A case for bitcoin

Mavrodi "biletov"

In this post I'm going to outline a case for bitcoin. I still think bitcoin is a bad medium of exchange and a rubbish store of value. It's just too volatile and unhinged, and it'll always be that way. But bitcoin still has an important role to play... just not the role that most people assume.

Sara Hess and Eugene Soltas recently published a fascinating article on the life of Russian ponzi-scheme architect Sergei Mavrodi, who passed away last month. I found it interesting that in the latter part of his career, Mavrodi openly advertised that his schemes were pyramids, yet people still bought in.

Ponzi-schemer Sergei Mavrodi clearly advertised MMM's risks and promised nothing in return, yet still people bought in. If he didn't trick people into joining, maybe society genuinely needed him to manage ponzis? https://t.co/5RAzDFvTgx pic.twitter.com/pUghQJQB00

— JP Koning (@jp_koning) April 26, 2018

This got me thinking. I've always sort of assumed that ponzi schemers were just con men who fooled innocent people into giving up there money. But even after Mavrodi lifted his skirt and told the truth, people still flocked to join his schemes. Maybe there is a constant demand on the part of willing and informed individuals for ponzis. Which would mean that folks like Mavrodi aren't just conmen. Rather, society genuinely needs them to manage ponzi games.

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We already knew that anyways, you might say. After all, Las Vegas exists, right?

The role that lottery and casinos operators play is certainly similar to that played by ponzi schemers. People take joy in gambling, and lottery operators and croupiers make sure these games run smoothly. Ponzis, lotteries, and poker are all versions of a zero sum game. If you win $10, it's only because someone else who was playing the game lost $10. Zero sum games are different from win-win games, say like stocks, bonds, and other liabilities including banknotes. Someone doesn't have to lose $10 on Google shares for you to be able to make $10 on Google. The underlying business generates income from its customer base and this provides each and every shareholder with a return.

What differentiates one type of zero-sum game from another is the rule used for redistributing money from losers to winners. Ponzis and pyramids are early-bird zero sum games: the jackpot goes to the earliest entrants and is funded by money provided by the latest entrants. A lottery, on the other hand, awards a randomly chosen participant with everyone else's money. Being the last buyer of a lottery ticket provides one with the same odds of winning the jackpot as the first buyer.

The coexistence of different types of zero sum games indicates that while the public has an ongoing demand for the chance to win jackpots, it also values the way those jackpots are rewarded. Perhaps a ponzi provide a different set of psychic returns than other zero sum games; getting in line early and looking back at all the late comers may offer a sense of satisfaction that a lottery can't provide.

Society has typically legalized lotteries while criminalizing ponzis and pyramids, although in Mavrodi's case there was some ambiguity since he cheekily advertised them as ponzis rather than trying to deceive the public. Luckily for authorities, ponzis and pyramids are easy targets. They have central points of failure. An administrator needs to collect money from new entrants and then pay it out to older entrants. So there is a physical entity with an address that can be sued by unhappy participants or pursued by the authorities.

Because they are illegal, ponzis have been driven underground. Unfortunately, the delegitimization of markets can have perverse effects. For instance, street drugs are often mixed with dangerous contaminants, say like how heroin is laced with carfentanil, an elephant tranquilizer. If the drug market were brought into the open, it could be that producers would be pressured by market forces to provide a purer product and fewer users would die from accidental overdoses.

The same argument applies to ponzis. Those who play them have to rely on fly-by-night operators who may abscond with the funds at any moment, the ponzi collapsing before reaching its natural end. If ponzis were legitimized, it would be much easier to have a transparent and well-run ponzi market.

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Like ponzis and pyramids, a chain letter is an early-bird game, a type of zero-sum game that use entrance order as its redistribution rule. And like ponzis and pyramids, they are illegal. The Circle of Gold chain letter that began in San Francisco in 1978 and spread to the rest of the U.S. through 1979 and 1980 is a good example of the genre.

In brief, I buy an existing copy of the letter from you for $50, and simultaneously mail $50 to the name at the top of the list, for a total outlay of $100. I then make two copies (removing the name at the top of the list an inserting my own at the bottom) and sell them for $50 each, for a total of $100, thus breaking even. By selling the letters directly rather than sending them via the mail, presumably I avoid mail fraud. The buyers in turn make copies and sell them on, the chain continuing. Once my name starts arriving at the top of the list the money will pour in. The letter exhorts recipients not to break the chain.

HODL is similar to the "DO NOT BREAK THE CHAIN" exhortations commonly found on chain letters. They're not wrong—if the chain holds, the money keeps flowing! https://t.co/Ha0qaJGWsC pic.twitter.com/xcgpW1OV25

— JP Koning (@jp_koning) December 22, 2017

Whereas a ponzi relies on a central node—or operator—for managing the game's flow of funds, a chain letter decentralizes the role of operating the system. Any participant who has bought a copy of the letter is delegated the job of faithfully modifying their version of the ledger (by removing the name at the top and inserting theirs at the bottom), sending the $50 by mail, and then passing the updated ledger on. Lacking attackable central nodes, chain letters are more difficult for the authorities to shut down than ponzis.

There are still a few key flaws with a chain letter. The first is that everyone who joins the chain letter needs to leave their physical address. And so it is possible for the authorities to target participants by getting a copy of the chain letter, visiting their home, and shutting it down that way. To avoid this risk, many would-be ponzi players will probably choose not to play.

The second flaw is that chain letters are not secure. Each participant has an incentive to mis-copy the list and put themselves at the top, thus cutting into the queue. This lack of credibility hurts the chain letter's ability to propagate.

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All of which gets me back to bitcoin.  Bitcoin is not a win-win game. It is a zero-sum game that uses entrance order as its redistribution rule, or an early bird game like a ponzi, pyramid, or chain letter. The only way to get ahead is if a subsequent participant buys one's bitcoins at a higher price.

But bitcoin brings a few unique features to the table. To begin with, Bitcoin is decentralized. Rather than a lone administrator like Sergei Mavrodi handling the scheme, the ledger is maintained by a disparate set of nodes. This makes bitcoin much harder to shut down than a ponzi.

Chain letters are also decentralized, but Bitcoin doesn't inherit the weaknesses of a chain letter. Although there are many different copies of the bitcoin ledger, these copies are constantly being checked against each other to ensure that they are all in sync. This means that—unlike a chain letter—there is no way to budge in line, say by re-writing the bitcoin ledger in one's favour. And this improves the durability of bitcoin.

Before I bring this all together and make my case for bitcoin, there is one other early bird game I haven't got into yet: the speculative bubble.

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Unlike chain letters, ponzis, and bitcoin, which are pure early bird games, bubbles occurs on the back of an already useful asset, say like a stock or commodity. During the late 1990s internet mania, for instance, the return on an internet stock could be decomposed into two components: a fundamental component and a zero-sum game that was being played on top of the stock's fundamental value. Those playing a zero sum game by purchasing internet stocks didn't give a damn whether the underlying internet business made sense. No, they were betting that a late-comer would arrive to take the stock off their hands at a much higher price.

To a fundamental investors (say like Warren Buffett), zero-sum game players are a nuisance. The zero sum game that they are playing adds a wasteful premium to stocks, pricing fundamental investors out of the market. At the same time, zero sum game players are probably just as annoyed by the fundamental component of the asset they are buying and selling. Its presence dampens the jackpot that they stand to win.

Prices provide useful signals to society. A zero-sum game that runs on top of an intrinsically valuable asset like a stock or a commodity distorts that signal. This can lead to wasted resources. Producers who decide to add capacity—say a new production plant—in response to a commodity's high price may only be reacting to the transitory mood changes of those playing that commodity's attached zero-sum game, and not a fundamental need for new supply.

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So having said all that, let me finally make my case for bitcoin. Bitcoin shouldn't be categorized along with monetary instruments like bank deposits, coins, and banknotes. Nor does it belong in the same category as win-win games like the stock and bond market. No, bitcoin should be grouped with other zero-sum games such ponzis, pyramids, speculative bubbles, and chain letters.

But this isn't necessarily a bad thing. It should be embraced.

City planners build bike lanes in order to prevent the dangerous mixing of cars and bikes. Likewise, if people who are playing zero-sum games on top of regular stocks and commodities can be diverted into bitcoin (and other pure early bird games like ponzis) instead, maybe that would make for a more ordered financial system. Early-bird games that are played on top of useful assets taint their price, and thus play havoc with the signal this price provides. But bitcoins, ponzis, and chain letters have no use as commodities, so there is no underlying real good that can be contaminated by the presence of zero-sum game players.

When criminalization drives ponzis underground, the supply of trustworthy ponzis shrinks and the supply of untrustworthy ones increases. Bitcoin has a role to play here. It is an open system. The set of rules that governs it are automatic and available for all to see, unlike the closed books of a ponzi administrator. There is no way for the system operator to abscond with everyone's funds. So bitcoin is a safer zero-sum game than an illegal ponzi. If people have a genuine need to play zero-sum games, shouldn't they at least be able to play a good one?

Is bitcoin expensive? Sure. Lots of electricity is required to ensure the integrity of bitcoin. But if bitcoin has managed to displace a bunch of poorly-run underground ponzis and pyramids, as well as reducing the signal-destroying participation of zero-sum game players in traditional financial markets, maybe the expense was worth it.

A market for corporate votes

Berkshire Hathaway annual general meeting

When you purchase a share you're not only getting the opportunity to make some extra cash. You're also buying a vote. Put differently, a share offers two different features: a) a claim on earnings and b) the right to exercise partial control over the corporation.*

Why not separate the two features and put each of them up for sale? Let's have one market for corporate votes, and a separate one for corporate returns.

Here's how it would work. Imagine you want to buy some Microsoft shares but don't care to participate in the governance of Microsoft. The quoted price on the market, $44.93, is for a whole share of Microsoft, both its attached voting rights and its capitalized return. So you buy 500 whole shares for $27,465.

Next you turn to the parallel public voting market. Microsoft votes are trading for around 25 cents each, say. You 'detach' each of the 500 votes from the shares you've just bought and sell those votes for 25 cents each in the voting market for a combined $125. Not a bad day's work. In selling the votes that you never wanted anyways you've defrayed your initial purchase cost.

A few years later you decide to get out of Microsoft. One way is to find a set of buyers who, like yourself, don't care to vote, and sell the voteless shares directly to them. Alternatively you can repurchase the 500 votes in the voting market, reattach them to the shares, and sell them in the whole share market.

Here's another hypothetical: imagine that you have 500 shares of Microsoft but feel that it's your destiny to have a much more active role in Microsoft governance than your 500 votes would otherwise provide. Say you'd like ten times the votes, or 5,000 votes. To amass that quantity of votes it would normally cost you the price of 4,500 additional shares at $44.93 each, or about $207,000, but that's far out of your league. That's where the market for Microsoft votes comes in. For a mere $1125 you can pick up 4,500 detached votes, assuming they trade at 25 cents each. Without having stumped up too much capital, you've become a much more formidable shareholder activist.

So why have a market for corporate votes?

According to Broadridge, some 70% of retail shares go unvoted. Participation rates are better on the institutional front where some 90% of institutionally-owned shares are voted, but this is due to a legally-mandated fiduciary responsibility to vote. The responsibility for voting these shares is usually outsourced to a proxy advisory company like ISS which, according to one account, advised on over 50% of corporate votes cast in the world. ISS's success is due in part to the fact that institutional shareholders have scarce resources, most of which are ready allocated to searching for new investments and monitoring existing ones. They can't spare the cost of setting up expertise in corporate governance.

So to a large proportion of retail and institutional investors, votes represent little more than a nuisance. In order to play the stock market game, these investors hold their noses and pony up enough cash to buy a share and its combined vote; but they'd really be quite happy if they didn't have to buy the latter, especially if it meant reducing their overall costs.

If those who view votes as a nuisance comprise the sell side of the corporate vote market, then the buy side would be comprised of a cadre of institutional investors who specialize in corporate governance and shareholder activism. Activist investors, say someone like Bill Ackman, have developed expertise and a set of practices that allow them to efficiently put votes to work, instituting change in a company's structure or management in order to make it more profitable. They place a much higher marginal value on the votes attached to shares than the majority of their not-so-active colleagues.

A market in corporate shares would allow both the apathetic and the active to meet, with the final result being a more efficient allocation of returns and voting rights.

What I'm proposing may sound a bit sci fi, but what if I told you that such a thing already exists?

The fact is that we already have an informal market of sorts in corporate votes. In Canada, for instance, firms often issue both non-voting, voting shares, and multiple voting shares. In the U.S. the practice is less common, one example being Google which has issued 'A' shares with one vote apiece; 'B' shares with ten votes each; and 'C' shares with no votes. Or consider Warren Buffet's Berkshire Hathaway. An owner of $10,000 worth of Berkshire Class B shares has 0.15% of the votes that an owner of $10,000 worth of Class A shares has.

When companies have dual share structures, to buy votes, an investor need only short the non-voting shares in order to fund a long position in the voting class. And to sell votes, do the opposite. The cost one would incur on this transaction indicates the dollar value the market places on the right to vote.** Canadian readers may well remember that Mason Capital engaged in this strategy with Telus shares back in 2012 when it purchased Telus voting shares and shorted its non-voting shares.

But there's a more interesting way to get one's hands on extra votes. Start by borrowing whole shares just prior to a vote, much like a short seller borrows shares prior to selling them short. Rather than selling the borrowed shares, however, an activist holds them in order to exercise their voting rights, then returns the shares soon after the vote to the lender. The cost they'll pay on this round trip represents the price of a vote. From the perspective of the the owner who has lent the shares out, they require a high enough fee in order to compensate them for having foregone their franchise over the interim.

For instance, in 2002, Laxey Partners, a hedge fund, held about 1% of the shares of British Land, a major U.K. property company. However, on the day of British Land's shareholder meeting Laxey controlled 9% of the votes, note Hu and Black, all the better to support a proposal to dismember British Land. Just before the record date, Laxey had borrowed 8% of British Land's shares.

The term used for having more votes than shares is empty voting. Someone with 5,000 votes and only 500 shares is in possession of 4,500 empty votes, since those 4,500 votes have been 'emptied' of their economic interest. Empty voting is welfare-improving when an activist investor with a good plan acquires votes beyond his or her economic interest in order to ensure that their plan is adopted. However, at the extreme, empty voting can get downright spooky.  Consider a fund that has amassed short position in a stock (ie. it expects the shares to fall in value) while building a long position in votes. Perversely, this 'rogue' fund could very well use their franchise to implement changes that hurt the firm, not help it, and thereby bolster their short position.

Hu and Black, who refer to the decoupling of votes and economic interest as "the new vote buying", note that vote transactions are often hidden from the public and regulators. All the more reason to have a formal market for votes as described at the start of this post rather than the terribly confusing one that already exists. A transparent price for voting would help reveal rogue attempts to corral large empty voting positions. Those activists who truly want to create shareholder friendly changes would be able to accurately price out the cost of resisting the rogues.

And all those investors who are too unsophisticated to understand the murky world of stock lending, ie. retail investors, would be able to use widely-disseminated prices to better gauge the value of their vote and access an open market for the transferral of those votes.

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* A share also offers a third feature, a liquidity return. I've pointed this out many times before. For the sake of this post, we'll ignore the liquidity portion.
** Strictly speaking, if the non-voting shares you short also happen to be less liquid than the voting shares you are long, then you are not only buying votes, you're also buying liquidity. But as I pointed out in the above bullet point, I'm ignoring liquidity returns for the sake of simplicity.
*** I have an ulterior motive for a market for corporate votes. I think the phenomenon of naked shorting doesn't deserve the vilification it receives in the press and on blogs. In fact, naked shorting is a necessary part of ensuring that liquidity premia on equities are kept at market clearing prices. The proper functioning of what I've referred to as the 'moneyness market' depends on naked shorting. The problem with a naked short is that the resulting synthetic security that the short seller creates doesn't have a vote. It is a non-standard instrument. With the existence of a corporate vote market, a naked short seller might re-standardize the instrument by purchasing a vote and attaching it to the IOU that they've created via their naked short. I do plan on writing about this next month, so if you didn't understand my point, just wait. 

Links:
Hu & Black, 2006. The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership
Aggarwal, Saffi, & Sturgess, 2010. Does Proxy Voting Affect the Supply and/or Demand for Securities Lending
Financial Post, November 2012. Empty Voting Clouds Shareholder Rights Law
Black, 2012. Equity Decoupling and Empty Voting: The Telus Zero-Premium Share Swap
Brav & Mathews, 2011. Empty voting and the efficiency of corporate governance

If your favorite holding period is forever...

[This is a continuation of my post on liquidity adjusted equity valuation.]

If your favorite holding period is forever, then today's stock markets just aren't meant for you.

As I pointed out in my previous post on stocks and liquidity, stocks can do more money-ish and cashlike things than in times past. For most people, the ability of stock (or any other good or asset) to be easily-exchanged is desirable since it ensures that come some unforeseen event, that stock can quickly be swapped for more suitable items. We can think of easily-exchangeable stock as insurance against uncertainty. Investors estimate the stream of 'expected comfort' or 'uncertainty alleviation' that a stock's degree of exchangeability will provide, discount these streams into the present, and arrive at some value for the liquidity return provided by a stock. The more moneylike or liquid a stock, the higher its liquidity return.

A stock's liquidity return makes up but one bit of a stock's total expected return. The other bit is the risk-adjusted real return, or the stream of dividends and price appreciation that a stock provides. When an investor buys a stock, they're getting a 2-in-1 deal. They're buying a real return and a liquidity return. The all-in price paid for a stock is a sum of the prices investors put on the value of these two different return streams.

It's for this reason that modern stocks are not an ideal investment for value investors, the species of investor whose favorite holding period is forever. While most people appreciate the 2-in-1 deal provided by equities, the ability to easily resell a stock is pretty much worthless to a value investor.  In order to enjoy a stock's real return stream (dividends plus price appreciation), a value investor must endure having that stock's liquidity return, which to them isn't worth a dime, forced down their throat.

Here's an analogy. Imagine that you're shopping around for a bare bones car. Unfortunately, the only models available have leather upholstery, oak trim, and a rear seat champagne cooler. Either you pay up for what you see as useless options or you walk away from the lot without a car. This is the same world that Warren Buffet type value investors face every day. Like it or not, they've got to buy stock with all the bells and whistles, even though they put zero value on these extras.

In the real world, a car dealer will let our car buyer strip out the oak trim, the champagne cooler, and the rest of the options they don't need until they arrive at a pared down car package that suits their needs and falls within their budget. Why not do the same in the stock market? Why not allow Buffet-style value investors to strip out the liquidity return of a stock so that they can own a pure real stream of returns?

The way to do this is to establish 'moneyness markets' for equities. In moneyness markets, the liquidity return of a stock is severed from the stock's real return and put up for auction. A value investor would be able to simultaneously buy a stock, sell off the stock's moneyness, or the right to enjoy that stock's liquidity, and be left holding a perpetually non-tradeable chunk of equity.

In doing so our investor has now effectively committed herself to an indefinite holding period. She will continue to earn dividends and enjoy price appreciation (or not), but she has limited her exits to either a cash takeover, the unwinding of the company, or a repurchase and cancellation of shares by company management. Gone is the traditional avenue for exit, the secondary markets.

In constricting her exits, our value investor is no worse off than before since her preferred holding time, moneyness market or not, was always forever. Indeed, moneyness markets have allowed her to improve her position. She has achieved the same final allocation that she would have without such markets, a perpetual long position in a stock, but she has succeeded in reducing the purchase price of her stock by auctioning off an option on which she placed no value whatsoever.

Let's say our value investor has a change of mind. Perhaps the circumstances surrounding a company in her portfolio have worsened and she no longer considers its shares worthy of an eternal holding period. Or maybe her personal situation is less stable and she wants to improve her ability to sell out should some unforeseen event occur. To return to a more liquid state our value investor would have to wade back into the moneyness market and repurchase the option to sell her stock. Put differently, she'd have to pay a fee to recapture her stock's old liquidity return.

How much would she pay to have these restrictions lifted? To restore her ability to freely trade in shares she'd have to pay others an amount sufficient to compensate them for being indefinitely deprived of that very same ability. This is the moneyness market.

This stock market story could be an allegory for all markets. Anyone with an indefinite holding period will usually overpay for things because most active markets are 2-in-1 markets. The asset being sold provides a real return and a liquidity return, whereas so-called "value" buyers typically only want the real return. Moneyness markets in everything would be a way to sell off the liquidity return so as to ensure people achieve the allocation they desire, at the right price.

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Over the next few weeks I hope to sketch out a few related posts dealing with the following rough ideas:

1. When a stock trades at a high multiple to earnings, is this because the stock has an excellent liquidity return or because it is genuinely overvalued relative to its earnings power? Without equity moneyness markets, it's difficult to be sure. With these markets, value investors would be provided with the full range of liquidity price information necessary to decompose real returns from liquidity returns. Liquidity-adjusted earnings metrics would lead to greater accuracy in the pricing of equities, and along with more accurate prices would come a greater degree of precision in capital allocation.

Because they like to buy when everyone is selling, value investors are some of the market's best natural stabilizers. Without moneyness markets, the ability of value investors to efficiently price assets is limited as as their wherewithal to participate. Introduce these markets and value investor's capacity to contribute to market stability expands.

2. While fundamental investors would be sellers of moneyness, I've been a bit circumspect who the buyers would be. Intertwined with this is the question of how to construct an equity moneyness market. Over-the- counter or a central clearing house? Would the terms of a moneyness contract be perpetual or would we see 1, 2, 5, 10, and 30 year moneyness contracts? How well would such a structure port over to housing, fixed income, commodity, and goods markets?

Beyond Buffett: Liquidity-adjusted equity valuation

One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as "marketability" and "liquidity," sing the praises of companies with high share turnover . . . but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise. - Buffett

Our favorite holding period is forever - Buffett

While Warren Buffett may not be fond of marketability, liquidity or short holding periods, the fact that stocks have moneyness—that they have varying degrees of liquidity—is vital to understanding stock prices. In this post I'll show why analysts can't ignore the liquidity factor when they try to evaluate whether today's S&P500 is over or undervalued.

With equity markets setting new highs by the day, the chorus of fundamental analysts shrieking "overvalued" is deafening. These analysts often buttress their point by an appeal to some sort of benchmark valuation metric, like Robert Shiller's cyclically adjusted price to earnings (CAPE) ratio. The "cyclical adjustment" bit refers to the fact that the divisor, earnings, has been smoothed over several cycles, in this case the last ten year's monthly earnings.

The average CAPE since 1881 has been about 16.5x. Today we are currently paying a hefty 22.9x for each dollar of cyclically-adjusted earnings. In order to return to the long run average of 16.5x, the S&P500 would have to plunge by around 28%. That's quite the bear market.

In the chart below I've flipped the cyclically adjusted P/E ratio upside down into an E/P ratio, or a measure of the S&P500's earnings yield. The earnings yield indicates what sort of cyclically-adjusted fundamental return investors might reasonably expect for each dollar they invest in the stock market. The yield currently clocks in at 4.4%, far below the historical median of 7.1%, and way lower than some of the more juicy returns of 10-15%.

The point that fundamental analysts take from this chart is this: why invest in stocks if they don't yield anything close to their long term average?

Adding liquidity to the valuation equation

The fundamental analyst's appeal to Shiller's CAPE ignores the fact that a stock yields not just a pecuniary earnings return, but also a non-pecuniary liquidity return. Stocks are moneylike—put differently, they have moneyness. This feature is valuable. The knowledge that a given good or asset will be relatively easy to sell in the future provides its owner with a degree of comfort. After all, if something unexpected happens to the owner—a tree falls on his house—he'll be able to quickly exchange away those liquid assets in order to get started on home repairs. Less liquid assets don't provide the same level of comfort. Their owner can never be sure that they'll be able to easily sell them should a tree fall, or a storm hit, or a car crash. Assets with higher degrees of moneyness provide greater discounted flows of comfort over time.

Because liquidity is a valuable property, any asset's return should be broken down into the pecuniary returns it provides (dividends + appreciation) and a liquidity return. The higher the liquidity return that an asset provides, the smaller the pecuniary return it need promise potential investors. For example, even though the pecuniary return on Federal Reserve notes is negative (ie. the market expects slow and steady inflation), people still hold notes because their liquidity return is so high. Or consider the difference between savings and chequing deposits. A savings deposit is frozen for a period of time whereas a chequing deposit is easily transferred. To compensate investors for foregoing the liquidity of chequing deposits, savings deposits need to provide higher pecuniary returns in the form of interest.

How high is a typical stock's liquidity return? Unfortunately I can't tell you since the ability to back out a stock's liquidity return from its overall return doesn't exist. While I won't hazard a guess about the current liquidity return on stocks, I'm pretty sure I know its shape over time. Due to institutional innovation, a modern stock's liquidity return is *far higher* than it was in the past. Put differently, stocks are more moneylike than ever.

Because they have been honed to provide ever higher liquidity returns, a modern day stock simply does not need to provide the investor with the same cyclically adjusted E/P yield that it did in the 1950s or 1960s. Just like a chequing deposit doesn't need to provide the same return as a savings deposit, today's stocks don't need to provide as much per-share earnings potential as yesterday's stock. This means that you should be very careful about mining Shiller's long term data for clues about present-day valuation since you'll be effectively comparing apples to oranges or, more correctly, illiquid shares to liquid shares.

Institutional changes increase the ease of transacting in shares

Here is a list of ways in which equity markets have evolved over time to increase the moneyness of equities.

1. Falling fees: Prior to 1975, the NYSE required that all members set minimum commission rates. Competitive pressures from over-the-counter exchanges (along with SEC pressure) finally convinced the NYSE board to deregulate commissions in 1975, the famous Mayday episode. In Canada, the changeover date was 1983. As the chart below shows, commissions plunged.

Figure from A Century of Stock Market Liquidity and Trading Costs - Jones (2002)

In addition to lower commissions, the emergence of competing exchanges like NASDAQ in 1971, and, more recently BATS, Direct Edge, and various dark pools, have led to ever lower exchange trading fees. Lower fees make it easier to get in and out of stock, rendering stock more useful as exchange media. A direct result of Mayday, for instance, was Charles Schwab and the discount brokerage boom, a phenomenon which dramatically increased the pool of investors and deepened liquidity in equity markets.

2. Collapsing bid-ask spreads: The influx of high-frequency traders has dramatically compressed the average spread between a stock's bid and ask price. But even before then, bid-ask spreads had been on a long term decline:

Figure from A Century of Stock Market Liquidity and Trading Costs - Jones (2002)

New practices like decimalization, implemented in Canada in 1996 and the US in 2001, have contributed to spread shrinkage. Stocks used to be quoted in eighths of a dollar. This was changed to sixteenths in 1997, but the practice of quoting in narrower fractions only meant that the minimum spread was now 6.25 cents rather than 12.5 cents. Decimalization allowed the spread in liquid stocks like MSFT to shrink to a cent or two. We're even seeing sub penny spreads these days, an impossibility just two decades ago.

Like lower commissions, narrower spreads make it easier to transact, therefore increasing the moneyness of stock.

3. Back-office changes: In the old days, stocks were traded in certificate form. When stock was exchanged, brokers employed "runners" to carry certificates from one broker to the other. In the late 1960s, to deal with backlogs, certificates began to be immobilized at central repositories. All trades were transferred by book entry, a far easier process than before. Nowadays, certificates are being dematerialized, meaning that they are being converted into digital form. All this makes trade in stock safer, more convenient, and cheaper.

In the 1930s, the convention was to settle stock trades five days after trade day, or T+5. We are now at T+3 and moving to T+1, or straight-through processing. Again, the trade process is speeding up.

4. Standardization and transparency: The increasing adoption of universal accounting standards and practices have increased the quantity, quality, and comparability of information emitted by public issuers. Investor relations departments of listed firms are far more concerned than in times past about the equitable distribution of information. Insider trading, while illegal in the US since 1934, has become increasingly frowned upon in practice. Equity research has become more formalized, ensuring that information is more efficiently processed.

As a result of all these changes, the perception (if not the reality) exists that the stock market is no longer the loaded game of yore, when investors were typically pitted against a clique of operators with inside information and tight control of a company's float. Rather, the modern day stock market offers a flat playing field. This homogeneity and verifiability has set the stage for stocks to become more moneylike.

5. Longer trading days: The NYSE used to open at 10 a.m. and close at 3 p.m, an easy five hour trading window. While the Exchange also opened on Saturday morning, the window was only for two-hours, a practice that ended in 1952. Nowadays, NYSE ARCA, the NYSE's electronic trading platform, opens at 4:00 AM and closes at 8:00 PM.

Due in part to all these changes, share velocity has exploded. Put differently, the average holding times of NYSE stock has plunged from 8 years in the 1960s to around 12 months today:

Liquidity-adjusted fundamental analysis

Fundamental analysts, who frame investment decisions as if they'll own a stock forever, dislike this trend. To them, the equity market's increase in velocity, combined with a 23x PE ratio, represents a maddening increase in silly speculation. All they can do is sit on the sidelines and snipe.

On the contrary, the rapid increase in share velocity isn't silly, it simply reflects the market's growing willingness to treat stock like cash on the back of constant institutional innovation. Cash is useful because it is liquid and can get you out of a bind. Same with modern-day stock. Rather than treat high PE ratios and the increasing velocity of stock as products of irrationality, fundamental analysts need to understand that the premium put on liquidity is the market's reward for a very real transactional service provided by stock. What should fundamental analysts do? Stop trying to figure out if a stock is overvalued or not. Rather, try and find out if that portion of a stock's value not attributable to liquidity is overvalued or not. Or, put differently, try to strip out the liquidity return provided by a stock in order to focus purely on the real return. This amounts to calculating a liquidity-adjusted CAPE. But that's a post better left for next month!

Summing up...

A stock today is not your grandfather's stock. Stock can do more moneyish and cashlike things. It can be exchanged faster, safer, and cheaper. Because such a large chunk of a modern stock's returns now arise from their moneyness, fundamental analysts shouldn't be using earnings yields from the 1900s, let alone the 1800s, as a baseline for estimating modern yields. As long as the decades-long process of liquefying stock continues, it's very likely that the market will never again require stock to provide 7.1% returns. Today's 4.4% yield might be more normal than most think.

[This post is continued at If your favorite holding period is forever]

Would Warren Buffett buy green pieces of paper?

Noah Smith has an interesting post in which he asks: "Is money fundamentally worth nothing more than the paper it's printed on?"

He goes into some soul searching on the definition of "fundamental." His concern with definitions is helpful. The recent debt super-debate was largely blown out proportion due to definitional differences, in my opinion.

If anyone is worthy of describing the word fundamental, it's the sage of Omaha. In deciding whether to purchase a stock or not, Warren Buffett conceptualizes the problem by imagining that he'll never be able to sell it again. He's stuck with it forever. If you abstract from an asset's ability to be exchanged onwards, what you're left with is pure fundamental value. This applies to commodities and consumer goods as well as it does to financial assets.

The definition of fundamental having been dealt with, we're left with a thorny problem. The word money is still undefined. As Neil Wallace pointed out, "monetary theories should not contain an undefined object labeled money." Is Noah talking about gold, cattle, gold-backed bank notes, bitcoin, yap stones, Federal Reserve notes?

In nomadic societies, cattle were highly liquid. What was a cow's fundamental value? Assume that it could never be exchanged again. What remains is the cow's fundamental value — it might be eaten, it could be used to make clothing, it can help rear more cows, it can help in the fields etc. Take another form of "money". In the 1800s, most bank notes were issued with gold redemption clauses. What was a gold-backed bank note's fundamental value? Assume that a note can never be exchanged onwards, and you're left with a security with some fine print on it that says that the issuing bank will redeem it for gold. Its fundamental value is the value of the underlying metal.

I'm going to assume that by green pieces of paper, Noah is specifically interested in the fundamental value of fiat money, perhaps Federal Reserve notes. Assume that a specific FR note, say the one in your wallet, can never be exchanged onwards. What is it worth?

This isn't an economic question. It's a question of security analysis. What does the fine print of your FR Note say? FR notes are liabilities of the Federal Reserve. They carry a "first and paramount lien" on the assets of the Federal Reserve. Having a first lien means that an FR note holder ranks higher than all other Federal Reserve creditors. In other words, your note is an excellent claim. What are the Fed's assets? They have a bunch of government bonds, some gold,* and a few foreign currency denominated assets. These assets aren't paid out on demand. Rather, as a note holder you'd have to wait for the Federal Reserve to be wound up before you could get their hands on these assets. So the fundamental value of an non-exchangeable FR note is the distant possibility that the note holder gets to exercise their senior claim on underlying Federal Reserve assets. That possibility is worth some non-zero value.

see chart in scribd.

This all reminds me of an old conversation I had with Nick Rowe. See here. In that conversation, Nick uses the same Buffetian concept of fundamental value as I use in this post, and argues that fiat money has no fundamental value. I argue the opposite.

Ok, that's my answer to Noah's question.

An interesting thought game is to consider what would happen if all FR notes are no longer exchangable. Say that for some reason or other, no one will accept notes anymore. The price of FR notes would immediately plunge towards their fundamental value. But a large component of a note's fundamental value is derived from the underlying value of the bonds which the Fed holds on its balance sheet. Because these bonds promise to pay a fixed quantity of dollars, the bonds themselves would simultaneously plunge in value along with the notes. And as the bonds plunge in value, the notes do too. And as the notes fall in value, the bonds plunge again etc. etc. until they both spiral to zero.

What halts this spiral is that the Fed holds more than just nominal bonds. It also owns some US dollar assets that pay an inflation-linked return, namely Treasury Inflations Protected notes. At the same time they hold gold. Lastly, they hold foreign denominated bonds whose value would be protected. At some much lower price for FR notes, the Warren Buffetts of the world calculate that the value of a note's senior claim on gold, TIPS, and forex is probably worth more than the market price of notes, and they step in to buy. The death spiral ends.


*the Fed doesn't actually own gold. It owns claims to gold. See this article.