Felix Salmon

My colleague Peter Rudegeair asked me a good question last week: even if the number of stocks listed in the US is falling dramatically, what’s happening in the rest of the world? He even helped answer the question, finding data from the World Federation of Exchanges. Which I then played around with a bit in Excel to generate this:

The US is clearly the outlier here: everywhere else in the world is still seeing the number of listings rise. (And now maybe it’s a bit more obvious why Deutsche Börse is buying the NYSE, rather than the other way around.) At the end of 2009, there were more companies listed in the Americas outside the US than there were inside the US.

US listings now account for only about 10% of all listed companies globally — that’s significantly less than America’s share of global GDP, which is closer to 20%. Even as the US is moving from public to private, or at the very least from many public companies to fewer public companies, the rest of the world is still moving fast in the opposite direction.

Looking at this chart, it seems to me that anybody with the bulk of their equity holdings in US companies is clearly missing out on something important. Yes, US companies are active globally, and those US listings do include a smattering of foreign companies, in the form of ADRs. But it’s a big world out there, and if you’re looking for an everything bagel, it’s going to be hard to find it if you confine your search to US counters.

I can highly recommend the big Reuters report on Glencore, a company likely to go public some time in the second quarter at a valuation somewhere in the neighborhood of $60 billion.

Even before the IPO, there’s lots of speculation about what Glencore will do with the proceeds, which could be $16 billion or more. Top of the list is further growth — a merger with Xstrata alone would probably suffice to push the capitalization of the combined company over the $100 billion mark. The deal will also mean a huge uptick in the wealth of Glencore’s partners, who currently cash out at book value. Given that the company is likely to trade on a multiple of 3x book, no one’s going to be doing that any more.

Glencore has been a highly secretive operation from its earliest days under Marc Rich, and constitutionally hates the transparency involved in being public. So if even Glencore is capitulating, what does that say about my thesis that the stock market is increasingly irrelevant?

For one thing, I think it says that Glencore is run by highly-aggressive traders who judge themselves and others on how much money they have. Billionaire CEO Ivan Glasenberg is no philanthropist, and neither does he feel, as many Silicon Valley founders do, that what their companies do is more important than how much money they make. Far from mistrusting speculators, Glasenberg is one. So the only real reason to stay private is the question of privacy. But Glencore already gives enormous amounts of financial information to so thousands of people around the world — it told Reuters that “full financial disclosure is made to all of the company’s shareholders, bondholders, banks, rating agencies and other key stakeholders.” As a result, anybody important who wants to know details of Glencore’s finances can probably find out pretty easily.

Going public will certainly mean more press for Glencore — and given what the company does, more press necessarily means more bad press. It’s hard to position yourself as a major force for global good when your main businesses are mining and commodities speculation, and when you generate a lot of your edge by being willing to do deals with highly-corrupt politicians that other companies won’t touch. But Glencore’s bosses are hardly the first people to make the calculation that for hundreds of millions of dollars, they’re OK with being hated.

There’s also a sense of statistical inevitability about going public. You can stay private for decades, but the option of going public will always be there, and there will always be charming investment bankers telling you what a wonderful idea it is. A single moment of weakness, and it’s done. And once done, it’s more or less irreversible. A unified and single-minded family like the Cargills can stay resolute — but that’s an impressive feat, and if Glencore starts draining Cargill’s milkshake after it goes public, even the Cargills’ resolve might waver.

This part of the Reuters report stood out for me:

Glencore’s arrival in the FTSE would intensify the London exchange’s shift into natural resource firms. Fox says the increasing domination by a single sector is a “big headache” for smaller British investors who want a diversified portfolio. “It concerns me as much from a financial perspective as a moral perspective,” he says. “Customers will not expect that when they invest in a mainstream UK growth fund that a third of their money will end up in commodities.”

The point here is that the stock market, at least in the UK, is becoming a commodities play — much as the Russian and Brazilian stock markets have been for some time, not to mention Canada and Australia. Betting on commodities is all well and good, but it’s not the same as investing in the economic growth of a country. “While the stock market is certainly not a perfect reflection of corporate performance,” Ira Millstein tells me, “it is one measure.” That’s true — but it’s a measure of declining utility. The Glencore IPO only serves to underline how the stock market is more of a reflection of global asset values and of financial speculation than it is of underlying corporate performance in the real world.

At the end of 2008, the loan market was in stunningly bad shape. There was almost no bid for loans in general, and cov-lite leveraged loans in particular were treated like they were radioactive. If you looked at the prices they were trading at, the market was clearly expecting a huge wave of defaults in the very near future, along with very low recoveries.

Two years later, the picture could hardly be any different. High-yield bonds are being issued within 40bp of the state of Illinois. Cov-lite loans are being churned out at bubble-era pace: the $8.8 billion so far this year is 25% of all loans year-to-date, already tops the 2010 total, and works out to an annualized pace of something in the region of $65 billion. The defaults that everybody was expecting generally failed to occur, and the few defaults that did happen had surprisingly high recoveries.

The WSJ‘s Mike Spector is at pains to point out that “creditors aren’t guaranteed to lock in these better recoveries. Distressed-debt exchanges, while giving good recoveries in the short-term, could later prove a mirage should firms falter again.” This is true broadly, but false narrowly: if creditors want to lock in their recoveries they can do so very easily by selling their shiny new bonds and loans in this frothy market at very high prices.

When I started blogging full-time in 2006, I formulated a principle — that the market is the best pundit. Sometimes the market is wrong and some specific pundit is right, as I’m sure my boss at the time, Nouriel Roubini, would love to remind you. But the expectations priced in to the market are a more reliable base case than any other forecast you might use.

That principle didn’t work out well for me in the case of mortgage bonds. Or just about anything else: the market took it upon itself to go completely bonkers, with a level of volatility bespeaking zero reliability whatsoever when it came to priced-in expectations. Even so, in the midst of a massive recession it did seem reasonable that crazy cov-lite loans would start defaulting en masse — no matter what the Fed did in terms of monetary policy.

But something interesting happened: it turned out that these bonds and loans were big enough to concentrate the minds of the creditors. Banks and investors worked hard to avoid realizing losses, in a manner which has most emphatically never happened in the mortgage market or with small business loans. You can call it “extend and pretend” or “delay and pray” if you like, but it seems to have worked, with a lot of help from the Fed. That was unexpected, and because it was unexpected it had a huge effect on prices, which outperformed massively in 2009 and 2010.

So when the market seemed unreasonably sanguine, in early 2007, it was wrong. And when the market seemed reasonable in its pessimism, in late 2008, it was also wrong. Right now we’re back to unreasonably sanguine again — Bethany McLean says, sensibly enough, that the recent uptick in cov-lite issuance is “a sign that some kind of reckoning is in store.” But the one thing I’ve learned over the past three years is that the market just isn’t a sensible or rational place.

If you’re being logical about such things, stocks look incredibly frothy right now, just as bonds do, both in terms of valuation and in terms of psychology. But this market has a way of making everybody look foolish, no matter how logical they are. Which is ultimately just another reason to spend as little time as possible paying any attention at all to the market. It’ll just drive you mad.

Comment of the day comes from TFF:

When asset prices go up, you are poorer.

When asset prices go down, you are richer.

That equation holds true as long as you are in the accumulation phase of your life. It reverses in retirement, and is perhaps ambiguous for somebody nearing retirement, but for somebody in their 20s, 30s, and 40s, it is undeniably true.

As someone who’s saving for retirement, this is clearly true. My preference is for assets in general, and stocks in particular, to be as low as possible for as long as possible, so that I can accumulate as many of them as I can before they go up and as few as necessary after they’ve become expensive.

But here’s the weird thing: most of the people cheering for the stock market to go up are in the accumulation phase of their careers, not the spending phase. They’re still putting money into retirement funds, and they aren’t intending on spending it for decades. So why are they so happy when stocks go up, and sad when stocks go down? Shouldn’t it be the other way around?

One good reason is that if you require a certain annualized rate of return over the years that you save for retirement, then every year that return is low only serves to push the necessary future return further and further out of reach.

A less good reason is the internalization of the false promise of compound interest — the idea that you want your money to be compounding from day one. In reality, yields go up when prices go down, and you still want to be able to compound at high yields, when prices are low, rather than at low yields, when prices have risen. If you can save for decades at a steady real yield of 5% with prices going nowhere, you’ll accumulate much more money than if you start saving at 5% and then rates quickly drop to 1%. Even after accounting for the capital gain on the first bonds you bought.

The main reason, however, is simply psychological. If asset prices go up, that means people with assets are richer, and have made money in the markets. If you’re rich and you’ve made money, that makes you happy. Even if over the long term you’d be better off if you were able to continue buying bargains.

At the end of 1993, Cisco Systems had a market capitalization of $8 billion. At the end of 2010, it was worth $112 billion. It hasn’t paid dividends, which makes things easy: if you want to calculate the amount of shareholder value that Cisco created between 1993 and 2010, you just subtract the former figure from the latter and get an impressive $104 billion. Right? Wrong. In fact, if you go through the history of Cisco’s stock actions year by year, it turns out that the company has managed to destroy $105 billion over the past 18 years. Microsoft and Intel have both destroyed $72 billion, Time Warner managed to destroy $130 billion, and Pfizer destroyed a whopping $188 billion. Four of the top five value destroyers, however, were financial: AIG, GE, BofA and Citigroup between them destroyed a mind-boggling $739 billion between 1993 and 2010, most of it in 2008.

All these numbers come from my new favorite paper, the product of some serious number-crunching at IESE Business School in Madrid. (Update: I missed some small print in the methodology, so while this paper is interesting it’s not quite as interesting as I thought at first. See below.)

Here’s the abstract:

In the period 1991-2010, the S&P 500 destroyed value for the shareholders ($4.5 trillion). In 1991-1999 it created value ($5.1 trillion), but in 2000-2010 it destroyed $9.6 trillion. The market value of the S&P 500 was $2.8 trillion in 1991 and $11.4 trillion in 2010.

We also calculate the created shareholder value of the 500 companies during the 18-year period 1993- 2010. The top shareholder value creators in that period have been Apple ($212bn), Exxon Mobil (86), IBM (78), Altria Group (70) and Chevron (67). The top shareholder value destroyers in that period have been American Intl Group ($-217), Pfizer (-188), General Electric (-183), Bank of America (-170), Citigroup (-169) and Time Warner (-130). 41% of the companies included in the S&P 500 in 2004 or 2010 created value in 1993-2010 for their shareholders, while 59% destroyed value.

How can the S&P 500 destroy $4.5 trillion of shareholder value over a period when its capitalization rose by $8.6 trillion? The answer is that companies issue stock when it’s expensive, rather than when it’s cheap. During the dot-com bubble, Cisco was an M&A monster, going on a massive acquisition spree and nearly always paying in its highly-rated stock. When that stock crashed, it took down with it all the value invested at the top of the bubble, which was many more shares than were oustanding back in 1993. More generally, companies with high-flying stocks are likely to pay their employees with stock or options. That can account for a lot of value destruction if and when the shares fall to earth.

That said, the S&P 500 would have created shareholder value, on a net basis, between 1991 and 2010 were it not for the annus horribilis of 2008, when $5.8 trillion of value was destroyed. In general, the down years are much bigger than the up years: the best year of all was 2003, when $1.7 trillion of value was created, while substantially more than that was destroyed in each of 2000, 2001, 2002, and of course 2008.

This is one of the main reasons why the returns that real individual investors get from investing in stocks are substantially lower than the theoretical numbers that financial advisers love to show you. And why you prefer to get paid in cash rather than in stock.

Finally, I think this paper demonstrates that Apple is a screaming long-term sell right now. No company, bar Apple, has even created $100 billion of shareholder value over the past 20 years, let alone the $212 billion figure that Apple is currently boasting. It’s an extreme outlier, and the downside is enormous: if you buy Apple shares now, there’s $327 billion of downside.

Google, by contrast, is much less of an outlier, having created a relatively modest $5 billion of shareholder value in its time as a public company. Go check out the number for your own favorite stock in the appendix of the paper, which lists shareholder value creation between 1993 and 2010 for all 633 companies which were part of the S&P 500 either in 2010 or in 2004. Most of the numbers — 59%, to be precise — are negative.

Update: Thanks to eagle-eyed commenters for catching something very big here: the paper is measuring risk-adjusted returns, not absolute returns. According to the definitions in the paper, “A company creates value for the shareholders when the shareholder return exceeds the required return to equity”. And the required return to equity is defined as the return of long-term treasury bonds plus a risk premium which seems to fluctuate between about 4% and 5%. Remember that long-term Treasuries did very well indeed over the period in question. So the value-destruction figures here are a bit fictitious: it’s not actual money being destroyed, but rather the hypothetical money that you would have got if you’d invested in instruments yielding about 4.3% over Treasuries. I’d love to see the numbers raw, without the risk adjustment.

Tim Duy asks me whether “the public is being pushed into a retirement dead end,” and “how the average investor should manage their 401k plans in this environment.” I have two answers to this; one’s facile and the other’s quite important.

The facile answer is “I’m not an investor” — don’t ask me, because the one thing I know for sure is that my investment calls have generally turned out pretty badly, I don’t have the courage of my own convictions, and insofar as I’ve managed my own personal finances in a non-disastrous manner that’s more been a matter of luck than judgment. I could try to give you investment advice, but it wouldn’t be worth very much.

The more important answer is “I’m not an investor” — and neither are you. Just because you have a 401k plan does not, ipso facto, make you an investor. This is a serious problem with defined-contribution pensions in general: they place an onerous set of responsibilities onto individuals who are wholly unqualified to discharge them in a sensible manner. Already, such plans tend to have far too many choices, many of which are expensive long-only mutual funds which seem like a pretty bad idea for just about anybody. Trying to add alternative investments in private equity or hedge funds to the mix would almost certainly be disastrous — the dumb money coming in at just the wrong time, just like it always does.

So your 401k is going to be made up of stocks, bonds, and cash, just like it always has been. Those asset classes are, it’s true, only a subset of the full range of investment opportunities available to sophisticated investors. But you’re not a sophisticated investor, so there’s no point in feeling aggrieved. It’s possible that you might be able to invest some of your 401k funds in Pimco’s Total Return Fund, which is an active and sophisticated investor, and which happily uses very sophisticated derivatives on a regular basis to get extra return and to make money in down markets. But generally speaking, people with 401k plans should stop at big-picture asset-allocation decisions: beyond that, they’re way out of their depth.

It’s possible to argue ad nauseam about the equity premium and whether it exists; I’m very sympathetic to those who say it’s smaller than you might think. But if you’re talking about retirement money you’re not going to touch for at least a couple of decades, then stocks do look a lot more sensible right now than bonds or cash, neither of which are going to do anything for you. Are they expensive? Yes: everything’s expensive. And at some point stocks will surely drop alarmingly. But at least the earnings yield on stocks is vaguely reasonable, and you can expect those earnings to rise over time as the economy grows. And you’re certainly not sophisticated enough to try to time the market and buy on dips.

The good news about 401k plans is that you put a more-or-less identical amount of money into them every month, which means you’re dollar cost averaging quite impressively. And ultimately the best way to save up lots of money for retirement is the same as it’s always been: to save up lots of money for retirement. By far the most important number here is the total sum of dollars that you’ve put into your retirement funds over time; the annualized rate of return on those dollars is secondary. So the more comfortable you want to be in retirement, the more money you should save while you’re working. Don’t expect the market to come to your rescue, and you won’t be disappointed when it doesn’t.

There’s no point in blaming the world for its unfairness. Sure, it would be nice if you and I could buy hot pre-IPO tech companies — or at least it would be nice if we were able to pick the winners. But again, Sod’s Law says that if we could do that, the returns in that space would turn negative pretty fast.

And it’s possible that we’ll have a resurgence in the stock market, if and when the US economy starts making things again. Dorian Taylor sent me a thought-provoking email this morning which said that one of the reasons we’re seeing fewer companies tap the equity capital markets is that we’re in a phase where all of the buzz and excitement is in what he characterizes as “networked information services.”

“Relatively speaking,” writes Taylor, “these companies don’t really need a huge amount of capital at any given time because they aren’t buying stuff with it; they aren’t making or building or physically shipping anything.” (Yes, I know that datacenters are expensive, but this is broadly true.) Taylor continues:

I suspect emerging industries for which production (eventually) eclipses R&D (i.e. physically consumes stuff to make things) may still do well in the stock market. Metamaterials, space tourism, alternative energy or tissue engineering perhaps. Just not information services.

If the greentech (or any other capital-intensive) revolution ever arrives, in other words, maybe the stock market will step up and become relevant again. And for the time being, those of us with 401k plans should just continue to put our money into stocks, or target-date funds, or the like. Because we literally don’t know any better.

I’m sad that my NYT op-ed on the decline of stock exchanges went to press too late to include the bonkers rhetoric emanating from Chuck Schumer:

The New York Stock Exchange is the cradle of American capitalism. It is a national treasure. In America, we start each day in our Congress and in our classrooms with the Pledge of Allegiance, and we also start it with the ringing of the bell on the floor of the stock exchange.

The NYSE is in no sense the cradle of anything. A cradle is a safe place for the young to develop until they grow up and become more self-sufficient. Y Combinator is a cradle. The NYSE is place for algorithms and speculators to make bets on financial assets. It last funneled real amounts of money into the broader economy during the dot-com boom, leaving behind a lot of Aeron chairs and little else. Since then, I get the feeling that the big capital raises on U.S. exchanges have been by financial institutions, rather than the real economy; maybe someone can find a breakdown for me of which sectors raised the most money in primary and secondary offerings over the past ten years.

As for the idea that the NYSE is a national treasure akin to the Pledge of Allegiance, well, yes. Which is to say, its value is symbolic, and rooted in the days of old, when “allegiance” meant something more than who you’re friends with on Facebook, and when institutions were judged on the size and weight of their Corinthian columns.

There’s one other point I would have liked to make in my piece, which is that the tax code is a large part of the reason why the stock market is bad at capital formation. Look at the trillions of dollars cash on corporate balance sheets: why aren’t those companies paying it out as dividends to their shareholders? In an efficient capital market, they would do just that, and then raise new equity capital as and when they needed it in future. After all, sitting on billions of dollars in cash is hardly a core competency of most exchange-listed corporations.

But companies don’t do that. It’s partly because they fear that the money might not be there when they need it. But it’s also because the cost to shareholders of dividending out money now and then getting it back again in future is enormous. For one thing, the underwriters of the secondary offering are likely to require a hefty seven-figure fee when you ask them to raise that money for you. And more importantly than that, the shareholders you send the dividend to are going to have to pay income tax on it, at rates in the region of 35% to 40%. There’s no way that can be efficient.

I’m not saying that we should abolish the income tax on dividends. But it does help to explain why U.S. capitalism can be very inefficient, and why the stock market, broadly speaking isn’t working very well these days when it comes to its core function of capital allocation.

That was quick! Barely had my NYT op-ed on the decline of public stock exchanges hit the web this evening than Ira Stoll was ready with a trenchant reply.

Stoll is sanguine about the fact that the number of companies listed on U.S. exchanges has declined from 7,000 in 1997 to 4,000 today. “Suppose that the number went to 4,000 from 7,000 because many of the 7,000 companies merged with each other to become even larger and more dominant,” he writes, “and that the current 4,000 listed companies have three times the sales and three times the market capitalization they did in 1997.”

Actually, let’s not suppose that and instead let’s look at some numbers. I don’t have sales numbers, but I do have market capitalization numbers, from the World Federation of Exchanges. At the end of 1997, U.S. exchanges had a total market capitalization of $13 trillion; by the end of 2010, that had risen by about 24% to $17 trillion. Which in real terms actually works out as a slight decline in market cap. Meanwhile, GDP grew from $8.3 trillion in 1997 to $14.7 trillion in 2010 — that’s an increase of 76% in nominal terms, three times the rate of growth of U.S. stock market capitalization.

But more broadly, Stoll is making my point for me — that the U.S. stock market is increasingly made up of enormous and dominant companies and features ever fewer of the smaller, fast-growing companies which really drive the economy. When public companies are acquired or delisted or go bankrupt, there’s not nearly enough in the IPO pipeline to replace them. The result is a market of dinosaurs.

I also claim that the market is doing a bad job at allocating capital efficiently — after all, the market hasn’t allocated any capital to Apple since 1981. I don’t for a minute think I have a better idea than Steve Jobs what to do with Apple’s cash pile and in fact have said quite explicitly that it shouldn’t be paid out in dividends. But when investors buy Apple stock, their money doesn’t go to Apple, but rather to the other investors that they’re buying the stock from. The stock market becomes a money-go-round for speculators, rather than a way of directing capital at companies.

Finally, the “ultra-rich elite” I’m talking about is not the broad universe of people who are considered accredited investors by the SEC, but rather the tiny group of individuals who are given the opportunity to invest in private companies. If you’re well connected in Silicon Valley — if your name is Ron Conway or Vinod Khosla — then you have loads of such opportunities. But the rest of us don’t, whether we’re formally accredited investors or not.

I’m not making any policy recommendations in this piece — I don’t think that the rules about accredited investors should be weakened further, or that all Americans have some kind of automatic right to be able to buy a piece of Facebook. But I do think that the public stock market is less important now than it was in the past and that its decline is going to continue in future decades just as it has done since 1997.

Guan Yang sends over a couple more charts showing the total number of stocks listed on US exchanges. First there’s the NYSE, Amex, and Nasdaq combined: this one goes back to 1973, and has never been lower.

And here’s the data just for the NYSE, going back all the way to 1926:

It’s pretty clear that the total number of stocks peaked with the dot-com bubble, and is now on a long-term secular downtrend. As a result, the stock market is increasingly failing to act as a proxy for the economy as a whole. Which is one more reason to stop obsessing whether or the stock market is up or down. That never mattered much, and it will matter even less in future.

When the news came out that Goldman Sachs was orchestrating a private offering of Facebook shares at a $50 billion valuation, those shares overnight became an even hotter commodity than they had been up to that point. Check out the results of the periodic SecondMarket auctions: the three auctions in December, before the Goldman news was public, cleared at between $21.01 and $22.75 per share. The first auction after the Goldman news, by contrast, cleared at an all-time record of $28.26 per share — that’s a valuation of over $70 billion.

Clearly the Goldman news moved markets — a lot. And equally clearly, that’s very problematic in terms of securities law. Andrew Ross Sorkin explains why Goldman now feels forced to restrict its offering to non-US investors:

Federal and state regulations prohibit what is known as “general solicitation and advertising” in private offerings. Firms like Goldman seeking to raise money cannot take action that resembles public promoting of the offering, like buying advertisements or communicating with media outlets.

This is a point which was made before Goldman’s latest announcement, for example by Chris Whalen:

Look, for example, how the Facebook portal got a lot of ink last week because of the superlative public relations job by GS. In feeding their “private investment” hype to the Big Media, GS was effectively front-running their own private market, the little ghetto called Face Book that they created apparently to evade securities laws.

All of this serves to underline the difficulties inherent in trying to put together a private market in Facebook stock. In Goldman’s ideal world, and quite possibly in Facebook’s ideal world too, Goldman could broker private transactions in Facebook shares for years to come, obviating the need for Facebook ever to go public.

Received opinion has it that Facebook might as well go public once it exceeds 500 shareholders and starts making public large amounts of information about itself in 2012. And today’s news only serves to underline how difficult it is for a highly-visible company, and its advisers, to maintain a market in its securities while remaining private.

Selling the shares privately isn’t going to be a problem, reports the WSJ:

A total of about $7 billion in orders for Facebook shares has poured in, according to a person familiar with the matter. That means it is highly likely that Goldman still can pull off the offering at its original size without U.S. investors. Chinese demand is especially strong, said one person familiar with the offering.

“They’re still committed to doing the deal at the original size,” one Goldman client said.

But Facebook is a US company, and while it can surely raise lots of money from Russian and Chinese investors, that’s always going to look like a stopgap solution. This news definitely increases the chances of a Facebook IPO in 2012, while at the same time decreasing the probability that Goldman will lead it:

The struggles of the offering may also deal a blow to Goldman’s relationship to Facebook and the firm’s prospects of leading the social network’s long-awaited initial public offering, expected in 2012…

However, in the past two weeks, the relationship between Facebook and Goldman has grown increasingly tense, people involved in the offering said. Accusations about the news leak have flown back and forth, these people said.

The fact is that although remaining private is very attractive in theory, in practice it’s likely to come with a lot of unwanted attention from the SEC, and its own set of downsides. Still, an IPO is far from a foregone conclusion.

If Goldman Sachs feels left out of the running when it comes to the Facebook IPO, it’s going to be even less likely to be a model shareholder when it comes to its own $450 million stake in the company. Here’s TED, making an important point:

Do you realize how difficult it is for investment banks to put their own capital at risk to earn an underwriting or placement mandate? We hate, hate, hate it, Mr. Mallaby. It goes contrary to everything we aspire to do. Goldman only did it because it thought it could make great fees on Facebook’s eventual IPO.

And here’s Peter Gallagher, who notes that Goldman’s boilerplate talks about how the bank “may at any time further reduce its exposure to its investment in Facebook through hedging arrangements”.

Goldman could write options against its own Facebook shares and likely has discretion to do so against the fund’s holdings.

In other words, Facebook has a speculative shareholder for the first time, now that it’s made its decision to get into bed with Goldman. And Goldman will think nothing of buying puts or selling calls on Facebook shares — or even dumping its shares outright, if it’s allowed to do so — if that’s what it needs to do to protect its $450 million investment.

As the same time, however, one of the main unwritten rules of IPOs of young companies is that they always need to be priced at a level above their last funding round. If Facebook can’t IPO at a valuation significantly north of $50 billion, then it probably won’t come to market at all. (That probably explains why bidders on SecondMarket are happy to buy at a $70 billion valuation: they’re betting that when Facebook goes public, it’ll be worth more than that.)

A lot of stuff can happen to Facebook between now and a 2012 IPO. And if Goldman is shorting Facebook rather than massaging its valuation and orchestrating an IPO which values the company at $70 billion or more, then maybe Facebook won’t go public at all next year. Maybe, indeed, Facebook will learn from this whole episode that dealing with investment banks is an unpleasant and expensive exercise, and will try to avoid doing so in future as much as it possibly can.

Eddy Elfenbein notes that the Dow has significantly underperformed the market of late. Here’s how it compares to the S&P 500 over the past 180 days: up 16.6%, which is great, but not nearly as great as the S&P’s 19.9% gain.

Is this a bearish sign of speculative activity? Perhaps; Eddy’s theory is that “the Dow hasn’t captured the strength in cyclical stocks.” But the big picture, of course, is that the Dow is a ridiculous way of measuring the stock market, and that it’s certain to diverge from the S&P 500 on an irregular basis. The real surprise, frankly, is not that it diverges as much as this now and then, but rather that it hews so closely to the broader stock market most of the time.

One thing worth noting here is that two of the top five companies in the US, by market capitalization, are essentially disqualified from being part of the Dow: Apple is over $300 a share and Google is over $600 per share, which makes it impossible for either of them to enter a price-weighted index. Google has 1.38 times the weighting of Bank of America in the S&P 500; if it entered the Dow, it would have more than 43 times BofA’s weighting.

I do wonder what it is about the Dow which keeps it alive in the popular imagination and the financial media. I think it might have something to do with having an index level in the thousands: it’s like video-game scores, which always add a few zeroes just to feel more impressive. The S&P 500 should probably have been set to 500 rather than 44 at inception in 1957: then there would be no need for the silly Dow at all.

Miguel Helft explains why Facebook is going to have to go public sooner or later:

Mr. Zuckerberg’s quest to keep Facebook private will not last forever. Federal regulations require companies with 500 or more investors to disclose their financial results, eliminating one of the principal advantages of staying private.

This is a classic non sequitur: Helft’s first sentence simply doesn’t follow from his second. Yes, it’s nice for companies not to have to disclose their financial results. But just because you’re disclosing your financial results doesn’t mean you have to go public. Indeed, there are many privately-held companies which issue bonds and therefore disclose financials, but which have no public shares outstanding.

Follow Helft’s link, and you arrive at Steven Davidoff explaining the conventional wisdom in a bit more detail:

The company can still stay private even if it is forced to begin reporting to the S.E.C. However, in the case of Google, which faced with a similar choice several years ago, it chose to go public. Google decided that if it was going to have to release its nonpublic financial and other information to the S.E.C. and the public, it might as well get its bang for the buck and do it in connection with an I.P.O. Though not required to do so, Facebook would probably come to the same conclusion if the S.E.C. brings this reporting requirement to a head.

The problem is that I’m having a lot of difficulty working out what kind of “bang for the buck” Facebook would get from going public. Indeed, it seems to me that for Mark Zuckerberg, the downside of being public outweighs the upside, whether or not Facebook is reporting its financials to the SEC.

The main thing to remember here is that Zuckerberg is the CEO, he’s always wanted to be the CEO, and he has zero intention of relinquishing that job. He’s not like Larry Page and Sergei Brin, who are happy being founders and letting Eric Schmidt do the less pleasant things associated with being CEO: this is Zuckerberg’s company, and he’s going to run it.

The problem is it’s been hard enough for Zuckerberg to grow into being CEO of a private company: he’s certainly gone through quite a few executives along the way. The job of being CEO of a public company is very different, and much more outward-facing. For one thing, it involves lots of interaction with journalists and analysts. More invidiously, it involves being judged by share-price performance to the exclusion of almost everything else. Public shareholders have the right to demand that the CEO do his utmost to increase the value of their holdings from quarter to quarter and from year to year; it’s easy to see why Zuckerberg has no interest in bringing upon himself that kind of pressure.

It’s easy to see Zuckerberg being attracted to the idea of living like, say, Mike Bloomberg, running a multi-billion-dollar company exactly how he wants, without constantly being second-guessed. And remembering too the cautionary tale of Apple, where the founder, Steve Jobs, was forced out by angry shareholders when the stock failed to perform.

Of course, Zuckerberg does have shareholders right now, but he reports only to a very small board of directors comprising himself, Marc Andreessen, Jim Breyer, Don Graham, and Peter Thiel. Those are not the kind of people to care much about complaints from people who bought at a high valuation that they’re having difficulty selling their stake at a profit.

If Facebook remains situated at one remove from the harsh scrutiny of public markets, then, it’s likely to be able to follow its own path much more easily, without having enormous pressure to justify its $50 billion valuation with massive growth in revenues and profits. That’s probably attractive not only to Zuckerberg, but also to much of his executive team, and even to the board, none of whom to be in any hurry to exit their positions.

So why go public at all? The main reason for an IPO is to raise money, but Facebook has just demonstrated, in its deal with Goldman Sachs, that it’s more than capable of raising as much money as it needs privately. Any time Zuckerberg needs new equity capital, Goldman can find it for him at a very attractive valuation, no IPO required. And if Facebook is now profitable, it probably doesn’t need any more equity capital anyway.

The secondary reason for an IPO is to provide a mechanism for shareholders and early investors to sell their stake in the company. Again, Goldman will happily perform that role, acting as a broker between Facebook insiders looking to sell and its own high-net-worth clients looking to buy. No public listing required.

The final main reason for a public listing is to give the company an acquisition currency—but even without a public listing, Facebook is more than capable of offering to buy other companies with its own stock. It’s very rare for a private company to have stock which is as liquid and as easily valued as Facebook’s—but now that Facebook has got there, it doesn’t really need to go any further.

There are other reasons to go public, but none of them are very convincing in the case of Facebook: the idea that a public listing gives a company a higher profile, for instance, or that it expands the pool of possible shareholders, thereby increasing its valuation.

So my feeling is that insofar as Goldman has just bought itself Facebook’s IPO mandate, it might have bought a unicorn. Not that Goldman would mind in the slightest if Facebook stays private—right now, it’s in the highly enviable position of having the exclusive ability to parcel out Facebook shares to its own clients, and to make money on pretty much every trade in Facebook shares. That, surely, is more valuable than any one-off IPO fee.

Update: A couple of other things I forgot I wanted to say. Firstly, public shareholders tend to be a litigious bunch. And secondly, there’s a real chance that the Goldman-brokered secondary market will fall, rather than rise, in value from $50 a share. And there’s no chance of an IPO below $50 per share in the foreseeable future.

Is Goldman Sachs going to start trading Facebook shares before they even go public? Dan Primack thinks it’s a possibility, and I’m inclined to agree.

We’ve already learned, from the NYT, that Goldman has put together a plan for creating a tradeable company:

In a rare move, Goldman is planning to create a “special purpose vehicle” to allow its high-net-worth clients to invest in Facebook, these people said. While the S.E.C. requires companies with more than 499 investors to disclose their financial results to the public, Goldman’s proposed special purpose vehicle may be able get around such a rule because it would be managed by Goldman and considered just one investor, even though it could conceivably be pooling investments from thousands of clients.

Such a vehicle would hardly be unprecedented: there’s even a company called Felix Investments which has already done something very similar. But the difference with the Goldman vehicle is that Goldman, being a broker-dealer, could easily start pitching its vehicle as something to be traded, rather than as a simple buy-and-hold investment in Facebook.

Since you need to be rich and special to become a Goldman client and therefore eligible to invest in this vehicle, let’s call it Status Upgrade. Status Upgrade will then buy 30 million shares of Facebook for $1.5 billion, and issue 30 million shares of its own to its investors, all Goldman clients. Status Upgrade will be a firm which invests in other firms, a bit like Berkshire Hathaway, except it won’t be publicly listed, and it will only invest in one company, Facebook.

Goldman will then act as a middleman between its clients who want to buy and sell shares in Status Upgrade. Because they’re shares of Status Upgrade rather than of Facebook, Facebook itself doesn’t have a right of first refusal to buy them back, and trades can happen at any time, rather than only during intermittent auctions on SecondMarket. As such, the secondary market in Status Upgrade shares would probably be much more liquid than the current secondary market in Facebook shares. (This is also a function of the fact that Status Upgrade will have a large market capitalization of somewhere between $1.5 billion and $2 billion.)

The more active the trading in Status Upgrade shares, the more accurately that Goldman will be able to price any future Facebook IPO. And meanwhile, shareholders in Facebook might be able to swap out their shares for new shares in Status Upgrade, thereby trading increased liquidity for decreased voting rights.

Henry Blodget, looking at the Status Upgrade shareholders, isn’t happy:

Does this new system–private IPOs only for Goldman clients–improve our financial markets? Are we–and you–better off now than when more companies wanted to go public and public-market investors were free to make their own decisions about what firms they wanted to invest in?

Specifically, is the economy better now that you are prevented from considering investments in small, speculative companies–and smaller companies have fewer and more-expensive ways to raise capital?

Certainly not from where we sit.

This doesn’t make a lot of sense: Facebook is not a small company by any stretch of the imagination, certainly not compared to genuinely small and speculative companies which are having public IPOs. But if multi-billion-dollar companies start trading in a shadowy private market accessible only to Goldman clients and which doesn’t have to comply with stock-exchange rules about reporting prices and the like, then we lose the level playing field and sense of equal opportunity which is afforded by public markets.

Back in 2007 I was saying that “the move from public and transparent markets to private and opaque markets is more than a blip,” and I still think that way: Facebook seems to be going out of its way to avoid public scrutiny.

To John Cassidy, this is a sign that Goldman is “trying to twist the securities laws for the benefit of itself and one of its clients” — the securities law in question being the one which says that once a company has more than 499 shareholders, it needs to disclose a lot more information about itself to the public. But as Dan Primack notes, Facebook has decent reasons to go down the private-exchange route even if it complies with all those disclosure rules:

This investment will not necessarily precipitate a Facebook IPO—even if the SEC finds the company in violation of the 500-shareholder rule, and requires it to publicly disclose financial information. Facebook clearly has no need for capital (a prime motivator for IPOs), has plenty of liquidity options for existing shareholders and still could avoid many public company hassles outside of the financial filings (no need to meet with analysts or hedge funds, do quarterly earnings calls, etc). In fact, one even could argue this deal makes an IPO less imminent.

It’s an intriguing possibility. Primack reported last week that Facebook is probably already in regulatory compliance, after more than a year of having David Ebersman as its CFO. Rather than rush to an IPO the minute that it breaks the 500-shareholder barrier, it could continue to allow its shares to trade on Goldman’s private exchange more or less indefinitely. Mark Zuckerberg clearly has no desire to run a public company, and he might be tickled by the idea that shares in Facebook, like his personal information on Facebook, are available only to a certain group of friends. The SEC can force him to disclose certain corporate information. But it can’t force him to go public.

Many thanks to Peter Lattman and Diana Henriques for answering my question from last week. Yes, as I suspected, there is a secondary market in Madoff claims — although from the tone of the article it seems more like a primary market, where hedge funds compete with each other to buy claims from people who have been defrauded, rather than a well-functioning secondary market where those funds actually trade the claims between each other. The going rate seems to be about 30 cents on the dollar, with an expected payout, somewhere down the line, of roughly double that amount.

For the Madoff victims who can afford to sit tight for the time being, then, the eventual losses are likely to prove manageable: the pretty healthy final recovery comes on top of the massive tax refund they got immediately after the fraud was uncovered, returning to them the taxes they paid on all that fictional investment income.

The NYT report comes from Dealbook, the bloggy arm of the business section, so maybe if I ask a question they’ll answer it. The story says that in October, “claims were trading at about 25 cents on the dollar” — does that mean that victims were willing to sell for 25 cents, or does it mean that there was an actual brokered market and that hedge funds or other non-victim investors were selling at that level? If so, that’s a very interesting datapoint, since it implies that the sellers either managed to buy their claims at a very deep discount indeed, or else got quite demoralized, for some reason, about the prospects for recovery.

Incidentally, while I’m on the subject of opaque secondary markets, Kerry Dolan is reporting that Facebook shares are now being valued at $23 each. That’s $115 on a pre-split basis, which works out at a valuation of over $50 billion — roughly the same as General Motors, somewhere between Morgan Stanley and Boeing. Wow.

I know this blog has been way too heavy on the QE of late; apologies for that. But Baruch has a fantastic new post up, which nails what I’m really worried about when it comes to quantitative easing.

Essentially, says Baruch, the stock market rally is like the cat in Pet Sematary: it looks real, but it isn’t. And in fact it’s likely to turn out very harmful indeed.

Part of the problem is that QE has become, in part, a game of “kill all the shorts”—a game which a glance at IOC or OPEN or even UTA will tell you is being played very well indeed. Correlations are high, which is always a bad sign, and that weakens the raison d’être of the entire market, which is to allocate capital efficiently. Instead, the stock market becomes a place where people park their money in the hope that it will go up and in the expectation that if it goes down, the Fed will step in and rescue them.

But Baruch isn’t reassured:

Will we crash? Will we carry on straight up? Will we pause and rally? Who can say? We’re in a period where anything is possible, as I’ve said before, a world of unintended consequences coming down the pipe. Some may be good, and some may be bad…

I’m not saying we’re in an undead homicidal zombie market, though we may be. But here’s an example of what the Pet Sematary market is capable of in terms of unintended consequences: QE inflates all asset prices, including commodities. This pressures the Chinese consumer, who we are relying on to pull us all out of this mess, who can suddenly not afford his new LCD TV because his Moo Shu pork Big Mac and fries is costing 20% more than it used to. Changes in commodity prices have a much greater impact on his consumption than Joe Schmoe in Idaho. The BoC has to raise rates to offset the inflation this is causing, hurting Chinese growth even more, and global GDP growth drops 50bp. Bravo the Bernank. With your Quantitative Easing you just killed off the only good thing in this market which was working naturally without outside interference.

Baruch doesn’t think this is going to happen, necessarily — but the point is that neither he nor anybody at the Fed is remotely able to judge its probability, or, for that matter, the probability that QE will actually work.

Kevin Drum makes the very good point that we’re not actually arguing about something hugely important here:

Despite the scary sounding $600 billion number, the actual impact of QE2 is almost certain to be fairly small. With interest rates already so low, there’s simply not enough money involved to move markets substantially.

But the key word here is “almost”: QE might well end up making very little difference either way, but there’s no doubt that it’s made the tails fatter. Global markets have ramped up a lot since QE2 was effectively announced, and a sudden unwind of that move would devastate confidence. There’s lots of things that can go wrong, and the chances that the stock market has its valuations right have never been smaller. If you’re buying stocks right now, I hope you’re able to withstand a very bumpy ride. Because there’s a substantial chance that you’re going to get exactly that.