Wednesday, September 13, 2017

Bitcoin, Marks

It's been a long time since posting last. I've gotten comments and emails wondering where I've gone. Actually, nothing has changed and it hasn't been a conscious decision to scale back here at all. I've been wanting to post.

Part of it may be that I was a little busy. I have been getting involved in volunteering here and there and sometimes it takes up a little more time than expected, and before you know it, you have no time for other stuff. Not to mention I have so many things I like to do, like coding/programming, reading etc.

The other reason for not posting much, I guess, is that things haven't really changed all that much. Maybe I'm coasting on things that I like that are doing well. I still like most of what I've talked about here and there hasn't been any reason to change anything.

Anyway, what triggered this post is another great memo from Howard Marks. If you are curious about bitcoin, or what to do about the markets (overvalued?), you should read this. Of course, most readers here probably already read it.

Howard Marks memo

This memo is fascinating because it deals with two things that I have been thinking about a lot over the past few years (OK, I haven't really thought about bitcoin all that much, actually, but I have been getting the indicators that it is indeed a bubble; people I know telling me it is going to $100,000 and are probably already calculating their net worth based on that price. At least that's what it feels like).

The Market
I haven't really changed my mind about the market at all. I've written a lot about what I think and nothing has really changed. The market is still expensive, and interest rates are still low. I still think a reasonable 'normalized' interest rate (10 year) is around 4.0%. And in that environment, stocks are still not expensive.

A lot of smart people are saying that it is way too expensive using some long term average, like the past century. Well, my view is that to use that as the norm, one would also have to assume that the average interest rate in the next century will be like the last century, and that's not at all a given. So in that sense, we can't really say what the average P/E ratio is going to be in the next century, let alone the next decade.

One argument is that low interest rates haven't helped Japanese stocks. This is an interesting thought and I may take a close look at that at some point as I did spend some time in Tokyo this summer. It is really an interesting, fascinating place. But it can also be incredibly frustrating too.

What To Do
Howard Marks writes about the options investors have at this point in an overvalued, late cycle market. He has a problem with people saying to do nothing and invest as usual. He makes a great argument but I sort of wonder about that.

Maybe it's different in fixed income versus equities; in fixed income there isn't much upside but a lot of downside. In the stock market, there is huge upside to offset huge downside.

Marks says that we do have to do something here, whether it be to lighten up, reduce return expectations, or some of the other things he lists (I agree we have to accept lower prospective returns; there is no arguing against that).

 First of all, one problem with this discussion has to do with who you are. If you are an equity fund manager, hedge fund, pension manager, asset allocator, individual investor (IRA, 401K, young person, old person) etc.

My guess is that for most people, do nothing should be fine. As Buffett said a while back, the stock market returned 10%/year in the last century, but most people who owned stocks didn't come close to that. Why? Because they kept getting in and out of the market trying to outsmart it.

When you think about that, it makes you wonder whether getting out or lighten up when you think the market is expensive is a wise decision. As I've said often before, when you look at the returns of the folks who do try to allocate capital according to forecasts, they haven't done all that well.

You can call this discipline, to get in and out according to the risk in the market. But go back to the fifties when dividend yields dipped below interest rates, which was unheard of. It's easy to imagine someone getting out of the market promising to keep discipline and go back in only when dividends yields are higher than interest rates (they would have finally gotten back in in the past few years!).

If you are young and are 100% in stocks in your IRA, that's fine. Even if you are not so young, it should be fine too as long as you understand the markets can be volatile and prospective returns are probably not going to be as high as in the past.

Keep in mind, the difference between stocks and bonds. If you are 100% invested in a great stock, say, Berkshire Hathaway, and you are worried about the market and want some spare cash just in case the market takes a dip. Well, if you are 100% invested in BRK, you are part owner of a heck of a lot of cash (on the balance sheet) and cash flow. If the market tanks, BRK will benefit. BRK will be buying. Would you not be better off letting the folks at BRK take advantage of the dip than you? Well, if the markets really tank, it's true that you might be able to get better deals (as you are probably more nimble).

But even if you stay 100% invested in BRK, they will take advantage of the dip and you will benefit.

Think about if you own a bond. If you own a BRK bond, you may not benefit on a dip in the market. BRK's bond value probably will not increase after a dip and recovery whereas the stock may very well come out bigger and stronger (maybe BRK's credit improves afterward, but probably not so much).

If you owned a high-yield bond and there is a dip, this mechanism wouldn't really work either, I don't think. A dip might hurt high-yield bonds more so you get killed, and the issuer may not come out the other side stronger as it's credit is not that strong to start with so may not be able to take advantage of a market dip to grow.

Old Greenblatt Memo
After the financial crisis, Joel Greenblatt posted a great comment on the Gotham website. He said that the mistake was not that people didn't see the crisis and didn't get out of the market in 2007. The mistake was that people owned too much stocks so that when it went down 50%, they panicked and sold out at the bottom.

He said that you should own an amount of stocks where a 50% drop won't be too upsetting to you. If you have a $100,000 stock portfolio, and a $50,000 mark-to-market loss would upset you, then you shouldn't have $100,000 in stocks. Many people invest too much assuming the bell will ring at the top so they will be able to get out.

I think the same applies today. It is not a mistake to be heavily invested (as long as you understand that markets will fluctuate, and will not return 10%/year going forward), as long as a 50% drop (and noone can predict when this will happen) won't be too upsetting to you.

If you are worried, lighten up, but lighten up because you think you might have too much exposure to stocks, not because you think you will be able to get back in at a better price later on because that probably won't happen.

The most interesting part of Howard Marks' memo is about bitcoin. He was apparently bombarded by emails after his previous memo when he said that the bitcoin is a Ponzi scheme.

Of the folks supporting bitcoin is the dynamic duo from FRMO, Murray Stahl and Steven Bregman. Marks spoke at length about bitcoin with them.

Here is the FRMO letter to shareholders where they talk about crytocurrencies:

FRMO letter

If you are on the fence about bitcoin, go read this FRMO letter, and then read the Howard Marks letter. You will get a really good overview and arguments of both sides.

I have to say as much as I love technology, I don't get this one. Jamie Dimon said the other day that this was a fraud. That may be a strong word for it. I don't know if there is really any intent to defraud; these people probably actually believe it can be a real currency alternative, in which case it's not really fraud. But maybe it is fraud. Who knows.

What I don't get is that they say that central banks can print as much money as they want, but we know the supply of bitcoin going out into the future; there can't be more than that produced.

But who said that the bitcoin is going to be the only alternative cryptocurrency? The U.S. dollar has value because it is backed by the U.S. government (but nothing else), and nobody can just buy a printer and just start printing them. You can't just print your own, private dollars either. Well, I guess you can (via gift certificates, frequent flier miles, bonus points etc.).

The whole point of something valuable is it's universal acceptance. Gold, too, has a limited supply, but it has been accepted as a store of value for centuries. I have no idea where gold prices will go, but it will probably stay 'valuable' for many years to come.

But bitcoin? People lose bitcoins because they lose their USB drive that held the code, some exchange gets hacked and people lose bitcoins. If someone hacked a U.S. bank and took people's money, the FDIC would back it up. What kind of insurance or guarantee comes with bitcoin? What if one day it just doesn't work or you can't get access to it. Who do you call? What if there is a flaw in the system? Are bitcoin fans well-versed enough in the technology to figure out what went wrong?

If I woke up and my bank's website wasn't there, I can walk to a branch. If the branch isn't there, I can go to another branch, or the headquarters office. If it's not there, I can call the State bank regulator or other regulator to ask what happened and try to retrieve my money.

What's the equivalent in the bitcoin world? Who really runs it? Yes, they say nobody (or everybody). But that too is kind of scary.

China just said they are going to shut down bitcoin exchanges, and Japan announced the other day that gains and losses from bitcoin trading/investing will count as other income (I think that's what it was) and will be taxable. They said that this includes purchases with bitcoin. If you buy something with bitcoin, then you have to pay taxes on the gain.

Now, think about that for a second. How complicated is that going to be? Every time you use your bitcoin to buy something, you are going to realize a taxable gain?! What kind of payment mechanism or currency is that? That's just crazy.

OK, bitcoin supporters would argue that this will not happen because bitcoin is not trackable. There will be no 1099 or anything like that associated with it so the IRS (or the Japanese equivalent) will never know. I don't know about that. It would be surprising if they did nothing and let it stay this way; then nobody would ever pay taxes in a few years!

It's kind of incredible that so many people have jumped on the bitcoin bandwagon before the governments around the world have figured out what to do with it. Just letting it alone is a low probability scenario, I think. More likely is something like what Japan did; make it a taxable item, whatever it is. I'm kind of surprised that people aren't looking at this also as a gambling vehicle. I don't know much about gambling laws, but bitcoin as it works now sure looks like a vehicle for gambling to me.

In any case, I haven't changed my views about bitcoin. It's an odd curiousity. Kind of interesting. But without knowing how the laws will handle it, there is no way to determine if it has any real value. At least that's what I think even though there are many people smarter than me that believe in it.

If I miss this party, well, it won't be the first. If I don't understand it, I'll just stay away.

Anyway, we'll see what happens!


  1. glad you are back.
    great Financial Times article on cryptocurrencies.

  2. bitcoin is interesting because of the underlying technologies it combines: (1) secured hashing -- see NIST, (2) merkle trees, (2) peer to peer networking, (3) ECDSA signatures -- like SSL, (4) transaction ledger - but this could be a ledger or list of anything, (5) distributed consensus -- uses proof of work, but this is just one of many methods -- variants of paxos are what is used by hadoop, cassandra and others as well as the ripple and stellar guys. turns out that when you bring these technologies together -- you can actually do a lot, and the fact that everyone is pre-occupied with the token just shows how little people understand... but that is how crowds work. then you add that 90%+ of existing network traffic is ad tracking that no one really "wants" -- and it looks like the world could be set up for an inversion. But god forbid that Dimon or Marks bother trying to understand this. Oh -- and I forgot the fact that an open blockchain is actually also a regulators dream -- compliance collapses to running a script and compliance reporting functionally disappears. Given that just compliance is in the neighborhood of 10% of some bank workforces -- yeah. this matters. but it's that the technologies combinations appear to promise the potential for a wave of tech disruption... but this has nothing to do with tokens or currencies... the tokens and currencies were just a primitive generic proof of concept -- but it is interesting how you could use the tokens to allocate network capacity and internalize payment for uses -- but no one is building any internalized general uses yet. From an evolutionary perspective, it feels like these systems just discovered barter - single use tokens. And what Dimon is probably missing is that something like bitcoin, which isn't controlled by any single government -- is actually really valuable to use for destabilizing some places with bad governance (China, Venezuela, etc...) and this is useful to some governments -- particularly democracies. It's just bad for banks which have pursued a long-term strategy of using regulatory systems to create moats around their businesses. Anyway -- fascinating topic... you just need to look at the underlying code and understand it. Few people actually do that, just like few people do investment research.