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... pay attention to the markets.

Specifically, let me remind you once again that when it comes to technology generally I've got a better handle on how this tends to go over the space of years and more than most, because I ran an Internet company (MCSNet) when there was only a nascent thing called the Internet, starting with character-based terminals (remember VT220s and their emulators?) through the introduction of NCSA Mosaic along with Win95 and Explorer.

Whistle-whistle-beep-beep-beep on your phone line.  Yeah, that.

And before that, MCS (Macro Computer Solutions Inc.was a company that ran data wiring, did some custom programming and sold PCs to businesses in Chicagoland, with our specialty being that I was very good at finding system configurations and specific boards (particularly disk and controller combinations) that were wildly (sometimes 2x or more) faster than the others on the market, and thus we could be either better or faster -- and sometimes cheaper too.

The point is that nobody kept that advantage for very long before someone else took it away from them.  That's the game in tech -- figure out who's in front, shift there, spend less money and get more done.  It has never been different in my forty years in this area of the economy and I never expect that to change, because I've never seen a single incidence of it occurring.

Not in televisions, personal computers, even washers and dryers.

Except...... where government conspires with various people to make things more expensive -- like cars.  Airbags anyone?  Do they save your butt?  Sure, they can, but do they provide much better protection than a seat and shoulder-belt?  Not really, if the seatbelt is on.  If its not well then the seatbelt provides nothing and the airbag provides something so, yeah.  Then the government mandated all cars have airbags and if one goes off most of the time the vehicle is totaled because of the repair cost to replace it, the trim it destroys when it discharges and the associated electronics.  This has wildly increased the cost of crashes, of course.  So has the push for all these "nannies" (e.g. lane departure, etc.) despite a lack of evidence that they actually prevent crashes in the first place and on balance make the entire experience of owning a car, including the costs of crashes and injuries, cheaper.  How do I know this?  Because if the total cost was cheaper your insurance cost would be dropping like a stone, and it is going the other way -- rapidly.

Nonetheless the current rage is "AI."  Except.... how's that going to be paid for, and by the way, who thinks if there is such a huge margin in selling those chips other people will not come after Nvidia and try to knock them off?  There's an age-old truth in business which is that once you cross the 10% operating margin threshold you attract competitors; below that someone may leave you alone because its simply not worth the cost and risk to take you on unless someone figures out how to do what you do at a lower price (and thus would have a better margin.)  But once you crest that 10% operating margin threshold it becomes worth it to shoot at you and thus people will -- in size.

This, even among profitable businesses, is why the outsized margins firms appear to be able to make are not sustainable.  Nvidia claims a 53% margin; that's five times what is necessary to entice people to come after them and they will, competing on price, output-per-input (e.g. power, cooling, etc.) or both.  Some people look at price/sales and that's a decent attribute to examine as well (and is in nose-bleed territory) but you can't argue over the fact that at this sort of operating margin you have to believe they're five times better than competitors, either current or potential.

Nobody is that good for very long.

That's not a prediction that the firm will fail -- that is, that its a zero.  It is, however, a statement that even if they are and can continue to be more than two times as good as their best competitor the stock trades $50, not $122.

And that presumes that as technology improves there will be no margin compression among chips for this purpose which has never occurred in the history of technology either.  If there is margin compression then it's not $50 -- its likely $20 or $25!

Examples of margin compression?  Where would you like to look?  Your cellphone has more computing power than a mainframe of a few decades ago, real processing throughput is doubling every couple of years while power consumption per unit of computing is down by half or more, for starters.  Most people don't think of the power consumption angle but you should for large-scale technology because it makes older devices uneconomic to simply turn on and use as the differential in cost for power, cooling and space over a year's time or less means you could literally buy the newer one and save money.  If you don't and the other guy you're competing with does (and he will) you're going to get run over.

Nevermind that all of this presumes there's a revenue model for this "whiz-bang" stuff.  Is there?  Who's generating revenue right now from it?  That was the thing back in the 1990s -- there was a revenue model and thus I could (and did) write a business plan with pro-forma P&Ls and income statements that had as their primary unknown market penetration, but most-certainly did not include whether anyone would pay for what we were doing at all.  I was, at that point, already selling real service to real people and collecting real money for it.  Yes, we and everyone else were spending on expansion and so were the all the suppliers but the final demand businesses for all that "stuff" were selling goods and services to real customers and collecting revenues.

Has anyone showed up with a revenue stream for these allegedly "wonderous" things or is all of it "on the come" that "oh we'll replace all these people" (but nobody has replaced anyone beyond what Amazon and other firms with their "chatbot customer service" has as of yet) never mind the pie-in-the-sky claims like "full-self-driving" cars and "you won't have to pay a programmer to write code anymore"?

By the way we were promised fully self-driving autonomous, personally-owned vehicles "in a couple of years" about ten years ago -- in 2013, in fact, by Elon Musk himself who said his vehicles would be able to do ninety percent of the miles you'd want to drive without a driver in just three year's time.  In 2014 he moved the time-line up to the end of the year.  Well?  Read the rest of that story -- all accurate, by the way.

Might some of those prognostications eventually prove up?  Sure -- but at what revenue numbers, and will it pencil out?  Nobody knows. There's a hell of a lot of money being thrown around on what looks to this guy, with 40 years of experience in the tech business, a lot like the sort of dreaming that someone who's stoned on too much of their own supply might engage in.

How many people got behind the 8-ball believing that the Airbnb craze here would never change and the demand and pricing picture of 2021 would be maintained?  Lots.  How many of them are sitting on a cabin or three today that went from a ten cap to a five and, by the way, Treasuries pay 5.25% with no risk, reserve or sinking fund requirements?  Oops.  Now if that was a 1031 exchange for cash with no debt out of California or something then all is not lost but if you're leveraged on that and demand comes down further due to a recession you are now cash flow negative and cooked.

Rotsa-ruck bouys and gurls.

Cheap money makes everything look profitable because there is a hidden payment to you in the borrowing of the money that most people do not account for or subtract back out.  They either don't understand it or lie to themselves that its not there when they know it is.  If that's a fixed-rate loan and you can't be forced out by circumstances then someone else is the sucker because they agreed to pay you literally for nothing and that sucks to be them, but do remember that the impact on the economy as a whole is still there when the bubble game ends and rates increase to above the actual rate of inflation which is the sum of both the government's fiscal deficit as a percentage of GDP and private credit creation because nobody can spend a given dollar twice -- so while you don't get shorted in spending power in the economy they do and it is everyone's buying power in the economy  which actually gets spent and that, of course, is the definition of GDP.

Those who think rates will never go back to a positive real return are wagering that trees will grow to the sky.  No they won't -- because they can't.

I do not know precisely when that turn will come.  Top-ticking the market is a rube's game -- in my years in the market I managed to get real close once, but never actually top-ticked a trade.  But its far better to take the money off the table and be early than to be biting your fingernails as what you had on paper as gains evaporates and so do your future plans.

I'm already seeing plenty of cracks in the armor.  Its not even -- it never is -- across places in the country or lines of business, but the desperation is palpable in certain areas even today, with "deals" being offered and services squeezed with an attempt to coerce spending you would otherwise not engage in.  Most of you have seen behavior by merchants and various suppliers of this kind, whether in the consumer of business space over the last few months -- I've seen multiple examples, and get reports of more every day.  This is picking up speed at a fairly rapid rate and I expect it to accelerate further through the summer and into the early fall.

Somewhere along that line people are going to ask the obvious question: If everything is so wonderful why the pressure and why the continued ratchet job?

The hour is late at this party, the booze has been flowing since 7:00 in size, I smell smoke and it appears to be coming from over in that corner of the room....  

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2019-02-27 08:15 by Karl Denninger
in Market Musings , 291 references
[Comments enabled]  

The lie factory in the media continues with regard to the economy and markets -- and it's you who take it up the chute.

Lawmakers on both sides of the aisle have recently criticized stock buybacks, including Sen. Chuck Schumer, D-N.Y., and Sen. Bernie Sanders, I-Vt., in a New York Times op-ed and Sen. Marco Rubio, R-Fla., in a tweet storm about his plans to release legislation on the subject. As the Tampa Bay Times notes, this is something “you might expect from Bernie Sanders or Elizabeth Warren, but not necessarily the Florida Republican.”

These objections to stock buybacks are, in a word, misguided. Critics’ complaints rest on the premise that they maximize shareholder earnings to the detriment of workers and at the expense of investments in the company. But this reflects a fundamental misunderstanding of how stock buybacks work and what drives business leaders’ decisions about spending profits and deploying capital.

False.

My complaint with them is that they are frauds.

Faux Snooz continues:

When a company turns a profit, one basic way to address the balance is to buy back shares; it’s a common mechanism for companies to distribute earnings to shareholders. The alternatives are to increase investment or pay out more in dividends, the latter of which is functionally identical to buying back shares.

No it's not.  Leaving aside tax differences, which are significant, the financial and market impact of buybacks is not functionally equivalent to a dividend.

When a company pays out dividends the total number of shares does not change.  Therefore the EPS does not change either for a given level of earnings.

If you earn $1 billion dollars and have one billion shares then the EPS is $1.00.  If you pay out half of that billion dollars in dividends then the EPS next quarter, assuming you still make a billion dollars, remains $1.00.

Now let's assume you take that half-billion and buy back shares.  The denominator gets smaller.  This means that for the same billion dollars in earnings next quarter (the size of the company hasn't changed) the EPS goes up.

This is a major functional difference.  It sounds like a free lunch to many people -- EPS goes up and since the "P/E" ratio is a common way to value stocks the instant effect on P/E is for it to fall, and thus price per share will tend to rise to make P/E the same.

This sounds like a buyback is superior to shareholders, and thus ought to be not only permitted but every firm should do it instead of issuing dividends.

If only it was that easy.

If only Unicorns that crapped out Skittles existed.

If only.....

When you reduce the denominator it is true that EPS goes up for a given level of earnings.  But so do the losses per share when there are losses, and by an exactly equal amount.  In other words market violence, which is called "volatility", associated with said firm's results increases exactly at the same ratio.

There is no free lunch in this regard.

Second, however, and the reason that buybacks were generally illegal before the government changed the rules is that this fact is actively hidden by everyone involved -- on Wall Street, in the media, in earnings reports and the statements made by everyone involved.

Why would all these people intentionally mislead the public?

Simple: They use buybacks as a mechanism to rob you as a shareholder.

Let's take a hypothetical company that issues 1,000 shares of stock.  We'll make it nice and small.  The insiders -- that is, the founders, mostly, and other key people at the outset hold 250 of those shares; they sell the rest of them to the public.  (This, by the way, is another scam that is commonly run -- companies sell a minority of shares to the public by one means or another and thus prevent the public shareholders from ever voting out the officers and directors!  That's fraud because such a firm is not publicly-owned and ought to be flatly illegal in the so-called public markets -- if you wish to do this you ought to be limited to selling to accredited investors who understand what's going on and are willing to buy what amounts to a private placement with no voting rights -- because that's what these companies are!)

Ok, so we have our 1,000 share company with 250 of them held by inside executives -- probably half of that 250 is held by the founder who is frequently the CEO.  All good so far; the other 750 shares are enough that you, along with the other public shareholders, can vote out and eject the CEO and board.

Now the company runs and makes a profit.  So what the board does is vote to buyback 100 of the shares in the public market.  What just happened?

The public's interest of 75% of the company just got cut; the insiders held 25% but now they hold 28%!

It doesn't end there.  The 100 shares gets bonused out as "restricted stock units" to the officers and directors!  So the total number of shares doesn't decrease; now there are 350 shares in the hands of insiders and only 650 in the hands of the public.

Do this for two more years and the public no longer has any control over the board or executives since they are now a minority and cannot vote anyone out!

You just had control of the company stolen from you.

The same strategy is sometimes used by closely-held firms where you have outside minority shareholders.  The reason you have to be an "accredited" investor to buy such a position is that it is very easy for the majority holders, who are usually the founders and running the place day-to-day, to steal from you and absent some extremely strong controls you have written into the bylaws of the company if and when it happens there's damn near nothing you can do about it.  Unless you're very savvy and insist on such as part of your deal you are open to a rank ramjob that will diminish your investment by an arbitrary amount as soon as the insiders decide to screw you.

There is nothing in the law, for example, to prevent the majority holder of such a firm who is the CEO from voting to bonus out more shares to himself as part of his compensation.  This dilutes your ownership interest and as a minority shareholder you can't vote a stop to it.  The only hope you have is to sue and you will probably lose so long as the firm can show that it's making money and the executive(s) who got the bonus are substantially why it's making money.  In other words you're almost certain to take it up the pooper with exactly zero recourse, and if you do sue not only will you almost-certainly lose the company defends against your lawsuit with what is ultimately your money since it comes out of company coffers and not the CEOs personal checking account.

Stock buybacks where the executives and other insiders are getting share grants are the exact same scam played out in the public markets.  The claim that it "makes value go up" is a lie.  Until you sell your shares all you have is numbers on a screen; the lower the float in a given firm (that is, the fewer shares outstanding) the less-likely you can sell them without moving the price downward, and thus your so-called "gain" is likely to be illusory.  In addition you permanently give up your voting control piece by piece until you have effectively none; while you may still own the same number of shares the public ownership of the whole is reduced and at the point it reaches less than 50% you have no voting control whatsoever.

Buybacks, in short, are nothing more than a parlor trick.  They look real good so long as the economy is very strong and there are no recessions.  But as soon as the inevitable downturn comes you discover that not only are losses magnified exactly as are "earnings" but you have had your ability to throw management out on their ear either diminished or completely destroyed by an under-the-table trick at the same time.

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