Dear Readers,
On Sunday, May 1 I was still in Omaha following the Berkshire Hathaway annual meeting. Shortly before President Obama announced the death of Osama Bin Laden that evening, I made a routine check of Bloomberg to see how the Asian markets had opened. Silver futures trading in Hong Kong had fallen at the open from about $49 to lower than $42, settling overnight around $45 before resuming its decline the next morning in New York. By the end of last week, the price of Silver had fallen another 23% to $34. Predictably, the reaction from bloggers and commentators has been divided over whether this represents the end of the bull market in Gold and Silver, or whether it is just a correction in the midst of a secular bull for precious metals. The confluence of several factors led to its swift decline, and while no one can say for sure where the medium-term price bottom will be, right now the volatility is so high that it would be ill-advised to recommend long or short positions.
The decline happened for several reasons. First, CME Group, parent company of the COMEX exchange, increased the margin requirement to hold physical Silver several times over the past two weeks. Indeed, such an announcement after the close on Friday, April 29 contributed to the swift decline that began on Monday, May 2. Effective on May 9, the margin requirement for a single contract (5000 oz.) is $21,600, up from $11,745 just two weeks ago, a full 84% increase. Therefore, the margin requirement has jumped from 5% of the price of a contract to about 12% after May 9, if last Wednesday’s closing price is used. Not surprisingly, this has caused fund managers who hold physical Silver, such as George Soros, and Eric Sprott, who runs the physical silver ETF PSLV, to reduce their holdings. In turn, the rapid decline triggered repeated sell orders on the way down, further amplifying the decline in both physical Silver and the SLV ETF. The sheer size of this decline in the face of margin hikes helps to illustrate just how over-speculated the Silver market had become. Going forward, it is going to be much more expensive to own the physical contracts, as the CME has made it clear this will not be the last of the margin increases.
One of two things is happening; this is either a long-term (10+ years) bubble popping and Silver will not reach those highs for another few decades, or it is a major, long-in-the-making correction within a secular bull market for precious metals. There are reasons to expect that the corrections within this bull market will continue to be sharp and swift. First of all, the price-tracking ETF’s (SLV and PSLV are two of the largest) that many traders use to trade the price of Silver are required to adjust their reserves of physical Silver bullion depending on the daily closing price of the ETF. In effect, this means that if the price of physical Silver experiences a sharp run-up like it has since last August, the ETF’s act like a sponge. They have to buy up boatloads of physical silver on the way up, constraining supplies on exchanges like the COMEX and depleting inventories, which contributes to further price increases. The vicious cycle works on the inverse on the way down, as well. Just as the ETF’s absorb physical supply like a sponge on the way up, they have dumped physical Silver on the market as investors have dumped their shares over the past week, exacerbating the rapid price decline. In fact, because the ETF’s selling their supply tends to lag the price declines of the ETF, the physical supply does not hit the market until after the price has declined, potentially opening up the door to further price decreases.
As a result of the rapid decline, the double-short Silver ETF that was mentioned in the March 19 newsletter, ZSL, has gone from a low of around $13 on Friday, April 29 to a high of $24.38 on Thursday, May 5, more than an 85% increase in only four trading days. I mentioned that Silver and its related mining stocks appeared risky right before the New Year and that early 2011 could bear witness to a correction. Obviously, the prediction turned out to be a bit premature. After declining a bit the first few weeks of the year, from late January until Friday, May 3 the price of Silver nearly doubled, capping off a remarkable 200% increase since last July. To illustrate the degree to which SLV and the related ETF’s were traded/speculated, from April 20-May 3 the daily volume on the SLV ETF regularly exceeded that of the most popular S&P 500 ETF, SPY. Think about that for a minute. The trading volume of an ETF that tracks the price of a precious metal that only a tiny percentage of investors own was exceeding the volume on the most popular ETF to track the broadest US stock market index. If that isn’t indicative of a frothy market for a commodity, I don’t know what is.
At the same time, this correction is what many long-term precious metals bulls have been waiting for, but most will tell you that buying Silver right now is risky. For example, the price appeared to have stabilized over the first two trading days of this week, and many investors got caught in what appears to be a classic “bear trap,” that typically occurs after the initial stage of a large asset price reversal. After some investors re-initiated long positions, the price resumed its decline by falling 8% on Wednesday, May 11. Looking at the Silver corrections over the past decade, the current decline is more likely to take a few months. Additionally, the decline could be as sharp as the run-up of the past two months, overshooting to the downside. Perhaps the best thing to remember at this point is that the big/fast money has taken over. It’s best to go with the trend and not fight it, especially during times of great volatility like the past two weeks. Hedge funds and other big money players by and large were the ones who pushed the price up 100% in less than five months and they are now the ones who are selling, with a few inevitably making lots of money off of its collapse.
Furthermore, as a result of the price run-up, all of a sudden many more economic commentators are paying attention to Silver. One advantage of this is that there will be no shortage of opinions to read and compare that will be issued over the next six to twelve months as to when the bottom has been formed. I will be one of them, and will issue it at that time. For now, my opinion is that there is still money to be made in the ZSL ETF or by shorting SLV or double-leveraged Silver ETF’s like AGQ. Whenever Silver has experienced mid-term corrections since the bull market began in 2001, the decline has, on average, lasted for two to three months and usually the bottom has formed around the 200-day moving average, currently around $28.50 today. As mentioned, because of the robust nature (albeit fueled by speculators who have access to cheap financing) of the most recent price run-up, the correction could be equally as harsh and overshoot to the downside as we head into the summer season, historically a weak time for precious metals. If the 200-Day Moving Average is breached to the downside, it could very well signal that Silver could correct to the low $20’s, or even lower.
Another thing to keep in mind is that the fundamentals supporting precious metals haven’t changed, and until governments around the world fix their nations’ financial problems the bull market in precious metals will probably remain in place. Many who hold Silver are concerned that if the Fed starts raising rates, the bull market will end. Looking back at the last precious metals bull market, in 1979 President Jimmy Carter gave Federal Reserve Chairman Paul Volcker a mandate to crush inflation, no matter what the cost. Volcker immediately started raising rates, but precious metals did not peak until January 1980 (the collapse was initiated when the COMEX raised margins and the Hunt Brothers, who had used a massive leveraged position to try and corner the market, were forced to sell amidst the large resulting losses). Interest rates and inflation did not peak until mid-1981, when the US entered a recession that would last until late 1982. Therefore, the oft-repeated argument that the precious metals bull will be done at the moment Bernanke begins raising rates is insufficient, especially because in the event that inflation picks up it will take much higher rates than the current ones to lower it. In addition, the US currently has a national debt that is many multiples the size it was in the 1970s. Back then, the US was still the world’s largest creditor. To illustrate this, Volcker’s raising rates back then contributed to financial crises and subsequent government defaults in several Latin American countries that were in debt to the US and the IMF, including Mexico in 1982 and Peru later in the decade. This time around, it is not as easy to raise rates quickly because the US Government would need to greatly reduce its expenditures first to accommodate the extra costs for paying the debt that would be issued at the higher rates.
In closing, at the present moment this appears to be a much-needed correction within a secular bull market for precious metals, and I expect precious metals to stabilize sometime before the end of the year. If inflation begins to gather steam and interest rates are not raised high enough to lower it, the precious metals bull could potentially be in the 5th or 6th inning of 9, so to speak. However, if inflation does reverse course like the Federal Reserve has been predicting, this correction in the metals could quickly become a multi-year bear market. Therefore, it is impossible to say for sure whether the bull market in precious metals is over. Many commentators try to call bubbles whenever a particular asset runs up in price, but in reality bubbles are all but invisible until they burst, and thus are only definitively identified in hindsight. Rational reasons are always given for the soaring prices, and then these same reasons are suddenly proved irrelevant as the price falls. That said, there are still plenty of relevant reasons for precious metals to keep rising in price over the next five to ten years. For now, the speculators have been curbed, and going forward investors will need to demonstrate their commitment to Gold and Silver by paying higher margin costs to own the metal. If the fundamentals do not change and prices resume their upward climb, you can count on hedge funds and other sophisticated investors jumping right back in as they recognize the sheer robustness of the bull market and get more serious about staying invested in it for longer than a few days or weeks. If this proves to be the case, get ready to take advantage of lower prices for Gold, Silver, and the equities of their miners. If the S&P 500 declines as well, there could be a few situations where we see the best opportunities to invest in Gold and Silver mining equities since late 2008. Such an opportunity would be nothing less than fantastic.
Respectfully Yours,
Matthew R. Green
May 12, 2011
Monday, May 23, 2011
Issue XXVI - US Dollar Rally
Dear Readers,
If Mark Twain were alive today, he could easily reference his own famous quote when speaking about the US Dollar; in short, rumors of the greenback’s death have been greatly exaggerated. After falling well over 15 percent since last June, the US Dollar appears to be setting up for a rebound, if not a multi-year recovery. Amongst all the negative commentary that has surrounded the greenback recently, the fact of that matter is that all fiat currencies will remain under pressure as the US and Europe continue to stagger through difficult financial times. With the looming problems concerning Medicare and Social Security, along with the recent budget impasses, many commentators believe that the Dollar will continue to fall. Over the longer term, this is likely true. Despite this, the impending end of QE2, the potential tightening of monetary policy, and technical signals point toward a bottom. In short, the US Dollar could be ripe for an upward reversal, potentially for the
short-to-medium term.
Even before the onset of the Great Recession and subsequent financial crisis in 2008, the US Dollar was in secular state of decline for most of the 2000s. The expenditures from the Iraq War, low interest rates in the US, massive budget deficits and the Euro coming into its own were among the reasons for the decline. The current massive amount of negativity surrounding the Dollar is being pushed by escalating fears of a potential US Government debt default, rising inflation and interest rates, speculation of a third round of money printing by the Fed, and the potential reduction of importance of the Dollar as the global reserve currency. These fears, while not unwarranted, are overblown and have resulted in the Dollar currently being oversold.
Due to its role as the reserve currency of the world, the performance of the Dollar has a greater effect than many, even seasoned professionals, realize. The value of the Dollar affects the equities markets, commodities, bonds, inflation, consumer confidence, and most of all, macroeconomic policy for not just the US but the rest of the world’s governments and central banks. In other words, economists, politicians, and just about everyone else who monitors financial markets study the Dollar’s movement because of its effects on their subsequent economies, policies, standards of living, and many other factors.
Recently in op-eds or on CNBC and Bloomberg, economists and commentators have covered the bullish and bearish cases thoroughly. First, the bearish argument. Public debt in the United States is already high, and continuing to rise at a staggering pace. On April 18, Standard and Poor’s downgraded the outlook for US government debt to “negative.” This followed a nearly 5% drop in the preceding month as Congress repeatedly failed to agree on the federal budget until the eleventh hour. If a formal downgrade of the US credit rating from the AAA level were to take place, it would immediately trigger selling of US Dollars by central banks around the world. This would likely be a harbinger of the US permanently losing its economic hegemony, although the arguments for and against this are too lengthy to discuss here. At any rate, this stems in part from the devaluation of the US Dollar due to the Federal Reserve’s quantitative easing programs since March 2009. While these programs have not been extended yet, last week Federal Reserve Chairman Ben Bernanke affirmed a commitment to exceptionally low interest rates for an extended period of time. This comes despite the Fed seeming to ignore rising inflation over the past year, as seen already in the prices of food and other everyday commodities. While a part of the rising prices of can be attributed to poor harvests in many food commodities and higher oil prices, the fact is that many economists and citizens alike are concerned that that Fed is counting on price rises to taper off, and are worried it may not happen. Rising prices would only hurt the Dollar more. The end of the Dollar as the world’s preeminent reserve currency could take place if one or a combination of the aforementioned events materialize. Additionally, a main concern of some economists is that if a watershed event such as a US debt downgrade occurred, the process could not be controlled. The Dollar’s decline would be exacerbated by central banks quickly moving to diversify their currency reserves, quickly selling Dollars and moving them into either gold or other currencies. To illustrate this, several prominent commentators have expressed concern at the fact that China holds approximately 70 percent of its reserves in US Dollars, and its future actions could lead the way in diversifying out of the Dollar. The concern stems in part on the fact that such a rapid decline of the Dollar could lead to a currency crisis and potentially hyperinflation.
The positive outlook arguments for the Dollar are largely contrarian in nature, and address the fact that at least a portion of the Dollar’s recent decline can be attributed to overblown fears. First and foremost, it needs to be considered that the extreme level of pessimism may already be priced into the current Dollar Index, which fell to as low as 72.70 last week before rising to close at 74.91 on Friday, a sharp increase that perhaps signals the beginning of a medium-term rally. The droves of investors that have been running to physical gold, silver, or precious metal ETF’s like GLD and SLV have been doing so in part to protect their portfolios from a collapse in the Dollar. While this was a major factor in the price run-up, the events of this past week in the precious metals sphere have revealed that it was at least in part being driven by speculation. Therefore, the rapid run-up and
equally swift decline of precious metals could be indicative that the big drop in the Dollar has already taken place, and it may be near or already has seen a medium-term bottom.
Second, a timely end to the second round of quantitative easing (QE2) could create further headwinds for the stock and precious metals markets. This was the case in 2009-10 with the start and end of the first round of quantitative easing (Refer to Chart 1). Note that the Dollar began to fall in 2009 after the March 2009 announcement of Quantitative Easing, and began to rise once again after the Dubai debt crisis in November 2009, continuing with the European Debt crisis and the end of QE1. The latest round of Quantitative Easing, along with the subsiding (but far from over) debt crisis in Europe, contributed to the Dollar’s slide since last summer that, in my opinion, has led to the Dollar being oversold. Indeed, tighter monetary policy has been argued for by members of Congress and the Federal Reserve Board alike. While the situation in Libya and the rest of the Middle East has contributed to higher oil prices, commodities in general have been rising. Tighter monetary policy in response to this will help ease inflationary concerns and help strengthen the Dollar. Although the Federal Reserve left rates unchanged at the latest meeting, it has thus far not expressed any intention to commence another round of quantitative easing, although maturing bond purchases will occur on a more limited basis.
Finally, a weak Dollar isn’t necessarily welcomed by the rest of the world, contrary to popular belief. For US trade partners with a large export sector, such as Germany and Japan, a low US Dollar is detrimental because that means lower levels of trade with the US and effectively puts a cap on future growth. A number of currencies, including all of the other currencies that make up the US Dollar Index, have appreciated against the Dollar. Therefore, it is possible the foreign central banks could increase their Dollar purchases in the name of slowing their own currency’s appreciation. This would help stabilize the Dollar, and perhaps even contribute to a medium-term rally.
Looking at the technical analysis, indicators are signaling, as they were in March, that the Dollar could be at or near a medium-term bottom. Looking at long-term charts, despite the Dollar’s pronounced downtrend over the past decade, it could potentially be setting up for a break to the upside. While the Dollar has dropped, the Moving Average Convergence-Divergence (MACD) has been rising. A positive divergence while the Dollar is in a downtrend could signal a pending reversal to the upside. This is also true of the short-term charts, as you can see from Chart 1. Looking at a chart of the Dollar over the past year, the charts are also showing divergence in the Relative Strength Index (RSI), which, despite the continuing drop in the Dollar, has failed to make significant new lows, instead floating around its previous lows (Refer to Chart 2). Such a divergence/chart pattern often precedes a reversal, in this case to the upside.
Therefore, with the robust upturn in the Dollar over the past week, the medium-term bottom may very well have been made. While all fiat currencies, at least amongst Western economies, will continue to be under pressure as currencies are devalued, for now the Dollar appears to be commencing a medium-term rally.
Respectfully Yours,
Matthew R. Green
May 8, 2011
If Mark Twain were alive today, he could easily reference his own famous quote when speaking about the US Dollar; in short, rumors of the greenback’s death have been greatly exaggerated. After falling well over 15 percent since last June, the US Dollar appears to be setting up for a rebound, if not a multi-year recovery. Amongst all the negative commentary that has surrounded the greenback recently, the fact of that matter is that all fiat currencies will remain under pressure as the US and Europe continue to stagger through difficult financial times. With the looming problems concerning Medicare and Social Security, along with the recent budget impasses, many commentators believe that the Dollar will continue to fall. Over the longer term, this is likely true. Despite this, the impending end of QE2, the potential tightening of monetary policy, and technical signals point toward a bottom. In short, the US Dollar could be ripe for an upward reversal, potentially for the
short-to-medium term.
Even before the onset of the Great Recession and subsequent financial crisis in 2008, the US Dollar was in secular state of decline for most of the 2000s. The expenditures from the Iraq War, low interest rates in the US, massive budget deficits and the Euro coming into its own were among the reasons for the decline. The current massive amount of negativity surrounding the Dollar is being pushed by escalating fears of a potential US Government debt default, rising inflation and interest rates, speculation of a third round of money printing by the Fed, and the potential reduction of importance of the Dollar as the global reserve currency. These fears, while not unwarranted, are overblown and have resulted in the Dollar currently being oversold.
Due to its role as the reserve currency of the world, the performance of the Dollar has a greater effect than many, even seasoned professionals, realize. The value of the Dollar affects the equities markets, commodities, bonds, inflation, consumer confidence, and most of all, macroeconomic policy for not just the US but the rest of the world’s governments and central banks. In other words, economists, politicians, and just about everyone else who monitors financial markets study the Dollar’s movement because of its effects on their subsequent economies, policies, standards of living, and many other factors.
Recently in op-eds or on CNBC and Bloomberg, economists and commentators have covered the bullish and bearish cases thoroughly. First, the bearish argument. Public debt in the United States is already high, and continuing to rise at a staggering pace. On April 18, Standard and Poor’s downgraded the outlook for US government debt to “negative.” This followed a nearly 5% drop in the preceding month as Congress repeatedly failed to agree on the federal budget until the eleventh hour. If a formal downgrade of the US credit rating from the AAA level were to take place, it would immediately trigger selling of US Dollars by central banks around the world. This would likely be a harbinger of the US permanently losing its economic hegemony, although the arguments for and against this are too lengthy to discuss here. At any rate, this stems in part from the devaluation of the US Dollar due to the Federal Reserve’s quantitative easing programs since March 2009. While these programs have not been extended yet, last week Federal Reserve Chairman Ben Bernanke affirmed a commitment to exceptionally low interest rates for an extended period of time. This comes despite the Fed seeming to ignore rising inflation over the past year, as seen already in the prices of food and other everyday commodities. While a part of the rising prices of can be attributed to poor harvests in many food commodities and higher oil prices, the fact is that many economists and citizens alike are concerned that that Fed is counting on price rises to taper off, and are worried it may not happen. Rising prices would only hurt the Dollar more. The end of the Dollar as the world’s preeminent reserve currency could take place if one or a combination of the aforementioned events materialize. Additionally, a main concern of some economists is that if a watershed event such as a US debt downgrade occurred, the process could not be controlled. The Dollar’s decline would be exacerbated by central banks quickly moving to diversify their currency reserves, quickly selling Dollars and moving them into either gold or other currencies. To illustrate this, several prominent commentators have expressed concern at the fact that China holds approximately 70 percent of its reserves in US Dollars, and its future actions could lead the way in diversifying out of the Dollar. The concern stems in part on the fact that such a rapid decline of the Dollar could lead to a currency crisis and potentially hyperinflation.
The positive outlook arguments for the Dollar are largely contrarian in nature, and address the fact that at least a portion of the Dollar’s recent decline can be attributed to overblown fears. First and foremost, it needs to be considered that the extreme level of pessimism may already be priced into the current Dollar Index, which fell to as low as 72.70 last week before rising to close at 74.91 on Friday, a sharp increase that perhaps signals the beginning of a medium-term rally. The droves of investors that have been running to physical gold, silver, or precious metal ETF’s like GLD and SLV have been doing so in part to protect their portfolios from a collapse in the Dollar. While this was a major factor in the price run-up, the events of this past week in the precious metals sphere have revealed that it was at least in part being driven by speculation. Therefore, the rapid run-up and
equally swift decline of precious metals could be indicative that the big drop in the Dollar has already taken place, and it may be near or already has seen a medium-term bottom.
Second, a timely end to the second round of quantitative easing (QE2) could create further headwinds for the stock and precious metals markets. This was the case in 2009-10 with the start and end of the first round of quantitative easing (Refer to Chart 1). Note that the Dollar began to fall in 2009 after the March 2009 announcement of Quantitative Easing, and began to rise once again after the Dubai debt crisis in November 2009, continuing with the European Debt crisis and the end of QE1. The latest round of Quantitative Easing, along with the subsiding (but far from over) debt crisis in Europe, contributed to the Dollar’s slide since last summer that, in my opinion, has led to the Dollar being oversold. Indeed, tighter monetary policy has been argued for by members of Congress and the Federal Reserve Board alike. While the situation in Libya and the rest of the Middle East has contributed to higher oil prices, commodities in general have been rising. Tighter monetary policy in response to this will help ease inflationary concerns and help strengthen the Dollar. Although the Federal Reserve left rates unchanged at the latest meeting, it has thus far not expressed any intention to commence another round of quantitative easing, although maturing bond purchases will occur on a more limited basis.
Finally, a weak Dollar isn’t necessarily welcomed by the rest of the world, contrary to popular belief. For US trade partners with a large export sector, such as Germany and Japan, a low US Dollar is detrimental because that means lower levels of trade with the US and effectively puts a cap on future growth. A number of currencies, including all of the other currencies that make up the US Dollar Index, have appreciated against the Dollar. Therefore, it is possible the foreign central banks could increase their Dollar purchases in the name of slowing their own currency’s appreciation. This would help stabilize the Dollar, and perhaps even contribute to a medium-term rally.
Looking at the technical analysis, indicators are signaling, as they were in March, that the Dollar could be at or near a medium-term bottom. Looking at long-term charts, despite the Dollar’s pronounced downtrend over the past decade, it could potentially be setting up for a break to the upside. While the Dollar has dropped, the Moving Average Convergence-Divergence (MACD) has been rising. A positive divergence while the Dollar is in a downtrend could signal a pending reversal to the upside. This is also true of the short-term charts, as you can see from Chart 1. Looking at a chart of the Dollar over the past year, the charts are also showing divergence in the Relative Strength Index (RSI), which, despite the continuing drop in the Dollar, has failed to make significant new lows, instead floating around its previous lows (Refer to Chart 2). Such a divergence/chart pattern often precedes a reversal, in this case to the upside.
Therefore, with the robust upturn in the Dollar over the past week, the medium-term bottom may very well have been made. While all fiat currencies, at least amongst Western economies, will continue to be under pressure as currencies are devalued, for now the Dollar appears to be commencing a medium-term rally.
Respectfully Yours,
Matthew R. Green
May 8, 2011
Saturday, March 19, 2011
Issue XXV - Japan S&P500
Dear Readers,
Over the course of the past month, several headwinds have formed for markets around the world. The political uprisings in the Middle East and the ongoing natural disaster in Japan have brought the S&P 500 down nearly 8% off its late February highs and sent oil back over $100/barrel, although it has fallen back below that level in the wake of the Tōhoku Earthquake in Northern Japan. Precious metals and oil could experience significant pullbacks, particularly Silver. For example, Silver stocks such as Silver Wheaton (SLW) are being affected by both the S&P 500 pullback and Silver falling from its highest levels since 1980. Even before the events in Japan, technical indicators on the S&P 500 signaled that a mid-term top may have taken place, and in the days following the earthquake several key support levels have been breached to the downside. The events that have taken place could continue to put downward pressure on world markets because the market’s momentum and technical indicators have been reversed. In this issue, I will briefly summarize the situation leading up to the earthquake and a few ETF’s that can be used to capitalize on the correction in Oil, Silver, and the Equities market.
To begin, it should be noted that what will ultimately transpire in the three markets covered in this issue will be determined in part by the performance of the US Dollar. Indeed, the dollar’s steady decline since July 2010 is one reason that Silver, Oil, and the S&P 500 have continued to move up. The dollar appears to be oversold, perhaps putting in a technical double-bottom on its longer-term chart. Of course, the Federal Reserve could announce a large third round of Quantitative Easing and send it even lower, as it did when Bernanke announced the possibility of QE2 in August, 2010 and formally announced $600 Billion of additional bond purchases in November. However, with the sovereign debt situation in Europe continuing to flare up, most recently a few weeks ago, and Japan injecting what may reach $500 billion in emergency funds into their economy, it is probable the dollar will trend higher over the next few months. A rebound in the Dollar Index in the near-term could take the Index back to the low 80s.
For all the tragic devastation that occurred in a matter of minutes during the quake/tsunami and could result from the Fukushima Daiichi nuclear fallout, a currency crisis triggered by the simmering Japanese debt crisis could hit just as quickly and would be much more destructive for the future of Japan and subsequent generations. Many analysts are commenting about how this disaster will be positive overall for the Japanese economy because of the future robust rebuilding program. While that could work, the fact is that Japan is on the cliff of a man-made debt disaster, and this natural disaster could prove to be the breaking point. Even before the earthquake, in January Standard and Poor’s downgraded Japan’s sovereign debt to the AA- rating. Another Japanese recession as a result of the quake would cause an increase in the cost of welfare and unemployment payments, combined with continuing unfavorable demographics. When added to a costly rebuilding and relief program, it wouldn’t be surprising at all to see Japan’s credit rating reduced to “junk” levels within a few years, maybe even sooner.
Some commentators are pointing to the 1995 Kobe earthquake and its aftermath for guidance about how the Yen will perform in the short-term. The yen rose in the aftermath of that quake, and while the yen has risen against the dollar in the immediate aftermath of the March 11 quake, in 1995 Japan had not yet resorted to nearly thirteen years of Quantitative Easing and over a decade of near-zero interest rates, a policy begun in 1997. With a 200% Debt/GDP ratio fifteen years later, if a flight to safety occurs it will likely not be to the Yen. The repatriation of funds back into Japan in the aftermath of the quake has taken the Yen to all-time highs against the Dollar on March 15-18, but each time the Bank of Japan has taken emergency measures to stem the tide. The G-7 has joined in this fight over the past several days, as well. Since a stronger yen is the last thing that the export-driven Japanese economy needs in the wake of the earthquake, it is all but guaranteed that the BOJ will continue intervening in conjunction with the other G-7 Central Banks. This marks other key difference between 1995 and 2011; the intervention is happening right away. In 1995 the yen rose relentlessly until the BOJ intervened nearly a month after the Kobe earthquake. Compare that to the immediate response of the BOJ and G-7, along with pledges from all the players to keep the Yen/Dollar ratio above a level of 80.
I have been an unabashed bull with respect to precious metals since late 2008 when the US Congress, Treasury and Federal Reserve chose to bail out the banks, and precious metals were trading at beaten-down levels. While the prices recovered in early 2009, it was the onset of the Fed’s Quantitative Easing program that set Gold and Silver ineluctably on the path upward. I believe these patterns will continue to play out over the remainder of the next few years and perhaps even longer, until the United States and other western nations fundamentally fix their budgets and get spending under control along with raising interest rates to more normal levels. At the same time, the events of the past month may have caused a mid-term top in the price of non-food commodities, particularly with Silver. After the robust advance of Silver over the final months of 2010, the price level of the metals suddenly has become risky, as mentioned in the issue sent out right before the New Year. Silver was about $30.50 at that time. While a pullback did occur in January, the onset of the Middle East crisis and rampant internet rumors about a shortage in Silver pushed the white metal to nearly $35 in February and early this month, much to the surprise of many commentators. With tensions beginning to subside and the events in Japan, markets around the world are responding with a correction.
After dropping nearly 15% in January, Silver came roaring back in tandem with Oil as tensions flared in the Middle East. In addition, the allegations about Silver manipulation that were mentioned in the August 4, 2010 edition of this newsletter have grown, and are currently rampant throughout the financial blogosphere. This rumor and additional untrue rumors of a pending shortage in Silver have reached the mainstream media, for example a column last week by William Cohan of the New York Times (You can read the column here). Despite the alleged manipulation, the fact is that no market goes straight up or straight down. The market shock that is being caused by events across the pacific could be the impetus for Silver to correct downward to its 200-day moving average. Such a pullback would be typical of the way Silver has tended to correct since its current bull market began in the early 2000s. It has always corrected to the 200-dma after large, breakout runs in which it often doubles in price. As can be seen in the chart below, the upward breakouts typically last 6-8 months, and are then followed by 18-24 month consolidations. This is what happened in 2004, 2006, and 2008. The financial crisis in 2008 caused the price to fall more than 50% from its early 2008 high, providing the best buying opportunity in years. At its current price, Silver is currently farther above its 50 and 200-day trend line that it has been at any point in this bull market. Simply put, the risk far outweighs the reward of investing at these levels, even more than at the end of December. If you are currently long Silver, an easy, liquid instrument to hedge a long position is ZSL. It is a Double-Short ETF, so if there is a pullback, ZSL will make up for some of the losses on silver mining equities or bullion. If Silver drops below its 50-day moving average in the coming week, look for further correction to take place.
Third, Oil and the S&P 500. Two weeks ago, Oil surpassed $100 for the first time since 2008. Obviously, the threat posed to oil supplies due to the revolutions in the Middle East were the main driver behind this. With the easing of tensions, the near-absence of violence in Saudi Arabia and the Tōhoku Earthquake, Oil appears to be heading back toward $90 per barrel or even less if the dollar continues to strengthen. As is the case with Silver, there is a Double-Short ETN to capitalize on this, the ticker symbol is DTO. Interestingly, DTO was issued around the time oil peaked at $147 a barrel in July 2008. Issued at $20, it was over $200 by early 2009 as oil crashed. I’m not suggesting that will happen again, but the point is that it is a good way to capitalize if the price of crude continues to decline.
Finally, the S&P 500. Since the Fed announced the second round of Quantitative Easing, investors have cheered as the S&P 500 surpassed its pre-Lehman Brothers bankruptcy high, and just two weeks ago the Dow Jones Industrial Average reached a level 100% above the March 2009 low. The onset of the Middle East crisis sent oil prices higher, and the S&P 500 responded by pulling back from what could be a midterm peak on February 22. Currently, the effects of the Tōhoku Earthquake are sending markets tumbling around the world, and the S&P 500 and Dow Jones Industrial Averages broke through their 50-day moving averages (one of the least-complex technical signs of a correction) in the past week. Unless the US enters another recession, we’re not facing a repeat of 2008, but more likely a 10-20% correction in the equities markets. On March 15, the Federal Reserve announced no change in interest rates or the current round of Quantitative Easing. Unless an expansion of the program is announced that sends the dollar lower in the short-term, this correction could take the S&P 500 to its 200-day moving average or below. To capitalize on this and/or limit the downside on long positions, the Double-Short S&P 500 ETF is SDS. For the inverse S&P 500 ETF which is not leveraged, the ticker symbol is SH.
Respectfully Yours,
Matthew R. Green
March 19, 2011
Over the course of the past month, several headwinds have formed for markets around the world. The political uprisings in the Middle East and the ongoing natural disaster in Japan have brought the S&P 500 down nearly 8% off its late February highs and sent oil back over $100/barrel, although it has fallen back below that level in the wake of the Tōhoku Earthquake in Northern Japan. Precious metals and oil could experience significant pullbacks, particularly Silver. For example, Silver stocks such as Silver Wheaton (SLW) are being affected by both the S&P 500 pullback and Silver falling from its highest levels since 1980. Even before the events in Japan, technical indicators on the S&P 500 signaled that a mid-term top may have taken place, and in the days following the earthquake several key support levels have been breached to the downside. The events that have taken place could continue to put downward pressure on world markets because the market’s momentum and technical indicators have been reversed. In this issue, I will briefly summarize the situation leading up to the earthquake and a few ETF’s that can be used to capitalize on the correction in Oil, Silver, and the Equities market.
To begin, it should be noted that what will ultimately transpire in the three markets covered in this issue will be determined in part by the performance of the US Dollar. Indeed, the dollar’s steady decline since July 2010 is one reason that Silver, Oil, and the S&P 500 have continued to move up. The dollar appears to be oversold, perhaps putting in a technical double-bottom on its longer-term chart. Of course, the Federal Reserve could announce a large third round of Quantitative Easing and send it even lower, as it did when Bernanke announced the possibility of QE2 in August, 2010 and formally announced $600 Billion of additional bond purchases in November. However, with the sovereign debt situation in Europe continuing to flare up, most recently a few weeks ago, and Japan injecting what may reach $500 billion in emergency funds into their economy, it is probable the dollar will trend higher over the next few months. A rebound in the Dollar Index in the near-term could take the Index back to the low 80s.
For all the tragic devastation that occurred in a matter of minutes during the quake/tsunami and could result from the Fukushima Daiichi nuclear fallout, a currency crisis triggered by the simmering Japanese debt crisis could hit just as quickly and would be much more destructive for the future of Japan and subsequent generations. Many analysts are commenting about how this disaster will be positive overall for the Japanese economy because of the future robust rebuilding program. While that could work, the fact is that Japan is on the cliff of a man-made debt disaster, and this natural disaster could prove to be the breaking point. Even before the earthquake, in January Standard and Poor’s downgraded Japan’s sovereign debt to the AA- rating. Another Japanese recession as a result of the quake would cause an increase in the cost of welfare and unemployment payments, combined with continuing unfavorable demographics. When added to a costly rebuilding and relief program, it wouldn’t be surprising at all to see Japan’s credit rating reduced to “junk” levels within a few years, maybe even sooner.
Some commentators are pointing to the 1995 Kobe earthquake and its aftermath for guidance about how the Yen will perform in the short-term. The yen rose in the aftermath of that quake, and while the yen has risen against the dollar in the immediate aftermath of the March 11 quake, in 1995 Japan had not yet resorted to nearly thirteen years of Quantitative Easing and over a decade of near-zero interest rates, a policy begun in 1997. With a 200% Debt/GDP ratio fifteen years later, if a flight to safety occurs it will likely not be to the Yen. The repatriation of funds back into Japan in the aftermath of the quake has taken the Yen to all-time highs against the Dollar on March 15-18, but each time the Bank of Japan has taken emergency measures to stem the tide. The G-7 has joined in this fight over the past several days, as well. Since a stronger yen is the last thing that the export-driven Japanese economy needs in the wake of the earthquake, it is all but guaranteed that the BOJ will continue intervening in conjunction with the other G-7 Central Banks. This marks other key difference between 1995 and 2011; the intervention is happening right away. In 1995 the yen rose relentlessly until the BOJ intervened nearly a month after the Kobe earthquake. Compare that to the immediate response of the BOJ and G-7, along with pledges from all the players to keep the Yen/Dollar ratio above a level of 80.
I have been an unabashed bull with respect to precious metals since late 2008 when the US Congress, Treasury and Federal Reserve chose to bail out the banks, and precious metals were trading at beaten-down levels. While the prices recovered in early 2009, it was the onset of the Fed’s Quantitative Easing program that set Gold and Silver ineluctably on the path upward. I believe these patterns will continue to play out over the remainder of the next few years and perhaps even longer, until the United States and other western nations fundamentally fix their budgets and get spending under control along with raising interest rates to more normal levels. At the same time, the events of the past month may have caused a mid-term top in the price of non-food commodities, particularly with Silver. After the robust advance of Silver over the final months of 2010, the price level of the metals suddenly has become risky, as mentioned in the issue sent out right before the New Year. Silver was about $30.50 at that time. While a pullback did occur in January, the onset of the Middle East crisis and rampant internet rumors about a shortage in Silver pushed the white metal to nearly $35 in February and early this month, much to the surprise of many commentators. With tensions beginning to subside and the events in Japan, markets around the world are responding with a correction.
After dropping nearly 15% in January, Silver came roaring back in tandem with Oil as tensions flared in the Middle East. In addition, the allegations about Silver manipulation that were mentioned in the August 4, 2010 edition of this newsletter have grown, and are currently rampant throughout the financial blogosphere. This rumor and additional untrue rumors of a pending shortage in Silver have reached the mainstream media, for example a column last week by William Cohan of the New York Times (You can read the column here). Despite the alleged manipulation, the fact is that no market goes straight up or straight down. The market shock that is being caused by events across the pacific could be the impetus for Silver to correct downward to its 200-day moving average. Such a pullback would be typical of the way Silver has tended to correct since its current bull market began in the early 2000s. It has always corrected to the 200-dma after large, breakout runs in which it often doubles in price. As can be seen in the chart below, the upward breakouts typically last 6-8 months, and are then followed by 18-24 month consolidations. This is what happened in 2004, 2006, and 2008. The financial crisis in 2008 caused the price to fall more than 50% from its early 2008 high, providing the best buying opportunity in years. At its current price, Silver is currently farther above its 50 and 200-day trend line that it has been at any point in this bull market. Simply put, the risk far outweighs the reward of investing at these levels, even more than at the end of December. If you are currently long Silver, an easy, liquid instrument to hedge a long position is ZSL. It is a Double-Short ETF, so if there is a pullback, ZSL will make up for some of the losses on silver mining equities or bullion. If Silver drops below its 50-day moving average in the coming week, look for further correction to take place.
Third, Oil and the S&P 500. Two weeks ago, Oil surpassed $100 for the first time since 2008. Obviously, the threat posed to oil supplies due to the revolutions in the Middle East were the main driver behind this. With the easing of tensions, the near-absence of violence in Saudi Arabia and the Tōhoku Earthquake, Oil appears to be heading back toward $90 per barrel or even less if the dollar continues to strengthen. As is the case with Silver, there is a Double-Short ETN to capitalize on this, the ticker symbol is DTO. Interestingly, DTO was issued around the time oil peaked at $147 a barrel in July 2008. Issued at $20, it was over $200 by early 2009 as oil crashed. I’m not suggesting that will happen again, but the point is that it is a good way to capitalize if the price of crude continues to decline.
Finally, the S&P 500. Since the Fed announced the second round of Quantitative Easing, investors have cheered as the S&P 500 surpassed its pre-Lehman Brothers bankruptcy high, and just two weeks ago the Dow Jones Industrial Average reached a level 100% above the March 2009 low. The onset of the Middle East crisis sent oil prices higher, and the S&P 500 responded by pulling back from what could be a midterm peak on February 22. Currently, the effects of the Tōhoku Earthquake are sending markets tumbling around the world, and the S&P 500 and Dow Jones Industrial Averages broke through their 50-day moving averages (one of the least-complex technical signs of a correction) in the past week. Unless the US enters another recession, we’re not facing a repeat of 2008, but more likely a 10-20% correction in the equities markets. On March 15, the Federal Reserve announced no change in interest rates or the current round of Quantitative Easing. Unless an expansion of the program is announced that sends the dollar lower in the short-term, this correction could take the S&P 500 to its 200-day moving average or below. To capitalize on this and/or limit the downside on long positions, the Double-Short S&P 500 ETF is SDS. For the inverse S&P 500 ETF which is not leveraged, the ticker symbol is SH.
Respectfully Yours,
Matthew R. Green
March 19, 2011
Wednesday, February 23, 2011
Issue XXIV - Groupon
Dear Readers,
The increased scrutiny that Groupon has faced recently is not limited to debate over what the company is worth. Other major challenges lie ahead for Groupon as it prepares for its IPO this year (no, the Tibet-themed Super Bowl ad is not one of them, although I must admit I liked the commercial but can see how others could view it as being in bad taste). First, it is debatable whether its business model is beneficial for its customers, particularly the small businesses. Second, Groupon is facing challenges from LivingSocial, Google and a host of other deal-of-the-day websites. In such an environment, will Groupon be able to effectively evolve as a business and maintain its competitive advantage? These challenges and how the company handles them will ultimately determine its long-term course. While it may not be the next Google or Facebook, decisions made today and in the near future will go a long way toward Groupon remaining a viable internet business that provides a crucial discount retail service.
First, a brief overview of Groupon’s business model might be helpful. The customer/merchant either contacts a Groupon sales associate or is solicited by one. The sales associate and Groupon then structure an offer. For example, a product that would normally cost $20 for $10; a 50% off deal that is sure to increase traffic on the day(s) the deal is offered. Then the merchant is featured on the website, and a cap is placed on the number of these deals that can be sold (the merchant can opt for packages ranging in number from about a dozen to many thousands). As these deals are sold on the website for $10, Groupon takes 50% of the revenue generated, in this case $5. The merchant then gets a $5 x 500 coupon redemption to be paid out over 90 days. A 500-coupon package at this price (assuming that the merchant could potentially be selling 500 items for $20 and adding in Groupon’s cut) will cost the merchant $7500. Compared to traditional methods of promotion via discounts, such as print ads or television, this is expensive, especially for small businesses.
In an economy like the present, Groupon is a haven for consumers who are looking for deals, not necessarily a merchant whom they can go back to on a regular basis. Thus, the subscribers that Groupon connects to the merchants inherently have a smaller chance of re-patronizing the businesses that are featured. For the merchant, it is up to them to entice the consumers to come back at full price, a task much easier said than done. Of course, some might come back, but coupon-clippers are a notoriously frugal demographic (just ask any seasoned consultant who is worth his or her billable hour). In this respect, Groupon is a beneficiary of fortuitous timing, launching at a time (late 2008) when even upper-middle class individuals began penny pinching and looking for deals. However, that doesn’t mean the situation is a win-win for all merchants.
The issue is not that a sizable percentage of merchants lose money on these deals (and close to 33% do, according to a 2010 Rice University study). A merchant who offers a Groupon deal, or for that matter any discount situation with the expectation to make a lot of money, is either naïve or missing the point of a deep discount. Discounts of any kind form the classic economic concept of a loss leader, intended to facilitate a sale that otherwise might not take place. The intention is not to make money, but to bring in new customers who otherwise would not have patronized that business. That said, many merchants are not only losing money on the deals, but are complaining that it didn’t result in a sustainable uptick in business. This is amplified within sectors where consumers have many choices as well as in sectors that are lower-margin businesses by nature. For example, there many deals for personal care services being offered among the deal-of-the-day websites. Many consumers in a big city will go across town for 50% off an expensive spa treatment or other such deal but would never be willing to pay full price (especially if doing so means going back across town). Of course, some do, but that is the exception. For smaller deals, i.e. 50% off a $20 men’s haircut, not as many are interested.
Even less interested are the merchants who shell out a bunch of half-price services and then don’t reap the benefits of repeat business. In the case of many small businesses, they usually are not using Groupon to clear out inventory. They are attempting to offer a discount, utilizing the marketing power of social media, to create awareness of their business. When that awareness doesn’t translate to higher profits and/or retained customers, they aren’t satisfied.
The aforementioned Rice University study surveyed 150 random businesses that ran Groupon deals between June 2009 and August 2010. Of those businesses, 42% said they would not offer another Groupon-type promotion again. The most commonly cited reason was that the customers were “extremely price sensitive, barely spending beyond a discounted product’s face value.” Repeat-purchase rates were found to be around 13%. It should be noted that spending beyond the coupon’s value was markedly higher in a few sectors, particularly restaurants, underscoring the fact that Groupon is more effective for certain business segments than others.
The study’s findings are consistent with decades of academic and corporate research that have found that price promotions do not produce many long-term benefits for businesses. Even worse, when promotions are repeated on a regular basis they chip away at brand value over time, and lead to customers who aren’t willing to buy without a deal. One of the first and most famous examples of these findings occurred back in the 1980s, when Sears had a revelation regarding discounts for its vaunted Craftsman tool line. Sears found that buyers of the tools waited for the weekly sale flyer, and then, would only buy what was on sale. If what they needed wasn’t on sale, then they would wait until it was before buying it. Effectively, Sears found that it was teaching its customers to wait for the sale. Businesses that run Groupon deals are faced with the same dilemma. Assuming the study is correct, even if all of the coupon users become repeat customers, only 13% would on their own volition and pay full price, while the rest would only be returning because they received yet another discount incentive. Over time, this effectively lowers the price for everything at a loss to the retailers.
Many of those who have defended Groupon in the business press and in the blogosphere tout the incredible amount of publicity that a merchant can get, especially a small business. That is definitely true. When selling deals, Groupon salesmen walk into various stores armed with spreadsheets containing hard numbers of the exposure that a business can expect to receive. But, as stated earlier, the fact is that this exposure is to consumers who are looking for deals, a group that is already preconditioned to not be willing to pay full value.
Groupon, LivingSocial and the other websites that have popped up since 2007 deserve credit for advancing yet another retail sector into the digital age: coupons. Realizing that discounts are just as effective, if not more effective, when distributed via the internet as opposed to newspaper clip-outs or television, many have jumped at the opportunity to provide merchants with such services. With more and more offers available as the sector has proliferated, the market can only get saturated more quickly, i.e. the number of viable, small-to-midsize merchants that are willing to run promotions can only be exhausted at an accelerated pace. But that is not to say that there will not be interested merchants. After all, over 60% of the merchants featured in the study made money off of their Groupon deal (other academic studies on Groupon will be published in the coming months; as of now the Rice study is the only empirical study available). The point is that it works for some merchants, and doesn’t seem to work for others. Eventually, the website’s customers could primarily be small and midsize businesses that find the promotions to be effective as well as large businesses. Indeed, deal-of-the-day websites are already increasingly offering deals from larger merchants, and are finding these deals to be very profitable.
Recent developments within the sector indicate that the momentum is shifting from small businesses to larger retailers. Some of the largest retailers in the country are now working with the deal-of-the-day websites. This trend first came to the forefront back last summer with Groupon’s August 20 deal with Gap (pay $25 and buy $50 of merchandise, nearly 500,000 of these deals were sold), and more recently, LivingSocial set sales records by offering gift cards worth $20 of goods at their partner Amazon.com for $10 (over 1,000,000 of these deals were sold in a 24-hour period).
Working with larger retailers may be where the sector’s ultimate destiny may lie. Small businesses will always be looking for exposure, but the fact is that larger companies have a greater wherewithal to absorb a few of these one-day discount deals once in awhile. Furthermore, although financials are not disclosed, I have a hard time believing that Groupon would take 50% from deal with such a large customer, as a large profit is virtually ensured even with lower margins. Within the small business sector, many of the upstart deal-of-the-day websites are charging less than the 50% that Groupon typically takes (LivingSocial is one of these), and thus the margins in the small-business deals are falling. As small businesses discover better deals offered by other websites, Groupon will eventually be forced to lower their margins. If the deals with large retailers/merchants prove to be more profitable and reliable for repeat business, then you can expect that this is where the sector will focus on in the coming years.
With so many questions that have yet to be answered about the sector, the biggest looming question is whether it will still be viable once the sheen of novelty has worn off. The answer is yes, as long as these websites can evolve and adjust. So far, they appear to be doing so. As stated previously, the dozens of deal-of-the-day websites that have popped up can only shrink the pool of interested merchants more quickly, continually forcing margins down. However, that may be a trend that keeps both parties coming back for more. As the merchants sense that there are better deals, they will go with those, and the more expensive players will be forced to adjust. In a few years, I could see local websites, perhaps sponsored by local newspapers that have seen their ad revenue eroded by Craigslist and other listing websites, launch deal-of-the-day sections to reconnect with local merchants who they are already familiar with, and who in turn could use them to reach their target local audience. If the margins are low enough, this could be a mutually beneficial venture. Additionally, there are new startups popping up within the sector that offer deals which are contingent on either repeat business from customers, or purchasing a certain amount beyond the deal’s value. If this catches on, expect merchants to favor that approach and for Groupon and the larger players to adapt.
On the other hand, even before their IPOs, Groupon and LivingSocial have begun buying up other deal-of-the-day websites not just in the US but all over the world. When these companies go public, expect them to attempt to purchase many of their competitors in order to obtain certain innovations their competitors may have pioneered, and thus maintain their competitive advantage. Thus, while the current social aspect/novelty of these websites may prove to be a temporary social fad, they aren’t going away. With adjustments that they will make either by choice or by necessity, you can expect deal-of-the-day websites to be an influence on the retail sector for years into the future.
Respectfully Yours,
Matthew R. Green
February 11, 2011
The increased scrutiny that Groupon has faced recently is not limited to debate over what the company is worth. Other major challenges lie ahead for Groupon as it prepares for its IPO this year (no, the Tibet-themed Super Bowl ad is not one of them, although I must admit I liked the commercial but can see how others could view it as being in bad taste). First, it is debatable whether its business model is beneficial for its customers, particularly the small businesses. Second, Groupon is facing challenges from LivingSocial, Google and a host of other deal-of-the-day websites. In such an environment, will Groupon be able to effectively evolve as a business and maintain its competitive advantage? These challenges and how the company handles them will ultimately determine its long-term course. While it may not be the next Google or Facebook, decisions made today and in the near future will go a long way toward Groupon remaining a viable internet business that provides a crucial discount retail service.
First, a brief overview of Groupon’s business model might be helpful. The customer/merchant either contacts a Groupon sales associate or is solicited by one. The sales associate and Groupon then structure an offer. For example, a product that would normally cost $20 for $10; a 50% off deal that is sure to increase traffic on the day(s) the deal is offered. Then the merchant is featured on the website, and a cap is placed on the number of these deals that can be sold (the merchant can opt for packages ranging in number from about a dozen to many thousands). As these deals are sold on the website for $10, Groupon takes 50% of the revenue generated, in this case $5. The merchant then gets a $5 x 500 coupon redemption to be paid out over 90 days. A 500-coupon package at this price (assuming that the merchant could potentially be selling 500 items for $20 and adding in Groupon’s cut) will cost the merchant $7500. Compared to traditional methods of promotion via discounts, such as print ads or television, this is expensive, especially for small businesses.
In an economy like the present, Groupon is a haven for consumers who are looking for deals, not necessarily a merchant whom they can go back to on a regular basis. Thus, the subscribers that Groupon connects to the merchants inherently have a smaller chance of re-patronizing the businesses that are featured. For the merchant, it is up to them to entice the consumers to come back at full price, a task much easier said than done. Of course, some might come back, but coupon-clippers are a notoriously frugal demographic (just ask any seasoned consultant who is worth his or her billable hour). In this respect, Groupon is a beneficiary of fortuitous timing, launching at a time (late 2008) when even upper-middle class individuals began penny pinching and looking for deals. However, that doesn’t mean the situation is a win-win for all merchants.
The issue is not that a sizable percentage of merchants lose money on these deals (and close to 33% do, according to a 2010 Rice University study). A merchant who offers a Groupon deal, or for that matter any discount situation with the expectation to make a lot of money, is either naïve or missing the point of a deep discount. Discounts of any kind form the classic economic concept of a loss leader, intended to facilitate a sale that otherwise might not take place. The intention is not to make money, but to bring in new customers who otherwise would not have patronized that business. That said, many merchants are not only losing money on the deals, but are complaining that it didn’t result in a sustainable uptick in business. This is amplified within sectors where consumers have many choices as well as in sectors that are lower-margin businesses by nature. For example, there many deals for personal care services being offered among the deal-of-the-day websites. Many consumers in a big city will go across town for 50% off an expensive spa treatment or other such deal but would never be willing to pay full price (especially if doing so means going back across town). Of course, some do, but that is the exception. For smaller deals, i.e. 50% off a $20 men’s haircut, not as many are interested.
Even less interested are the merchants who shell out a bunch of half-price services and then don’t reap the benefits of repeat business. In the case of many small businesses, they usually are not using Groupon to clear out inventory. They are attempting to offer a discount, utilizing the marketing power of social media, to create awareness of their business. When that awareness doesn’t translate to higher profits and/or retained customers, they aren’t satisfied.
The aforementioned Rice University study surveyed 150 random businesses that ran Groupon deals between June 2009 and August 2010. Of those businesses, 42% said they would not offer another Groupon-type promotion again. The most commonly cited reason was that the customers were “extremely price sensitive, barely spending beyond a discounted product’s face value.” Repeat-purchase rates were found to be around 13%. It should be noted that spending beyond the coupon’s value was markedly higher in a few sectors, particularly restaurants, underscoring the fact that Groupon is more effective for certain business segments than others.
The study’s findings are consistent with decades of academic and corporate research that have found that price promotions do not produce many long-term benefits for businesses. Even worse, when promotions are repeated on a regular basis they chip away at brand value over time, and lead to customers who aren’t willing to buy without a deal. One of the first and most famous examples of these findings occurred back in the 1980s, when Sears had a revelation regarding discounts for its vaunted Craftsman tool line. Sears found that buyers of the tools waited for the weekly sale flyer, and then, would only buy what was on sale. If what they needed wasn’t on sale, then they would wait until it was before buying it. Effectively, Sears found that it was teaching its customers to wait for the sale. Businesses that run Groupon deals are faced with the same dilemma. Assuming the study is correct, even if all of the coupon users become repeat customers, only 13% would on their own volition and pay full price, while the rest would only be returning because they received yet another discount incentive. Over time, this effectively lowers the price for everything at a loss to the retailers.
Many of those who have defended Groupon in the business press and in the blogosphere tout the incredible amount of publicity that a merchant can get, especially a small business. That is definitely true. When selling deals, Groupon salesmen walk into various stores armed with spreadsheets containing hard numbers of the exposure that a business can expect to receive. But, as stated earlier, the fact is that this exposure is to consumers who are looking for deals, a group that is already preconditioned to not be willing to pay full value.
Groupon, LivingSocial and the other websites that have popped up since 2007 deserve credit for advancing yet another retail sector into the digital age: coupons. Realizing that discounts are just as effective, if not more effective, when distributed via the internet as opposed to newspaper clip-outs or television, many have jumped at the opportunity to provide merchants with such services. With more and more offers available as the sector has proliferated, the market can only get saturated more quickly, i.e. the number of viable, small-to-midsize merchants that are willing to run promotions can only be exhausted at an accelerated pace. But that is not to say that there will not be interested merchants. After all, over 60% of the merchants featured in the study made money off of their Groupon deal (other academic studies on Groupon will be published in the coming months; as of now the Rice study is the only empirical study available). The point is that it works for some merchants, and doesn’t seem to work for others. Eventually, the website’s customers could primarily be small and midsize businesses that find the promotions to be effective as well as large businesses. Indeed, deal-of-the-day websites are already increasingly offering deals from larger merchants, and are finding these deals to be very profitable.
Recent developments within the sector indicate that the momentum is shifting from small businesses to larger retailers. Some of the largest retailers in the country are now working with the deal-of-the-day websites. This trend first came to the forefront back last summer with Groupon’s August 20 deal with Gap (pay $25 and buy $50 of merchandise, nearly 500,000 of these deals were sold), and more recently, LivingSocial set sales records by offering gift cards worth $20 of goods at their partner Amazon.com for $10 (over 1,000,000 of these deals were sold in a 24-hour period).
Working with larger retailers may be where the sector’s ultimate destiny may lie. Small businesses will always be looking for exposure, but the fact is that larger companies have a greater wherewithal to absorb a few of these one-day discount deals once in awhile. Furthermore, although financials are not disclosed, I have a hard time believing that Groupon would take 50% from deal with such a large customer, as a large profit is virtually ensured even with lower margins. Within the small business sector, many of the upstart deal-of-the-day websites are charging less than the 50% that Groupon typically takes (LivingSocial is one of these), and thus the margins in the small-business deals are falling. As small businesses discover better deals offered by other websites, Groupon will eventually be forced to lower their margins. If the deals with large retailers/merchants prove to be more profitable and reliable for repeat business, then you can expect that this is where the sector will focus on in the coming years.
With so many questions that have yet to be answered about the sector, the biggest looming question is whether it will still be viable once the sheen of novelty has worn off. The answer is yes, as long as these websites can evolve and adjust. So far, they appear to be doing so. As stated previously, the dozens of deal-of-the-day websites that have popped up can only shrink the pool of interested merchants more quickly, continually forcing margins down. However, that may be a trend that keeps both parties coming back for more. As the merchants sense that there are better deals, they will go with those, and the more expensive players will be forced to adjust. In a few years, I could see local websites, perhaps sponsored by local newspapers that have seen their ad revenue eroded by Craigslist and other listing websites, launch deal-of-the-day sections to reconnect with local merchants who they are already familiar with, and who in turn could use them to reach their target local audience. If the margins are low enough, this could be a mutually beneficial venture. Additionally, there are new startups popping up within the sector that offer deals which are contingent on either repeat business from customers, or purchasing a certain amount beyond the deal’s value. If this catches on, expect merchants to favor that approach and for Groupon and the larger players to adapt.
On the other hand, even before their IPOs, Groupon and LivingSocial have begun buying up other deal-of-the-day websites not just in the US but all over the world. When these companies go public, expect them to attempt to purchase many of their competitors in order to obtain certain innovations their competitors may have pioneered, and thus maintain their competitive advantage. Thus, while the current social aspect/novelty of these websites may prove to be a temporary social fad, they aren’t going away. With adjustments that they will make either by choice or by necessity, you can expect deal-of-the-day websites to be an influence on the retail sector for years into the future.
Respectfully Yours,
Matthew R. Green
February 11, 2011
Thursday, February 3, 2011
Issue XXVIII - Tech 2.0
“Past may be prelude, but which past?” - Henry Hu
In the first week of December 2010, one of the major business stories involved Google’s (GOOG) $6 billion offer to purchase Groupon. Founded in 2008, Groupon has expanded at an extraordinary pace to become the largest deal-of-the-day website. Every day, Groupon e-mails subscribers an offer for heavily discounted items or services from a particular merchant in the subscribers’ local market. In the economic climate of the past few years, it has proven to be very popular. To the shock of many, Groupon CEO Andrew Mason turned down GOOG’s offer. Early in January 2011 GOOG announced it is launching a similar service, dubbed Google Offers, while Groupon is planning an IPO. Reports have put the anticipated size of Groupon’s IPO around a staggering $15 billion. The rapidly increasing valuations of websites such as Facebook and LinkedIn, as well as deal-of-the-day websites – reminiscent of the first wave of technology overvaluation – have raised concerns of another tech bubble in the making.
Despite the bad memories elicited by “tech bubble,” websites today such as Groupon are probably not going to be the next crop of high-profile flameouts like Pets.com or Webvan ten years ago. For one, Facebook is already so large that its position could be similar to that of GOOG in 2004, in which it can go public and subsequently use its IPO cash to acquire other companies, increasing its market share and gradually building value for investors. Therefore, the unfolding situation could have characteristics of the tech bubble and successes such as GOOG. Parallels to the past will inevitably exist, but the question is which scenario will be more closely mirrored, and for which startups. Ultimately, a lot of these websites may not be worth as much in a few years as they are today. At the same time, lessons learned from the first tech bust have resulted in today’s websites being in better financial shape as they prepare to go public. This is Part 1 of what will be a 2-issue topic. This week, the focus will be on the present valuations within the sector, and next week the focus will be on what the future may hold and what Groupon in particular will need to do to stay competitive as the sector evolves.
One of the factors in the high valuations within the tech sector is simple supply and demand. Assisted by SecondMarket and other facilitators of private-stock transactions, accredited investors are able to invest in startups such as Facebook and LinkedIn with relative ease. In such transactions, the selling party is often the startup’s employees cashing out their private shares in the company. Since these shares are relatively hard to come by and the market is not as liquid as it would be on an exchange, investors have bid up the prices relatively quickly. However, the valuations may be entering a territory in which legitimate arguments can be made that they are overvalued. SecondMarket’s latest share auction values Facebook at approximately $70 billion. This is half of what GOOG is valued at, despite GOOG having $25 billion in revenue, $10 billion in earnings, and, most importantly, higher operating margins than Facebook. I am not flat-out suggesting that those who have invested in Facebook via private transactions will not make money. It is entirely possible that Facebook’s valuation could surpass $100 billion before its IPO, which is expected to come before 2013. However, the higher the valuation climbs, the more likely it becomes that there could be a rapid exodus as lots of individual investors seek to get out once the lockup on their shares expires.
For those who doubt that this is a possibility, look no further than Yahoo! (YHOO) circa 1999. YHOO was the character of the first tech bubble that was most synonymous with the internet as a whole, not confined to a retail sector like Amazon or EBay. Adjusted for inflation, YHOO’s market cap at the end of 1999 was approaching $150 billion. Today, stripping away YHOO’s tangible book value, the market currently values the company at close to $0. That’s right, net of its cash position and other tangibles, such as investments, the market values YHOO at $0. I am talking about a business that generates $1 billion in cash flow on $5 billion of revenue. Needless to say, a decade later YHOO is no longer the gorgeous new girl on campus. While Facebook, LinkedIn, and Groupon are in great shape right now, if something better comes along, unless these websites evolve accordingly, then they will be on track to become as old as, well, YHOO.
With current valuations high, the time is ripe for these companies to go public. Wall Street is currently gearing up for what will undoubtedly be two of the hottest IPO’s in 2011, Groupon and the just-announced IPO of LinkedIn. While Groupon has not yet filed for an IPO, bankers are aggressively (and smartly) vying for the assignment. Although the valuation may be frothy, bankers know that in order to get the most successful IPO for a client in the rapidly-growing deal-of-the-day sector, now is the time to move forward. Even if the valuations do eventually deflate, Facebook and Groupon are more than likely here to stay and will be major clients for Wall Street in the future, just as YHOO, AMZN, EBAY, etc. were viable businesses that thrived and were active clients for Wall Street throughout the 2000s despite the tech crash early in the decade. Amidst the excitement about the pending IPO, many on Wall Street are concerned that Groupon is overvalued, even more so than Facebook. Concerns about the viability of Groupon’s business model compound these concerns.
To compare the two companies, Facebook has over 600 million users and a scalable business model with very low fixed costs. Most importantly, it is by far the most widely-used social network. Groupon, on the other hand, is finding itself in competition with a plethora of other deal-of-the-day websites. Thanks to the low barriers to entry provided by the internet and an easily replicable business model, many of these new players are undercutting Groupon’s margins to provide better deals for the featured merchants. As is the case with most industries/sectors that proliferate, as new participants enter the market profit margins will become thinner, profits will decline, and eventually revenue will stop growing and perhaps even fall. Additionally, with GOOG launching its own service and Amazon teaming up with DC-based LivingSocial, two large players with deep pockets will increasingly be nipping at Groupon’s heels. While Groupon has indeed achieved tremendous growth in a short amount of time (in fact, in August 2010 Forbes named Groupon the fastest-growing startup in history), to maintain growth it has had to add thousands of local salespeople and has to continue doing so to find new local and national merchants to feature. That is not as scalable of a business model as Facebook and many other websites. Yet, a $15 billion IPO is being planned in the midst of an increasingly saturated market.
Another challenge to Groupon’s valuation is the fact that the business sector led by Groupon is inherently lower-growth than many others on the internet. When GOOG’s offer for Groupon was announced, a few commentators compared it favorably to GOOG’s October 2006 acquisition of YouTube. However, significant differences between Groupon and YouTube would not have made Groupon as good of an acquisition as it may have seemed. A few analysts noted that GOOG bought YouTube for $1.65 billion when the latter’s revenue was a mere $11 million per year. On the surface this makes Groupon seem like a steal, as it is projected to earn somewhere between $1.3 and $1.5 billion in 2011. However, despite the meteoric growth rates of Groupon, it should be noted that YouTube’s customer base is simply any internet user who wants to watch or upload videos. For Groupon’s 40 million online subscribers, the service is very popular and growing. But those people are not the customers. Groupon’s customer base consists of the merchants who utilize it as a loss leader to bring the public into their stores, hopefully stimulating future business and/or purchases of other products at full price. Thus, Groupon’s customer base is inherently more fickle, especially those for whom the deal doesn’t work. Eventually, there will be a core group of merchants in any given local market who will be regular customers of Groupon and other such websites, and the rest won’t use it. That puts a lid on growth for the company in its current form. For YouTube, on the other hand, the user base and revenue-generating ad clicks are constrained only by the overall number of internet users, which is continually growing worldwide. Facebook is the same way, as it is constantly entering new countries around the world. Eventually there will be limits to its growth, but that is further off for Facebook than Groupon.
With a number of copycat websites eroding market share, even if Groupon does remain the sector’s leader, it may not be worth $15 billion in a few years. Although it incorporates the easy distribution and powerful marketing characteristics of social networking, Groupon is neither an all-encompassing hub for the world’s information like GOOG nor is it a social network like Facebook. It is more akin to a discount service provider while borrowing a few characteristics of a social network. Businesses in the discount service sector are typically not worth $15 billion. For example, Overstock.com has $1.2 billion of revenue and is valued at about $370 million. Just five years ago, that valuation was nearly $2 billion. In the brick-and-mortar discount retail sector, Dollar General has $14 billion of revenue and is valued at approximately $10 billion. Currently, a large part of Groupon’s valuation derives from, like GOOG and Facebook before, the prospects of exponential growth. However, the valuations of businesses like Overstock.com and Dollar General that are more similar to Groupon may give a better indication of what its true valuation should be, especially if Groupon’s growth prospects are increasingly limited.
Despite the increasing valuations for tech startups, this is not simply a repeat of the first tech bubble. If this were the late 1990s, Facebook, Groupon, LinkedIn, etc. likely would have gone public several years ago. After the successful Netscape IPO in August 1995, historically pointed to as the beginning of the tech bubble, tech startups were increasingly geared toward fast-track IPOs. Entrepreneurs, venture capitalists, and bankers alike all contributed to this against the backdrop of the soaring NASDAQ, which helped to mask the fact that not all of these startups could possibly be successful. YHOO was founded by Jerry Yang and David Filo in 1994 and went public two years later. Similarly, Jeff Bezos founded AMZN in 1994 and it went public in the spring of 1997. Yet, many others were taken public with little to no earnings of which to speak. Still others burnt through their venture capital even before going public. This isn’t the case today with Groupon, LinkedIn and Facebook. They are highly profitable and growing. Yet despite an improving IPO climate since 2008, they are waiting for the right moment to go public. Groupon would be the exception in this case, as it is two years old. Facebook and LinkedIn are seven and eight years old, respectively. Even GOOG did not go public until it was nearly six years old, in 2004. So there is definitely a prudence that may have been lacking in the late 1990s when the internet sector temporarily seemed to be invincible. Yet, a better managed process of growth doesn’t mean that these startups aren’t overvalued at present and could still be when they go public.
The verdict about whether these soon-to-be-public startups are overvalued is still out. While my opinion leans toward yes, it should be noted that in the case of Groupon there have been several well-respected parties, Google and Goldman Sachs among them, who have taken a peek at the numbers and clearly didn’t pick those $6 billion and $15 billion respective valuations out of a hat. Obviously, the valuations take into consideration the company’s rapid growth and potential to do so in the future. Thus, two main questions need to be answered to more accurately gauge the sector’s prospects.
First, will the deal-of-the-day sector become so crowded that it will become significantly harder for Groupon to compete in the future? The sector is evolving as quickly as it is growing (indeed, one of the main reasons an IPO would be helpful to Groupon is so it can have cash to evolve via acquisitions). The robust activity within the sector in December was furthered by Amazon’s $175 million investment into LivingSocial, the second-largest deal-of-the-day website. LivingSocial’s deal with Amazon has enabled it to quickly diversify its offerings beyond its subscribers’ local markets and perhaps represents a more intelligent route toward growth. Not surprisingly, Groupon is increasingly offering national retail deals as well.
Second, deal-of-the-day websites could prove to be a fad that fades away because the economy improves or because consumers/merchants tire of the concept. Will Groupon still be worth $15 billion in that case? Most likely not. However, as stated before Groupon is not going away. After all, consumers are always looking for deals in good economies and bad. If the sector fades it will be the weaker players who will vanish, leaving only Groupon and a few of the stronger competitors. An improving economy may reduce traffic to the deals, however. Additionally, there are serious questions about the viability of Groupon’s current business model above and beyond the aforementioned issues. Such will be explored further next week.
Respectfully Yours,
Matthew R. Green
February 3, 2011
In the first week of December 2010, one of the major business stories involved Google’s (GOOG) $6 billion offer to purchase Groupon. Founded in 2008, Groupon has expanded at an extraordinary pace to become the largest deal-of-the-day website. Every day, Groupon e-mails subscribers an offer for heavily discounted items or services from a particular merchant in the subscribers’ local market. In the economic climate of the past few years, it has proven to be very popular. To the shock of many, Groupon CEO Andrew Mason turned down GOOG’s offer. Early in January 2011 GOOG announced it is launching a similar service, dubbed Google Offers, while Groupon is planning an IPO. Reports have put the anticipated size of Groupon’s IPO around a staggering $15 billion. The rapidly increasing valuations of websites such as Facebook and LinkedIn, as well as deal-of-the-day websites – reminiscent of the first wave of technology overvaluation – have raised concerns of another tech bubble in the making.
Despite the bad memories elicited by “tech bubble,” websites today such as Groupon are probably not going to be the next crop of high-profile flameouts like Pets.com or Webvan ten years ago. For one, Facebook is already so large that its position could be similar to that of GOOG in 2004, in which it can go public and subsequently use its IPO cash to acquire other companies, increasing its market share and gradually building value for investors. Therefore, the unfolding situation could have characteristics of the tech bubble and successes such as GOOG. Parallels to the past will inevitably exist, but the question is which scenario will be more closely mirrored, and for which startups. Ultimately, a lot of these websites may not be worth as much in a few years as they are today. At the same time, lessons learned from the first tech bust have resulted in today’s websites being in better financial shape as they prepare to go public. This is Part 1 of what will be a 2-issue topic. This week, the focus will be on the present valuations within the sector, and next week the focus will be on what the future may hold and what Groupon in particular will need to do to stay competitive as the sector evolves.
One of the factors in the high valuations within the tech sector is simple supply and demand. Assisted by SecondMarket and other facilitators of private-stock transactions, accredited investors are able to invest in startups such as Facebook and LinkedIn with relative ease. In such transactions, the selling party is often the startup’s employees cashing out their private shares in the company. Since these shares are relatively hard to come by and the market is not as liquid as it would be on an exchange, investors have bid up the prices relatively quickly. However, the valuations may be entering a territory in which legitimate arguments can be made that they are overvalued. SecondMarket’s latest share auction values Facebook at approximately $70 billion. This is half of what GOOG is valued at, despite GOOG having $25 billion in revenue, $10 billion in earnings, and, most importantly, higher operating margins than Facebook. I am not flat-out suggesting that those who have invested in Facebook via private transactions will not make money. It is entirely possible that Facebook’s valuation could surpass $100 billion before its IPO, which is expected to come before 2013. However, the higher the valuation climbs, the more likely it becomes that there could be a rapid exodus as lots of individual investors seek to get out once the lockup on their shares expires.
For those who doubt that this is a possibility, look no further than Yahoo! (YHOO) circa 1999. YHOO was the character of the first tech bubble that was most synonymous with the internet as a whole, not confined to a retail sector like Amazon or EBay. Adjusted for inflation, YHOO’s market cap at the end of 1999 was approaching $150 billion. Today, stripping away YHOO’s tangible book value, the market currently values the company at close to $0. That’s right, net of its cash position and other tangibles, such as investments, the market values YHOO at $0. I am talking about a business that generates $1 billion in cash flow on $5 billion of revenue. Needless to say, a decade later YHOO is no longer the gorgeous new girl on campus. While Facebook, LinkedIn, and Groupon are in great shape right now, if something better comes along, unless these websites evolve accordingly, then they will be on track to become as old as, well, YHOO.
With current valuations high, the time is ripe for these companies to go public. Wall Street is currently gearing up for what will undoubtedly be two of the hottest IPO’s in 2011, Groupon and the just-announced IPO of LinkedIn. While Groupon has not yet filed for an IPO, bankers are aggressively (and smartly) vying for the assignment. Although the valuation may be frothy, bankers know that in order to get the most successful IPO for a client in the rapidly-growing deal-of-the-day sector, now is the time to move forward. Even if the valuations do eventually deflate, Facebook and Groupon are more than likely here to stay and will be major clients for Wall Street in the future, just as YHOO, AMZN, EBAY, etc. were viable businesses that thrived and were active clients for Wall Street throughout the 2000s despite the tech crash early in the decade. Amidst the excitement about the pending IPO, many on Wall Street are concerned that Groupon is overvalued, even more so than Facebook. Concerns about the viability of Groupon’s business model compound these concerns.
To compare the two companies, Facebook has over 600 million users and a scalable business model with very low fixed costs. Most importantly, it is by far the most widely-used social network. Groupon, on the other hand, is finding itself in competition with a plethora of other deal-of-the-day websites. Thanks to the low barriers to entry provided by the internet and an easily replicable business model, many of these new players are undercutting Groupon’s margins to provide better deals for the featured merchants. As is the case with most industries/sectors that proliferate, as new participants enter the market profit margins will become thinner, profits will decline, and eventually revenue will stop growing and perhaps even fall. Additionally, with GOOG launching its own service and Amazon teaming up with DC-based LivingSocial, two large players with deep pockets will increasingly be nipping at Groupon’s heels. While Groupon has indeed achieved tremendous growth in a short amount of time (in fact, in August 2010 Forbes named Groupon the fastest-growing startup in history), to maintain growth it has had to add thousands of local salespeople and has to continue doing so to find new local and national merchants to feature. That is not as scalable of a business model as Facebook and many other websites. Yet, a $15 billion IPO is being planned in the midst of an increasingly saturated market.
Another challenge to Groupon’s valuation is the fact that the business sector led by Groupon is inherently lower-growth than many others on the internet. When GOOG’s offer for Groupon was announced, a few commentators compared it favorably to GOOG’s October 2006 acquisition of YouTube. However, significant differences between Groupon and YouTube would not have made Groupon as good of an acquisition as it may have seemed. A few analysts noted that GOOG bought YouTube for $1.65 billion when the latter’s revenue was a mere $11 million per year. On the surface this makes Groupon seem like a steal, as it is projected to earn somewhere between $1.3 and $1.5 billion in 2011. However, despite the meteoric growth rates of Groupon, it should be noted that YouTube’s customer base is simply any internet user who wants to watch or upload videos. For Groupon’s 40 million online subscribers, the service is very popular and growing. But those people are not the customers. Groupon’s customer base consists of the merchants who utilize it as a loss leader to bring the public into their stores, hopefully stimulating future business and/or purchases of other products at full price. Thus, Groupon’s customer base is inherently more fickle, especially those for whom the deal doesn’t work. Eventually, there will be a core group of merchants in any given local market who will be regular customers of Groupon and other such websites, and the rest won’t use it. That puts a lid on growth for the company in its current form. For YouTube, on the other hand, the user base and revenue-generating ad clicks are constrained only by the overall number of internet users, which is continually growing worldwide. Facebook is the same way, as it is constantly entering new countries around the world. Eventually there will be limits to its growth, but that is further off for Facebook than Groupon.
With a number of copycat websites eroding market share, even if Groupon does remain the sector’s leader, it may not be worth $15 billion in a few years. Although it incorporates the easy distribution and powerful marketing characteristics of social networking, Groupon is neither an all-encompassing hub for the world’s information like GOOG nor is it a social network like Facebook. It is more akin to a discount service provider while borrowing a few characteristics of a social network. Businesses in the discount service sector are typically not worth $15 billion. For example, Overstock.com has $1.2 billion of revenue and is valued at about $370 million. Just five years ago, that valuation was nearly $2 billion. In the brick-and-mortar discount retail sector, Dollar General has $14 billion of revenue and is valued at approximately $10 billion. Currently, a large part of Groupon’s valuation derives from, like GOOG and Facebook before, the prospects of exponential growth. However, the valuations of businesses like Overstock.com and Dollar General that are more similar to Groupon may give a better indication of what its true valuation should be, especially if Groupon’s growth prospects are increasingly limited.
Despite the increasing valuations for tech startups, this is not simply a repeat of the first tech bubble. If this were the late 1990s, Facebook, Groupon, LinkedIn, etc. likely would have gone public several years ago. After the successful Netscape IPO in August 1995, historically pointed to as the beginning of the tech bubble, tech startups were increasingly geared toward fast-track IPOs. Entrepreneurs, venture capitalists, and bankers alike all contributed to this against the backdrop of the soaring NASDAQ, which helped to mask the fact that not all of these startups could possibly be successful. YHOO was founded by Jerry Yang and David Filo in 1994 and went public two years later. Similarly, Jeff Bezos founded AMZN in 1994 and it went public in the spring of 1997. Yet, many others were taken public with little to no earnings of which to speak. Still others burnt through their venture capital even before going public. This isn’t the case today with Groupon, LinkedIn and Facebook. They are highly profitable and growing. Yet despite an improving IPO climate since 2008, they are waiting for the right moment to go public. Groupon would be the exception in this case, as it is two years old. Facebook and LinkedIn are seven and eight years old, respectively. Even GOOG did not go public until it was nearly six years old, in 2004. So there is definitely a prudence that may have been lacking in the late 1990s when the internet sector temporarily seemed to be invincible. Yet, a better managed process of growth doesn’t mean that these startups aren’t overvalued at present and could still be when they go public.
The verdict about whether these soon-to-be-public startups are overvalued is still out. While my opinion leans toward yes, it should be noted that in the case of Groupon there have been several well-respected parties, Google and Goldman Sachs among them, who have taken a peek at the numbers and clearly didn’t pick those $6 billion and $15 billion respective valuations out of a hat. Obviously, the valuations take into consideration the company’s rapid growth and potential to do so in the future. Thus, two main questions need to be answered to more accurately gauge the sector’s prospects.
First, will the deal-of-the-day sector become so crowded that it will become significantly harder for Groupon to compete in the future? The sector is evolving as quickly as it is growing (indeed, one of the main reasons an IPO would be helpful to Groupon is so it can have cash to evolve via acquisitions). The robust activity within the sector in December was furthered by Amazon’s $175 million investment into LivingSocial, the second-largest deal-of-the-day website. LivingSocial’s deal with Amazon has enabled it to quickly diversify its offerings beyond its subscribers’ local markets and perhaps represents a more intelligent route toward growth. Not surprisingly, Groupon is increasingly offering national retail deals as well.
Second, deal-of-the-day websites could prove to be a fad that fades away because the economy improves or because consumers/merchants tire of the concept. Will Groupon still be worth $15 billion in that case? Most likely not. However, as stated before Groupon is not going away. After all, consumers are always looking for deals in good economies and bad. If the sector fades it will be the weaker players who will vanish, leaving only Groupon and a few of the stronger competitors. An improving economy may reduce traffic to the deals, however. Additionally, there are serious questions about the viability of Groupon’s current business model above and beyond the aforementioned issues. Such will be explored further next week.
Respectfully Yours,
Matthew R. Green
February 3, 2011
Monday, January 10, 2011
Issue XXII - Lost Decade
Dear Readers,
As the economic recovery drags on at a turtle-pace, several commentators have begun to make the inevitable predictions of a “lost decade.” This description is often thrown about when discussing Japan during the 1990s – although as Japan’s malaise continued into the 2000s, “lost era” is perhaps a more accurate description. Before this description is applied to the US, it is helpful to look first at whether the performance of the US economy over the past decade truly mirrors that of Japan. Moreover, what should be the metrics by which developed economies are measured against each other? By these measures, does the Japanese experience of the 2000s even qualify as a “lost decade?”
In the United States, the economic history of the 2000s began with the bursting of the technology bubble that, combined with September 11, created a circumstance about which former Federal Reserve Chairman Alan Greenspan said “historically can result in the undoing of a society.” In response, the Fed quickly initiated a series of aggressive interest rate cuts. Other central banks around the world followed suit in order to prevent, as several central banks directly stated at one point or another, a prolonged period of Japanese-style stagnation. Most economists, all the way up to Greenspan himself, did not anticipate the extent to which these interest rate cuts would inflate bubbles in the housing and credit markets.
After the housing collapse and subsequent credit crisis in 2007-08, central banks once again acted quickly to ease monetary policy and prevent a prolonged period of low growth. In addition to cutting rates to zero, the Federal Reserve initiated a program of quantitative easing in March 2009 and expanded the program by $600 Billion in early November 2010. One of the reasons given in defending this practice was to expedite the current recovery to the point that it becomes self-sustaining. This would prevent a double-dip recession that could, in turn, lead to a repeat of the Japanese experience.
As often as one may hear that the Fed is trying to prevent a “Japanese experience,” it is helpful to establish whether Japan truly underperformed given its circumstances. Since 1990, the Japanese economy has faced a real estate collapse and subsequent banking crisis more damaging than the recent US recession, battled deflation, and dealt with unfavorable demographics. While the banking problems are largely behind it, deflation and an aging population have continued to linger. Through that, Japanese GDP growth averaged 0.6% over the past decade according to the World Bank.
In general, the rationales behind much of the economic policymaking since at least the 19th century have been dominated by “lessons learned” that are drawn from throughout the course of economic history. However, it is debatable whether the example of Japan is an economic scenario that should be avoided entirely. Daniel Gros, Director of the Centre for European Policy Studies, stated recently that “the basis for the scare story about Japan is that its GDP has grown over the last decade at an average annual rate of only 0.6% compared to 1.7% for the US. The difference is actually much smaller than often assumed, but at first sight a growth rate of 0.6% qualifies as a lost decade.”
If that is the case, GDP growth in much of the Eurozone might also fit the popular definition of a lost decade. According to the World Bank, in the 2000s Germany experienced nearly the same growth rates as Japan (0.6%) and Italy was even worse (0.2%). France and Spain performed somewhat better, but the Eurozone as a whole was not much better off. With sovereign debt problems now engulfing the continent over the past year, growth rates for the 2010s will likely not be much better.
Nonetheless, while this may look like economic stagnation on the surface, it elicits the often-asked question of how to properly measure the economic performance of developed countries against one another. The answer lies in the economic trajectory of countries that industrialize, as emerging markets transition into developed countries. The development of industry brings hundreds of millions of people from the countryside into the cities, fueling a rising industrial sector. All of a sudden, a former farmer or migrant might be a factory worker, contributing a bigger, and more easily measured, piece of a national GDP. This happens to millions of workers who are within the “working-age population” (WAP), those who are not too old or too young. Therefore, a more accurate measurement of the economic performance of developed countries might be GDP per member of the WAP as opposed to the widely-accepted GDP per capita. With regard to Japan, this is important because of demographics.
In Japan, that 0.6% average GDP growth was achieved despite a contracting WAP. This number is shrinking rapidly as the Japanese population declines, as birthrates have fallen since the 1980s and Japanese couples have chosen to have children later in life - and have had less of them (the same trends that are currently taking place in the US). When charted, the Japanese population is taking the shape of an inverse pyramid, with the greatest percentage of its population over 60 years old. Consequently, Japan actually performed better than the US and most European countries during the 2000s based on GDP per WAP (GDP/WAP). Indeed, these demographic differences are relevant to comparing the US not only to Japan but to the developed economies of the Eurozone as well. By the GDP/WAP figure, many European nations, especially those with shrinking populations, have also done better than the US.
As mentioned, the difference between Japan and the US over the past decade was about one percentage point in favor of the US on an annual basis, but in terms of working-age population growth rates, the difference was about 1.5% annually. This is because the US’s WAP increased by 0.8% on an annualized basis (though not necessarily the workforce, if one considers illegal immigrants and such). In Japan, this same figure contracted by 0.8% annually over the past decade. Additionally, another reason the “lost decade” has been expanded to include the 2000s is that Japanese unemployment has remained more or less constant over the past decade. It has held around 4-5% even after the late 2000s recession. Compare that to the US, which approached 10% in 2010, although it fell slightly based on data released last week. Therefore, despite a stagnant unemployment rate and falling WAP, Japan managed to eke out growth. The point is not that the Japanese model is one to be emulated, but the fact that it has managed to grow in such an economic environment should be looked at by the Federal Reserve and corporate leaders who seek to squeeze out growth from an environment of deleveraging, increasingly unfavorable demographics, and stagnation.
What does this mean for the next decade? The use of GDP/WAP as presented here suggests that it can be used to predict the growth rates of the G-7 and other developed countries based on the growth/contraction patterns of their WAP. These can be predicted for at least two decades onward, as WAP consists of a country’s population aged 20-60, so the future workforce that will enter at age 20 has already been born. In the case of a few nations, particularly the US and the UK, immigration trends should be factored in, but obviously this cannot be predicted as accurately as the number of new births. Based on these facts, Japan will continue to fade as a major economic power, especially within Asia due to the rise of China. Nearly all of the Eurozone members are showing similar trends to Japan, albeit at an earlier stage. The WAPs of Germany and Italy are already in decline, and they and the rest of the Eurozone will have similar growth rates over the next decade. In the case of Germany, the decline will be even faster than Japan beginning shortly after 2015. In contrast, the US, UK, and France are likely to grow faster because the WAPs of all three are continuing to grow, even if it is at a slower pace than in previous generations.
There are two main takeaways from this confluence of demographics on economic growth. First, the popular notion of a Japanese-style “lost decade” may be misleading even if applied to its nation of origin. The slow growth in Japan was not entirely due to what one commentator described as “insufficiently aggressive macroeconomic policies.” Since Japan’s banking crisis in the 1990s, the stagnation has arguably been more demographically-caused. While these demographic trends have played a big role in Japan’s difficulties over the last two decades, the US will not be confronted with the same degree of difficulty in that respect due to an increasing WAP. Second, a decline in the growth rates of many developed countries appears to be unavoidable, particularly in the Eurozone, as the WAPs decline. Even in the western countries that are still in good shape in this respect (US, UK, France), population growth rates are declining. Within Europe, even some of the countries that are viewed as healthier because they have not experienced the debt problems that swept the continent in 2010 will eventually succumb to this, Germany in particular. For countries such as Italy, which have existing debt problems and an already-declining population, the outlook is even worse, with stagnation perhaps being a best-case scenario. Add in the inevitable austerity measures and budget cuts that will need to take place, and stagnation begins to look optimistic. In either case, it is going to be an interesting decade as governments throughout the western world will need to come to grips with these trends.
Respectfully Yours,
Matthew R. Green
January 10, 2011
As the economic recovery drags on at a turtle-pace, several commentators have begun to make the inevitable predictions of a “lost decade.” This description is often thrown about when discussing Japan during the 1990s – although as Japan’s malaise continued into the 2000s, “lost era” is perhaps a more accurate description. Before this description is applied to the US, it is helpful to look first at whether the performance of the US economy over the past decade truly mirrors that of Japan. Moreover, what should be the metrics by which developed economies are measured against each other? By these measures, does the Japanese experience of the 2000s even qualify as a “lost decade?”
In the United States, the economic history of the 2000s began with the bursting of the technology bubble that, combined with September 11, created a circumstance about which former Federal Reserve Chairman Alan Greenspan said “historically can result in the undoing of a society.” In response, the Fed quickly initiated a series of aggressive interest rate cuts. Other central banks around the world followed suit in order to prevent, as several central banks directly stated at one point or another, a prolonged period of Japanese-style stagnation. Most economists, all the way up to Greenspan himself, did not anticipate the extent to which these interest rate cuts would inflate bubbles in the housing and credit markets.
After the housing collapse and subsequent credit crisis in 2007-08, central banks once again acted quickly to ease monetary policy and prevent a prolonged period of low growth. In addition to cutting rates to zero, the Federal Reserve initiated a program of quantitative easing in March 2009 and expanded the program by $600 Billion in early November 2010. One of the reasons given in defending this practice was to expedite the current recovery to the point that it becomes self-sustaining. This would prevent a double-dip recession that could, in turn, lead to a repeat of the Japanese experience.
As often as one may hear that the Fed is trying to prevent a “Japanese experience,” it is helpful to establish whether Japan truly underperformed given its circumstances. Since 1990, the Japanese economy has faced a real estate collapse and subsequent banking crisis more damaging than the recent US recession, battled deflation, and dealt with unfavorable demographics. While the banking problems are largely behind it, deflation and an aging population have continued to linger. Through that, Japanese GDP growth averaged 0.6% over the past decade according to the World Bank.
In general, the rationales behind much of the economic policymaking since at least the 19th century have been dominated by “lessons learned” that are drawn from throughout the course of economic history. However, it is debatable whether the example of Japan is an economic scenario that should be avoided entirely. Daniel Gros, Director of the Centre for European Policy Studies, stated recently that “the basis for the scare story about Japan is that its GDP has grown over the last decade at an average annual rate of only 0.6% compared to 1.7% for the US. The difference is actually much smaller than often assumed, but at first sight a growth rate of 0.6% qualifies as a lost decade.”
If that is the case, GDP growth in much of the Eurozone might also fit the popular definition of a lost decade. According to the World Bank, in the 2000s Germany experienced nearly the same growth rates as Japan (0.6%) and Italy was even worse (0.2%). France and Spain performed somewhat better, but the Eurozone as a whole was not much better off. With sovereign debt problems now engulfing the continent over the past year, growth rates for the 2010s will likely not be much better.
Nonetheless, while this may look like economic stagnation on the surface, it elicits the often-asked question of how to properly measure the economic performance of developed countries against one another. The answer lies in the economic trajectory of countries that industrialize, as emerging markets transition into developed countries. The development of industry brings hundreds of millions of people from the countryside into the cities, fueling a rising industrial sector. All of a sudden, a former farmer or migrant might be a factory worker, contributing a bigger, and more easily measured, piece of a national GDP. This happens to millions of workers who are within the “working-age population” (WAP), those who are not too old or too young. Therefore, a more accurate measurement of the economic performance of developed countries might be GDP per member of the WAP as opposed to the widely-accepted GDP per capita. With regard to Japan, this is important because of demographics.
In Japan, that 0.6% average GDP growth was achieved despite a contracting WAP. This number is shrinking rapidly as the Japanese population declines, as birthrates have fallen since the 1980s and Japanese couples have chosen to have children later in life - and have had less of them (the same trends that are currently taking place in the US). When charted, the Japanese population is taking the shape of an inverse pyramid, with the greatest percentage of its population over 60 years old. Consequently, Japan actually performed better than the US and most European countries during the 2000s based on GDP per WAP (GDP/WAP). Indeed, these demographic differences are relevant to comparing the US not only to Japan but to the developed economies of the Eurozone as well. By the GDP/WAP figure, many European nations, especially those with shrinking populations, have also done better than the US.
As mentioned, the difference between Japan and the US over the past decade was about one percentage point in favor of the US on an annual basis, but in terms of working-age population growth rates, the difference was about 1.5% annually. This is because the US’s WAP increased by 0.8% on an annualized basis (though not necessarily the workforce, if one considers illegal immigrants and such). In Japan, this same figure contracted by 0.8% annually over the past decade. Additionally, another reason the “lost decade” has been expanded to include the 2000s is that Japanese unemployment has remained more or less constant over the past decade. It has held around 4-5% even after the late 2000s recession. Compare that to the US, which approached 10% in 2010, although it fell slightly based on data released last week. Therefore, despite a stagnant unemployment rate and falling WAP, Japan managed to eke out growth. The point is not that the Japanese model is one to be emulated, but the fact that it has managed to grow in such an economic environment should be looked at by the Federal Reserve and corporate leaders who seek to squeeze out growth from an environment of deleveraging, increasingly unfavorable demographics, and stagnation.
What does this mean for the next decade? The use of GDP/WAP as presented here suggests that it can be used to predict the growth rates of the G-7 and other developed countries based on the growth/contraction patterns of their WAP. These can be predicted for at least two decades onward, as WAP consists of a country’s population aged 20-60, so the future workforce that will enter at age 20 has already been born. In the case of a few nations, particularly the US and the UK, immigration trends should be factored in, but obviously this cannot be predicted as accurately as the number of new births. Based on these facts, Japan will continue to fade as a major economic power, especially within Asia due to the rise of China. Nearly all of the Eurozone members are showing similar trends to Japan, albeit at an earlier stage. The WAPs of Germany and Italy are already in decline, and they and the rest of the Eurozone will have similar growth rates over the next decade. In the case of Germany, the decline will be even faster than Japan beginning shortly after 2015. In contrast, the US, UK, and France are likely to grow faster because the WAPs of all three are continuing to grow, even if it is at a slower pace than in previous generations.
There are two main takeaways from this confluence of demographics on economic growth. First, the popular notion of a Japanese-style “lost decade” may be misleading even if applied to its nation of origin. The slow growth in Japan was not entirely due to what one commentator described as “insufficiently aggressive macroeconomic policies.” Since Japan’s banking crisis in the 1990s, the stagnation has arguably been more demographically-caused. While these demographic trends have played a big role in Japan’s difficulties over the last two decades, the US will not be confronted with the same degree of difficulty in that respect due to an increasing WAP. Second, a decline in the growth rates of many developed countries appears to be unavoidable, particularly in the Eurozone, as the WAPs decline. Even in the western countries that are still in good shape in this respect (US, UK, France), population growth rates are declining. Within Europe, even some of the countries that are viewed as healthier because they have not experienced the debt problems that swept the continent in 2010 will eventually succumb to this, Germany in particular. For countries such as Italy, which have existing debt problems and an already-declining population, the outlook is even worse, with stagnation perhaps being a best-case scenario. Add in the inevitable austerity measures and budget cuts that will need to take place, and stagnation begins to look optimistic. In either case, it is going to be an interesting decade as governments throughout the western world will need to come to grips with these trends.
Respectfully Yours,
Matthew R. Green
January 10, 2011
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