Tesla, Amazon, Bitcoin, Efficient Markets and FTT
By Dean Baker
Dean Baker is co-director of the Center for Economic and Policy Research. Adapted from http://english.hani.co.kr/arti/english_edition/e_editorial/826656.html and https://rwer.wordpress.com/2018/02/16/bitcoin-efficient-markets-and-efficient-financial-sectors/
The soaring price of Bitcoin is a useful lesson about markets for people who seem to very quickly forget the last lesson. Bitcoin, a digital algorithm, backed by absolutely nothing, sold for more than $16,000 each in late 2017.
Bitcoin’s price could still double or even triple. After all, who knows how badly people need digital currencies that are not really currencies? But more likely the market will run out of people who are willing to trade real money for nothing. At that point Bitcoin’s price will plunge further and may approach its underlying value of zero.
The price surge in 2017 shows us that markets are capable of enormous amounts of irrationality. This is helpful for people who can’t remember the stock bubble at the end of the 1990s. Favored stocks, like AOL, often reached price to earnings ratios in the stratosphere, if they even had earnings. In AOL’s case, its market valuation topped out at more than $220 billion in December of 1999. When it was sold to Verizon sixteen years later the company was worth just over $4 billion. Many other high flyers of the bubble years, like Webvan and Pets.com, simply went out of business.
For those who consider 1999 and 2000 the distant past, we need only go back to 2006 and 2007 when subprime mortgage backed securities (MBS) all got top investment grade ratings from the bond rating agencies. These MBS were worth just a small fraction of their face value a couple of years later after the housing bubble burst. Nonetheless, “informed” investors placed trillions of dollars in MBS assuming them to be almost as safe as U.S. government bonds.
But even this may be too far in the past for many of today’s market whizzes. For this reason we should all be thankful that we have Bitcoin to remind everyone that just because lots of money sits behind a product or company, it doesn’t mean the valuation makes sense.
While I don’t think we again have a bubble in the stock or housing market, there are certain stock and housing markets where irrational exuberance seems to be determining prices. To take two of my favorites in the stock market, this certainly seems the case with Tesla and Amazon.
Based on its end of year market price, Tesla had a market capitalization of $52.3 billion. (Its value had been over $60 billion earlier in the autumn of 2017, so perhaps some re‐evaluations by shareholders are already taking place.) By comparison, GM had a market capitalization of $58.2 billion and Ford had a market cap of $49.6 billion.
Over the prior year GM earned over $6.5 billion in after‐tax profits. Ford earned almost $4.5 billion. By contrast Tesla lost over $600 million in the third quarter of 2017 after losing $300 million in each of the prior two quarters.
Stock prices are of course forward looking, not focused on the past. Tesla investors are presumably betting that Tesla will turn around and stop making losses and rather at some future date have considerably larger profits than either of its two major U.S. competitors. The question is why would anyone believe this, and perhaps more importantly, why would anyone believe this turnaround would happen any time soon?
The idea is that Tesla will be a leader in electric cars, and that as electric cars displace gas fueled vehicles, Tesla will dominate the market. Of course anything can happen, but GM and Ford also produce electric cars, and these companies have much better records of meeting production deadlines with their products.
Perhaps more importantly, foreign car manufacturers are also producing electric cars, especially in China. China is on a path to sell close to 160,000 electric cars in the fourth quarter of 2017, more than three times the volume in the United States.
It surely is only a matter of time until they look to export these cars to the United States. Perhaps Tesla’s president, Elon Musk will become a world class protectionist and insist the Chinese cars be kept out to protect his profits. But if that doesn’t happen, it is difficult to see how the company’s stock price could ever make any sense.
Amazon’s stock price is perhaps even more out of line. Its market capitalization based on end of its yearend price was $563.5 billion. This compares to after‐tax profits of $1.9 billion. Investors seem happy with Amazon because it sales continue to rise rapidly. But most of these sales come at a loss to the company, without the profits from cloud computing division the company would be showing losses.
But again, the stock price is supposed to be justified by future profits. Let’s imagine what this could look like ten years out at the end of 2027. Suppose Amazon’s stockholders get a 7.0 percent real return over the next decade, a modest assumption given the company currently makes almost no profits and therefore should be viewed as highly risky.
In that case, the market cap would be just over $1.1 trillion, in 2017 dollars. Suppose its sales rise at an average rate of 10 percent annually, after adjusting for inflation. This would put its 2027 sales at just over $360 billion, also in 2017 dollars. If we assume that as a relatively mature company (Amazon will be 30 years old at that point) it should have a price to earnings ratio of 20 to 1, this implies profits of $55 billion.
To generate $55 billion in profits on $360 billion in sales, Amazon would have to mark up its prices by 15 percent over current levels. (This is after adjusting for inflation.) Perhaps Amazon could still keep its market share if it raised prices by 15 percent, but that seems a rather heroic assumption. Who knows, maybe Bitcoin will have gone to $1 million by then.
Anyhow, there are plenty of investors with lots of money to throw around. They often have no clue what they are doing as we are continually reminded by crashes in various markets. The case of Bitcoin is perhaps just a bit more obvious than most.
What does this suggest for economic theory? John Quiggin had a good piece in the NYT, pointing out how the sky-high valuations of Bitcoin undermine the efficient market hypothesis that plays a central role in much economic theory. In the strong form, we can count on markets to direct capital to its best possible uses. This means that government interventions of various types will lead to a less efficient allocation of capital and therefore slower economic growth.
Quiggin points out that this view is hard to reconcile with the dot-com bubble of the late 1990s and the housing bubble of the last decade. Massive amounts of capital were clearly directed towards poor uses in the form of companies that would never make a profit in the 1990s and houses that never should have been built in the last decade.
But Bitcoin takes this a step further. Bitcoin has no use. It makes no sense as currency and it is almost impossible to envision a scenario in which it would in the future. It has no aesthetic value, like a great painting or even a colorful stock certificate. It is literally nothing and worth nothing. Nonetheless, at its peak, the capitalization of Bitcoin was more than $300 billion. This suggests some heavy-duty inefficiency in the market.
Quiggin is on the money in his analysis of Bitcoin and its meaning for the efficient market hypothesis, but it is worth taking this line of thinking in a slightly different direction. The purpose of the financial sector is to allocate capital. In principle, we would want as small a financial sector as possible, just like we would want a small trucking sector.
Both sectors are providing intermediate services. While they are both essential for the operation of the economy, they do not directly provide benefits to people, like health care, education, and housing. In general, we think more of these and other final goods and services are better, but we want to have as few resources (labor and capital) tied up in finance and trucking as possible.
We have seen the opposite story with the financial industry over the last four decades. If we go back to the mid-1970s, the narrow financial industry (securities and commodities trading and investment banking) accounted for a bit more than 0.5 percent of the economy. It has nearly quintupled relative to the size of the economy, as it now accounts for more than 2.3 percent of US GDP. The difference of 1.8 percentage points of GDP is almost $360 billion annually in today’s economy. This should be a cause for serious concern.
We currently have a bit less than 1.5 million workers employed in the trucking industry. Suppose that the industry were more than four times as large and instead employed 6 million workers. This would be a huge drain on the rest of the economy since we would have to pay for the salaries, trucks, and fuel for four times as many workers.
If we had something to show for these additional trucks and drivers then we might decide the additional cost was worth it. If it meant, for example, that we had less food spoil in transit or that we were all getting the goodies we ordered online within minutes after we clicked the purchase button, then perhaps the additional expense from this much larger trucking industry would be reasonable. But suppose we had four times as many trucks and truckers and our service was no better than it had been before.
Arguably, this is the story of the financial industry. Is there any reason to believe that it has done a better job of allocating capital to its best uses in the last two decades than it did back more than forty years ago? Sure, some innovative companies have gotten startup capital and changed the world, but that was true fifty years ago as well. Just at the most basic level, productivity growth was much more rapid in the 1950s and 1960s, when we were devoting a much smaller share of our resources to the financial sector than is the case today.
This is why I am such a big fan of a financial transactions tax (discussed in chapter 4 of Rigged: How Globlalization and the Rules of the Modern Economy Were Structured to Make the Rich Richer [it’s free]). Even a modest financial transactions tax (FTT) would effectively take a sledgehammer to the financial industry. A tax of 0.2 percent (20 cents on one hundred dollars) on stock trades, and scaled for other financial instruments, could plausibly cut the size of the narrow financial sector in half, freeing close to $200 billion a year for productive purposes. (That’s more than $600 per year for every person in the country.) In addition, this would be a huge blow against inequality since many of the richest people in the country get their income from the financial industry.
Anyhow, that’s the economics of an FTT and it follows pretty directly from the demolition of the efficient market hypothesis. If we can’t count on a larger market and more transactions to move us to a better allocation of capital, then let’s look to make the sector smaller and stop wasting resources that accomplish nothing. This would essentially mean fewer stock trades and fewer complex financial instruments. That would be a better world.
From: pp.10-11 of WEA Commentaries 8(1), February 2018