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Market Update – January 2016

January 21, 2016/in Market Update /by David Matias

I usually like to use the Market Update to offer you reflections on events of the past quarter and observations of underlying trends looking forward. Unfortunately, the disappointment of 2015 and the disastrous start to 2016 defy most sound analyses. Namely, the first two weeks of 2016 gave us the worst opening to a year since 1929, and it is a fact that will cloud every analysis that you read, including this one.

The phrase that perhaps best describes the past year is “paradigm shift.” While the years 2010-2014 were characterized by massive monetary stimulus (an unprecedented $4.5 trillion of new money in the form of quantitative easing, augmented by a zero-interest rate policy), the removal of that stimulus has left us with a volatile, rocky market that is dealing with some unanticipated side effects. Recall that the Fed has purchased tens of billions of dollars of various debt instruments from banks over the past seven years, creating new money in the financial system in the form of Fed credits to these institutions. From the end of Quantitative Easing 3 (QE3) in October of 2014, volatility has spiked and U.S. equity returns have been flat or down. The global markets have fared far worse, as you’ll see from the charts that follow.

Financially, economically, and socially, we have never seen conditions such as these. Keep in mind that the Great Recession of 2008 exposed gaping holes in our economic foundation, bringing the global economy, as well as the financial markets as we knew them, to a halt. Certain things we held sacred — the safety of U.S. Government debt, the security of money market funds, the fundamental solvency of the banking system — were all destroyed. The U.S. Federal Reserve stepped into this void and, for seven years, pumped trillions into the economy to keep it growing. Now that the pump has been closed, we are in a new period of transition and the economy is struggling to find its footing.

Markets

The negative trend that began in the third quarter of 2015 continued through the end of the year and into the first weeks of this year. Domestic equities showed little progress: major indices were down, and dividend yields pushed them slightly positive. International equities were a veritable disaster: developed markets showed small losses while emerging markets blew through all sorts of support levels. The poster child for this was China, which witnessed a mercurial rise followed by a full collapse, followed by a second collapse this past week.

Bonds didn’t do much better. U.S. Treasuries, usually the safest bet, were able to generate a small gain of 1.3%, but didn’t manage to beat inflation. Any bond with some sort of risk associated with it, even small, showed some losses for the year. The biggest story in the bond market was the non-investment grade or ‘junk’ sector. After years of steady gains based on interest income and tightening corporate spreads, the decline in oil and other commodities caused a dramatic reversal. Company defaults for energy firms will rise in 2016 – it remains to be seen how far that will spread to other bond sectors.

In contrast, the tech and healthcare sectors performed above the norm. Amazon, Netflix, Google and Facebook showed growing profits despite significant skepticism from prior quarters. The big name in tech — Apple — wasn’t so fortunate. As one of the largest companies in the world, it is simply impossible to sustain the level of growth it has shown over the past few years. Despite their record-breaking profitability, this dampening of expected growth is beginning to impact its stock price.

The interesting movements mostly happened in healthcare. With the cost of debt virtually zero, and with slowing growth of top-line revenues, there were some amazing mergers that drove strong market returns. An interesting anecdote is Allergan; it announced in July of 2015 that it would sell its generics business to Teva, then later in the year, announced a “merger” with Pfizer with serious expected synergies and tax benefits. If you were an investor in Allergan, you would have seen swings of 25% during the year, with impressive gains along the way if you timed it correctly.

The biggest disruption in the markets continues to be China, where signs of trouble cause serious reverberations through the S&P 500 and the energy markets. The logic driving this is deceptively simple: if China slows down, we lose the growth equivalent of the European Union (as discussed in the October Market Update). But the reality is far less straightforward. China’s total market capitalization is $5.57 trillion, and volatility is driven almost exclusively by failed regulation and the dominance of domestic retail investors.

The link between these factors and U.S. equity markets is most likely a familiar theme: financialization, which drives short-term market dynamics away from fundamental values. We have seen it with gold, oil, the Swiss Franc, and a host of other assets that have been whipsawed by trading momentum. Once an asset or company gets into the trading spotlight, there is a pile-on effect that wildly drives the price, usually down.

Timing will continue to be important given these factors, particularly until there is greater clarity about the direction of the economy and the Fed. While we prefer to focus on fundamentals and long-term holds, our style of active trading is the only one that generated notable gains in the past year, and it is likely the same for this one.

Economy

The Fed rate increase has been a dominant news item for the entire year. The year started with the expectation that the Fed would increase rates pretty early on, which was followed by delays and ultimately doubts over whether it would happen at all. While the impact of the actual rate increase of 0.25% is negligible, the information communicated has a huge impact on the perception of the economy.

In theory, the Fed assembles the country’s smartest minds to analyze the most timely and complete data on the economy available. If they see that we need a tighter policy, it implies strong economic expansion ahead. If they lower rates, it implies weak growth. How the market interprets Fed announcements has become a bit of a sport, with players and spectators wringing meaning from every move of the Fed.

Currently, the Fed’s plans to continue policy firming signals expectations of steady growth in the coming years. The dot-chart below shows the range of expectations of Fed participants on direction and pace. Unfortunately, the market has a different view. And as one trader recently joked with me, “[T]he Fed has accurately predicted eleven of the past zero economic recoveries.” The timing of its predictions have been consistently wrong, and we have yet to see success following a low inflation, low growth mode.

This leads us to share in the concern that the Fed could have it wrong again. Given the market action of the past few weeks and legitimate concerns over global growth, any moderate Fed tightening could risk pushing the economy into a recession. With no room to lower rates, we would be looking instead at somewhat draconian measures to stimulate the economy. Fiscal stimulus, for example, has been conspicuously absent in this recovery. Given current government debt levels and the political environment, increasing deficit spending is largely untenable. So in sum, a recovery is far from certain and there are few options to rely on in the case of another slowdown.

While concerns focus mainly overseas, the domestic figures we track — housing and employment — remain pretty stable. Jobs continue to grow at a steady clip: nearly 300,000 new jobs in December. It is important to note, however, that the overall employment ratio remains at historic lows. Most who lost their jobs in 2008/9 have yet to be re-hired into comparable positions. Millennials, on the other hand, have yet to achieve full-time employment at typical levels and are inhibited by $11 trillion in student debt, which has grown at 12% a year for the past 10 years. Given these nuances, job gains are far from enough to further economic expansion.

The housing picture is similar. Although there is relative stability and some growth, a large impediment here will be mortgages. With rates increasing, banks unwilling to lend in less-than-perfect situations, and regulation shooting up, further increases in the housing market will have to come from fundamental demand as opposed to increased leverage. Growth in the sector is critical to pushing forward the U.S. economy, with labor and raw materials heavily dependent on this dynamic.

So while the recovery is uncertain, there is enough strength in key sectors to believe we will avoid recession. There are dangers that continue — the strong dollar is a headwind for exports and the housing market might stall out — but the fundamentals are still sound. The major exception is the dynamic in the energy market, a major employer in this country and consumer of capital expenditures.

Energy

The factors that lead to sub-$30/barrel crude are myriad, but the most salient pieces of information are the lack of reliable data and complex political dynamics. As we have seen across asset classes since 2008, an asset can be destroyed by traders the second that cracks form, irrespective of fundamentals. A good example is gold, which rocketed up in 2011 to later collapse in 2013 over just a two-day trading period, and it has not recovered since.

We have seen a similar action on oil since mid-2014 when OPEC ceased defending the price just at the time that U.S. shale producers were ramping up to historic highs. Political dynamics play an enormous role in oil: from Libya to Venezuela, there are a range of governments — some more dysfunctional than others — that rely almost entirely on oil revenues, without which the leaders would struggle for legitimacy. The result is an irrational supply dynamic with each actor producing as much as possible to make up for lower prices, driving the oil to nearly worthless values.

A second storyline has emerged that places the focus on the hostility between the Saudis and Iran. Consider the fact that the price of oil is this low at exactly the moment that the Iranians plan to start new exports. While the two countries are partners in OPEC, they are regional enemies representing the competing Muslim sects and fighting their wars through proxies. Iran supports various terrorist organizations and Saudi Arabia unapologetically represses Shia rights and existence internally. It is possible that the oil market has become the Saudi’s latest proxy in ‘containing’ Iran’s influence in the region, despite its impact across the rest of oil producers and their own economy.

At this point, most every major oil producer is producing at or near maximum capacity. The only exception is Iran, which intends to increase exports starting this month but is unlikely to get to pre-sanction levels for years given the nature of their oil fields and their decline in productivity with disuse. Iran has already announced a need for $30 billion in capital expenditures by foreign corporations to restart their fields. In hard numbers, OPEC currently produces 32.6 million barrels per day (mmbd). While the U.S. production peaked at 9.3 mmbd in Q2 of 2015, that figure is starting to decline and has already lost 0.2 mmbd since then. Given the shutdown of two-thirds of the drilling rigs in the U.S. in 2015, that decline will continue for many quarters, even with the relative ease of drilling for shale.

On the demand side, cheap oil and gasoline does only one thing: increase usage. Cornerstone estimates that global demand moved up by 5.0 mmbd since 2014, to 97.0 mmbd, and shows signs of steady increases on an annualized basis. Even demand from China, with their supposed slow-down, increased 2.7% through 2015. With the supply figures stagnant at best, and demand increasing, we will soon flip to net shortages. The problem is that most oil statistics are generated by econometric models, rather than actual measurements. As a result, the data is subject to changing market conditions, taking months and sometimes years to get accurate measures.

We will also see changes in inventories, which reached historic highs in 2015 and are now seeing slow but accelerating declines. The challenge going forward is not low oil, but the shock that is building as all these dynamics develop into unmovable trends. About forty companies in North America have gone into bankruptcy protection because of the fall in prices, and investment by the survivors has come to a virtual halt. It takes years to develop new reserves, far slower than what will be needed to meet the expanding demand for oil. While there are many steps between here and an energy-induced recession, the price becomes disconnected from the fundamentals when one barrel of oil is traded 26 times in one day, as it is now. In short, we are “priming the pump” for a nasty whiplash in oil prices that could create an entirely new set of dynamics in the years ahead.

COP21 and the Climate Agreement

Ironically, the major highlight to 2015 is the complete antithesis to the oil situation. While oil producers have created a situation in which oil consumption will reach historic highs, 195 nations agreed to find ways to reduce carbon emissions to avoid global warming beyond 1.5ºC. While this limit is unlikely to be enough to prevent dramatic change to the environment, it is projected to be enough to allow the planet to be habitable beyond the next century.

The dynamics here are complex and difficult. It took over 20 years to reach this consensus, during which time most of the damage is already done and not reversible. Getting all the countries to agree was a herculean effort, but the compromise is that this is not binding and not funded. It is also unclear what each country needs to do to get there.

But despite the shortfalls, the ramifications will impact the economy and the markets for decades. The changes today are nascent: solar and wind companies have started to grow in market cap and are investable sectors, but they have yet to generate the sorts of returns one would expect from disruptive technologies. Energy has dominated the equity and debt markets for decades, as one of the core growth drivers and income producers. Going forward, as we shift away from a carbon-based energy infrastructure, those market fundamentals will have to find a new home, presenting significant challenges to asset managers. At the same time, the opportunities that open up will be enormous.

Despite the bottoming out of oil, coal and natural gas, renewables saw more money invested and capacity added in 2015 then ever before. And of all champions of renewables to emerge, China spent a record $111 billion on clean energy infrastructure in 2015. But an unintended consequence of this investment is that it has wiped out profitability. Take the solar industry as an example: back in 2008, First Solar soared in value to $300/share on the prospect of panels on every home and building. But after the Chinese entered the market in the way that a rhino enters a swimming pool, the profitability of that industry disappeared. With the help of extensive government subsidies, Chinese manufacturers reached massive scale driving down global prices on panels. Now First Solar trades at $60/share.

How this all impacts the investing community is still unclear. But given the burst of new capacity, it is global agreements such as COP21 that will foster increases in demand necessary to restore profitability. In time, investment opportunities will become clearer, whether it is direct manufacture of alternative energy components, delivery systems or enabling technology to improve existing systems. All companies need to adopt sustainable business models that balance the needs of environmental stability with those of society. Without that balance, revenues will be challenged and profits will diminish. Businesses able to strike the balance will not just survive, but thrive, in the next economy.

Summary

We are in the most difficult period since 2008, and it is not clear when the next recession will hit this country, or if we are insulated from the next global slowdown. But despite the emotional anxiety of the markets, the fundamentals in the U.S. are still strong. What we haven’t experienced in a long time is a domestic market devoid of government stimulus.

Adding to the anxiety and uncertainty is this backwards dynamic of plummeting energy prices at a time when the global community acknowledges that our energy infrastructure needs to be radically different in the future. With this layered on top of a growing global population, it is no wonder that the markets are unclear. The world is changing dramatically, and that can be frightening.

We will continue to invest in this market with some risk assets (such as equities), but will continue to be very selective about these areas. The balance needs lean towards predictable, stable investments, which are plentiful yet only marginally better than cash in some instances. The resulting mix emphasizes that returns will be muted in this period of transition, until there is greater clarity on the sources and sustainability of economic growth.

We are staying patient, and expect many interesting opportunities to emerge. In the mean time, the volatility and uncertainty will continue to spook the markets and investors. A steady perspective, and a keen eye on identifying value in the rubble of market volatility will continue to be the basis of our management of the situation.

Regards,

David B. Matias

Managing Principal

Market Update–October 26

October 30, 2015/in Market Update /by David Matias

The past three months have been a troubling time in the markets. If you were to listen only to the financial media, you might believe that China is falling apart at the seams, the U.S. economy is tipping into a recession and El Nino is about to push California into the Pacific. However, the reality is very different from this perception. There are many issues to raise alarm in the current market environment, but the fundamental core of the economy continues to show signs of strength. The volatility of the markets, however, has been severe and worrisome.

As I write this update, the market just completed a late summer gyration of down -10% and then up +8% to get back to its starting point for the year. While zero growth in the stock market may sound benign as compared to mounting losses, the volatility has been unlike any we’ve seen since 2008 and the source of much of this public concern. More important, many sectors of the market have seen near collapse this year, as we will discuss, and the large funds are suffering. We will not see the final fund returns until the end of the year, but interim reports show many large funds posting excessive losses for 2015 triggering further selling.

With conflicting or incomplete data, the factors causing this disruption in the market have been elusive to both the experts, and me, though there are some likely explanations. One of these centers on the impact of hedge funds and electronic trading on the markets and the volatility it can create. I will also discuss the Exchange Traded Fund (ETF) market and the tensions created by its rapid growth in so many directions at once. Meanwhile, asset allocation strategies are also facing an impending shift. The end of Fed stimulus programs last year, the expected rise in interest rates, and a slower-growth China are all factors that will contribute to a change in the investment landscape and an important shift in money management allocations that follows.

The Headlines

The summer and early fall brought news about the slowdown in China and fears of its impact on the global economy. Their central bankers acknowledged these issues when they devalued the currency in August, triggering the first spate of market volatility. While China has grown to become the third largest economic region (behind the U.S. and the European Union), the pace of its growth makes it the largest single contributor to incremental demand. The chart below shows the relative size of the major economies, and the impact that Chinese growth has on global consumption.

With consumption representing roughly half of all economic activity, global growth is highly sensitive to this dynamic in China. The economy needs to maintain some growth in order keep the existing job base, and also to expand that base as the working population grows. Those incomes lead to spending, generating both demand and wealth. Trends such as the growing middle class (and indirectly, increasingly stable political environments) are directly rooted in this process. As an example of this process, look at sales of iPhones in China, and Apple’s marketing plans there. China is going to be the largest iPhone market for Apple this quarter. If China isn’t buying as many phones, Apple doesn’t hit their growth targets on which investor expectations are built. It is far from the end of Apple if his happens, but with a market on edge, there is no room for such a miss with Apple.

The world’s production and supply of everything from raw materials to iPhones is based on projections for demand. With China growing at 7%, you need “X.” With China growing at only 5%, you need significantly less than “X.” That is the problem right now: China is still growing, it is just that the forecasting done two years ago was overly ambitious, and the world’s supply chain was built for more.

Over the past twelve months, the oversupply in raw materials has resulted in precipitous drops in prices. Whether the price action matches the true oversupply or reflects the exacerbating impact of financialization is a dynamic that will play out in the coming months. Financialization continues to expand as derivatives products of all kinds expand access to each of these markets. For instance, each barrel of oil that is generated each day is bought and sold 26-times by the end of that day. Minuscule manipulations in the price of that barrel and every other barrel can have an enormous impact on the market for oil.

The oil price drops have had devastating impacts on energy companies, ripping out their capital expenditure budgets and causing growth to slow in related sectors. The clearest example of this is the contraction in the industrial sector as oil companies have less and less incremental spending – and we are sure to see this anemic growth continue. Take, for instance, Caterpillar (CAT), which supplies mining equipment to mines and combines to wheat growers. Facing lower prices across the board, the first measure producers take is to cut capital spending and delay replacing old equipment. CAT took a beating earlier in the year because of this dynamic. In late September, they took another beating when they announced the immediate implications in terms of employee cuts. One could argue that this is an opportunity for the company to cut excess and to be much more profitable when demand resumes, but that is lost on the market in a trading environment that is hostile to deviations from expectations.

Reality Check

The reality test is to look at economic indicators, and how those indicators have been trending. China’s data is not always accurate, which creates uncertainty, and the market abhors uncertainty. The U.S. has the opposite problem. From our massive government infrastructure for reporting data to private drones mapping growing activity, we are flooded with information. The following charts are the ones that we like to look at most closely, and the trends are consistent with a year ago.

Trading Dynamics
What is troubling is the turbulence of the recent market correction. The chart below shows the VIX – a measure of expectations of future volatility – since 2008. Namely, after China devalued their currency, the VIX moved to levels that we haven’t seen since October of 2008, when things truly were a disaster in the world and the economy was falling apart. While the economy was vastly different in August then it was in 2008, it takes far less to drive volatility to those levels.

Since 2007, we have seen a number of events, pretty much on an annual basis, in which volatility spikes to levels that are typical of once-in-a-decade events. The volatility swings of 2008 were the first; the Flash Crash of 2010 was another, Black Monday 2011, gold in 2012, the Swiss Franc in 2014, and now the S&P 500 with commodities this past summer. The underlying situation is typically the same – the market moves in a manner that has no bearing on the economic fundamentals.

The way trading technology has evolved lockstep with financial engineering is one of the more cogent of possible explanations for the dislocation. High frequency trading allows thousands of trades to be executed in nanoseconds to capture minuscule profits at massive scale. Financialization compounds the problem. But Exchange Traded Funds (ETFs) are starting to take center stage, as a growing and significant portion of the daily trading is related to these funds. While there is no definitive evidence on the topic, it appears that ETFs were at the center of the Flash Crash and the gold collapse.

Monday morning, August 24, is a good example of this dysfunction and the impact of ETFs. On the prior Friday, the market had lost 3%. Monday morning, it looked like the market was going to lose another 3-5%. The ETF market, where a massive amount of retail money is invested, was frozen. Quite literally, over 1,000 individual ETF issues could not trade. And when they did trade, the execution was up to 30% away from the underlying securities. For reference, ETF’s rarely trade more than 0.1% away from the underlying index value.

We have three factors that have weighed heavily on the long-view investment managers who control the bulk of long-term public investments. First, as you might recall, the quantitative easing program by the U.S. central bankers ended with its final block of buying in October 2014. The Fed has effectively stopped printing money, removing the ‘methadone’ for the market. While the Fed has yet to remove this liquidity from the market, it is still a significant change of flows.

Next, we have the imminent increase in Fed borrowing rates that will take place either this fall or into 2016. It was over nine years ago, in June 2006, when we last saw these rates rising. That is a dramatic change for an industry that is heavily populated with young traders and managers. The Wall Street Journal reported that Minneapolis-based U.S. Bank estimates that 70% of employees in impacted positions haven’t experienced a rate hike – a phenomenon exacerbated by layoffs that followed the financial crisis.

The final factor in the sea change is China. While they are still growing and will likely do so for a long time, the tapering of that growth has dramatic implications for commodities, and subsequently industries that support commodities producers. Factor all this together, and you have an environment in which long-term asset managers are using new allocation strategies that will take months to deploy. The first step in that reallocation it to sell existing positions. Later comes the buying, that lag driven by the perception of current market volatility.

Looking Ahead

Given the absence of key growth drivers, we expect to continue to see a stable but slow growth domestic economy, without inflation, and a Europe that will benefit from a weaker currency and their own central banking stimulus programs. The jobs data continues to show a low level of unemployment claims with modest jobs growth. Corporate earnings have not come far short of expectations, but are not creating too many surprises to the upside either. In essence, the fundamentals are pretty solid and not yet giving anyone reason to turn instead to risky assets.

The strong dollar and the related increase in the cost of our exports doesn’t help matters, but with the Fed rate policy is such limbo, the dollar may start to lose some value this winter, helping that sector of our economy. We also see significant upside in the price of oil given the irregularities in reported demand by the IEA. Any prolonged spike in oil prices combined with a weakening dollar would be a tremendous boost to both the energy and industrial sectors in the U.S.

The use of individual equities in this volatile market environment is key to generating strong returns. Companies that possess strong growth potential or are beaten down simply because of the systemic fears in the market or in their particular sector – rather than individual fundamentals – are our focus. The carnage in the healthcare sector this month was a good example of all companies getting punished despite any resilience individual companies may possess in their respective markets.

Furthermore, a continued focus on non-equity assets classes will help to stabilize portfolios through the uncertainly. Held-to-maturity bonds continue to be a strong income driver, while alternative investment strategies around private pooled funds continue to perform well irrespective of market volatility. In essence, the basics of investment for value and long-term horizons become far more important in this environment than any short-term play on market volatility.

In the mean time, all the best for an early start to this winter and a spectacular fall foliage season.

Regards,

David B. Matias

Managing Principal

An Ad-blocker, a Vendetta, and the future of Online Media

October 20, 2015/in Market Update /by David Matias

“Adblockalypse” is the end of days for publishers and advertisers. Once it arrives,
content creators on the internet will never be the same again. Many will be destroyed.
The ones who survive will be forever transformed.And that might not be a bad thing.

—Brian Alvey

Once the excitement over the announcement of the iPhone 6s and its ‘3D touch’ feature quieted down, discussion quickly turned to the ad-blocking capabilities quietly tucked inside Apple’s new mobile operating system. Many are aware that ad-blocking has been available for years on other desktop browsers, but many others are convinced that ad-blocking undermines the key engine of a majority of online businesses and that its uptick will cause massive upheaval in the online media world.

And its true: entertainment, news, and information organizations hastily adopted ad-based business models as a matter of survival (see Newspaper Death Watch). But because users do not think of the implicit transaction, “in exchange for this content, I give you access to my eyeballs, and I guess my personal data as well”, users now want the content for free, and Apple played the white knight by helping them get it. Far from either creating a pristine browsing experience or marking the death of online media, this instead represents a natural evolution in its delivery methods. And as serial entrepreneur Brian Alvey suggests, this might not be a bad thing.

Ad-based business models create a problem for content providers when the interests of its users conflict with those of its actual customers, advertisers (hence the emergence of ‘clickbait’). If users prevent companies from selling personal information and ad-space and are faced with the decision to pay for it or be denied access, content providers will be forced to be more responsive to their interests. We see this leading to a consolidation in media resulting in more reliable information and higher quality content.

A straightforward comparison is that of two leading online streaming sites: Netflix and Hulu. Netflix derives revenue from users, who pay a subscription fee for unlimited access. They are leading the way in adapting to the tastes of its users, bringing high quality documentaries and tv series raising the bar in terms of diversity in television. Hulu on the other hand, is essentially an extension of cable networks on the web, and though they are now offering an ad-free premium service, a majority of its revenue is from advertising. Accordingly, it developed innovations such as in-stream purchases and engagement through ad-selection, given who their keeper is.

Another comparison is that of the two tech giants at the center of this debate: Apple and Google. Apple is traditionally a hardware company whereas Google is a services company powered by ad-revenue. Following Steve Jobs’ publicized vendetta against Google, this move can be viewed as Apple chipping away at Google’s base by blocking ads and making slow progression towards a search engine of its own. And of course, a shift from ad-based models to subscription-models would likely feed into sales on Apple’s App Store, which Apple would take a cut from.

Beyond aligning a company with the interests of its users, ad-blocking has clear benefits by protecting privacy, reducing data use, and improving speed. Silicon Valley figure Jason Calacanis compares blocking ads on a mobile phone to “moving from from a crowded apartment complex in a polluted, violent city to a peaceful lake house.” Attitudes towards privacy are both cultural and multi-faceted, concerning the collection and treatment of personal data, the use of this personal data by corporations vs. by government agencies, and the appropriate level of transparency of both the corporations and government agencies.

Many accept that the collection of personal information allows companies to provide them with an improved customer experience as well as services and content either free or highly subsidized. Others believe that while corporations should be blocked from collecting and bartering personal data, government agencies should have full access in the name of national security, supporting government-mandated loopholes to encryption technologies. Others believe that the government should fully support encryption and set a high standard of privacy protection as a human right. Just like any question of individual rights, it boils down to a question of balancing an individual’s freedom and those of other individuals. One individual’s right to private browsing may not outweigh others’ right for the state to monitor browsing that may prevent terrorist or criminal threats.

Scientist and tech-futurist David Brin takes a third path and notes that the problem is not the collection of personal data, but the manner in which data brokers and government agencies operate in darkness, preventing people from monitoring their behavior and responding to improper or abusive use. He supports a future with so-called ‘reciprocal accountability’ based on the power of reputation and informal social pressure: “It’s not that we will lose privacy. Its that we’ll lose the illusion of privacy and gain real privacy because we’ll catch the peeping Toms and the voyeurs.” He believes the greater risk is preserving the darkness in which bad actors flourish.

While these changes will reveal themselves over time, the impact of ad-blockers will likely be felt in the nearer future, as long as they overcome the potential barriers to adoption such as hassle, apathy, and even capitalistic ‘fairness’. Take for instance developer Marco Arment who decided to remove his top-ranking ad-blocker after 36 hours given its inability to offer a more complex solution to a complex problem. While users have the right to avoid or boycott sites that sell advertising to pay for its content, users don’t have a fundamental right to content if they use ad-blocking software to prevent the providers’ method of bringing it to them. Many believe this is why there would potentially be legal action against Apple and the developers of ad-blocking apps for interference into a company’s ability to do commerce, if ad-blocking software reaches more scale.

All these issues aside, you can never fight the tide. If people want an ad-free experience, media companies have to find a way to give it to them on their own terms. A core marketing concept is that consumers are ether time-constrained or money-constrained. The direction forward is to capture both through diversified delivery methods. Giving users a choice between paying for content or receiving it free, supported by advertising, or new forms such as sponsored content, native advertising and ‘recurring crowdfunding’ (aka the ‘public radio model’), will be next evolution in online content.

Market Update – July 2, 2015

July 2, 2015/in Market Update /by David Matias

The first half of 2015 has been marked by some surprises, but at the end of June, the markets were in neutral, without any clear directional trend. While events such as the Fed move, oil price stabilization and disappointing economic indicators in the U.S. are all worth exploring, the Greeks are currently stealing the summer headlines. This update will address the current events in brief, while focusing on the prospects that we see for the second half of the year in what I’m calling the “durable economy.”

Thus far, the financial markets in the U.S. have generated negligible returns. Although there are some bright spots over the past six months, the collective S&P 500 is hovering around 2%, and the Barclays Aggregate Bond index remains slightly negative. Overseas markets are better in some areas, such as developed European markets, but with the prospect of a Greek exit from the euro, those returns just got halved for the year. The drag on overseas returns is China, which just entered a bear market this week after a series of missteps and miscues around sustained growth.

We don’t see this as all bad, and in fact, we are fairly optimistic about the prospects for the second half of the year. In a sense, the pause that the past six months have provided is beneficial to the markets over the long term. Keeping in mind that we’ve had a raging bull market for many years now, a breather in the climb gives the economy a chance to catch up to market expectations. In addition, we are also experiencing a significant shift in the manner in which the domestic economy generates growth.

I will address these factors in a longer Research Note this month, but for now, we appear to have shifted into a domestic economy that is resilient to a recession, yet unlikely to grow at the four to five percent pace that we have come to expect in past expansions. Two percent growth is all that the Fed projects for the next couple of years – not one of the most reliable predictors, but a good proxy. Given our heavy reliance on consumption for growth and a movement away from manufacturing, the modest expectation is reasonable. We appear to be shifting away from consumption as the primary driver of new growth and creeping into an innovation economy that would provide for a durable expansion over many years.

The downside to two percent growth is the threat of recession should there be any significant shock to the economy. Global events such as those in Greece, or conditions in Russia ranging from erratic military action to a decimated ruble, all have the ability to be that shock. Other possible shockwaves could emanate from increased occurrence of financial dislocation in markets driven by financialization (explained later), such as we experienced in the 2008 collapse. Similarly, more recent events, such as violent movements in the price of gold, the Swiss franc or oil could have an impact. But, we view the domestic economy at this time as stable enough to withstand most shocks.

With this in mind, we are looking at a variety of investment areas for the second half of the year. Energy, with the halving of oil prices last year, is one of the brightest spots in the durable growth scenario. Carbon-based sources and other alternative energy sources, plus the combination of an innovation economy with the dramatically lower energy prices this year, have stoked demand globally. That demand is translating into economic stability in some regions, and unexpected growth in others. We are incorporating the perspective of Mike Rothman at Cornerstone Analytics, which posits that demand for oil will outstrip supply by the end of 2015. While this prediction is counter to prevailing market sentiment, the growth in demand combined with a dramatic slow-down in drilling in the U.S. and declining well production in all other regions makes a strong case for this inversion later in the year.

Aside from energy, the disruption from Greece could present some interesting opportunities in Europe. Despite their market rally in the first quarter, the earnings multiples of European equities are still relatively modest, and the prices are even cheaper in dollar terms because of the devalued euro. If the region slips into another recession, then those valuations are too high; if the current situation resolves without significant economic damage to the broader continent, then the prospects are strong. Add to the picture the extensive exports by Europe to the U.S. and China — both of which are growing at a substantial clip on an absolute basis — and there is important upside for the European companies that operate globally.

Market Review

The context for the markets is fairly consistent with our discussion back in January: we’ve seen a relatively flat market with noted volatility around specific events. The flat markets in the U.S. are striking — equities have struggled to improve their gains for the year, while bonds are showing losses. Although some of the chronic underperforming markets had a strong start to 2015 (Europe in particular), the perpetual Greek crisis has already derailed many of those gains.

The chart below shows the three major asset classes in the US: the S&P 500 equities, Barclays Aggregate Bond Index, and the Deutsche Bank Commodities index, our rough benchmarks for most accounts. They are not ideal reference points, but here they show you the general trend for the markets this year, keeping in mind that we’re seeing a very narrow trading range in all three asset classes.

Chart 1 – Market Total Return 2015. Source: Bloomberg

As you’ll see in this chart, U.S. stocks have had a year of relative quiet with gains of 1% – 4%. Bonds, with the anxiety around Fed policy and interest rate movements later in the year, have moved only slightly. The stock and bond indices combined, on a 60/40 basis that is typical of a diversified asset allocation model, yields a return this year of about 0.8%, depending on the week.

Also note the relatively tight range of trading on these assets – stocks have moved in a total range of 6% from high to low. Even commodities, a volatile asset class this year, has stayed within a 9% range.

Despite the perception of turmoil for the year, the volatility measures have been remarkably quiet. In fact, the equity markets have had their narrowest range of movement in the past two decades. According to Bloomberg, the range of movement from highest to lowest points for the year is just 6.5% a very modest move where the range is typically 10% – 40%. Add the VIX to the picture — the measure of expected future volatility in the S&P 500, which has not traded above 20 since January — and the realized and expected volatility is the lowest it has been in a very long time.

The key exception to this flat market with a narrow trading range is energy. Oil, in particular, has been all over the place. Starting with a 50% drop in crude prices going back to last fall, we saw a 30% jump in the early spring. The short-term impact of trading dynamics on oil prices far outweighs the impact of the supply and demand situation. Specifically, the amount of financial products that are traded daily on oil is roughly twenty-four times the actual demand for oil. This financialization is not new to the asset class. The phenomenon is a function of both growing derivative markets and the computerization of trading strategies, and drives many of the market dislocations across asset classes that we experience on an annual basis.

The take-away from financialization is the fragility of many markets, which are influenced by perceptions on any given trading day. Whether we are discussing gold, Swiss francs, corn, oil, or even Apple stock around a product release, the disconnect between fundamental value and trading price can be severe. Despite the anxiety that can arise around these fluctuations, financialization also creates enormous opportunity when actual value is separated from perception.

Economic Review

The factors that we continue to monitor for predictive market behavior are employment, GDP, and housing. We have gradually added energy to this discussion, given the volatility in the energy markets and the skewed dynamics it has created.

The U.S. economy is again expected to show slow growth in the past quarter, somewhere in the 1.8-2.0% per annum growth rates. Unemployment dropped again over the quarter, and the jobs creation picture is holding steady and promising. With close to 300,000 new jobs created every month, we are slowly mending the employment picture. But labor participation rates hide the broader story, as many folks simply are not participating in the trend. This causes a drag on domestic consumption, but also gives us tremendous room for growth before serious inflation is triggered.

Chart 2 – Labor Participation Rate in the U.S. 1945 – 2015. Source: Bloomberg

While our labor market has shown tremendous tightening in the past two years, the broader employment picture is masked by the historically low participation rate in the U.S. Driven by a combination of changing worked demographics (retiring boomers, for instance) and the perception of poor opportunities, we are at a level not seen since before women entered the labor force in earnest.

The part of the picture that I am most optimistic about is housing. New home construction (housing starts) have reached the one million annual level again – and are holding that level – after a dismal slowdown in the Great Recession. With a long-term average of roughly 1.5 million new homes per year, we have a long way to go. The competing factors here are housing stocks, which decline every year as homes are demolished, and the growing population, the impact of which has been partially offset as retirees team up with Millennials to consolidate households. Doing some simple economic math, an extra 500,000 new homes a year with the associated jobs, materials and durable goods purchases can add 1.0 – 1.5% to the annual GDP figure. In an economy still in need of consumption for growth, that could prove to be a tremendous stimulus for economic stability and market gains.

Chart 3 – Housing Starts 1970 – 2015. Source: Bloomberg

Housing starts hit epic lows after the Great Recession, bringing that sector of the consumption cycle to a virtual standstill. We are seeing significant gains in housing prices, and with eight years of contracting housing stock, we are poised to see a return to healthy housing starts. Between the jobs, materials and consumption that go into each new home, this recovery would add significantly to the GDP.

Turning to energy, U.S. “energy independence” threw a theoretical monkey wrench into the oil market. Lower prices have caused supply growth to decelerate with the prospect that OPEC might be fully tapped out. U.S. oil producers may be headed for annual declines in production by Q4 2015 due to a halving of capital expenditures and the high depletion rate of fracking wells. Yet demand growth seems to be picking up faster than economic surveys would suggest. Interestingly, this latter fact points to increasing economic activity in many emerging markets, even though traditional commodity prices have yet to show the correlated movement.

Overall, we are monitoring the energy picture extremely closely given the manner in which it can impact global demand and domestic inflation. Factors such as ISIS or the Iranian nuclear talks are just a few of the wildcards in this equation, with the ability to derail all of the models described above. It also continues to prove the case for alternative energy sources and inventive ways to use energy, stimulating innovation that will ultimately change the way our economy grows and how we live.

We are weighing all these factors as we rebalance our commodity exposure for the second half of the year. In recognition of the volatility in the commodities market driven by financialization, we are shifting to companies that profit from increasing demand as opposed to futures-based ETFs. The shift on specific commodities is also changing, with a heavier emphasis on energy and a movement away from metals and some agricultural commodities. On agriculture, our view is that the middle class growth will continue to drive food demand, but that going forward, we will invest in that area in a way that avoids the vagaries of temporary oversupply and political intervention.

Greece

The biggest risk as of this writing to the global growth scenario is Greece. We have never seen a country exit the euro, and the last time that a major borrower defaulted on their debts was the Lehman collapse of 2008. Back then, the global markets came to a freeze, with the prospect of a collapse in the financial system, as a trillion dollars of assets were wiped from the system and dozens of institutions teetered on the brink of failure.

Today, the situation is very different. Institutions have had years to assess the prospects of a Greek default, shoring up balance sheets and putting risk management tools into place. Most important, key institutions have trimmed their holdings of Greek sovereign debt to nominal levels. That said, someone is holding the debt and will suffer the consequences. In many cases, these are the hedge funds that once played this gambit with tremendous success. A Greek default would most certainly torpedo these funds, either through complete insolvency or a gradual rush of redemptions over the coming months.

The Greek financial system, however, would be in tatters. Aside from massive financial failures, the basic system of currency and payments will go into a tailspin. As one analyst put it, the Greek voter will be sorely disappointed when the supermarket is out of food and their ATM card no longer works. For these reasons, we don’t expect Greece to take themselves over the cliff. The political posturing is dangerous, yet the uncertainties of a break would do so much damage to their domestic situation that it would amount to national suicide.

Conclusion

“May you live in exciting times,” my Chinese cookie fortune recently told me. What we are seeing today is unprecedented, potentially dangerous, but rife with opportunity. The resilience of the capitalistic model is being tested, and at the same time, the benefits of technology are expanding in ways that are beyond comprehension. Many social issues need to be addressed now and for the long-term, but with the right perspective and an ability to see past the fears, we see this as a time to be thoughtful, cautious, and creative in our investment strategies.

Regards,

David B. Matias

Managing Principal

eCurv featured in Xconomy…

May 18, 2015/in Market Update /by Melissa Pierce

The year eCurv spent pitching its energy management software to potential customers has taught its founder a few lessons.

“The opportunity is much bigger than we thought,” said Edison Almeida, founder and chief executive of the Cambridge, MA, startup, which raised $2.5 million last June and has its eyes on another round of financing by the end of this year.

ECurv presented its software to dozens of the largest retailers in the United States, and the company’s cloud-based power management software now runs hundreds of their electrical systems. The company’s software juggles power use in commercial and industrial buildings and tries to cut electric bills without curtailing operations….

Using Telecom Tech, eCurv Looks to Lower Energy Bills, Raise Money
By Thomas Miller

The year eCurv spent pitching its energy management software to potential customers has taught its founder a few lessons.

Like residential electric customers, businesses pay a charge for how many kilowatt-hours of power they use. But they also pay a “demand charge” based on the maximum power they use at any one time. For example, running three hair dyers together for 20 minutes would have a higher maximum power than running one hair dryer for an hour. In some areas, demand charges are close to half of a commercial electric bill.

Almeida’s system corrals all the air conditioners, lighting systems, motors, refrigerators, and other appliances that request power independent of one another—“loads” in energy management-speak—and it puts them into a queue so that fewer pull power from the grid at any one time.

This shaves down the highest peaks of demand. “The more loads, the better it is,” Almeida said. “It’s more pieces and parts that we can coordinate to improve performance.”

Almeida, who started his career developing mobile phone systems in his native São Paulo, Brazil, built the eCurv system from the same complex algorithms that arrange the calls, texts, pictures, and data requests that all compete for bandwidth on phone lines.

With his software running in more places, Almeida said the results are better than initially expected. He had projected that eCurv would cut customers’ bills by about 11 percent, but its results are coming in closer to 22 percent.

That is all good news to eCurv’s Series A investors: Constellation Technology Ventures (the investment arm of energy firm Exelon), Vodia Ventures, and the Massachusetts Clean Energy Center.

The next big step for eCurv is raising a Series B round, which Almeida said could close as soon as October. The company has eight employees and is looking to hire software developers.

The industry around electricity demand management is growing from an already sizeable base, according to Ryan Hledik, a principal at the Brattle Group in San Francisco who researches demand management. From Boston’s EnerNOC to Gridium in Menlo Park, CA, a handful of companies are targeting the demand charges that commercial customers pay.

Many of the energy management firms out there analyze companies’ power consumption and come back with times to reduce loads or other ways to dodge demand charges. ECurv’s product finds these times, but it goes a step further by reorganizing the timing of the loads to cut demand.

“It’s an emerging, growing opportunity for these energy management firms,” Hledik said. “As they get further up the learning curve and customers need to manage escalating energy cost, this would only become a bigger opportunity that we will see more companies pursuing in the future.”

SolarCity jumped into the demand management market in late 2013 when it started selling Tesla battery units that can be charged by the sun and discharged during peak times to lower demand charges. Last month, the company said it had raised a $1 billion fund dedicated to commercial solar projects, which could take advantage of this technology.

On Friday, Tesla announced a battery system for utilities and commercial customers, the software brains of which were built by EnerNOC. The units could store up energy from solar panels and other sources for use in the afternoon periods of highest demand.

Almeida sees eCurv’s growth from hundreds of locations to thousands. Beyond the horizon of the next few years, though, he has larger ambitions for eCurv. Today, the company’s technology manages electric loads behind the meter. Someday, it could take on the power grid, or at least a slice of it.

And the vision isn’t too far off: Appliances and electronics could someday queue into the electric grid for power, much like cellphones do with telecom networks for bandwidth.

“That is exactly what we want to do,” Almeida said. “We have chosen demand management as a way to go to market and get a foothold in the market, but our end goal is to get to critical mass so we can demonstrate our technology on the grid scale.”

But the timing for that demonstration is less than ideal. Too few appliances are smart enough yet to communicate with a server. And then there’s getting a utility company or a grid operator to turn over the reins. “Because of that we could not pursue a direct to utilities go-to-market model—that would just take too many years and would be very frustrating to get that done,” Almeida said.

Market Update – April 2015

April 29, 2015/in Market Update /by David Matias

This year was marked by volatility, and this should come as no surprise. Our economic situation, our jobs market, the swings in oil production, and highly unpredictable political situations across the globe contribute to this volatility. Furthermore, we have relied on the U.S. economic stewards to create the foundation for unprecedented market growth, but now as we transition away from stimulus to self-sustaining growth the prospects are increasingly unclear. And with a new presidential election looming, who knows what the future holds? Let’s take a look at each of the factors that contributed to an interesting year in the markets and the economy.

Markets

Any review of the U.S. markets truly depends on the day of the week. As of this writing (fourth week of April), the Dow is up 1% for the year and the S&P 500 is up 2%. Although this figure does not include dividend income, it is a meager start to a year in which we are experiencing solid economic growth.

The good news is that we do have clarity on an economic recovery that continues to gain traction. While the figures are still well below historical averages, our jobs level continues to grow and the labor force participation rate continues to climb. Don’t be distracted by the unemployment figure, however. With participation rates still the lowest they have been in 40 years (and before women participated at significant levels in the workforce), it would be a mistake to think that most Americans have jobs. With only 58% of Americans working full-time, our economic recovery will continue to be dependent on continued improvement in both jobs and GDP.

The flow of money out of U.S. equities this past quarter was substituted by a flow into European equities for the first time in a long while. And while the economic fundamentals still do not look good for Europe (high unemployment, low organic business growth, deep strife within society), the prospect of easy money through a coordinated quantitative easing program in Europe has been temporarily attractive. We call this temporary because it is unlikely to change the economic picture anytime soon – at least not in this generation (I will cover this issue more in a different blog post).

Chart 1: Equity index movement year-to-date (S&P500, Dow Industrials and FTSE 50. Note the continued swings below the line for the U.S. markets, and the inability to generate any consistent movement for the year. Europe’s strong move is mostly attributed to the ECB’s quantitative easing program. – Source: Bloomberg – Date Range: 2015 Year to Date

Most interestingly, the volatility measure of the equity markets has remained at extremely low levels. The VIX, which measures the expectations of future volatility, has been trading in a range of 12 to 23 for the year-to-date, which is not far from its historical lows. Although the range may seem wide on a nominal basis, it is still a fraction of the level that VIX reaches in times of true market distress. Prior to the 2008 collapse, VIX was peaking in the 30s, and during the collapse, it traded over 80.

Given the VIX numbers, we are still in a period of relative calm compared to the type of volatility that we have seen during deep market dislocations. This relative calm, however, could be significantly disrupted by any abrupt yield curve movements. With the Fed slated to raise rates this year, and inflation expectations still extremely low, the yield curve could shift in either direction. It is the single factor that has the highest likelihood of changing the tenor of the markets..

While it is difficult to predict how the yield curve would shift – whether long rates would increase more than short rates or if they simply invert – the ramifications could ripple through all asset classes. The relative yield on bonds impacts valuations on everything from stocks to real estate, with the lower-yielding of these assets likely to take the biggest hit in a higher rate environment. The mitigating factor in a higher-yield environment would be the economic growth that would trigger the Fed’s move.

Despite all these uncertainties in the equity markets, stock levels continue to hover near all-time highs. In fact, the NASDAQ finally broke a high not seen since March of 2000. Back then, company valuations were at astronomical levels and most of the index was composed of technology firms. Today, the index is very different, with less than half of it being in technology, and a much greater representation by consumer services and health care. The diversity of companies represents a more balanced and sustainable high than the last time.

Economics

The economic situation has not changed very much since the last update. The U.S. GDP continues to generate growth, but does so at an “in-between” level that does not give much clarity for the future. Growth in the first quarter was weak due to the brutal winter much of the country experienced, but based on jobs figures, we are continuing along at a reasonable pace. As long as jobs are being created, the consumption part of our economy can grow.

The challenge we faced this past quarter is the strength of the U.S. dollar. While domestic consumption is able to grow with new jobs, our exports are suffering because of pricing pressure. That does not portend well for this earnings season, as so many of the U.S. firms are now global in their sales base. With China also decelerating in growth, sales are dragging. [A notable exception is Apple’s explosive iPhone growth in China during Q1, which is now the largest iPhone market surpassing the U.S.]

The jobs situation is worth exploring a bit further. The number of Americans with jobs relative to the population is still at a multi-generational low. The implications are not to be underestimated: baby boomers are retiring earlier than anticipated, the millennials are facing bleaker job prospects, and families that used to think in terms of dual-incomes are learning to make do with one.

Charts 2 and 3: While unemployment is at a low, the number of folks who participate in the workforce is the lowest we’ve seen in 40 years. This dynamic is driving total employment levels that are also at 40-year low despite all the jobs creation in the past five years. Until this dynamic changes, the U.S. economy will not be able to sustain economic growth, given the reliance on consumption and disposable income. The counter argument is the ability to tap in to large pools of workers – albeit folks who have been out of the labor force for a while now – and grow the economy without triggering inflation and the need for strong monetary tightening.

Chart 3: Percentage of people with jobs relative to the total population. See Chart 2 above. This picture is vastly different than the unemployment numbers that are headlined by the financial media. – Source: Bloomberg – Date Range: 1980 – 2015

The strong entrepreneurial culture in the U.S. is a silver lining that might be overlooked. People are having to reinvent themselves and their careers. We continue to see amazing growth on the venture fund side of our business with experienced founder teams redeploying technologies to find new niches in the economy and create jobs along the way. Unlike the last time that the NASDAQ was reaching new highs – back when the venture boom was largely focused on hype surrounding then-new technologies –, we are now seeing a boom based on more realistic expectations, more diverse technologies, and business plans focused on revenue and profit supporting the valuations.

The aspect of the economy that is most challenging to understand today is the energy situation. As we addressed in our last update, the precipitous drop in oil prices was unforeseen by most. What was supposed to be a steady squeezing of supply by OPEC to maintain oil prices in the fall, was, in fact, a widening of the spigot and pumping of oil at maximum capacity. Today, OPEC’s excess production capability has dropped to nominal levels, and countries such as Iran and Russia continue to pump as fast as they can.

What we are seeing is a rapid acceleration of the economics of supply and demand. With oil prices at half their prior levels, the cost of exploration does not justify the revenue in many situations. As a result, the U.S. oil rig count has dropped by half during the first quarter, and continues to decline each week. While this will ultimately result in lower production, there is a delay of at least a few months before we see the impact in supply.

Meanwhile, demand continues to increase steadily with the cheaper oil prices, namely in the developing markets (non-OECD). Ironically, the emerging markets are notoriously bad at reporting their oil needs, creating a significant lag in demand projections and chronic underestimation of global oil demand. For instance the major reporting agency, the International Energy Agency, has repeatedly revised future and past demand upward for the past six months. With traders relying on this date, it creates the potential for greater volatility in the trading of oil futures as we’re seeing right now.

The dynamic we see evolving is something akin to an overstretched rubber band. Lower prices are increasing demand which curtailing investment into production. Analysts working with published data are projecting oil prices accordingly, yet the data itself is changing, given the accelerated change in prices.

Rubber bands can and do rebound – sometimes fiercely. That amounts to volatility – not just in the price of oil, but in all the other factors that are heavily dependent on oil, including inflation. Without getting into the political ramifications of the situation (Iran, Libya, Venezuela, and Russia are all in a deeply challenged fiscal state for this reason), there is the likelihood that this oil dynamic will continue to disrupt economic and market conditions for the rest of the year.

Whatever the final outcome on demand, supply, price, inflation or political stability, the prudent investment direction in this situation is to use caution and a tremendous amount of wherewithal as we navigate the rest of the year. Maintaining a strongly diversified portfolio without an over-reliance on any single asset class continues to drive our investment direction. Combined with additional techniques to mitigate risk, this provides a core foundation for the ability to buffer our portfolios from the volatility these markets can bring.

Regards,

David B. Matias

Managing Principal

Market Update: January 2015

January 22, 2015/in Market Update /by David Matias

2014 presented a set of challenges that we have not seen in a long time. While the financial markets continue to have generally positive results, the global political situation is changing drastically. The continued dichotomy in financial returns — some markets up, others down – – is putting extreme stress on institutional money managers. In addition, the shifting fortunes of oil have changed global politics overnight, even as wealth inequality and social stresses continue to challenge our world in potentially disastrous ways.

The S&P 500 again finished the year with strong gains: 13.7% with dividends included. On top of 2013’s gains of twice that, one might think there should be little concern about markets and the ability to make money in them. Unfortunately, that is not the case. The developed markets in Europe and Asia had another year in which they vastly underperformed. In fact, both developed non-U.S. markets and emerging markets showed negative returns this year. Even within the U.S. market, performance among sectors and indices varied wildly, with the Dow lagging the S&P 500 by 4%.

Although the U.S. economy posted one of its best quarters for growth in Q3 with a 5% annual rate (the strongest in 11 years), most of the world’s major economies are shrinking, stagnant or slowing down dramatically. Europe is still in a recession; the threat of a broken Euro is being viewed as inevitable; and Japan continues to experience lost growth.

The 50% drop in oil prices over the past six months has created a geopolitical windfall for the U.S. that we could never have created on our own. Three of our major “adversaries” are reeling from the decline: half of Russia’s revenue comes from oil sales, Iran’s economy depends solely on oil, and 95% of Venezuela’s exports are oil. Each of those three countries are now forced to bargain with their U.S. surrogates as they face economic collapse. Even the renewal of diplomatic relations between the U.S. and Cuba has been connected to the oil situation, as Cuba faces the real prospect that Venezuela will stop subsidizing their economy.

Let’s take a look at how the three things I mention above – the financial picture, economic conditions, and political situations around the globe — played out in more detail:

Financial

This was a difficult year to make consistent returns, especially for institutional money managers who work with large pools of money and are solely assessed on their ability to “beat the market.” Equity mutual funds had their worst performance in 25 years, with 79% of U.S. stock funds failing to beat their market benchmark.^{^[1]} Ironically, the most common predictor of this trend is Apple stock: four out of five funds this year underweighted Apple stock anticipating the company to do poorly.^{^[2]} With Apple up 42% this year, that was a painful miscalculation. Those funds with market neutral or heavy Apple exposure were up 8% for the year. The rest were up just 6.2%.

Hedge fund returns are another set of indicators of a challenging year. These massive pools of capital are aimed at generating market-like returns with lower volatility. Their performance again has suffered with an average return of just 1.4%. As a result, the extreme volatility in December, with the market down 5% then up the same in just a few days, was blamed on these institutional managers trying to chase returns in the last month of the year. Bloomberg’s news service reported in December that hedge fund closings in 2014 were at the fastest pace since the collapse of 2008, all due to poor returns in the past few years.

Bonds, surprisingly, rallied another 6% this year, with the bulk of the gains being driven by long-term U.S. treasury bonds. While short-term bonds held mostly steady on rates, long-term interest rates on safe bonds plummeted from 4% to 2.8% on short supply and falling inflation expectations driving up long-maturity treasury prices by 24%. This flattening of the yield curve went against expectations, setting the stage for new challenges in 2015 as bond investors try to find yield while protecting against any unexpected movement in rates. With the Fed slated to raise short-term rates later this year, it promises to be a volatile asset class.

Chart 1: Returns for the major assets classes in 2014, with a wide disparity between sectors within the same asset classes. For comparison, the Dow 30 generated 10% while the Bloomberg Hedge Fund index was up 1.4%. Note that the bar for Energy was shortened for visual purposes – the actual bar would have gone down to the next paragraph.

Looking at market sectors, healthcare had one of its best years, with the sector up 25% and many of the major gains a result of frenetic merger and acquisition activity. Utilities, surprisingly, had a phenomenal year as well, with the fall in long-term interest rates making the dividends on these stocks extremely attractive. The rest of the sectors hovered around the market average, while key sectors like energy had a miserable year.

Investing overseas, however, was almost certain to generate losses this year. The major non-U.S. markets mostly suffered from very little growth on top of increasing volatility from political events. The biggest issue in global investing is the divergence in currency values. Specifically, the U.S. dollar is stronger than ever, battering the local currency price of any investment overseas. Although this trend may not persist, it would be a dangerous time to invest against it.

Economic

The economic situation in the U.S. seems to be improving and we have oil to thank for that. From an environmental perspective, I am loath to credit oil with anything good, but the economic reality is hard to avoid. For all its problems, fracking has done two remarkable things for our economy: it generated jobs and brought down the cost of energy through increased supply. As we outlined in our July 2014 update, the U.S. has increased production by roughly 5 million barrels per day, and in combination with improving consumption dynamics, has decreased our imports by 70% (depending on which source you look at).

The employment picture is the most critical aspect of our economy today. The labor participation rate – those who are employed or want to be employed – is the lowest it has been since the 1970s when women started to enter the workforce en masse. The factors I’ve heard are varied: changing demographics as baby boomers retire, hangover from the Great Recession, folks not being able to reenter the workforce and college debt overhang on the millennials.

But whatever the reason for the smaller workforce participation today, the number of jobs for those who are looking for work is back at pre-recession levels. What looked to be important wage rate increase earlier in the quarter fizzled out with a total annual gain below inflation. But with the addition of the actual savings from low gasoline prices, we see that disposable income suddenly increased for the first time in a decade.

The other aspects of the economy all continue to look encouraging: new housing starts are above one million per year, real estate prices are still climbing and back to pre-crisis levels in many communities, lending standards are relaxing for mortgages and equity lines, and disposable income is increasing with a lower cost of living from the decline in oil.

With all these tailwinds, the U.S. growth picture is the best in the world today, and in fact has once again passed China as the largest driver of growth dollars in the world. That is quite a change from just three years ago, when China took the definitive lead over the U.S. and Europe. The trick going forward, however, is that we won’t hit true long-term stability until global demand for our goods improves and there is a broader jobs base to drive consumption here at home.

The success of our overall economic situation is dimmed by a black cloud of wealth inequality in the U.S. and abroad. The disparity in wealth in the U.S. hasn’t been this great since the 1880s, and the gap continues to grow here and overseas. The challenges this presents are vast, from social unrest and nation-states at war, to an inability to support a growing consumption economy on the back of diminishing disposable income. Until this problem is addressed, the issues will grow and further threaten the financial markets.

Chart 2: The disparity between oil producers and oil reserves is a startling insight into the longevity of the political and economic systems that depend on oil. Russia in particular is at risk within a generation, while the U.S. is highly dependent on new discoveries, without which we will deplete our reserves in five years.

Data: www.eia.gov, 2013 or 2014 used based on country.

Political

The foreign relations impact of the oil slump is startling. The significance of potentially bankrupting Putin and the Russian economy is not to be understated. As portrayed in my favorite Cold War movie, Three Days of the Condor with Robert Redford and Faye Dunaway, oil and energy security has dominated all aspects of our foreign policy for the past five decades. From the trillion dollars we spent over the last fifteen years to secure the Middle East (which arguably is in the throes of failure), to the massive drilling efforts within our own borders, oil overshadows all other policy matters.

The dynamics of oil are one of the most intricate issues I’ve had to grapple with. The chart above might shed some light on those dynamics. As you see, the top oil producers are Saudi Arabia, the U.S., and Russia. Each of those nations heavily depends on those oil revenues to keep their economy and society intact. The Saudis have used oil over the decades to keep a vastly underemployed and a religiously intolerant population at relative peace through expansive subsidies on everything from energy costs to quality of life. The Russians have taken the hundreds of billions in excess foreign currency to both enrich an elite class of oligarchs and to support regional conflict. And the U.S., as you know, has used cheap energy to drive a $16 trillion economy to generate the highest per-capita wealth in the world.

The fascinating part of this dynamic is the longevity of those oil sources. The Saudis can pump for decades, given the size of their reserves and health of the wells. The Russian wells on the other hand, have a short life-span. They have just a fraction of the Saudi’s reserves, and their well production is diminishing at an increasing pace. Russia has barely a decade to establish their place in a post-oil economy. It is a frightening prospect, given Putin’s quest for power and the prospect that his source of that power will disappear in his lifetime. He is not beyond actions and events that would bring us back to global conflict.

The Saudi/U.S. dynamic is even more intricate. According to popular thought, the Saudis are attempting to drive U.S. fracking out of business and regain their global dominance in oil. That narrative is fundamentally flawed, however. The U.S. must drill for an additional 1.7mm daily barrels of oil each year to compensate for the lost efficiency of their wells, with a cost of new production averaging $65-70/barrel.^{^[3]} The corollary is that fracking has an extremely short well-life, of just a few years, while the Saudis have a well life that spans generations.

The U.S. surge is a production surge, which is vastly different and has a finite impact. American energy independence is by no means assured, and in fact not likely to ever be complete. In 2012, the International Energy Agency reported that the US could become energy independent in the future, but that such a dramatic shift in production would be disastrous for greenhouse gas emissions. That fact was distorted in the American press to say that we will be energy independent, ignoring the obvious constraints associated with such a shift.

Oil is likely to cause significant upheaval and volatility in the financial markets in the coming year. The impact on debt markets is also non-trivial, as American energy producers face a cash flow crisis at these oil prices.

Change is a scary concept. It can be even more damaging to financial markets. Prosperity here will continue, but the durability of investments will be tested in this environment, and the volatility of the past will continue into the near future. Nevertheless, we at Vodia remain confident that our skillful, careful, and relatively conservative approach to wealth management and our vigilant eye on markets will steer us through rough waters.

Regards,

David B. Matias

Managing Principal

^{^[1]} WSJ, 27 December 2014, B1

^{^[2]} Bloomberg New Services, December 15, 2014,: “Shunning Apple Tops Long List of Bad Market Calls in 2014.”

^{^[3]} Two sources of data are The Economist (December 6th-12th, 2014) and the US Energy Information Administration, www.eia.gov.

Using Telecom Tech, eCurv Looks to Lower Energy Bills, Raise Money By Thomas Miller

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Using Telecom Tech, eCurv Looks to Lower Energy Bills, Raise Money
By Thomas Miller