Weekly Commentary March 24th, 2014

The Markets

After a series of moves that proved far more effective, but were almost as complicated as the Acme Corporation strategies Wile E. Coyote employed in pursuit of the roadrunner, Russia dropped an anvil on Ukraine and annexed Crimea. In response, Ukraine’s acting Prime Minister Arseniy Yatsenyuk signed a political association agreement with the European Union (EU), and the United States slapped sanctions on some of Russia’s President Vladimir Putin’s wealthy allies and Bank Rossiya.

The EU also took action although the BBC reported Russia’s foreign ministry called the European Council's decision to impose sanctions "regrettable" and "detached from reality." European and Russian economies are interdependent. Twenty-five percent of the EU’s gas comes from Russia, and more than one-half of Russia's budget is derived from oil and gas sold to the EU. In addition, experts cited by the BBC indicated sanctions on Bank Rossiya could tie up monetary transactions in EU banks and potentially affect individual European countries’ business dealings with Russia if economic sanctions are implemented.

Economists cited by The New York Times said, “The uncertainty that now hangs over nearly every profitable enterprise in Russia is what poses the gravest threat to the country’s long-term prosperity, rather than any immediate consequence of the specific sanctions.” While many of Putin’s allies seemed relatively unaffected by the sanctions, at least one has experienced consequences. Reuters reported Russian billionaire Gennady Timchenko was forced to sell his ownership stake of almost 50 percent in a global commodities trading firm after sanctions against him disrupted the company’s operations.

Russian markets have been unsettled by recent events. Consumers and businesses already have been stung by interest rates which are very high by western standards and may move even higher. Rating agencies, like Fitch and Standard & Poor’s, have warned they will downgrade Russia’s credit rating. Russian consumers have been thwarted as both Visa and Mastercard have stopped doing business with Russian people or companies that have been targeted by sanctions.

U.S. stock markets remained relatively blasé about events overseas but were alarmed by Federal Reserve Chairman Janet Yellen’s comments during her first quarterly press conference. She suggested the Fed might begin tightening interest rates in 2015, just a few months after tapering ends.

some worry the U.S. stock market, LIKE A FIRST TIME MARATHONER a few miles from the finish, may be getting a little wobbly. There is no denying the Standard & Poor’s 500 Index has had a good run. It has gained about 172 percent since its low following the financial crisis, and its earnings have grown by 121 percent since 2008, according to Barron’s. Of course, that growth has been supported by extraordinary measures including very low interest rates and multiple rounds of quantitative easing.

Low interest rates have meant businesses could borrow money relatively cheaply. Barron’s pointed out lower borrowing costs were reflected in bond spreads – the difference between the current yield on one type of bonds (for example, high-yield bonds, investment-grade bonds, or government bonds) and that of other types of bonds with similar maturities. The differences in yield between higher risk and lower risk bonds are a lot smaller than they once were. According to Barron’s, from late 2008 through early 2014, the yield on high-yield bonds and comparable Treasury bonds has narrowed from about 22 percent to about 4 percent.

As private borrowing costs have dropped, companies have been able to borrow billions of dollars and pay relatively little in interest. Some have returned the money to shareholders as dividends; some have used the cash to make acquisitions; and others have repurchased shares on the market or directly from investors. Typically, when companies repurchase stock, their earnings per share rises and so does the value of any outstanding stock. Regardless, low interest rates and cheap borrowing costs have helped fuel share price appreciation and the bull market in stocks.

Three rounds of quantitative easing (the Fed’s bond buying programs) also helped push stocks higher. An expert cited in Barron’s noted “there has been a more than 90 percent correlation between the growth of the central bank's assets and the S&P 500 since the bull market began five years ago.”

Now, the Fed is tapering quantitative easing and has indicated tighter monetary policy may begin as soon as early next year. Should investors worry the bull market will go away as these exceptional support measures are taken away?

If an investor has long-term financial goals, the answer is no. The portfolio allocation may have been chosen to help pursue those goals through all kinds of market conditions. If the stock market is slowing down, an investor may experience slower growth but that doesn’t mean the goals have changed or the holdings are unsound. We may want to stay focused on the finish line.

 

Weekly Focus – Think About It

“Humility is not thinking less of yourself, it's thinking of yourself less.”

--C. S. Lewis, novelist, scholar, broadcaster

Weekly Commentary March 17th, 2014

The Markets

Russian President Vladimir Putin sure has stirred up a hornets’ nest. Why is annexing the Crimean peninsula and, possibly, Ukraine such a priority for the Russian leader? When asked, Putin has indicated Russia’s military influence is necessary to protect Russian-speaking populations in Ukraine. However, The Economist has a different take on Putin’s actions:

“Russia’s economic stagnation has exposed the limits of Mr. Putin’s political and economic model, which relied on rising oil revenues and allowed him to buy the support of the elite and the acquiescence of the population at large. Real disposable incomes, which rose by 12 percent in 2007, on the eve of the war with Georgia, are forecast to rise by 3 percent this year. The Kremlin faced a choice between political liberalization and mobilization of the country by the means of war and repression. Mr. Putin has chosen the latter. Confrontation with the West is one of the main goals of Mr. Putin’s operations. Any sanctions imposed will allow him to blame Russia’s economic downturn on the West, though that may not placate the ruling class, with its cash stashed abroad in property and bank accounts.”

No matter what Mr. Putin’s motivation really is, he faces clear opposition from the international community. Last week, a United Nations Security Council resolution was introduced which stated Sunday’s referendum in Crimea – a vote to determine whether Crimea would remain part of Ukraine or join Russia – had no validity and could not form the basis for any alteration of the status of Crimea. The resolution was supported by 13 of 15 member nations. China abstained from voting and Russia vetoed the resolution.

Perhaps more importantly, the economic consequences of Russia’s actions have been quite harsh. According to Barron’s, the ruble has fallen to a record low against the U.S. dollar. As a result, the Russian central bank has spent $28 billion to support the currency and has increased short-term interest rates by 1.5 percentage points, pushing yields on 10-year bonds to nearly 9.75 percent. In addition, capital is fleeing Russian markets. During the past three weeks, the MICEX equity index, in U.S. dollar terms, has lost about one-third of its value relative to its 2013 high.

Russia’s failure to back away from Crimea unsettled U.S. markets last week and gave the Federal Reserve pause when its holdings of U.S. Treasury securities for foreign and official accounts fell by more than $100 billion (for the week ended Wednesday). Since Russia had threatened to sell its U.S. Treasury bonds if sanctions were imposed, some believe the drop was Russian muscle-flexing. Others suggest Russia hasn’t divested itself of its U.S. holdings; it simply moved them outside of the United States so the assets wouldn’t be vulnerable to sanctions.

 

 

How quickly do we adopt new technology? More quickly all the time, it seems. MIT Technology Review looked at the time it took for nine different technologies to fully saturate the U.S. market. They started back in 1876 and looked through 2010, breaking the process into three phases:

 

• Traction: The period from consumer availability to10 percent market penetration
• Maturity: The period from 10 percent to 40 percent market penetration
• Saturation: The period from 40 percent to 75 percent market penetration (the point at which new demand typically slows)

 

Some innovations, like the original telephone and electricity, took time to saturate markets. Alexander Graham Bell’s patented telephone took 25 years to gain traction, another 39 years to reach maturity, and almost a full century before the market for landlines was saturated. Electricity also was slow to reach saturation. Both technologies were hampered by infrastructure issues, like running enough cable and wire to provide services to businesses and homes.

 

Newer technologies have been and are being adopted far more rapidly. Television took more than a decade to gain traction, but progressed through maturity to saturation in less than a decade. The mobile phone caught on a lot faster than landlines, becoming mainstream in less than half the time. That’s nothing compared to smart phones which took about 10 years to reach maturity. Tablets appear to be catching on even faster. In fact, in a separate 2012 article, MIT Technology Review pointed out, “Mobile devices outsold PCs last year for the first time, and top smart-phone apps need little more than a year to win the kind of audience it used to take technologies decades to reach.”

 

The mobile revolution is progressing rapidly, and some businesses still need to prepare. According to Forrester Research, as reported via CSO.com, about 15 percent of employees are accessing sensitive data that may include client information, non-public financial data, intellectual property, or corporate strategies from their own devices rather than those provided by their employers. As a result, many firms need a more scrupulous identity management strategy, not to mention a chief mobility officer.

 

Weekly Focus – Think About It

“Success is not final, failure is not fatal: it is the courage to continue that counts.”

--Winston Churchill, British Prime Minister

 

Weekly Commentary March 10th, 2014

The Markets

Okay, so Russia sending troops into Ukraine’s Crimean Peninsula did unsettle world markets. At least it did on Monday.

Like a diver plummeting off a cliff, markets in various parts of the world lost value last Monday as investors responded to the possibility of war between Ukraine and Russia. The New York Times said it like this:

“The escalating crisis in Ukraine created turmoil in global markets on Monday, hitting stocks from Wall Street to Ukraine and causing a spike in oil and natural gas prices that could reach into consumers’ wallets. But despite fears that the conflict between Russia and the West over Ukraine could shift into a military confrontation, analysts said there was little risk of global financial contagion or of major blowback to Western economies.

Perhaps that was the reason markets generally did so well during the rest of the week. That and the fact Russian President Vladimir Putin seemed to pause for a breath and, possibly, a reconsideration of strategy after the Russian stock market lost about $58 billion on Monday. (That’s more than the cost of the Sochi winter games.) There were other economic consequences, too. A rapid decline in the value of the ruble led to a sharp rise in short-term Russian interest rates, and the Russian central bank was compelled to spend about $12 billion defending the country’s currency.

Meanwhile, back in the United States, the bull market celebrated its fifth birthday. During the last five years, the value of investors' holdings in U.S. stocks has increased by about $16 trillion, according to Wilshire Associates as reported in Barron’s. As if that weren’t remarkable enough, last week the Federal Reserve reported the net worth of U.S. households rose by nearly $3 trillion during the last quarter of 2013. It’s enough to make you wonder whether the cost of quantitative easing, which expanded the Federal Reserve’s by more than $3 trillion, was worth it.

where are they now? Remember that island in the Mediterranean that was in turmoil about a year ago and turned to the European Union (EU) for a bailout?  The situation in Cyprus was a bit confounding because the country was growing relatively robustly and had a small budget deficit. The issue was the country’s banks which were bigger than its domestic economy. Cyprus had about 8 trillion euros in deposits and only 4.5 trillion euros of annual government revenues, according to BCA Research cited in The Economist. Since bank deposit guarantees are only as good as the country providing them, Cyprus needed some help.

Eurozone leaders responded to the Cypriot bailout request with demands for austerity and reforms – pretty much the same thing they’d been requesting from other bailout recipients – but a ‘bail-in’ also was part of the package. What is a bail-in?  The EU required debt holders and uninsured depositors help absorb bank losses and fork up new capital. Although the idea was initially rejected by the Cypriot parliament, the government capitulated relatively quickly. The Economist described it like this:

“At first, a raid on insured [bank] deposits was envisaged, though ultimately they were spared and the main victims were uninsured depositors – a decision made easier by the fact that many of them were Russians. But getting creditors both to absorb losses and to recapitalize the country’s biggest bank (which also had to absorb the second-biggest and even more comprehensively bust bank) is not proving to be a great success.”

How unsuccessful has it been? The Cypriot economy contracted by about 5 percent in 2013 and is expected to continue to wither this year. Unemployment in the country is at 17 percent.

There are several lessons that can be learned from events in Cyprus, according to The Economist: 1) It’s important to have a state-backed ‘bad’ bank where bad loans can be held and dealt with over the long term; 2) Forcing uninsured depositors to take a hit helped protect taxpayers, but it also damaged public confidence in banks; and 3) Fiscal policy makers need pragmatic and flexible solutions because every banking crisis is different.

 

Weekly Focus – Think About It

“If your actions inspire others to dream more, learn more, do more, and become more, you are a leader.

--John Quincy Adams, Sixth President of the United States

Weekly Commentary March 3rd, 2014

The Markets

If you think Russia could have found a colder place to hold the winter Olympics than Sochi, where the average January 2014 temperature was 51° Fahrenheit, you’re right. In some Siberian towns, negative double-digit temperatures are considered the norm during winter months. If you thought Russia sending troops into Ukraine’s Crimean Peninsula would unsettle world markets, you would have been wrong.

While the world was watching the winter Olympics, the Ukrainian people were staging a revolution. They ousted President Viktor Yanukovych and, according to The Economist, Ukraine’s new leaders began forming pro-European government. Russia’s president Vladimir Putin asked the Russian parliament for permission to deploy troops in Ukraine. America warned there would be consequences for such an action.

Regardless, Mr. Putin persisted, perhaps believing the West will be more “worried about keeping Russian oil and gas exports flowing than about standing up for the idea of a Europe whole and free.” It’s probably fair to say neither the winter Olympics nor reality TV about housewives in any county or city has ratcheted up the drama in the way Mr. Putin did last week.

So, how did markets respond? Six world indices lost value last week (in Australia, Japan, China, Indonesia, United Kingdom, and Mexico), 17 showed gains, and one remained unchanged.

Why were markets so bullish? According to Barron’s, markets in the United States focused on strong consumer confidence data, evidence of sales growth for durable goods, and new Federal Reserve Chair Janet Yellen remarking the last six weeks of economic data have been surprisingly weak (which some hoped could signal a pause in tapering).

There are only 10 types of people in the world: those who understand binary numbers and those who don't. The joke is funnier when you understand that 10 in the binary system is the same as the decimal number two.

There are two distinct ways of thinking, too, and both appear to be essential to companies that are trying to turn a profit through innovation. In an article about the World’s most innovative companies, FastCompany.com had this to say about innovation:

“…But there's another kind of faith in business: The belief that a product or service can radically remake an industry, change consumer habits, challenge economic assumptions. Proof for such innovative leaps is thin, payoffs are long in coming (if they come at all), and doubting Thomases abound. Today, pundits fret about an innovation bubble. Some overvalued companies and overhyped inventions will eventually tumble and money will be lost. Yet breakthrough progress often requires wide-eyed hope.”

Perhaps it’s less of a hope and more of a commitment to fostering both divergent and convergent thinking within a company, which probably is not an easy thing to do. Divergent thinking is the process of generating many ideas related to a single subject or many solutions for a specific problem. For instance, strong divergent thinkers can come up with dozens of answers for questions like: How many uses can you think of for a knife and a brick? As it turns out, young children are terrific divergent thinkers. A longitudinal study of kindergarten children found that 98 percent of them were genius level divergent thinkers. By fifth grade, that percentage had dwindled to 50 percent or so. After another five years, even fewer were strong divergent thinkers.

Convergent thinking, on the other hand, is the process of applying rules to arrive at a single correct solution to a problem or a limited number of ways to address a specific issue. Convergent thinking occurs in a more systematic and linear manner. Strong convergent thinkers rely on analysis, criticism, logic, argument, and reasoning to narrow down options and choose a path forward.

According to Psychology Today, “The highest levels of creativity require both convergent thinking and divergent thinking. This idea has long been known in creativity research… creativity involves a cyclical process of generating ideas and then systematically working out which ideas are most fruitful and implementing them. The generation stage is thought to involve divergent thinking whereas the exploration stage is thought to involve convergent thinking.”

 

Weekly Focus – Think About It

“Everybody gets so much information all day long that they lose their common sense.”

--Gertrude Stein, American writer