stock market bubble are quite high, the fact is that it is not yet a reality.