VCs need to fund an official Exchange for Bitcoin

De_Waag_BitcoinOver the years, I have argued that venture capitalists should fund a regulated, US-based, preferable New York or San Francisco, Bitcoin exchange. Not necessarily for direct ROI, but to solidify the footing underneath their many Bitcoin-related portfolio companies. I also wrote that “one VC-backed company is in serious talks to move forward this something like this, likely via a ‘seat’ model.”

That VC-backed company is SecondMarket, whose investors include FirstMark Capital and The Social+Capital Partnership. The New York-based company, which once was known primarily as a middleman for pre-IPO Facebook trades, plans to spin its existing Bitcoin business out into a stand-alone company that eventually will include a New York-based exchange for the cryptocurrency. The current assets include an 11-person trading desk, the Bitcoin Investment Trust (kind of like a currency ETF) and $20 million of cash and Bitcoin.

The exchange’s goal would be to reduce Bitcoin price volatility, by using spot pricing once or twice per day (like gold spot pricing) and serving as a clearing company in which member firms would clear all transactions by day’s end. Members also would keep enough cash in Bitcoin to maintain exchange liquidity.

SecondMarket CEO Barry Silbert says that he’s modeling it after the early days of The IntercontinentalExchange, and that he hopes to have a set of founding members in place by the end of March. Expect them to include Wall Street banks and well-funded Bitcoin startups (but not, interesting, VC firms). Non-member firms or individuals would not be allowed to trade — at least at the outset — but likely could do business indirectly via the member firms.

All of this comes amid reports that one of the world’s most popular Bitcoin exchanges, Mount Gox, is shutting down after a hack that has cost its users more than $400 million. Silbert declined to comment on the developing situation at Mount Gox, except to say that SecondMarket employees were prohibited from buying/selling Bitcoin once the company learned of what was happening at Gox (a discovery that seems to have occurred hours before it became public knowledge).

From my perspective, Gox’s collapse is both a challenge and opportunity for SecondMarket’s spin-out; a challenge because Gox’s collapse could cause even the most ardent Bitcoin enthusiasts to distrust the cryptocurrency. And opportunity because there is now a market void that could a trusted entrepreneur like Silbert may be well-poised to fill. The exchange, which does not yet have a name, would launch as a self-regulated organization. But Silbert recognizes that its ultimate future is likely to be under the auspices of the New York Department of Financial Services, which recently held a Bitcoin hearing at which Silbert testified.

How America is dividing itself between Wall Street, Main Street and DC

Wall-Street-vs.-Main-StreetJulius Caesar’s treatise on the war that the Roman Empire fought against the Gauls famously starts with the words: “All Gaul is divided into three parts.” The same is true for the United States of America today.

In contrast to Caesar’s division of what is today known as France, which went along ethnic lines (Belgians, Celts and Gauls), America’s division today splits the country into the disjointed politics in DC, the real economy on Main Street and the return to old glory on Wall Street.

Trouble in Washington

The dysfunction on the inside of the Washington Beltway by now has gone from the ridiculous to the absurd. Elected federal politicians that get paid with taxpayers’ dollars continue to ignore the business of governing while nobody holds them to account for anything. They are mainly busy with raising campaign funds for re-election.

Meanwhile, President Obama’s White House is stumbling from one scandal to the next. Admissions of excessive NSA surveillance of U.S. citizens and foreign leaders are chased by the disastrous launch of “Obamacare”. What will be the next fumble?

Last month, Mr. Obama’s approval rating in year five of his presidency fell to below 40% and to the same level as George W. Bush’s was at the equivalent point in his tenure (in November 2005). The President’s only solace in this could possibly come from the fact that 39% is still a whole lot better than the 9% that Congress is getting these days.

Slow recovery and a nation of tenants

As Washington is stuck in a high stakes poker game between elephants and donkeys, the real U.S. economy displays difficulties of its own. Statistically, the Wall Street-induced Great Recession has been over for four years, but the economy is still recovering.

This most sluggish of recoveries also comes with a U.S. labor participation rate that sits at less than 63%, the lowest level since 1978. More than a third of the U.S. population that could technically be working is not. They either dropped out of the workforce permanently, or they haven’t started entering it because there are no jobs and would rather stay in school.

The drop in labor market participation marks the flip side of the relatively stable official unemployment rate at or above 7.0%. As the participation rate shows us, the unemployment rate dropping from the record highs of 2009 is not an indication of more jobs, but of more folks staying out of the workforce. That is troublesome.

Job creation in America is not just slower than expected. The jobs that are being created often come with fewer hours and a lesser wage. The recovery is agonizingly slow, both quantitatively and qualitatively.

 Today, people with poorer quality jobs are spending their hard earned money to reduce their credit card balances which is good for their credit rating but bad for an economy where consumer spending accounts for over 70% of output.

Less easily available credit is also one of the root causes why the United States is slowly turning from a society where the majority of families own their homes to one where the majority are tenants.

At near record-low prices for single and multi-family residences, this situation benefits a new generation of landlords that are picking up deals of the century to rent apartments at rates dictated by limited supply and growing demand.

Wall Street is back!

The contrast to a broken political system and a struggling real economy can be found on Wall Street these days. Mega-IPOs and mergers are back and with them the bonuses for those investment bankers that survived the recession purge.

U.S. corporations have cleaned up their balance sheets and used the recovery to improve corporate earnings. This is the stuff that markets like.

While the economy overall is still struggling with job creation and solid growth, the Federal Reserve’s generous quantitative easing and asset purchasing program made sure that there is enough liquidity around to make sure Wall Street could enjoy an almost magical recovery before anybody else.

The idea was that a fast recovery on Wall Street would eventually trickle down into the real economy, create new jobs and get GDP growth back to the 3-4% that everybody wants to see.

The reality is that the few with the means to invest in the markets are enjoying incremental wealth from the Dow Jones at record levels. Meanwhile, the many stuck in their daily struggles of getting by are still waiting for better jobs and more opportunity.

We are also likely to see a continuation of the erosion of the American middle class. The silver lining for those that still have money left in their 401k plans will be that the bulls keep roaming on Wall Street and whatever their retirement plans are invested in will help growing their nest egg.

Bubble in the Market, I think not just yet BUT…

Edward Tj Gerety BubbleOver the last few weeks, I’ve been chatting with friends about the potential formation of a bubble in the US equity market as represented by major indices and index ETFs such as the S&P 500 (SPY) and Dow Jones Industrial Average (DIA), driven by the conjunction of both record quantities of excess liquidity and declining liquidity preferences.

Starting two or three weeks ago, a flood of analysts have been falling over themselves trying to characterize the current stock market as a “bubble,” or variously as “bubbly.” So has the bubble that I have presaged aging already started?

I believe that this talk of a current bubble in the stock market is exaggerated and mostly unfounded.

This Market Ain’t A Bubble

Current consensus 12 Month Forward operating EPS for the S&P 500 is around 113. A reasonably conservative estimate would be 110. This implies a forward PE of 15.9. While this forward operating P/E is rich on a historical basis, it is not indicative of a bubble.

The analysis of historical P/E valuation does not change much if we base the P/E on trailing GAAP EPS. Assuming a trailing GAAP EPS of 94.00 at the end of the third quarter, this implies a trailing P/E of 18.6 versus a historical average of 15.5 since 1871 and a median of 17.4 since 1960. I believe that the latter figure is a more relevant basis for comparison. Either way, the current trailing P/E is not representative of bubble conditions.

Anecdotal approaches to characterizing the current market as a bubble does not work either. Let’s assume for a moment that Tesla (TSLA), Facebook (FB) and Twitter (TWTR) are bubbles. So what? There are always a few bubbly stocks in any market.

Cherry picking high P/Es as a method of “analysis” does not work either. One article I read a few weeks ago claimed that US large caps were a bubble based on citing three or four stocks with P/Es in the high teens and the low 20s. But if you objectively survey the largest 50 US stocks by market capitalization, less than 25% have forward P/Es of over 15. And less than 10% have P/Es of over 20.

Here are just a few examples of the top stocks in the US by market cap and their forward P/Es: Apple (AAPL) 11.1, Exxon (XOM) 10.8, General Electric (GE) 13.5, Chevron (CVX) 9.9, IBM (IBM) 10.3, Microsoft (MSFT) 12.1, AT&T (T) 12.9, Pfizer (PFE) 12.7, JPMorgan (JPM) 8.6, Oracle (ORCL) 11.1, Wal-Mart (WMT) 13.3. There is no bubble going on here.

In fact, the overall forward P/E for the 50 largest US large caps is less than 14. This compares to the forward P/E of the Nifty Fifty in 1972 which peaked at around 35. The top 50 US stocks by market cap also traded at a forward P/E of around 35 in 2000. Clearly, by any reasonable absolute or historical measure, there is currently no bubble in US large cap stocks.

And there is no generalized bubble in the US equity market as a whole.

Will Talk of Bubbles Prevent Them?

One potential consequence of all of this bubble talk is that it could actually serve to prevent one by placing investors on guard and getting them defensive.

However, if historical experience is a guide, I would not bet on this loose talk about bubbles actually preventing one from ultimately forming. People were loudly proclaiming bubbles in 1997, a full two years before the real bubble took off in 1999.

An important step in bubble formation is capitulation by various bears that were previously proclaiming a bubble and the simultaneous development of a narrative about a “new era” that justifies higher-than-normal valuations. Valuations are not much higher than normal now, so that sort of hyper-bullish argument would not even make any sense at present.

Bubble-Like Speculation About Profit Margins

If anything, the predominant narrative today is one of skepticism about the economic fundamentals and corporate earnings that underlie current P/E ratios.

To illustrate just one example of such skepticism, analysts such as John Hussman and James Montier have been arguing loudly that profit margins are currently in a bubble and will revert to their means of the last 30 years as soon as the US budget deficit as a percent of GDP declines. Unfortunately, while appearing theoretically plausible, this line of argumentation has virtually no empirical basis and is based on flawed theoretical constructs that were first developed in the mid 20th century by an obscure Marxist economist from Poland by the name of Michal Kalecki, and which have largely been discredited.

Contrary to Kalecki’s theoretical speculations, and general popular belief, there is no consistent history of mean reverting profit margins for corporations. To the contrary, the available empirical evidence directly contradicts the theory. For example, profit margins remained very high throughout the 1950s despite rapidly declining budget deficits as a percent of GDP. Similarly, profit margins did not exhibit any mean reverting behavior in the 1960s and 1970s. In fact, contrary to the Kalecki theory, profit margins experienced a secular decline in the 1960s and 1970s through periods of both rising and falling deficits, but mainly through rising deficits. During the ’80s, profit margins did not show any great mean-reverting behavior nor any tight relationship to budget deficits. During the 1990s, budget deficits plummeted throughout the decade while profit margins soared, in total contradiction to the Kalecki theorem. In fact, profit margins have not mean reverted at all in the past three decades regardless of budget deficits!

Profit margins have been in a secular uptrend for over 30 years through periods of both rising and declining budget deficits (as a percent of GDP). Furthermore, these increases in profit margins are based on empirically identifiable and likely sustainable developments such as globalization (capital and labor arbitrage), lower effective corporate taxation, lowered capital intensity of modern industry, cost-saving technologies, barriers to entry via intellectual property, oligopolistic industry concentration global branding and a host of other factors that have been empirically quantified in various detailed reports published by analyst such as James Bianco at Deutsche Bank, Tobias Levkovich at Citi and Dan Suzuki at Merrill Lynch.

Indeed, it may seem ironic to say so, but Hussman’s and Montier’s theories about declining budget deficits driving profit margins down, or even more simplistic mean-reversion arguments by commentators such as Doug Kass, are far more speculative and empirically unfounded than the much-maligned consensus forward EPS estimates that currently underpin the market value of stocks in the US equity market.

Speculation about a profit margin bubble in US stocks has become almost a bubble onto itself.


US stocks are currently not in any sort of generalized bubble. There are some signs of “frothy” behavior in a few isolated segments of the market. However, the stock market as a whole is still within 1 standard deviation of its historical mean in terms of forward and trailing P/Es.

When we stop hearing all the talk about bubbles and start to hear widespread talk about how much-higher-than-average P/E multiples are justified, then we can start to seriously suspect that a bubble might be in the works.

Before then, the possibility of a bubble forming in the US stock market is just that: A possibility. While I think the probabilities of the formation of a future stock market bubble are quite high, the fact is that it is not yet a reality.


World likely to have 11 trillionaires within two generations

In the past year, aggregate global household wealth increased by 4.9% to reach $241 trillion, a sign that even as the tepid economic recovery plays out, households are still accumulating wealth.  And that number is poised to grow over the next five years by 40%, reaching $334 trillion, according to Credit Suisse’s annual Global Wealth Report, out Wednesday.

Here’s what the distribution of that wealth looks like in pyramid form:

It’s pretty disconcerting to see over two-thirds of the world’s adults have wealth of less than $10,000, while the wealthiest 0.7% hold 41% of the world’s wealth.

But there are some heartening signs in the report. One suggests that some measures of mobility are high. Future projections of growth rates based on historical averages show that the fraction in the bottom category of wealth will fall steadily over a 60-year time-frame. After the first 30 years, the number of people currently at the bottom will be cut nearly in half. The authors write:

“Two generations ahead, future extrapolation of current wealth growth rates yields almost a billion millionaires, equivalent to 20% of the total adult population. If this scenario unfolds, then billionaires will be commonplace, and there is likely to be a few trillionaires too – eleven according to our best estimate.”

Here’s what it looks like in colorful chart form:

Wealth mobility within the period works the other way as well. The top 100 billionaires in the Forbes billionaire list in any given year tends to fall in consecutive years, the authors found. So, for example, of the top 100 billionaires on the list in 2011, only 37 remain. It’s a small sample size that hinges on a number of factors, but it goes to show that just because you’re perched on the top of the pyramid doesn’t mean you’ll stay there.

This chart shows the trajectory:

Graphs created by Credit Suisse

How the Market Views the Debt Ceiling

marketmoneyThe financial markets digested the Administration’s scare tactics on Thursday and quickly rebounded on Friday.  Apparently, the sentiment tone remains that investors want to be long for the deal that everyone knows must be made. The lack of a deal has the S&P 500 futures down 50 basis points tonight. Continuing with the trend thus far in 2013, the shallow nature of most sell offs has reinforced the “buy the dip” mentality.  Now it appears the purchases are being made more enthusiastically, with the mindset that a deal announcement would create an immediate 1-1.5% rally.  As the S&P 500 remains within a stone’s throw of all-time highs, it is safe to say the equity market has not priced in any potential ill effects of the Government shutdown and Debt Limit battle.

This is right. With just over a week to go, the market is incredibly sanguine about how this all plays out. Nobody thinks anything can go wrong, and everybody is afraid to be short or to sell lest they miss the “deal.”

This is pretty different from recent fiscal shenanigans.

This kind of blind bullishness and fear of missing even a shred of the rally speaks to a worrisome level of confidence.

For the market’s sake, DC better navigate this smoothly.


The United States looks like the “Land of Oz run by the Munchkins”

government-shutdownIt is an embarrassing manifestation of U.S. political malfunctioning could become economic disaster if the market gets spooked about the debt ceiling and the potential of a sovereign default.

Washington politicians have become “irresponsible” over trying to maintain a health system that no one really wants anymore except the politicians who are not forced to join it.

The most serious potential consequence of the current situation is that markets will become alerted to the “danger” of the approaching U.S. debt ceiling. However, that the current situation “need not be too serious”.

Echoing comments made by ratings agency Standard & Poor’s on Monday. The agency warned that if the warring Republican and Democrat factions don’t reach an agreement by Oct. 17, the Treasury would probably miss debt repayments and default on the U.S.’s nearly $17 trillion national debt.

That in turn could lead to a downgrade of the country’s rating. And the fallout would not be confined to the world’s biggest economy.

“If the U.S. is to default on even a small portion of its debt it could pull the rug under the global economy, U.S. sovereign debt is the linchpin of the global economy.”

650 Fifth Ave seized by the Feds due to links to Iran

650 5th AveThe United States is set to seize control of a midtown Manhattan skyscraper prosecutors claim is secretly owned by Iran, the justice department said, though the ruling is to be appealed.

The seizure and sale of the 36-story building, in the heart of New York City on Fifth Avenue, would be “the largest-ever terrorism-related forfeiture,” the statement added.

A federal judge ruled in favor of the government’s suit this week, saying the building’s owners had violated Iran sanctions and money laundering laws.

Manhattan Federal Prosecutor Preet Bharara said the decision upholds the justice department claims the owner of the building “was (and is) a front for Bank Melli, and thus a front for the Government of Iran.”

Bharara said the funds from selling the building would provide “a means of compensating victims of Iranian-sponsored terrorism.”

Prosecutors allege the building’s owners, the Alavi Foundation and Assa Corporation, transferred rental income and other funds to Iran’s state-owned Bank Melli.

Alavi also ran a charitable organization for Iran and managed the building for the Iranian government, the statement said.

Built in the 1970s by a non-profit operated by the Shah of Iran — and financed with a Bank Melli loan — the building was expropriated by the new Iranian government after the 1979 revolution, prosecutors allege.

They said the Shah’s non-profit, the Pahlavi Foundation, was renamed the Mostazafan Foundation of New York and then the Alavi Foundation.

A former president of the Alavi foundation pleaded guilty in 2009 to obstructing justice in destroying evidence related to the case, which was first filed in 2008.

The Alavi foundation plans to appeal, saying on its website it was “disappointed” with the ruling and that “it did not have the opportunity to rebut the Government evidence before a jury.”

The US Treasury Department has instituted tight sanctions against Iran, blacklisting a number of Iranian companies and organizations and putting controls on the ability of any group or business to transfer funds into Iran.

The restrictions seek to pressure Tehran into giving up what the West says is a program to develop nuclear weapons.

Market move indicators flash warning for stocks

stock_market_crashSome important momentum indicators are flashing warnings after the stock market’s explosive move to new highs this week.

Traders look at a plethora of signs and indicators to help guide their decisions. One particular area has to do with momentum, or whether the prevailing trend in prices will continue or is due for a reversal.

A number of these momentum indicators have reached a point that’s indicative of a reversal of prevailing trends. You’ll hear terms like Bollinger Bands, Relative Strength and MACD, among others. Simply put, these are statistical measures that tell a trader when prices have gone too far, too fast.

As the S&P 500 hovers near record highs, many traders are heeding some of these caution flags. Over the course of the year, we’ve seen near-term peaks like we’re seeing now two other times. A common point between the three peaks is that these statistical indicators have shown that momentum was due for a reversal.

“From a technical perspective, the S&P is in or near overbought territory, as are several sectors such as Industrials, Consumer, Tech and Materials,” said Max Breier, a senior equity derivatives trader at BMO Capital Markets.

During the market peak in early August, we saw signs that stocks were overbought. The market did eventually pull back, but not enough to be characterized as a correction. From that peak Aug. 2 to the trough Aug. 28, the S&P 500 fell 4.8 percent. From the market peak May 22 to the trough June 24, it fell 7.5 percent.

So, the average drop over those 2 occurrences was 6.2 percent. Hypothetically, if the market were to fall by that amount from the record high, that would put the S&P 500 at around 1,625. Even if the market were to pull back to that level, the longer-term uptrend would still be in place.

As of now, 26 are being set, or 25 percent of the index. Back around the August highs, we saw a similar number of new highs. We saw 187 of them before the market peak in May. Those last two surges in the number of fresh yearly highs also preceded drops in the stock market.

“The S&P is now up 23 percent year to date and has risen a whopping 36 percent since June 2012, in almost a straight line ” said Matt Maley, strategist at Miller Tabak Equity. “We just think the market is getting a little ahead of itself.”

The Federal Reserve shocked just about everyone in its September interest rate decision. The investing world fully expected the central bank to pull back on some of its stimulus measures, or to “taper” its bond purchases. Instead, the Fed chose to keep the bond-buying program in full effect, and markets rocketed higher.

Full stimulus measures will be here until the economy really starts showing improvement. Stocks hit a record high, but traders and investors are left wondering if the upside move can be sustained.

Experts will provide well-researched theories on what comes next. History may or may not be able to provide insight into the future, but some traders will look to the past for clues. And these are just a couple of the data points that are helping to provide a moment of pause.

“When you put all the pieces together, it feels like the market is at a stalemate, without any catalyst to push us in one direction or another,” Breier said.

If you’ve been long during the rally, you’ve done well. There’s no real dispute that stocks have surged since the lows of the financial crisis. Maley advises patience for his clients looking to get in on the market.

“Investors might want to buy on weakness,” he said, “rather than chase the market at these levels.”

To use a shopping analogy: Traders are looking at stocks right now like they’d look at buying the hot gift item of this holiday season. Those items are pricey now, but they could be on sale later. On the other hand, if you don’t get them now, you may end up paying even more for them if supplies dry up.

That’s why traders are taking a breather. They’re thinking about whether to chase prices higher, or wait for Black Friday or clearances around Christmas.

Student loan deal may have unintended consequences

A government program designed to help students deal with crushing debt loads could have the unintended consequence of encouraging some students to borrow more – and some schools to charge more – than they would have otherwise.

Under the public service loan forgiveness program, if you make payments on your federal direct student loans under certain payment plans for 10 years while you are working for a government or nonprofit employer, after 10 years any debt remaining will be forgiven.

About one-quarter of U.S. workers are in public service jobs that might qualify, according to the Consumer Financial Protection Bureau.

One caveat: If you are working at a government agency or nonprofit as a contractor through a private-sector company, you do not qualify, says Lauren Asher, president of the Institute for College Access & Success.

There is no limit on the amount of debt that can be forgiven. The biggest winners are those who attend expensive graduate and professional schools.

That’s because there is a limit on the amount of federal student loans undergrads can take out each year. Dependent undergraduates who take out the maximum allowable Stafford loans will leave school with about $32,000 in qualifying debt. (Their debt will be higher if they also took out Perkins loans, but most students don’t qualify for them.)

Federal Plus loans that parents take out for their children’s college generally do not qualify for public service loan forgiveness, nor do any private loans that are not federally guaranteed. Plus loans that graduate students take out themselves do qualify for forgiveness.

Forgiveness criteria

Unlike undergrads, students in graduate or professional schools can borrow up to their school’s full cost of attendance – including living expenses – with federal Stafford and Grad Plus loans. In the case of law school, this could be $75,000 per year.

Students with large debt loads could have some forgiven even if they end up making more than $100,000 per year, says Jason Delisle, director of the New America Foundation‘s federal education budget project.

“The program is a safety net for undergraduates and a very large tuition assistance program for graduate students.”

To qualify for forgiveness, you must make 120 on-time monthly payments while working in public service, under either a standard 10-year repayment plan or one of the government’s income-linked payment plans. The latter include income-based repayment, income-contingent payment and pay as you earn. The 120 payments do not have to be consecutive.

If you make 120 payments under a standard 10-year repayment plan, there is nothing left to forgive after 10 years. So in reality, you must make at least some of your payments under one of these reduced-payment plans.

Repay based on income

Income-based repayment, or IBR, is available to any borrower with federal student loans, no matter where they work.

Under IBR, your payment is based on your income and family size. If your IBR payment is lower than your standard 10-year plan, you can enroll in IBR and make the lower payments. Unpaid interest accrues, but is not necessarily added to your loan balance.

If your income rises to the point where your IBR payment equals or exceeds your standard payment, you can stay in IBR, but make the standard payment instead. However, at this point, unpaid interest is capitalized, or added to your loan balance, Asher says. After 25 years, any remaining principal and interest is forgiven.

Under pay as you earn, a newer version of IBR for recent grads and current students, your payments are even smaller and remaining debt is forgiven after 20 years.

If you work in public service and make 120 monthly payments under either program, your remaining balance is forgiven after 10 years.

Delisle gives an example of two people who graduate from college. Each enters public service making $50,000 a year and get a 3 percent annual raise thereafter. Both qualify for pay as you earn.

The only difference is that John graduates with $32,000 in debt, Mary with only $26,600 in debt.

Over 10 years, both make payments totaling $32,270. But John has $18,740 forgiven while Mary has only $8,206 forgiven.

High debtors benefit

The benefits only get bigger as debt mounts.

The Association of American Medical Colleges, on its website, gives an example of a doctor who takes out $170,000 in federal student loans and owes $195,000 when he begins repayment. He works for a nonprofit employer and qualifies for IBR.

His first three years, he makes a little over $50,000 as a resident and pays $410 to $490 per month on his federal student loans. In year four, his salary jumps to $120,000 and goes up a moderate amount thereafter. In years four through 10, his payments are $1,400 to $1,700.

Over 10 years, he will have made about $144,000 in loan payments and had $169,000 forgiven.

These examples ignore “one more crazy loophole” borrowers can take advantage of, Delisle says. If you graduate in June, your first-year IBR payment will be based on the previous year’s tax return. If you were in school and earned little or nothing the previous year (and were not claimed as a dependent on your parent’s return), your first-year IBR payment is zero.

If you worked only six months your first year out of school, your second-year IBR payment would be very low. Yet these first two years of payments will count toward public service loan forgiveness.

‘Word is spreading’

The public service program is still new. Only payments made after Oct. 1, 2007, count toward the 120 required payments. It will be 2017 before borrowers have any debt forgiven. Many students still don’t know about the program, “but word is spreading,” Delisle says.

Cost of College EducationSome graduate and professional schools are promoting it as way to afford their lofty tuition. Delisle fears it could keep upward pressure on college costs at a time when President Obama is urging colleges to provide better value.

Delisle is in favor of loan forgiveness, but says it should be for all borrowers and “the amount you can have forgiven should be about what the government would give someone in Pell Grants,” which go to the neediest undergraduate students. The maximum Pell Grant this year is $5,645.

Deborah Fox of Fox College Funding, which helps families find ways to pay for college, says he would never encourage clients to take on debt just to have it forgiven because there is no guarantee a student will stay in public service for 10 years. “We try to keep people out of debt, no matter what,” she says.

The $64 billion question is:

Can Tesla make and sell profitably enough model Es to dominate the mid-priced automobile market?

So the first question is whether Tesla can produce them at a low enough cost to be able to sell them profitable or not. I have only a clue or three. My clue is that Toyota (TM) can produce a Prius for less than that price and make a profit selling it. True, Toyota has decades of experience in mass producing vehicles and Tesla does not. Perhaps that will make the difference between success and failure in profitably producing model Es. There’s no way to know for certain at this point but I think not. The techniques are known, the equipment is available; and Elon Musk is a smart man. A nicely equipped Prius plug-in sells for $41,008. Since Toyota makes a profit selling it at that price, it must cost less to produce.

The Chevy Volt sells for $34,995 before incentives and the Nissan Leaf for $34,830 for the SL model with no extras. The mass production costs of those cars are approximately the same as for a Tesla model E, plus the cost of the battery, minus the cost of an internal combustion engine.

How approximately? I don’t know. As you must all know by now, I’m fond of speculating about the unknown based on educated guesses from oversimplified assumptions. For exploration purposes, I’m going to assume that those costs are equal and compare the cost of an internal combustion engine (“ICE”) to that of a Tesla battery. I’m going to use $3,000 as the typical cost of an ICE. I’m also going to assume that Tesla has gotten up to scale producing model S’s and model X’s so that it now knows how to efficiently mass produce vehicles.

Now I’m going to compare the cost of the Tesla battery to the cost of the ICE. You may have read in Barron’s or the New York Times that a Tesla battery costs $400 per kilowatt-hour. Hogwash. Tesla does charge $400 per kilowatt-hour if you upgrade from the 65 kWh battery to the 85 kWh battery, but that is not what it costs Tesla, just what it charges. Panasonic (PCRFF.OB), which is Tesla’s battery supplier, advertises 3100mAh cells at about $1.70 to $2 per cell, which comes to about $153 to $180 per kilowatt-hour. So all other things being equal, the battery costs $8,700 more than the ICE.

But all other things are not at all equal. $153 to $180 per kilowatt-hour is the cost of cells in small quantities. The largest battery cell purchaser in the world must get better pricing. Say, 20% better. This brings the price down to $122 to $144. Also, the cells in question are not equal. The cells Panasonic sells to everyone other than Tesla have individual expensive safety mechanisms built into them to prevent fire. This is necessary for laptops but not for Tesla batteries which have a fire safety mechanism installed for the whole battery. Removing the redundant fire safety mechanisms built into each cell lowers the cost. The bottom line is that Tesla is paying no more than about $1 per cell for a battery-pack, or about $90 per kilowatt-hour. Since the model E will be 80% shorter than the model S, it will use a 6,000 cell battery-pack for a total cost of about $6,000. So the battery will cost $3,000 more than the ICE, all other things being equal.

That accounts for the extra cost of the battery pack. But we have not accounted for the fact that the other components of an electric vehicle are a lot simpler, and therefore less expensive, than those of the ICE vehicle. How much less expensive? I don’t know. I’m going to guess $3000 less expensive just because it produces simple comparisons at equal production costs. I did say that I was fond of speculating about the unknown based on educated guesses from oversimplified assumptions, didn’t I?

So we have a presumed cost differential between the cost of production of an ICE vehicle and a 65kWh battery powered Tesla-designed middle market vehicle of zero.

What does it cost Toyota to build a hybrid Camry?

The 2014 Camry hybrid has a base price of $26,140. The identical Camry non-hybrid has a base price of $22,235, or $3,905 less. That gives us an idea of how much a consumer will pay for a greener, more fuel efficient car. It also gives us an idea of what it costs Toyota to substitute a small battery and electric motor for the ICE in the vehicle.

But let’s use the non-hybrid price because that is where the high volume sales are. That $22,235 price is for a car with no options. No one would buy it that way but it is perfect for estimating the cost of making it. So let’s use it for that. That $22,235 price has to cover dealer markups and a profit margin for Toyota. Let’s say 10% for dealer markup and 10% for Toyota’s gross margin. That leaves a cost of 80% or $17,788. Let’s say Toyota is 20% more efficient than Tesla. That puts Tesla’s cost back to $22,235. Then let’s add another 20% for whatever we forget. That brings Tesla’s production cost to $25,793. At a $35,000 selling price and the same cost, Tesla would have a gross profit of $9,207 or 26.3%. These numbers are no doubt off; and they could be way off; but they do give us insight into the feasibility of manufacturing the model E at a cost-effective price.

My conclusion is that it is feasible for Tesla to make $35,000 model Es which it can sell at a profit, if it can make them in sufficiently massive volume.

What is sufficient massive volume? Tesla’s current production facility has an annual production capacity of approximately half a million cars. A half a million cars is clearly sufficiently massive volume. A much lower number may also do but let’s go with a half million vehicles and see what happens. Can Tesla produce 500,000 vehicles across all models combined? That is the next question.

I think it depends. It depends on whether Tesla can buy or make enough batteries for 500,000 vehicles.

What about the batteries? By this point in time, we are already making about 80,000 model S’s a year and about 30,000 model X’s a year. That’s a lot of batteries. Is there any capacity left to make model Es with?

It will cost Panasonic $200 million to reopen closed battery plants (plural) and install new production lines for small and large format cells. My authority for that statement is John Danner himself. He also says in that Panasonic went from a $500 million to $1 billion loss in its lithium-ion battery division, when Tesla was not buying battery cells from it, to a $41.6 million operating profit, thanks to Tesla purchases. I accept that. That gives Panasonic and others such as Samsung (SSNLF.PK), LG (LGEIY.OB), and Sony (SNE), a large profit incentive to build plants and make lithium-ion cells for sale to Tesla at that same profitable price. Well, maybe not quite that same price. John points out that the Panasonic plant had been fully depreciated, so it had no depreciation cost built into the battery cells it sold to Tesla. John seems to think that fact was the only reason those sales were profitable.

I disagree. If Panasonic could reopen at least two closed battery plants and install completely new production lines for $200 million, then the cost of that is no more than $100 million a plant. What’s missing? The land and an industrial box. What could that cost? My guess is no more than $20 million. So we’re talking $120 million in original cost for a lithium-ion battery cell plant which, depreciated on a straight-line basis over 20 years, gives you depreciation of $6 million a year. Panasonic made $41.6 million without depreciation. Taking depreciation into account it would still have made $35.6 million. I think John is wrong. I do not think that the only reason Panasonic made money producing lithium-ion cells for Tesla is because it did so in fully depreciated plants.

Samsung, which produces almost as much lithium-ion cells as Panasonic, is negotiating with Tesla to supply it with lithium-ion cells right now. And there is also LG, Sony and other smaller producers in the game.

So the supply is not there now. But it will be. The law of supply and demand will, as always, prove valid. If they want to buy ‘em at a price I can make a profit selling ‘em for, I’m going to make ‘em. If I don’t have what I need to make ‘em, I’m going to buy it or build it. I believe that the battery constraint argument is a tempest in a teapot. The supply will materialize at a workable price.

Might cells cost more. Possibly. Supplies cost more all the time without putting the manufacturer out of business. Your suppliers don’t want to put you out of business. They’d lose a big customer. And they can’t replace this customer with anyone at all. No one uses lithium-ion cells in this quantity. Put Tesla out of business and you have put yourself out of business. The converse is not true though. There are multiple lithium-ion cell producers. But only one major buyer. Who do you think has the bargaining power in that situation?

I haven’t even considered the fact that, if push came to shove, Tesla could always vertically expand and make its own lithium-ion cells. After all, if Panasonic stops supplying Tesla, and no one jumps in to fill the gap, all those technicians are now out of work and it only cost $120 million to make a plant. But push will not come to shove. The fact that Tesla could do it, means it won’t have to. Been there, done that.

Now we are up to the $63 question. (That’s not a typo – there’s always at least one more question we all forgot)

Can Tesla sell enough model E’s (together with model S’s and X’s) to justify its present valuation?

I think that it depends on whether Tesla can eliminate range anxiety by building an extensive SuperCharger network that allows a Tesla driver to go most anywhere without wasting a lot of time planning or deviating from his intended route or sitting for long periods at slow charging stations. I know some of you think differently. Those of you who think there is no range anxiety issue can skip to the last page of this article because what follows assumes that there is range anxiety and analyzes the costs of resolving it.

What does it take to resolve it? A SuperCharger network that spans the relevant geographic area with SuperChargers every 180 miles along major highways and a few in each large city. How many is that and how much does that cost? Let’s figure that out.

In the U.S. I calculate it takes 136 SuperChargers to crisscross the country every 180 miles north to south and east to west. At $300,000 each that comes to a capital expenditure of $40,800,000. Now let’s put five Superchargers in each city with a population over a million. There are nine of them. Three in each city with a population over a half-million but under a million. There are twenty-four of them. And one in each city with a population over two hundred thousand but under a half-million. Another eighty-three. That comes out to 197 Superchargers. That’s another $59,100,000 for a total capital cost of $99,900,000. Less than $100 million to blanket the country with SuperChargers. Everywhere you go you pass a SuperCharger – or three. $100 million isn’t much for a company with $750 million in cash; $400 million in quarterly GAAP revenue; and which recently raised a billion dollars publicly. Tesla can do it.

Tesla’s newly published SuperCharger road map goes further. It calls for 247 SuperChargers throughout the US and Southwest Canada by the end of 2015. This is an ambitious schedule and Tesla has already proven that it knows how to fall behind. My slower, less ambitious schedule will support sales just about as well and is more feasible.

At the present time, Tesla isn’t doing either. It has come to a dead stop in expanding the SuperCharger network. Today’s map of SuperChargers actually shows one less than the current number last shown as already open. One in Texas went missing. Tesla is falling behind in its scheduled SuperCharger expansion. From its website, it seems that Tesla did not build any during the summer and missed the projected number completely. Tesla has put off until Fall its next milepost which it now call “most metropolitan areas.”

Looking at the map for Fall 2013, it does not look like “most metropolitan areas” to me. It looks more like West Coast, East Coast, Chicagoish, and Texas. I’m from New York and we are known to be provincial but even I know that there are many metropolitan areas in the middle of the country besides Colorado.

But that aside, why did Tesla build no SuperChargers at all during the second quarter? One possibility is that it was so busy building model S’s and selling them that the SuperChargers fell by the wayside. I think that is a big mistake and very short sighted indeed.

Another thing worth noting about the SuperCharger road map is that many of the SuperChargers shown as already existing on the present Fall 2013 map do not exist on the “Today” map. What they are is the SuperChargers that were supposed to have been built during the second quarter but were not. They amount to eight missing SuperChargers. And one of the two that were shown as existing previously in Texas seems to have disappeared. Details, details, details. I hope that they don’t lose billions of dollars as easily as they lose SuperChargers.

Anyway, let’s assume that Tesla gets with it and builds, builds, builds. Let’s say that, by the time the model E goes into production, the SuperCharger network is built in the US; midway to being built in central western Europe; and started in Asia.

Let’s limit our SuperCharger network to the European Union since that is where the money is. Eastern Europe has some very large, but also very poor, cities. For convenience, when I talk about Europe from now on I mean the European Union. Europe is smaller than the U.S. but it has more cities with high populations. Putting five Superchargers in each European city with over one million population would take 90 SuperChargers. There are eighteen of them. Let’s put three in each city with a population over a half-million but under a million. There are 41 of those, so another 123 Superchargers. And 45 more to put one in each city with a population of 300,000 or more, but less than 500,000. Europe is crowded with cities. There are not so many wide open spaces which do not go through a major city as in the U.S. There’s also a lot of large bodies of water in the way. That limits the North-South and East-West driving routes. So covering the major highways between cities will only take another 18 SuperChargers. That’s a total of 276 SuperChargers at a total cost of $82.8 million.

Tesla has announced that it intends to have all of Central Western Europe except for France (Germany, the Netherlands, Switzerland, Belgium, Austria, Denmark, Luxembourg and Southern Sweden) covered as well as 90% of England and Wales.

In Asia, I will ignore cross-nation travel since many bordering Asian nations are not friendly to each other. Asia really needs to be done city-by-city. Asian cities are big. There are 146 Asian cities with a population greater than one million. Many are poor and poor candidates for automobile sales. I’m going to limit Superchargers to the 10 larger, more affluent cities at five each for 50 Superchargers total. That’s another $15 million.

Obviously we don’t have to do this all at once. We can concentrate on the U.S. and Europe, where the money is, and leave Asia with just Hong Kong for awhile. We can put six in Hong Kong and stop there. Hong Kong is small. What if we built about twenty SuperChargers each quarter in the U.S. until we had saturated the country, then five a quarter after that. We build thirty-five each quarter in central Europe until we have saturated it and then five a quarter after that to get France, Spain, Portugal, Italy, Finland, Ireland and other western European markets. We build six in and around Hong Kong and then five each year in Asia after that picking affluent cities to place them in like Singapore. This tracks Tesla’s newly published SuperCharger road map pretty closely. Let’s see what that looks like. Here is a spreadsheet screen-shot showing each fourth quarter.

Why continue building after we’ve saturated these areas? Because we’ve saturated them at 180 mile distances. It takes a while to SuperCharge for a 180 mile leg. But you can charge to half the battery capacity in 20 minutes – a long bathroom break. So I would keep going and putting SuperChargers midway between the ones that are 180 miles apart. Not in Asia since we are not driving cross country there. In Asia, we add cities. We build five SuperChargers a year there.

Notice that I am not taking account of any advances in battery technology. Will there be advances? Of course there will. I expect battery technology to continue to improve at a capitalized annual growth rate of 4.5%. How will it improve? The same sized battery-pack will hold 4.5% more usable charge each year than it did the year before. So the SuperChargers will get 4.5% closer to each other, measured by the amount of the vehicle’s charge you have to use to reach it. And the same capacity battery pack will get 4.5% smaller and lighter than it was the year before. Let’s call this the shrinking law.

If the shrinking law proves true, in no more than sixteen years it will take only half as much charge to reach the next SuperCharger. At that point, charging enough to get to the next SuperCharger will take only 20 minutes. But sixteen years is too long a time for me to wait. So let’s go on.

OK, so now it’s the end of the first quarter 2016 and we’ve invested $160.2 million. We’ve sold a total of 200,000 vehicles, so our federal tax credit for customers has expired. Our share count has increased by about 8.7 million shares as a result of stock option exercises and/or public or private financings. Either way, the purchasers paid for the shares. Let’s say the stock held steady at $150. That means we raised about $1.3 billion. That covers the cost of building out the SuperCharger network and probably the cost of a second plant in Europe. If that second plant costs more, we sell more stock or wait longer until more employees exercise more stock options.

At this point, we have SuperChargers all over the U.S. and Southwestern Canada; all over central western Europe (except France); and in Hong Kong and Singapore. We’ve been making and selling model Es but now we can sell a whole bunch more. Let’s go make and sell a whole bunch more model Es. Wait a minute. Can we do that?

OK, we can build them. Can we sell them? At $35,000? That’s another important subsidiary question.

A nicely equipped Camry hybrid goes for about $31,000 list. A Buick LaCrosse starts at $33,135 and goes to $40,280 nicely equipped. A plug-in Prius at $41,008. So $35,000 is competitive with moderately priced ICE and hybrid and hybrid plug-in cars price-wise.

But is it competitive feature-wise? Cool-wise? Mileage-wise? What car is Joe and Jane America going to want to drive. If the model S is any indication, the model E will blow away the competition in safety, features and coolness. OK, maybe it won’t. But it could. Let’s see what might happen to Tesla’s valuation if it does.

In exploring this scenario, I’m going to make assumptions on the optimistic side in general because I want to see what might happen. This is ultimately a risk/reward ratio assessment, so I want to look at the better side first. If it’s not good enough, I save myself a lot of work since I don’t have to look any further. This is my usual approach to relatively higher risk investing.

The assumptions that I am making are all stated in the spreadsheet on the input worksheet. As usual, you can change any assumption and the numbers will update across the whole spreadsheet to reflect the new assumption you made. Also as usual, I’m looking forward to hearing about the logic or calculation mistakes I made. I’m sure I made some. I always do. And lastly, also as usual, I’m looking forward to your feedback in telling me what you think I got wrong and what, if anything, you think I got right.

I used non-GAAP numbers since they are easier to work with and since I think they will converge to GAAP numbers over time.

So here are my input assumptions:

  1. Tesla model S will grow sales at a rapid pace annually until it comes to dominate the super luxury worldwide car market with about a third of the total sales in that market by 2020.
  2. Tesla model X will grow sales even more dramatically reaching over a quarter million vehicles sold in 2020.
  3. Tesla’s model E will grow sales even more dramatically than model X and will reach annual sales of about 120,000 vehicles annually with no end in sight.

The Average Selling Price of the vehicles are:

  • Model S: $90,408
  • Model X: $80,408
  • Model E: $35,000

Each vehicle’s annual growth rate starts at 100% and slows up by 30%, 20% and 10% annually for the model S, X and E respectively. The net profit margin on each car is 10%.

Outstanding shares start out at 126,729,861 and grow at 3% annually for stock option exercises and public or private placements. SuperCharging stations cost an average of $300,000.

With those inputs, the results I get are disappointing to me. I get EPS in 2016 of $8.94. I state the three-year-out projection since projecting further than that becomes an exercise in creative magic. But I fancy myself a bit of a magician so I did it anyway. I get EPS of $28.43 in 2020 with a still healthy annual growth rate in EPS of 24% annually. This might justify a PE in the neighborhood of 20 for a stock price of about $560 a share. That’s a potential gain of 250%. The key words for me are potential and optimistic. Remember, I said that I thought my assumptions were on the optimistic side.

I compare that with the potential risk. Of course, there is always a possible risk of a total loss on any stock but I don’t think that has a significant probability. More realistically, there is a risk that the growth rate will flatten out at 20%; or the model E will not blow away the competition; or the model X will flub; or Elon Musk will have a heart attack; etc., etc., etc. Should one or more of those risks materialize; or any one of hundreds of others, the stock could reach an equilibrium of mid double digits. My personal requirement for higher risk investing requires more than a potential 250% profit potential over seven years to justify the risks. Those are my personal requirements because I do rather well and so I have a high opportunity cost.

So I’m still on the sidelines on Tesla. I love the car. But I would not buy the stock yet nor would I touch a short position with a 20 mile pole. I’m still watching and waiting for a catalyst to trigger my interest in placing a wager. A large pull-back in the stock would do it. A $35,000 model E that I absolutely love would also do it.

I do have to tell you that I carried out the “projections” all the way to 2032. This is truly fairy tale make believe based on mathematics. But I’ll give you the results anyway. The results are that by 2032, Tesla has become the number one automobile manufacturer in the world totally dominating worldwide automobile production from the mid range to super luxury markets. This, of course, assumes that everyone else stands still and just lets Tesla take away their market shares. I’ve never seen that happen before and I don’t believe it will happen here. How much market share can Tesla take with Ford, GM, Toyota, Porsche, Mercedes, etc. kicking and screaming all the way. Maybe we’ll all find out.

Your mileage may vary. Actually, I’m sure it does. That’s why the spreadsheet is configurable.