Issue 93 – March 18, 2014

Q1 2014 – Technology Asserts Itself


The first quarter of 2014 has been a remarkable period of economic transformation. On a number of levels, evolving trends which had been steadily flowing for years suddenly developed critical mass and became large scale disruptive forces. Tipping points, in time such as these, present investors with many unique opportunities as well as numerous risks to previous well understood business models. Equity and fixed income markets responded by trading within fairly tight ranges throughout the quarter. However, these modest top line changes belie the turbulence taking place below. These forces also have called into the question the very accounting systems that various governmental entities have used for decades to measure such sectors as employment, retail sales, and inflation. To complicate all of these factors further, the weather for much of the United States was sufficiently ferocious as to dampen economic activity to the point that seasonal adjustments never anticipated. In sum, we now live in a world where people are working and shopping in ways as never before, and we are attempting to measure this very 21st century economic behavior with mid-20th century tools. All of which is taking place within the backdrop of a blazing snow storm.



In This Edition


·         Q1 2014 – Technology Asserts Itself

·         Shopping 2.0

·         The Meaning of Uber

·         Earnings, Rates, Geopolitics

·         The Road Map



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Past Issues


92 - 01.06.14
2013 – The Year is Review/ 2014 – The Year of Capex/ $4 Trillion Flood in the Basement/ The US vs. the World – a Differential in Speed

91 - 09.25.13
Implications/ Opportunity/ No Taper for Now

90 - 07.08.13
Half Time 2013/ Shape of Things to Come/ The Path Forward for Detroit/ Second Half Outlook

89 - 05.31.13
Strong Hands/ #1 The New Federal Funds/ #2 Income as a Commodity/ #3 New Buyers, Fewer Markets, New Terms/ #4 Changing Demands for Leverage/ Measuring Our Multi Speed World with a 12 inch Ruler

88 - 03.27.13
European Union?/ Global Arbitrage/ 1940s Fed

87 - 03.08.13
Pulling & Pushing/ Deus ex Machina/ Perfect as the Enemy

86 - 01.04.13
The Fiscal Alps/ The Paradox & the Rub/ Next up - Zero Rates Forever/ 2013: Promises & Plausibility/ On a Positive Note

85 - 12.13.12
Giving Sausage a Bad Name/ Drowning in a River 2 Feet Deep/ Scarcity in US Treasuries

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/ Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward






Shopping 2.0


Just as it took the railroads and the highway system a period of time before there was sufficient scale and capacity to ensure broad based adoption and use; internet providers have been relentlessly laying fiber and improving networks to the point where now reliable, high speed access is changing the nature of long standing economic behavior. When we speak of a transformation, no industry exemplifies the impact of a fully operational and distributed internet more than retailing. As much as customers may have been previously shopping on the web, these past few months appear to have seen a dramatic acceleration away from the brick and mortar physical stores and onto the web. We say that it “appears” to be that way, because the historical measures of retail sales do not provide a satisfactory job of measuring online sales. (For example, the several hundred thousands of “merchants/reseller” listed on eBay are not captured anywhere by the government data.) Therefore, when we have a measure of retail sales that is less than expected, it is virtually impossible to discern what today’s data is telling us. Is the economy truly weaker with people buying less goods, or perhaps the weather dampened shopping trips? Or, is it simply that the traditional measures of accounting for retail sales fail to capture the movement to online sales and are no longer meaningful given 21st century patterns of behavior? Perhaps some combination of all three? Almost certainly. But where does this leave us as investors if the government data is suspect? Well, the retailers know for sure what they have sold and they know for sure if they have sold a spoon in a store or online. Their accounting and earnings are audited and attested to their accuracy under penalty of jail time (Sarbanes Oxley). It is not seasonally adjusted, nor is it revised the following month. The information provided by public companies is, in other words, by far the best read on the overall economy we will have for the foreseeable future.

We know that we now live in the world of “Big Data”. Even if the Labor and Commerce departments are struggling to make sense of their antiquated models, public companies are moving aggressively to make the most of their own data treasure troves. The Wall Street Journal ran an article in the February 27th edition entitled, “Corporate Economists are Hot Again”. The article featured Parker Hannafin’s efforts to use internal forecasting to make sense of all the data on their worldwide operations and to help them forecast on how best to drive their business units in this time of rapid change. This is not to say that these corporations will make perfect use of their own data sets. Consider the plight of UPS. Bloomberg Magazine wrote a glowing article in their December 23rd edition featuring the lead up preparations that UPS had employed to move an anticipated 132,000,000 packages over the holiday. The trouble arrived almost immediately thereafter. UPS, despite all their best thinking, massively underestimated the flow of internet sales. They were swamped by the tremendous flow in the final days leading up to Christmas. To date they have not released how many packages they did move over the holidays, only to say that it was more than the 132,000,000 items that they had planned for. But taken in conjunction with the poor sales number out of the brick and mortar dominated retailers and the pockets of strength we saw out of those companies who had offered a compelling online experience, common sense tells us it is not just the weather that is keeping people out of the malls. We are changing our consumer habits. Not because we have to, but because we can easily, and conveniently.


The Meaning of Uber


Many people across the United States have been introduced in the past year to ride sharing services located in major metropolitan areas. These firms known as Uber, Sidecar, and Lyft offer their services through mobile apps which match riders with drivers. Sounds simple and straightforward. But these companies find themselves at the eye of a storm which may play out in this and other forms around the country as technology frog leaps well entrenched legacy business models. Uber, which has the backing of some serious Venture heavy weights like Benchmark Capital, Menlo Ventures, and Bezos Expeditions, has drawn the ire of the local taxi medallion holders. Those medallions have represented an increasingly valuable minority interest in a monopoly enterprise. According to Forbes, not a single new medallion was issued by the city of Seattle from 1990 through 2012 (that’s 22 years) while the population grew 23%. That’s what you call a supply and demand imbalance. The Seattle City Council in wanting to respond to the howls from the established Taxi interests and also (in fairness) to provide some basic safety provisions is now assessing how to move forward by limiting the number of ride sharing vehicles that can be out and about at any one time. Good luck with that – in this tech savvy and wet city. The three car sharing services now have something north of 2,000 cars in their local Seattle fleets according to Forbes. The technology and the demand are already in place and the companies are operating at times at significant premiums to taxi pricing. The disruptive force of the ride sharing companies is reminiscent of what Apple and iTunes did to the traditional music distribution channel. It was transformative despite the entrenched business interest’s efforts to the contrary. When iTunes achieved scale, it was an economic tsunami supporting a multitude of businesses and employment well beyond their immediate charge.

The meaning of Uber and of other recent disruptors like Airbnb (home and vacation rental Application) is to recognize that technology has become an even more powerful and valuable business tool than was the case previously. Taken together with the increasing comfort and adoption of new consumer habits; relatively modest additions of technology can have outsized returns to the productivity and ultimately the valuations of public companies.


Earnings, Rates, and Geopolitics


From a 35,000 foot level, the earnings reports from the first quarter of 2014 came in much as expected. Approximately 70% of public companies outperformed their expected earnings which is right in line with the historical average. It was only as you looked at the single company specifics where the true level of seismic change revealed itself. We have already touched upon the changing consumer habits impacting retailers. But across the broad spectrum of companies, we have seen an extraordinary amount of debt issuance, much of which is being used to retire outstanding stock.



Interest rates continued to play their role of “forecast spoiler” as the benchmark US Treasury 10 year note actually rallied throughout the quarter rather than trending towards higher levels as was widely anticipated. This pattern came despite the actions of the Federal Reserve which continued on its path of “tapering” their open market purchases by $10BB per meeting. At this current pace, the committee will be finished with this program at year end. This does still leave some $4 Trillion dollars on their balance sheet which will need to be worked off over time.

US Treasury rates were also well bid for as a result of the tension surrounding the Ukraine and the Russian advances on the Crimean peninsula. Europe receives 1/3 of their natural gas from Russia through pipelines located across Ukraine. Concerns surrounding the slowing growth in China and the government’s ability to manage their markets in an orderly fashion also drove global investors into the US market.

Lastly, improving economic conditions in the US has attracted global investors into our bond market. This has come to a certain extent, at the expense of the emerging world. These markets have then been forced to either raise rates or devalue their currency or both in order to compete for investor’s attention. An interesting aside to this has been the swiftness that all of the non-Euro based emerging nations demonstrated in addressing their situation. Unlike Portugal, Italy, Greece, and Spain which did not control their own currency, Brazil, Indonesia, Turkey, and South Africa do. They have used that control in order to make the necessary and painful adjustments in order to set their economies back onto a path to sustainability. 


The Road Map


The road ahead for financial markets is always far from certain. The incredible pace of technological change is increasing the amplitude of risk and potential return. There are though, a number of factors that are present and that are likely to benefit the owners of equities in general.

The first is the continuation of relatively low to modest interest rates. Technology is an inherent deflationary force and as we have noted it is becoming more and more pervasive in our economy. Therefore, we can assume that the Federal Reserve will want to continue their policy of supporting growth and to target a modest level of inflation. One element of the economy which would directly benefit from continued low rates is housing. The labor element of building either commercial or residential properties is at least to this point fairly impervious to technology improvements. Rick Reider of Blackrock, argues this very point. Taken in conjunction with the attractiveness of US markets on a relative global basis, we should expect to see rates stay on the low side of their historical levels.

The second is the rise of technology as a substitute for labor. One of the most vexing mysteries to modern economists has been the lack of a pick-up in the labor force that has been traditionally coincident with an improving economy. This is unprecedented in the modern era. Never before have we seen productivity and payrolls move in opposite directions.


*BlackRock as of March 5, 2014


Simply stated, a tablespoon of technology CapEx, can be far more impactful today in many cases than a pound of hiring. Consider retailing as we began this note; it does take many people to conduct online commerce, but it takes a lot fewer people than it does to run the same amount of goods through traditional physical locations. Speaking then in terms of equity valuations, a business which can run with more technology and potentially the same or less labor, should be worth more than it might have been in the past with historical labor and productivity correlations. If we also consider the lower rate environment we are in as an additional factor in favor of the equity basket, we can certainly make the case that equities as an asset class are not currently over the moon in terms of their valuations.

As we know, many factors impact market valuations. In spite of our well-considered thoughts, there are plenty of variables that might assert themselves in the coming months. As we noted earlier, the geopolitics of the world are far from settled. The many references to the seeds of today’s conflicts both in Europe and the Mideast being sown during the First World War period are sobering. They suggest that the relative calm of the past 50 years might give way to long simmering feelings which were never truly resolved – only repressed. That being said, the US should continue to be a magnet for growth. We did not touch on the energy revolution or the associated manufacturing renaissance in this note, but that continues as a powerful investment theme in its very early innings.

We will continue to do our work and to create those balanced and resilient portfolios that meet the needs of each of our clients. We look forward to seeing you all in the coming months.


Best Wishes,

Jen & Patsy


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