What Coronavirus? Says the Market - My take on why central banks can still dictate the market and for how? long

‘Cognitive dissonance’ is the word the Guggenheim Partners Global CIO Minerd used when he described the disconnect between the economics and financial markets right now.  

For a long time now, financial markets have been living on ‘QE’. The program to buy up government debt using created money 1) has lowered the cost of borrowing for the economy 2) pushed investors to buy other financial assets as they are crowded out from government securities. Whether one liked it or not, the result has been clear. Central bank balance sheet expansion drives up market prices. Many have made comments similar to Minerd over the past 12 years and they were shrugged off. However, the coronavirus is making comments like this relevant again.

China, the world’s second largest economy at around 15% of global, has been devastated by the coronavirus, but the market still marches on. Many believe the disruption is temporary and things will go back to normal (V-shape recovery) so there is nothing to see.

Yet, behind the sanguine outlook lies the more important assumption, which is that central banks are always here to save the day. Therefore, bad coronavirus news is actually good news because it makes supportive central bank policies more likely. For instance, if the gets worse in China, perhaps China’s People’s Bank of China will cut interest rates to zero and do QE for the first time. To take it a step further, if the virus spreads to the US and it becomes a pandemic, then perhaps the Federal Reserve Bank will cut rates to zero and do QE for the fourth time. We, as people who may contract the virus and die, know that these certainly are not good outcomes, but if China does QE and US does QE4, you can bet the market will just rip up mechanically.

Given this outlandish, but perhaps probable, scenario, it is a good time to ask the big questions: why does QE still work, when would it stop working, and how long can this ‘cognitive dissonance’ last?  (working as in it drives up real asset prices)

Why does it still work?

1)      Globalization, Moore’s Law, aging demographics in the developed markets have kept inflation low. This allows central banks to use their powers without limits and push back.

Globalization allows goods, services, labor, and capital to flow so that things can be done as efficiently, if not as cheaply, as possible. Moore’s Law predicts that chips’ processing power doubles about every two years, this makes technology cheaper and more widely adopted. Aging demographics in the developed markets are the richest group. If they aren’t spending on goods to drive up prices, then who can move prices? In the end, central bank can keep on creating money to buy government securities, but as long as these factors are at full force, the consumer price index will stay low. This allows central banks to use their powers without limits and push back.

2)      High quality asset needs

There is a lot of wealth in the world ($240 tn in 2014), but not enough high quality assets (something that generates a return). Don’t blame it on the rich either, this is an everyday person problem. The rich actually can afford to buy risky assets since they have more than enough already. It is the middle class who are saving for their retirement/children’s education or relying on their insurance to help them that need high quality assets the most. When central banks are making prices go up, the ETFs, money managers, and insurance firms will follow, often times no questions asked.

3)      Asset holders cooperating supports paper profits

Even though trading is a zero-sum game, global investors have cooperated with each other. Instead of rushing to sell the asset to realize the paper profit at once, they understand that they are in it together. By taking turns to sell, nearly all existing investors can realize their profits over time.

4)      Wealth effect

The paper profits are not real until realized, but the asset holders’ spending on goods and services are real. The wealth effect, the increased spending from the financial asset market wealth, does improve conditions. As the economy improves from the spending, the high assets prices become a bit more justifiable.

How long can it last?

The short answer is when capitalism gets diluted, too many people get in on the QE secret, and when there are better things to invest in.

Based on the four reasons mentioned above, central banks’ easing would stop working when inflation increases and middle class savers get scared. Yet, these scenarios may only be temporary. For instance, inflation will pass as supply or demand adjusts, the market fear behind any asset dump will fade, and consumer sentiment will bottom out at some point. For things to really change, we may need to see fundamental changes in capitalism, investor behaviors, and market structures. 

1)      A global shift away from capitalism may lead to more sustained inflation. In other words, if the profit incentive goes away, it will take longer for producers to find cheaper, faster, and better ways to produce whatever that is in short supply. This will make it permanently more difficult for the central bank to respond to support the market.

2)      A spike in investor interest given the central bank support would drive prices into a bubble. If too many people get in on the QE secret, major stock indices will be driven up like Bitcoin or TESLA. This will lead to a bubble burst, before investors come back betting on central banks’ support. In the end, successive rounds of bubble burst will either lead to central banks or investors walking away. At that point, the stock market will still exist, but at levels much lower than the bubble period. 

3)      The invention of a new market could drive interest and capital away from the major stock markets today. In a world where lifestyle, culture, and technology have changed so quickly over the past decades, who is to say the middle class savers and wealthy’ investment preference wouldn’t’ change.

As for these fundamental changes, things are already gradually happening. First, the world is moving away from the raw form of capitalism. There is now growing scrutiny over businesses’ environmental, social, governance, moral, and cultural standards. It is possible that all these forces contribute to future inflation from a supply standpoint. As for the second point, there may never be too many who get in on the QE secret. It has already been mainstream for 12 years and inequality makes it hard for everyone to participate in the market. Third, while a new market seems unlikely, weirder things have happened. Bitcoin's market cap is $130 bn because enough people said so. The difficulty is for a new market to get to a sufficient size. In 2014, there was about $240 tn of wealth in the world (Marginal Revolution). Today, global equity markets add up to $50 tn (BofA), global debt markets is about $135 tn (150% of global GDP), and US and China’s housing market is about $75 tn (Economist, Goldman Sachs). Unless there is a credible new market that rivals major equity market, middle class savers' money will still flow there. 

Ultimately, for those wondering whether the ‘cognitive dissonance’ of the market can last, watch how the market is treating the producers and whether a new asset market is on the horizon.

 

Disclaimer: risks such as political checks on central bank powers, financial stability concerns, and any end of the world scenarios are all possible, but are excluded for the sake of this thought exercise.

Is Marie Kondo bad for the economy? A Thought Exercise on Global Demand

U.S. consumers spend, and the global economy depends on it. Though the 320 mn U.S. population is only about 4% of the global population, U.S. consumption represents 10.6% of global GDP, and this figure’s impact is understated since the rest of the world’s investments, exports, and consumption associated with U.S. consumption is excluded. So, if ‘Tidying Up with Marie Kondo,’ the new Netflix show that helps people combat hoarding embrace minimalism, becomes the new norm, does it mean the economy will suffer?

I believe the answer is no, but it requires advanced economies to sort out housing and emerging markets to figure out politics. With 7 bn in global population, there is no shortage of people who want to live the good life. Regardless of the different views on materialism and frugality and the different stages on Maslow’s hierarchy of needs, people want modern shelter, appliances, technology, and conveniences. However, the first problem is that increasingly those who have the means don’t need or want to spend. The second problem is that those who truly need don’t have the means to spend.

Let’s take Japan, the third largest economy in the world, for example. Japan’s elderly owns most of the wealth, but the lack of desires, retirement insecurities, or concerns for their kids’ future keep them from living it up. The problem underneath is Japan’s bad demographics. The country’s bad demographics, characterized by the rapidly aging population and low fertility rates, threaten the stability of the stability of the retirement system and the vibrancy of the economy and its future prospects.

As for what explains the bad demographics, I believe housing played a big role. Japan’s massive housing bubble made having children expensive, unreachable, and undesirable. Buying a home or paying rent is an option for a young individual, but having a stable home becomes more of a necessity for a couple looking to raise a family. As a result, when Japan’s housing price outpaced wage gains, it became rational for people to have fewer kids or forgo having kids.

Increasingly, this trend may play out in U.S. as well. The combination of the knowledge economy’s cluster effect and global wealth investing in U.S. cities have driven up housing prices in metropolitan cities. For instance, the tech jobs in San Francisco, the finance jobs in New York, and the biotech jobs in Boston draw young talents to these cities. This results in a cluster effect where the talent influx creates a bigger ecosystem for these jobs, which draws even more people to these cities. In addition to the increase in demand from the population growth, investors also add to those who wish to own a piece of these growing cities.

In the end, the high home prices reduce these residents’ disposable income in the short-run and may reduce their willingness to have children in the long-run. While wage gains and home prices ebb and flow, these advanced economies’ demand becomes permanently impacted once demographic takes a dip. As a result, housing plays a big role on why advanced economies may decide to spend less than they are able to.

As for the second problem, emerging markets’ messy politics often prevent them from achieving their full potential. China is a poster boy on how politics matter. Since Deng opened up China with a single-minded focus on pursuing growth, China has been on a tear. In the past decades, China has lifted close to 800 mn of its 1.3 bn population out of poverty. Growth inducing policies allowed people to get jobs and buy things to improve their quality of life. However, things may be starting to slow in China.

Automobile sales contracted for the first time in 20 years and smartphone sales have been falling for over a year now. This doesn’t mean that China is running into a wall or a crisis, but it does mean that it is important for other emerging market to take over the baton for demand. The difficulty is that there are few countries can match China’s size and trajectory for growth. Messy politics have kept other large emerging markets such as Brazil, India, and Indonesia from achieving their full growth potential. Politics matter because bad policies prevent technology and organizations from maximize productivity and full utilizations of their land, labor, and capital.

China Automobile Sales (mn of units)  

China Smartphone Shipments (mn of units)

As I see it, there are five ways to tackle the two problems so that Marie Kondo doesn’t become the new scape goat for a global economic slowdown.

1. Transfer money from the haves to the haves-nots in the advanced economies and emerging markets for them to spend.
2. Lend money to the haves-nots in the advanced economies and the emerging markets for them to spend.
3. Encourage investments in financial securities and discourage investments in real estate.
4. Loosen building and zoning laws and adopt accelerated building techniques to meet housing demand.
5. Influence emerging markets to pursue better growth policies and achieve more global economic coordination for mutual gains.

However, not all of these solutions are feasible, practical, or advised. First, transferring money is not productive and will be lobbied hard against. Second, lending money to those who can’t payback results in high non-performing loans at best and another economic crisis at worst. Third, channeling wealth from real estate is possible, but the current homeowners will become unhappy voters. Fourth, turning every desirable metropolitan city into dense concrete jungles of stacked modular apartments works on paper, but not in practice. This leaves the last option, which is also the best out of all the potential solutions.

The difficulty here lies in the world’s current state of political economy. As politicians around the world see global economy as a zero-sum game (maybe globalization or the winner-takes-all development has indeed turned it into a zero-sum game), this also makes the last option unlikely. 

So, what will happen and will Marie Kondo become the scapegoat? I don’t think so, but may be it is not impossible. 

What Would Warren Buffet Do? Big Tech vs Productivity

When Warren Buffet speaks, people listen. In 2017, 42,000 showed up for the annual Berkshire Hathaway meeting and another 17 million streamed the event online. While it is his views on cryptocurrency (he hates it) that grabbed the headline this year, I believe his bit on productivity (from 2015) below is far more relevant, especially in the current environment, which has many calling for breaking up big tech and universal basic income.

“Too few Americans fully grasp the linkage between productivity and prosperity. To see that connection, let’s look first at the country’s most dramatic example – farming – and later examine three Berkshire-specific areas. In 1900, America’s civilian work force numbered 28 million. Of these, 11 million, a staggering 40% of the total, worked in farming. The leading crop then, as now, was corn. About 90 million acres were devoted to its production and the yield per acre was 30 bushels, for a total output of 2.7 billion bushels annually. Then came the tractor and one innovation after another that revolutionized such keys to farm productivity as planting, harvesting, irrigation, fertilization and seed quality.

Today, we devote about 85 million acres to corn. Productivity, however, has improved yields to more than 150 bushels per acre, for an annual output of 13-14 billion bushels. Farmers have made similar gains with other products. Increased yields, though, are only half the story: The huge increases in physical output have been accompanied by a dramatic reduction in the number of farm laborers (“human input”).

Today about three million people work on farms, a tiny 2% of our 158-million-person work force. Thus, improved farming methods have allowed tens of millions of present-day workers to utilize their time and talents in other endeavors, a reallocation of human resources that enables Americans of today to enjoy huge quantities of non-farm goods and services they would otherwise lack. It’s easy to look back over the 115-year span and realize how extraordinarily beneficial agricultural innovations have been – not just for farmers but, more broadly, for our entire society. We would not have anything close to the America we now know had we stifled those improvements in productivity. (It was fortunate that horses couldn’t vote.)

On a day-to-day basis, however, talk of the “greater good” must have rung hollow to farm hands who lost their jobs to machines that performed routine tasks far more efficiently than humans ever could….The answer in such disruptions is not the restraining or outlawing of actions that increase productivity. Americans would not be living nearly as well as we do if we had mandated that 11 million people should forever be employed in farming.”

In other words, society should welcome progress, but also help those left behind. Buffet’s maxim is simple enough, but do monopolies and the speed of disruption complicate things? Is there a case for breaking up big tech because it actually hurts progress and productivity?

Investors have always recognized and valued productivity. As a result, the market rewards technology stocks with high valuations even if they make no money. Today, investors have become even more enamored with them. Given the monopolistic positions companies have built using their network effects and ecosystems, Apple, Microsoft, Amazon, Facebook, and Alphabet (Google) now have a market cap of $3.78 trillion dollars (March 12). These five make up of 15% of the S&P’s market value, more than the entire financial, health-care, or industrial sectors. Taking a step back, one finds that the tech sector’s 25% share of the S&P is the highest since the dot-com bubble, when it peaked at 35%.

A big question now is if these companies are monopolies, what are their implications for productivity? Do they help productivity in the short-run, but harm it in the long-run? Would they resist the temptation to buy out competitors and hike prices on consumers in the future? On the other hand, is it possible that they keep their disruptive spirit and drive productivity gains? Just as Amazon is entering into healthcare, is it possible that it will upend the DMV and save the day too?

Another big question is whether the technological disruptions today are any different for their effects on the labor market. While the farmers who were put out of work by machines may have found other jobs, is it possible that future disruption will be so widespread that the farmer equivalent today will not be able to find any job? This is presidential hopeful Andrew Yang’s view. He says that “we’re going to have a million truck drivers out of work who are 94 percent male, with an average level of education of high school or one year of college.” In other words, self-driving trucks “will be enough to create riots in the street. And we’re about to do the same thing to retail workers, call center workers, fast-food workers, insurance companies, accounting firms.” To play devil’s advocate, one can then ask whether technology actually improves productivity if it puts a large part of the labor force out of a job. If people are constantly asked to re-train their skills because technology keeps on making them obsolete, then maybe society’s productivity has not improved much after all.

In response to these questions, I am sure Warren Buffet will hold his ground, but I do not know the answer to these questions. Maybe it is inevitable that information technology’s network effect produces large companies and only they can be productive given the high fixed costs. Maybe savvy consumers, activist shareholders, and conscientious employees can prevent big tech from doing evil. Maybe robots will takeover, but people will find something else to do like people have always done.

One thing I do know is that when big tech takes over the market, may be the only active management left will be for tech analysts (sarcastically). 

Source - WSJ graphics 

Don’t Buy What You Don’t Understand: ETF for Millennials and Finance Nerds.

What is an ETF?

With the rise of robo advisers such as Betterment and the word of mouth praises for how cheap and good it, more and more have dabbled in ETFs, but many may not know much more than what the acronym stands for and how it is a stock that buys a basket of stocks. Here is my ETF primer for my fellow millennials and finance nerds.

According to Bloomberg analyst Eric Balcunas’s ETF origin story, one of ETF’s inventors Nate Most said the idea of ETFs came from commodity warehouse receipts. Given it is costly and difficult to move commodities around the globe, commodity traders keep them stored at the warehouse and trade the warehouse receipts around. ETF does the same thing, except the commodities are stocks and they are stored at a custodian bank rather than in a warehouse.

ETFs are essentially the same, except slightly more complicated. To begin, the ETF issuer finds a fund custodian to store the basket of stocks. The ETF shares are created off of the basket of stocks stored at the fund custodian. Then, the ETF issuer finds a broker dealer bank to serve as the authorized participant (AP) to help manage the size of the ETFs and the basket of stocks stored at the custodian bank. For instance, if people want to buy more shares of ETF than created, the AP may buy stocks and exchange them for newly created ETF shares and sell these ETFs to the investors. Thus, the AP helped increase the size of the ETFs and the basket of stocks stored at the custodian bank. Similarly, if people want to sell their ETFs, the AP may buy ETFs and exchange them for stocks from basket of stocks stored at the custodian bank. Thus, the AP helped decrease the size of the ETFs and the basket of stocks stored at the custodian bank.

If this again sounds like gibberish, here is an analogy that might help. The basket of stocks is gold, the ETF is gold standard British Pound, the ETF issuer is the Bank of England, the custodian bank is Bank of England’s vault, and the AP is the Bank of England’s bankers. During the gold standard era, one could theoretically go to the Bank of England to exchange one’s British Pound into gold from its vault. As a result, gold and British pound are interchangeable (this requires the ridiculous assumption that there is no fractional reserve banking and there is enough gold to cover all the British pound). Similarly, the ETF and the basket of stocks are the same because one could theoretically exchange one’s ETF into the basket of stocks from the custodian bank. Also, when Bank of England has more gold, it can issue more British pound, which is no different from the ETF issuer creating more ETFs when it has a bigger basket of stocks. This is how ETF works.

What are its risks? (More for finance nerds)

First, what if the gold in the vault is impure or fake? In that case, the people who bought British Pound for the gold would have lost all faith in their British Pound. They will rush to the bank to exchange whatever pure or real gold in the vault and sell the rest of their British Pound. This could happen to ETFs. Since many ETFs hold financial derivatives that mimic the value of the basket of stocks rather than the actual stocks, it is possible that when investors rush for the exit one day, the financial derivatives will fail to mimic the value during extreme periods, leading to panic. Second, what if Bank of England changed British Pound’s conversion to include silver because it ran out of gold? In this case, people may also lose faith in their British Pound and rush to the exit. This could also happen to ETFs. There have been instances where too many people wanted to buy ETFs and not enough stocks to back them up. In this case, the ETF issuer decided to add other stocks into their basket of stocks so that they could keep on creating and selling ETFs. Third, what if many new countries are formed and they all start creating their own precious metal backed currencies? How will it affect the normal mining and trading of precious metals? The liquidity of ETFs and stocks are now called into question as ETF continue its explosive growth both in terms of size and number.

What are the implications of its risks? (definitely for finance nerds)

If the financial derivatives that back up many ETFs fail or lose value unexpectedly, many will take big losses. This may be just another market sell-off like the dot com bubble or it could lead to a bigger financial crisis where large systemically important financial institution are challenged. One reason to feel downplay this risk is that the global ETF market is only about $3 tn compared to the $240 tn total wealth worldwide and it is unfeasible that all ETFs will suffer big value losses due to the unforeseen risks mentioned above. However, one must also refrain from being complacent. The supposed infallibility of Mortgage Backed Securities led to the massive credit default swap bets on the side. While the MBS market at the time was only $8 tn, the notional value of the CDS was around $60 tn! It is often difficult to see the risks lurking in the shadows until it is too late. Lastly, even if it is unlikely ETF will be a trigger of a financial crisis, it is possible that ETFs’ explosive growth in terms of number and size have introduced changes to the market ecology that increase the system’s vulnerability. 

How Technology Has Disrupted the NBA and What Does It Mean?

Technology changes everything, including in basketball. While I have only watched basketball since the mid-2000s, I can’t help but to notice the effects of technology disruptions in the past 10 years alone. Like all disruptions, it creates winners and losers. This thought motivated me to tally the effects and see if there are lessons to help me navigate the changes in my own field as well.

Well, here are my observations below and my conclusion comes at the end.

1. More 3 pointers and faster pace.

Competing against streaming, the golden age of TV, to apps, NBA evolved to garner viewers (and also win games). The league average 3 pointer field goal attempts increased from 18.1 in 2007 to 28.7 in 2017. Likewise, the league average possessions per 48 games increased from 92.4 to 97.8 in the same period.

Winner – J.J Redick signing a 1 year $23 million a year deal with the Philadelphia 76ers. Making 3 pointers help.

Loser – Roy Hibbert went from an All-Star in 2014 to a 2^nd round draft pick trade piece in 2016 and out of the league in 2017. Being 7’2 and setting good screens don’t help anymore.

2. Social media.

Facebook, Instagram, snapchat, twitter, etc have given players and participants a platform and access unlike anything we have seen before. Charles Barkley even said young players are forming super teams of social media. There is no taboo in talking to each other when one can bypass calling each other’s household.

Winner – ESPN Columnist Adrian Wojnarwowski’s name has become synonymous with NBA break news. His tweets during the free agency season has been termed “Woj bombs.” 

Loser/Winner – Eric Bledsoe. After a disastrous start to the Phoenix Sun’s season and the firing of head coach, Bledsoe tweeted “I don’t wanna be here.” It led to a $10,000 fine from the NBA and benching, but it worked out in the end. He got sent to a good team in the Milwaukee Bucks. He got himself fired from his job, but he also got him to an even better job.

Loser – D’ Angelo Russell’s leaked snapchat video of his then Laker teammate Nick Young’s cheating confession led to Young and Iggy Azalea’s broken engagement and his expulsion from the team.

3. Content Platforms.

The strong network effects of social media content sharing and high smartphone penetrations have given life to content producers across multiple platforms. The days when sports content creation is limited to papers, radio shows, and TV are long gone.

Winner (Youtube Entertainers) – Brandon Armstrong’s basketball impersonations under BdotAdot5 has led to invitations to NBA All Star Weekend’s celebrity games and appearances on the Jimmy Kimmel Show.  ChrisSmoove’s NBA 2K video game playing led to his collaboration videos with NBA players Tony Parker and John Wall. He is also selling T-shirts based on his catch phrases.

Winner (Youtube Video Editors)- The Frishberg brothers’ basketball mixes on Youtube under Maxmillion711 has garnered him over 45,000 subscribers and over 20 million views. He has also become an in-demand editor for a number of sports organizations. There are also lots of NBA highlight reel editors who constantly play a mouse and cat game with Youtube over copyrights issues.

Winner (Podcasters) – Bloomberg’s article on Dunc’d On, a basketball podcast by Duncan and Leroux, says it all. These two NBA outsiders quit their law professions to produce between 5-15 hours of content each week and they are commercially profitable. Podcasts from active/former NBA players, J.J Redick, Randy Foye, Richard Jefferson, Channing Frye, etc have also become a thing.

Winner (New Media Groups and Writers) – Bill Simmon’s The Ringer, Lebron James and Maverick Carter’s The Uninterrupted, and Nate Silver’s FiveThirtyEight have all found success with or without the affiliation of large media organizations.

Losers – other content creators. There are only so much eye balls to go around and the competition is fiercer than ever.

4. Big Data. 

Sports analytics have been around since econometrics and popularized since Michael Lewis’ Money Ball, but the NBA is undergoing a big data revolution, credit the abundant hardware, software, and human resources.

Winner – Noah, a sensor technology company, used to track basketball shooting is employed by the Toronto Raptors to help players train. NBA has hosted its 2^nd annual hackathon in 2017 to promote and recruit basketball analytics talents. Houston Rockets GM Daryl Morey has long been a proponent of sports analytics. He co-founded the MIT Sloan Sports Analytics Conference and may get the last laugh one of these days if his Houston Rockets wins the championship.  

Loser – Coaches, scouts, trainers, and managers from the last generation. Also, Charles Barkley, a long and strong opponent of analytics.

After going through all the winners and losers, I did learn several things about industry changes and career paths. 

Don’t be stubborn and ignore trends.

If you are on the court, learn how to shoot some 3s. If you are behind the scenes or on the sidelines, know some analytics. It is fine to recognize one’s limited aptitude for whatever is trending and focus on one’s strength, but it is important to stay relevant and literate.

Stay alert and seize the window of democratized opportunities.

Successful basketball content producers seized the leveled playing field created a path despite their lack of degree or access. The window of democratized opportunities is limited because the first mover advantage disappears and new barriers to entry are inevitably rebuilt. When seizing opportunities, there is a balance between preparing and acting. Don’t go in unprepared, but don’t act only when you are 100% prepared because by then it is too late.

Build on what makes you unique, including what you might perceive as your disadvantage.

Reading Bloomberg’s coverage on Dunc’ed On, I learned that Duncan and Leroux leveraged their lawyer background into being experts on NBA’s Collective Bargaining Agreement, a key puzzle in understanding NBA salaries, trades, and teams.

Also, it reminded me of what I read about Kyrie Irving and Xi Jingping. Kyrie said he developed his acrobatic layups because he grew up playing on a hoop with a broken backboard. He joked that he imagines how much better he would have been if he played on a good hoop. However, my thoughts are the opposite. It is precisely because of the broken backboard, he developed his now unstoppable acrobatic layups. Similarly, Xi learned from his disadvantaged youth and turned it into a strength. “Many of Xi’s generation agree that when their schooling stopped and they learned to survive on their wits, they developed emotional toughness and independence of thought. Xi later reflected on his ability to listen to other points of view without necessarily bowing to them. I had to learn to enjoy having my errors pointed out to me, but not to be swayed too much by that. Just because so-and-so says something, I’m not going to start weighing every cost and benefit. I’m not going to lose my appetite over it.” (quote =/= endorsement)

Either ETFs cools down or I am dead

I may be chicken little and think the sky is falling, but it is unclear what my financial analysis skillset in will get me in the future, especially the long run.

Financial professionals often tout the power of free markets. They speak highly about creative destruction and speak with ease about re-training programs for those left behind. However, they, including me, may get a taste of their own medicine. Challenges from passive investing may render the traditional finance skillset useless and anachronistic for many. Either ETFs cools down or I am dead.

It came fast and furious, passive investing through ETFs will account for about 50% of all assets under management by 2017-year end. As more people put their money into ETFs, fewer people are putting their money in mutual funds and hedge funds. So far, there is a good reason for this. Since QE started in 2008, the broad market has been performing very well. While good stock/bond picking is nice, investors say no thanks when the whole basket of stocks/bonds was rising. It is reasonable to say that ETF will cool down because the market will eventually underperform active management, especially when global QE stops.

However, I worry this won’t be the case. Overtime, it may be become a habit that is hard to kick. After Japan suffered its bubble burst, cheap 100 yen stores selling daily items sprung up and became part of life. 30 years later, it does not matter whether one is rich or poor, they all go to the cheap 100 yen stores because it is a part of life. It also may be a genuine low cost disruption that is here to stay. Regardless of whether it is piggy backing on QE or not, ETF is a true innovation in terms of its efficiency and cost. Similarly, fast fashion, ecommerce, ride sharing, and streaming have toppled their incumbents in recent years and have not looked back. Lastly, the case for ETF may be tied up in the same mystery of low inflation. In this low growth and low return era, it is reasonable for investors to want to minimize their management fees because they lack confidence.

*ETFs may also blow up and start a financial crisis due to its now wacky construction, liquidity concerns, and bubble characteristics. However, this discussion deserves a blog post of its own.

As of now, it is hard to say conclusively whether this is a big fad or a big seismic shift, but either way it is impacting the financial industry ecosystem. Due to the accessibility and popularity of ETFs through robo advisors, financial advisors who make commission from helping investors are hurting investors opt to “Do It Themselves.” Trickling down to the next level, since people are buying ETFs instead of mutual funds, money managers who charge a fee off their assets under management are pressured. Further down the chain, investment banks who relied on money managers’ trading business are also hurting. There is a chance that a counterbalance will set in since the ecosystem change will impact the market in the long run, whether in its liquidity, asset allocation, or productivity. However, until then, the pie for financial analysts has shrunk and is shrinking.

Additional forces that threaten to reduce the size of the pie are regulations. A European regulation called Midfid II will dictate how money managers pay for research and it will lead to job losses. Before Midfid II, money managers paid for research through soft dollar, which means they paid for research through their trading commission they pay to the bank. Banks agreed to it because at the very least, research was another service differentiator that helped them stand out amongst the competition. Given the debates around the usefulness of investment bank research and the squeezed margins for money managers, many research firms will be caught swimming naked. Eventually, the bottom performing research will get cut. Another US based regulation called Fiduciary Duty Act, which aims to improve transparency and accountability, will force financial professionals act in the best interest of their clients. One direct effect is that financial professionals will now opt for the cheapest and most convenient options because they want to stay out of trouble. Since ETFs are cheap and popular, they will direct clients to ETFs because they don’t want to have to explain themselves.  

The passive management and current regulatory trend may be the perfect storm for industry professionals. The laid off investment bank research analysts will rush to get jobs at money managers, but money managers are constrained. Not only is their revenue shrinking due to challenges from ETF, but also their expenditure is growing because are forced to pay for research. This means that a crowd of people will rush to squeeze into an already crowded and possibly shrinking room.

As I said before, it is unclear what my financial analysis skillset will get me in the future. If ETF is here to stay in the long run, then a financial analyst may become no different than the horse breeder in early 20^th century. Both professionals have nice skills and both were valuable when horse carriages and active management mutual funds ruled the world. However, if ETFs becomes what car is to horse carriages, then financial analysts may suffer the same fate. They either have to become the best analysts in the world and work for Warren Buffet, similar to the horse breeders who work for the few domestic and race horse owners, or they have to re-train and find a new job. They either have to find something translatable or go into the automobile or new finance industry.

I maintain that either ETFs cools down or I am dead. Just kidding, I won’t be dead. I will just have to think hard about where else I can apply my skills or re-train for a new craft. I will not be the first to experience this type of industry shifts, nor will I be the last.

*I will follow up with my own rebuttal piece about why I may also be wrong and why the sky is not falling down. 

Casino Like Financial Markets

In this world where too much money is chasing too few assets, asset price inflation and subsequently, gambling on prices, become inevitable. This means that financial markets may turn into casinos, but this outcome is better than the alternatives.

To begin, money and assets are different in that money is cash, deposits, and cash like funds while assets are things that provide future benefits. In the past 70 years, the combination of post WWII peace, globalization, and the break from gold standard has led to the creation of lots of money. Peace allows households to just live and enjoy life, giving them the opportunity to make money without interruption. Globalization enables those who are good at making money to make lots of it. Lobster men in Maine and miners in Mongolia can now sell their goods far and wide at speeds and scales unseen before. Fiat currency made money printing possible. Whether the printing is to meet genuine economic demand or spurred by government stimulus, central banks no longer had to worry whether they have enough gold to back their money up. Putting it all together, it has been a perfect storm for money creation.

As for assets, there is simply not enough of it. There are lots of consumption goods, but there are not enough investment goods. While they both provide future benefits, only investment goods are assets worth chasing with one’s money. Since consumption goods’ values expire and depreciate, it makes little sense for people to park their money in these assets that lose value. As a result, money naturally gravitates toward investment goods, lured by the promise of capital preservation and appreciation. (Preservation is important because inflation eats away the value of money and appreciation is desired because what is a better way to make money than to make money with money).

What does this mean altogether? It means that asset prices will rise over time since there is too much money chasing too few assets.  Money has to go somewhere and it will pour into available assets. However, the process is messy and unpredictable (largely). The inflow of money is disorderly, unlike water filling an ice cube tray. Money will come in and out and assets will rise and fall. This volatility makes it difficult for assets to find and stay at an equilibrium price. Such opportunity to make quick bucks by predicting the direction of prices draw people in and those who captured by their animal spirits turn into gamblers. Also, as markets become more sophisticated, the typical buy low sell high strategy has evolved beyond one’s imagination. Instead of picking good stocks or a good house, there are now strategies betting on prices, interest rates, exchange rates, spreads, volatilities, and everything else.   

However, this is not a bad thing. This casino is better than other forms of gambling. Financial markets create much more good than Las Vegas’s casinos or horse race betting. Furthermore, it is much better to isolate the gambling on investment goods than consumption goods.

First, unlike Las Vegas and race tracks that end up creating lavish hotels and genetically engineered horses, this casino allocates capital, creates endless jobs, and spreads financial literacy. Though gambling sounds bad, the large number of market participants help enable a deep market. This deep market increases the possibility of someone out there willing to take the other side of the trade as a buyer or a seller. Whether it is buying a stock, foreign exchange, or an interest rate swap, one can feel confident that their transaction will go through at a given price. Through this deep market, resources can be allocated more efficiently. Stock picking rewards good companies by giving them a cheaper cost of capital. Foreign exchange forwards allow companies to put their idle foreign exchange to good use to those who wants to buy it now for the future. Interest rate swaps enable companies to swap their less desired fixed interest rates for a preferred floating exchange rate. Also, ever since financial markets evolved from a room of loud traders to electronic markets that now exists in the clouds, financial markets can now create jobs anywhere. In comparison, the jobs created by casino and race tracks are mostly limited to those within the proximity of these sites. Lastly, working as part of the value chain of financial markets, one is able to become an expert in financial matters. These workers are not only able to use these skills for themselves, but also become agents to spread financial literacy to others. Financial skill is much more applicable and useful compared to knowing how to deal in black jack and knowing how to brush horse’s hair.  

Second, it is much better to have this casino on investment goods than consumption goods. If the flood of money is channeled toward chasing consumption goods, it would no longer be known as capital appreciation, but as hyperinflation. The first allows people to preserve and grow their wealth while the second destroys their wealth through the erosion in their purchasing power. One is happy to see his or her 401K investment balance goes up, but one will be distraught to see the price of daily items spin out of control. One observable example can now be seen through housing. Homes are both a consumption good and investment good. People consume housing for shelter, but they also invest in homes for their retirement. The dual purpose real estate serves doubles the demand for this asset. As a result, home prices have skyrocketed in past decades as more and more wealth chases this asset, which often struggles to keep up with the demand. This phenomenon has forced poorer people out of their neighborhoods at best and created destructive housing bubbles at worst. Even till today, housing continues to be a thorny issue despite the numerous painful experiences of housing bubble bursts in Japan, US, Europe, and elsewhere.

In the end, we are left to choose our own poison. By accepting conflict, protectionism, and gold standards, one can create a world with less money. However, the weak and powerless will undoubtedly suffer more. Destruction is more costly to them, protectionism hurts poor nations’ income and deprives rich nations from cheap goods, and gold standards limit stimulus and cheap credits. If one accepts the current arrangement and let money creation continue, then one may be left with hyperinflation or casino like financial markets. I do not know about you, but between the two, I pick casino like financial markets.