Wednesday, April 30, 2014

Nokia's New Strategy: Oy!

Microsoft's financial, accounting and legal troops are presumably all over the books and records of Nokia's devices and services business.

Today, the financial press carried the parallel story about the surviving Nokia ADR (NOK), with an equity market capitalization of $28 billion and a price of $7.53.  A new CEO, Rajeev Suri, was also announced.
Although I am sure that Mr.Suri has a bold vision for the company, it's hard to contemplate public investor interest in the company, looking to the future.

According to the report in the New York Times, Nokia will receive some $7.5 billion from Microsoft for the sale of its handset and services business.  At the same time, Nokia announced that it plans to spend some $6.9 billion to pay down debt, issue special dividends to shareholders, and to buy back its shares.  The pay down debt part, I can understand.

Why would the company in its current condition be interested in hewing to the classical activist shareholder agenda of dividends and share buybacks when the company's future seems so vague?

In addition to owning what was the 50% stake of Siemens in the former Nokia-Siemens wireless network infrastructure business, Nokia plans to make this expanded business one of the future pillars of the company. Equipment, generally, hasn't been the place to be in the IT/Communications space.

The second pillar of the future business will be research and development, including the development and monetization of the IP portfolio. Again, how can an investor value this opportunity?

It wasn't that long ago that Nokia was being touted in magazines like Wired and glossy tech rags as the next Microsoft, Cisco, yada yada.  Oy, was that a bad forecast!

Monday, April 28, 2014

What Microsoft Doesn't Understand About Consumers

Microsoft and Apple are both in NDXT, the NASDAQ-100 Technology Sector Index, along with Intel, Cisco, Google, Facebook and other mega-cap companies.  Apple, in a real meaningful sense, achieved its post i-Phone success by becoming much more of a consumer-focused company.

We've written before about Apple's always having been a technology and design innovator, but this led it to many dead end devices like Lisa, which was nice to look at and cleverly designed; ultimately, it was too expensive in price-performance terms, and it was anything but intuitive to use.  It died.  More of these machines and Apple would have been  in a microcap technology index.

We recently wrote,
"Apple can charge outrageous prices for their devices for a few reasons: they all work relatively intuitively, the design and functionality of the phones and tablets are clean and present a consistent philosophy, the attention to detail even in the packaging is obsessive, and if there is anything wrong with the consumer's experience with the device or using it, the company stores make it right."
Right after this post came the announcement that "Apple has determined that the sleep/wake button mechanism on a small percentage of iPhone 5 models may stop working or work intermittently.  iPhone 5 models manufactured through March 2013 may be affected by this issue. Apple will replace the sleep/wake button mechanism, free of charge, on iPhone 5 models that exhibit this issue and have a qualifying serial number."

The process is clear, simple and owners have up to two years from their purchase to have their phone fixed or replaced.  I can tell you from experience that people on the floor are empowered to make a decision in the store to give a customer a deal, even if they strictly don't qualify.  I have never heard of a customer leaving their retail stores angry or unhappy. 

Apple has become a technology company with the customer focus and post-purchase relationship mindset of a premium consumer product or luxury goods company.  People are so satisfied that they rarely think about the cheaper price of a comparable Android device.  Of course, this can be pushed too far, but why does the opportunity persist?  Because of the engineering-driven, MBA mindset of Microsoft.  

The Nokia acquisition could easily become this company's Waterloo.  Value creation at Microsoft won't happen with the Ballmer-created organizational rabbit warren, bloated cost structure, and dysfunctional culture that we've written about in our most widely read posts.  

Analysts are making a big deal about the emerging hockey stick for revenue growth from Office 365, and since Microsoft is adopting the Intuit model of shoving customers into death march upgrades, it is true in the short term the revenue per conversion is significant.  This is certainly good for cash flow and margins.

We pointed out in our last post that over 80% of revenue and 95% of gross margin come from software licenses and the enterprise businesses.  In the future, this behemoth needs to lose weight and get a different culture in charge of businesses like phones, entertainment, and games.  

Thursday, April 24, 2014

Microsoft's Third Quarter Shows a Strong Platform and Challenges Ahead

Microsoft reported FY14 Q3 revenues of $20,403 million versus an adjusted $18,831 million for the prior-year period, an increase of 8.3%, or about 7% on a constant currency basis.  Gross margin increased 3% year-over-year on an adjusted basis, and diluted EPS of $0.68 per share increased by 5% over the adjusted $0.65 per share in FY13 Q3.

$1,895 million was returned to shareholders through share repurchases in the quarter, and $2,322 million through dividends.  $4,167 million out of $10,099 million in cash flow from operations is a healthy amount of cash to return, and it fits with the now well established activist shareholder creed.

The strength of the company shows, I believe, when you consider that 81% of the quarter's revenues came from Devices and Consumer Licensing ($4,382 million), Commercial Licensing ($10,203 million), and Commercial, Other ($1,902 million).  

Even more telling, 95% of the corporate gross margin came from these same three business segments: Devices and Consumer Licensing ($3,906 million), Commercial Licensing ($9,430 million), and Commercial, Other ($475 million).

Despite all the hype around tablets, and "Bring Your Own Device" into the enterprise, Windows and the Office suite are still what most people comfortably use to do their real work in the enterprise.  So, Windows Pro OEM revenue grew 19%, as business PC growth in developed markets led the way in the quarter. Non-Pro Windows revenue declined by 15% (9% excluding China), so Windows OEM revenue increased 4% in total. 90% of enterprise desktops run Windows 7 or Windows 8.

The Office 365 nascent franchise now has 4.4 million users, and the company added a million users in the quarter.  Making the free version of Office 365 available for iPAD, and engineering it specifically for that platform, was a long overdue step, and the new CEO made it with aplomb.  Making Office for iOS 7.1 count for the five device licenses included in Office 365 enhances the value proposition for the product.

Bing's ad revenue was up 38% , and its share of search grew by 170 basis points.

Microsoft's server business, hardware and database, give it a lot of credibility with corporate IT officers. SQL server revenue increased by more than 15% in the quarter.Cloud revenue doubled from a relatively small level, as it has for HP.

The acquisition of Nokia Devices and Services is about to close, and hence the financial comparisons in the coming quarters will be even fuzzier than they are now.

The question and challenge will be "What can Microsoft make of Nokia Devices and Services?"  Microsoft continues to really lack a champion for its consumers, whether of Office, XBox, games, tablets and phones. What credibility it has on the corporate enterprise hardware and software sides comes from a different mindset.  CEO Satya Nadella came from this business, and he brings lots of easy credibility because he speaks the language of customers and developers in those businesses.

Check out his video presentation at Build 2014.  The way he handled questions was relaxed, sincere, and credible to his developer audience.  There was none of the ear shattering volume, bluster and rote litany of buzzwords from the Ballmer reign.

I wonder if anyone in the organization can speak for the consumer experience with those same virtues? Apple can charge outrageous prices for their devices for a few reasons: they all work relatively intuitively, the design and functionality of the phones and tablets are clean and present a consistent philosophy, the attention to detail even in the packaging is obsessive, and if there is anything wrong with the consumer's experience with the device or using it, the company stores make it right.

If Nokia is going to be the hardware platform that carries the Windows environment forward into a "Mobile-first, Cloud-first" world then can this be done without suffering the kind of 23% gross margin rates Microsoft is experiencing in its consumer devices now?  Can someone, perhaps from Nokia or wherever, inculcate that care of the retail customer to the levels to which the IT and developer customers have been accustomed?

Microsoft has never treated its retail customers well, and it has never provided them with the kind of experience they deserve.  A monopolist never acts that way, because it doesn't have to amaze or delight: it merely has to satisfy.

Here was a very simple, but penetrating question for Satya Nadella from an Android third-party developer, "Why should I spend my time and resources developing for Windows?" (paraphrase)  Here's the CEO's response:
?You want to build for Windows because we are going to innovate with a challenger mindset. We're not coming at this as some incumbent trying to do the next version of Windows. We're going to come at this by innovating in every dimension, the dimension of hardware, the software experiences across the Windows family, and go after this in such a way that you see us make progress with rapid pace.
In fact, today was a massive milestone. If you look at what we've done on the phone, the update to the PC and tablet, the new devices Stephen showed, this is all what you can come to expect from us, and we'll keep pushing at it.
There will be a couple of things that will be pretty unique to what we do. One is what I call the sensibility we have of bringing end users, developers and IT professionals together. That's one thing that we've always felt is what birthed the magic of platforms, from sort of the first version of Windows to what we think is Windows in this era of mobile first, cloud first. (I don't think the real end users were ever in anyone's mind at Redmond)
And then the second real attribute for us is to be able to create a developer opportunity which is broad. So one of the things that we are doing is making sure that the opportunity for you as developers across the Windows family is expanding. Some of the changes that both Joe described and Terry alluded to where we are going, which is to be able to make your new applications built for WinRT and the Windows Store, in fact, the fact that you can use them in the desktop mode, that completely opens up a huge base of users for your applications that you're targeting Windows with.
So this notion of creating the broadest Windows opportunity for your sockets for you is a huge priority for us, and we have huge volume still. We have hundreds of millions of PCs, tablets and phones still on a run-rate basis, and a billion-plus PCs that will all be upgrading. So therefore we have a significant opportunity for any application you target Windows.  (This is the "ching ching" answer that is music to their ears.) 
And then the last thing is, we are betting on this platform ourselves. You saw from Kirk Koenigsbauer how we're building the next generation of Office applications for this platform. So we are going to basically use the same platform that we want you to target to build our own set of applications.
So those would be the three reasons, because we're going to innovate with a challenger mindset, we're going to create the broadest platform opportunity in terms of sockets for you, and we are going to bet on that platform ourselves, and that's the reason why you should target Windows. (Applause.)"
So, the stock is fairly valued on its near-term prospects, with good support from the dividend, and the new CEO is bringing a fresh look to his long-time employer. (he has a nice quote from T.S. Eliot that covers his experience well) A new independent board member who comes from the analyst perspective has joined the board.  A critical acquisition, its integration and the opportunity to really become a premier consumer technology brand await.  

Tuesday, April 22, 2014

China Makes The Predictable Play in South China Sea

Back in 2011, we wrote about the web of problems that could be expected from the U.S. failure to sign the Third UN Law of the Sea Treaty, and about our foreign policy with no vision or principles, beyond climate change.

We recently wrote,
"China is probably glad to see that the West doesn't have any teeth in assertions about rolling back territorial grabs like it contemplates in the South China Sea and elsewhere. Japan has to wonder how it could go it alone were territorial disputes with China turn into armed conflicts. Our Saudi friends have already expressed their displeasure at our "leading from the back." "
Now, the Chinese has served their notice to Taiwan, Malaysia, Vietnam and the Philippines that it intends to press its uniquely conceived territorial claims in the South China Sea.  Our hollow claims of some sort of right to free military passage won't pass muster, but worse they won't change Chinese behavior.

The Chinese have also made it clear from 2011 that any challenges to their territorial claims which they say date back to 1947 will be viewed as attacks on Chinese sovereignty.

Coming home in the car today, I heard a report on Vice President Biden's speech visiting Ukraine where he reportedly said that the U.S. won't recognize any Russian annexation of Crimea and that Russia must stop fomenting violence through proxies in masks.  This kind of speech is one the President should have made, but it's good to put something clear, fundamental and principled on the table.

German Chancellor Merkel, who had been very visible during the long, drawn on European currency crisis is conspicuously absent on the world stage.  She must be ruing her ill-conceived energy policies.  Mothballing the German nuclear power industry, creating expensive, inefficient renewable targets, and selling out to Gazprom--a trifecta of policies to play into Russia's hands.

President Putin continues to pull the strings in the Ukraine, but market disciplines through the flight of capital are the only clear signal the Russian President is getting that he may have to tack from his full speed ahead attempts to recreate the Russian empire.

Friday, April 18, 2014

Who Needs A Driverless Car?

The founders and executives at Google are very smart about their business, and very, very rich--no question. These two factors have led to Google becoming a mature cult stock.  Why the word "mature?" In  Google's first quarter 2014 earnings report, online ad volume, its core business, rose 26%, but the average ad generated 9% less revenue.  Operating expenses and capital expenditures rose faster than expectations, and revenues were below expectations.  Investors were upset, right?

Wrong. They lauded for buying companies like Titan Aerospace in the robotics and drone areas.  They have applauded commitments to things like developing a driverless car.  This is the cult aspect. Who needs a driverless car? Smart phones could send out GPS coordinates to Apple or Google networks.  Ads could be even better targeted, which might eventually affect how payouts went for key constituencies.

I think I get it.  If people are still in their car driving, but they don't have to pay attention to the actual task, then 100% of the time in the vehicle can be used for browsing, texting, and downloading content like movies. Wow!

After spending 25 hours on the road and back from Dayton, OH last week, the entire driving experience could have been made much safer and less stressful through the use of relatively simple sensors combined in a better packaged, heat and dust protected computer system that did things like maintain the adequate spacing from the vehicle in front, based on the car's speed. Helping drivers who might be older, have poor eyesight, or who misjudge stopping distances, these kinds of sensors could add great value.  Then, I happened to see any ad for Mercedes Benz where they showed a car with kind of feature already in production.

We have the technology to make driving safer, which is the real point, no?  Since 60% of the market carry smart phones. these would be good platforms on which to develop apps for parents and grandparents which collect, analyze and store data about driving habits and conditions. We can do something like this now.

The driverless car sounds techy-geeky cool.  But really, should Google be applauded for throwing money at this kind of product that nobody needs?

Thursday, April 17, 2014

Our Biggest Banks Are A Mixed Bag

Our March post on the Fed stress tests on our "Four Horsemen" of banking seems like a good background for discussing the first quarter's results for Bank of America, JP Morgan Chase, Wells Fargo and Citigroup.

Bank of America had a lackluster quarter with the biggest surprise being its $6 billion in litigation expense five years into the purported economic recovery.  Analysts concluded that litigation expense was impossible to model, especially given the Catch-22 of the company's not wanting to tip its hand to the plaintiff's bar about how much goodies the legal reserve cookie jar held.  The acquisition of Countrywide Financial continues to plague this company, and no one is in jail.

The return on equity was a paltry 4.6%.  Yet, the P/E is the highest among JPM, BAC, and WFC.  Merrill Lynch may eventually be passed for the most AUM by Morgan Stanley Wealth Management, and it's unclear what synergy the Thundering Herd gets from association with Bank of America.

We've said for a long time that the biggest problem at JP Morgan Chase was not size but complexity.  We characterized this leviathan as "Too Complex To Manage," even for the loquacious, highly numerate, quick witted Jamie Dimon, as the London Whale episode pointed out.  His lieutenants, through all the musical chairs, have not served him well. As time has gone on, our faith in the TCTM thesis is stronger than ever, no matter what any cyclical improvement over trashy quarters might suggest.

The number driven, traditional banker's philosophy that Jamie Dimon brought to Bank One was one of the reasons for its success, plus it was already a well established, high quality name before he became CEO. JP Morgan Chase is a completely different animal, crafted by putting together one of the premier investment banks in the history of American finance with a badly managed Chase Manhattan, a well managed Bank One and many other acquisitions which all together result in the beast that is now a collection of very large fiefdoms.

The management should clean up the portfolio and structure before multiple regulators so something more damaging to shareholders. Average loan balances fell across all market segments, and mortgage originations fell by 68% over the TTM.

Wells Fargo's performance was the best overall in the quarter with its 17th consecutive quarter of earnings growth (+14%) and its dividend increase of 17%, without any surprise in its capital plans with the Fed. It continued with its share repurchases as well.

Deposits grew by 8%, a very healthy number in this environment. Net charge offs were 0.41% of average loans in the quarter and they were down 42% year-over-year.  ROA was a healthy 1.57%, up 76 basis points, and ROE was 14.35%.

The company has quietly moved its institutional and high net worth asset management businesses upstream to customers with significantly higher minimums, and in some areas like stable value the Galliard Capital subsidiary will end the quarter with assets over $100 billion.

The one thing missing from WFC which JPM and C have is significant international exposure.

Which brings us to Citi.  This is still the biggest rabbit warren. It is a structurally messy, grossly under managed managed bank, but the problem didn't originate with Vikram Pandit or even with Charles Prince.  It goes right back to the Sandy Weill-John Reed fractured relationship over decades ago.  Citi, however, has the potentially most valuable future franchises in Asia and Latin America.  It must escape its legacy of Citi Holdings and somehow craft a rational organizational structure and a responsible culture, which it sorely lacks.  It has no Jamie Dimon or John Stumpf.  It could use some activist investors to help whip itself into shape.

Monday, April 14, 2014

Russia Checkmates the West in Ukraine: There Were Never Any Good Options

Let's look at some of the economic, military and foreign policy options for the Western powers in Ukraine.

Senator John McCain's plea to answer the Ukraine government's call for arms and military assistance makes good theater, but it is a real non-starter. Germany and France would never bring the EU along, and we would have to go this option alone.  The government of Ukraine is itself fragile, incompetent and corrupt, as it always has been.  How would the arms arrive in Ukraine?  Whatever arrived would be commandeered by Russian "activists" who are Russian special forces in disguise or by other agents of the Kremlin.

A call for United Nations peace keepers can't succeed because a Security Council resolution, which is the only way the Secretary-General can form and send such a force, would be vetoed by Russia, with China likely abstaining.  Even if UN peace keepers were assembled, they would be hemmed in and beset by Russian enemies wearing several masks.  Supplying and replenishing a UN force would be impossible given Ukraine's infrastructure. Scratch this idea.

Economic sanctions on a few high profile officials. Have you heard anyone squealing yet?  I wouldn't think so.

As late as mid-March, Secretary of State John Kerry called for every department head at State to mobilize around climate change, as Putin's noose was tightening around Crimea.  This must have given the Russian President great comfort, as it erased any doubt that U.S. foreign policy's main concern was our own election cycle, not on saving Ukraine.

What about German Chancellor Merkel?  She seems to be busy reveling in Greece returning to the capital markets and making progress on its budget deficit reduction targets.  Going forward, some of her government's own politically motivated decisions will now come home to roost.

In order to capture the inordinately influential Green Party into her coalition, Chancellor Merkel embarked on a misguided program:
"Merkel decided in 2011 to close eight German nuclear reactors and phase out the rest by 2022 following Japan’s Fukushima Dai-Ichi disaster. Public support for the 550 billion-euro plan to expand wind and solar power is rising, even as government subsidies for the “Energiewende,” or energy shift, increase electricity bills."
Partnering with Germany's political and industrial elites to build the Nord-Stream sub-sea natural gas pipeline has now locked Germany into a reliance on Gazprom as the key supplier for natural gas, which in the absence of nuclear power, will be the preferred fuel for the German factory exports.

Despite the current bleak outlook for Ukraine, its longer-term prospects aren't good simply because of its below-replacement birth rates, which observers like Columbia's David Goldman and Mark Adomanis of Forbes contend have put it too far down the path towards inevitable economic decline.  Even if the West were to throw economic and military aid at Ukraine, the long-term battle would still be lost.

What about American and European financial markets?  The recent pull back in U.S. markets is being cited as a healthy pause in a continuing bull market.  The ECB states that European growth may exceed the diabolically low levels projected over a year ago.

Where do we go from here?  President Assad of Syria is probably drinking a nightly toast to President Putin for distracting the world from the continuing starvation, torture and religious persecutions being inflicted on Syria's own population by the Russian-backed regime.  China is probably glad to see that the West doesn't have any teeth in assertions about rolling back territorial grabs like it contemplates in the South China Sea and elsewhere. Japan has to wonder how it could go it alone were territorial disputes with China turn into armed conflicts. Our Saudi friends have already expressed their displeasure at our "leading from the back."

Much as President Putin seems to hold the cards in this year's game, his tactics, while appealing to the souls of Russian nationalists, probably signal the eventual, inevitable irrelevance for the one trick pony economy of Russia, which is built on energy and on little else.

Russia too has its own demographic issues. David Goldman notes that the Russian republic may not be ethnically Russian in a generation or two.  The oligarchs, as we've noted before, are continuously diversifying by markets and by investments. President Putin, like Warren Buffett for so long, has no succession plan.  It's highly unlikely that another figure could be found with his combination of skills and lucky timing to continue Russia forward on its current path, that is unsustainable in any case.

There is no longer any need to curry favor with the Russian President because any fantasies about his being a modern technocrat and potential partner have been smashed forever.  His leadership is all about looking back to a Russian restoration, such as in Crimea.  This isn't what his many, multi-ethnic and largely impoverished populations need or want.

Western Europe, especially Germany, has to do a strategic rethinking about talking too much and thinking only about short-term, internal politics.   While Greece has made progress on some cosmetic numbers, significant economic and fiscal reforms have still not been initiated.   The euro will continue to require subsidization of the periphery by Franco-German core, which may ultimately be the German core.  Political union will continue to be a tune piped only in Brussels.

We are still in bull market, though, as the pundits tell me.

Wednesday, April 9, 2014

Andarko Gets Caught For Kerr-McGee Subterfuge

Kerr-McGee was founded in 1929 as an exploration and production company.  Over time, it diversified into a number of other extractive industries, such as its 1952 entry into uranium mining and milling.  At a time when the Cold War had the U.S. and Russia in an all out nuclear arms race, this probably seemed like a good business to enter. Uranium mining and processing operations were carried out at multiple locations, including on tribal lands of the Navajo nation.

In 1963, Kerr entered into a creosote business for treating lumber, and in 1967 it acquired American Potash and Chemical Company in Henderson, NV which produced perchlorate ("perc") for use in rocket fuel, targeting demand from government space programs and Defense department projects.

Over time, investors grew disenchanted with the conglomerate or portfolio approach to creating public companies. "Focus" became the mantra, partly because it made investor valuation easier and, the story goes, leads to higher multiples without the conglomerate discount.

Lehman Brothers, as Kerr-McGee's banker, encouraged the company to slim itself down into an E+P company, the original business, and a titanium dioxide business, the critical commodity for all manner of residential and industrial paints.   By 2005, Kerr-McGee had reinvented itself, but court documents note that exploration and production produced $1 billion in income in that year, while the Ti02 business generated a little over $100 million in income.

As early as 2002, Andarko Petroleum had taken a hard look at Kerr-McGee but it clearly had no interest in the peripheral businesses, and Andarko wanted to stay away from the large legacy environmental liabilities from businesses like creosote and uranium mining, among others.

So, the bankers came up with the classic, cookie cutter strategy of creating a corporate entity into which to deposit all the legacy liabilities.  In itself, this is neither new nor inherently sinister strategy, provided that the new entity, called Tronox Worldwide, LLC had adequate funding and prospects for financial viability. This structure has been used successfully for asbestos, lead paint, and other long-tailed, costly liabilities.

Andarko acquired Kerr-Mcgee in 2006, a few weeks after the Kerr had divested the legacy environmental liabilities via Tronox becoming an independent company.  When I first read about the liabilities coming back to Andarko, I wondered if regulators had once again overreached arbitrarily into structures that had been used before in the normal course of business.

Reading the court documents, this is clearly not a case of regulatory overreach, although the suit was based on the theory of fraudulent conveyance in the assignment of liabilities to Tronox, including pension obligations. Kerr also raided the cash coffers of the former subsidiaries.  Bondholders of the old KM didn't protest, because they got some special protections, since their indentures specifically prohibited this kind of financial 'three card Monte.'

The executives at the old Kerr-McGee ran an organization whose normal industrial safety and environmental policies were woefully deficient.  They also had the temerity to suggest that the creation of Tronox had nothing to do with offloading the liabilities and weren't motivated by thoughts of a transaction.  Given the record, and common sense, this is laughable.

Prior to cutting Tronox loose as an independent company, the old Kerr-McGee stripped out 83% of the revenue and 113% of corporate income, according to the court documents. Lehman Brothers had looked for other options for Tronox, including spin-off, but they clearly knew that it was a dog, or in the parlance of the financial crisis, a "piece of ***t."

So, the argument of fraudulent conveyance, ex post, proved to be an easy case to make.  Andarko seems to be able to deal with the now, much larger environmental liabilities and associated fallout from the Tronox bankruptcy.

This unfortunately is an example of agency problems with the interests of executive management as agents lying with the creation of Tronox, either in ignorance or of a cynical assessment that the day of reckoning would be down the road after they were all gone.  So it goes.

Friday, April 4, 2014

Fed Paper on Unconventional Monetary Policy

A paper by J. Rogers (FRB), C.Scotti, and J.Wright (Johns Hopkins) was reported in the Wall Street Journal, but it has been out for a while.  We had read it, and it's interesting.  But, it limits its questions to the paths of interest rates, stock prices and exchange rates under the unconventional policies across developed economies.

The paper does not address our question about the broader and much more significant, unintended consequences of the policies, especially for the future. For the question asked, the unconventional policy and its communication to the market performed in line with standard policies, especially as regards bond yields.

The paper indirectly points out the market's acceptance of the Bernanke Fed's communications or forward guidance code, which certainly became as comfortable as an old flannel shirt.  As regards the Yellen Fed, "We aren't in Kansas any more, Toto."

The Yellen Fed Doesn't Sound Like A Central Bank

Too much was made over the choice of successor to former Fed Chairman Bernanke.  Making the choice a political or gender equity issue would not have been a good thing, and it seemed logical that someone who had been a longstanding partner to Bernanke would assure continuity, thereby assuaging nervous markets.

Unfortunately, the early "communications" issues have unsettled even the most experienced Fed watchers I know and respect. John Cochrane, AQR Professor of Finance at Chicago Booth School of Business, has identified the underlying problem as being that central banking globally has morphed into something that it is not, claiming powers that it does not have.

That was made manifest recently, in Fed Chair Yellen's public pronouncement about the Fed focusing its policies on labor markets and unemployment.

Given that macroeconomic models don't incorporate any kind of realistic financial sector, and given our very weak recovery, in its fifth year, had its origins in the financial sector and asset markets, no responsible economist could claim that the Fed has the understanding or tools to address failures and frictions in the labor market.

As we've written about many times, unconventional monetary policies such as quantitative easing and unbounded periods of low interest rates have have essentially done nothing for the economy, as evidenced by the unemployment rates.  Again, as we warned from the outset, these novel constructions would have unintended consequences given our lack of experience with their mechanism of action.

Former BIS Economic Adviser William White's paper, which we've cited before, is still worth reading. Focusing on the shadow banking system, he cites research suggesting the shadow banking system was procyclical in the credit upturn, which seems well agreed upon; he also suggests that it may be procyclical in the credit downturn, which is debated.  In a simple model, he shows that the behavior of this sector and our financial sector as a whole, may be a powerful mechanism for increasing inequality of both income and wealth.

Right now, we have a disconnect between expectations for what central banks can achieve (remember Mario Draghi?) and what they really can do.  Dodd-Frank has made the Fed the de facto Regulator-in-Chief of the financial sector, and the guardian of asset prices, housing prices, and architect of financial stability.  To this we are adding labor markets and unemployment.

We've written before that one of the greatest strategic blunders made by the Bernanke Fed was to effectively become an enabler for fiscal profligacy by his employers in the White House and Senate.  The role of the Fed Chair historically was more 'big picture' focusing on rates, inflation, and the currency.  This is a massive agenda in itself, but the Fed was never to be the engineer of policy.  It provided the backdrop for markets to set the term structure of rates and for the economy to move forward with real economic growth.

When warranted, the Fed Chair would call for fiscal responsibility from the executive and legislative branches, and sometimes the Chair would have to 'lean against the wind,' even if only rhetorically.  That's because the Fed was always independent of elections, politics, and of the noisy public square, including Wall Street.

Today, the Fed no longer makes any call for responsible fiscal policy, and now it is firmly in the camp of perpetuating the current status quo of discretion based, as opposed to rules based policies, which is disquieting to experienced Fed watchers who could always infer a path from Taylor Rules and the like. Now, all bets are off. So, financial markets continue to soar, our inflation rate is minimal, corporate profits are up, and the bubbles continue in corporate assets (companies) fueled by large appetites for investment grade corporate debt.

Meanwhile, the traditional financial sector, namely the six mega-banks are effectively becoming ensconced as the heart of our financial system, with no effective competition.  We still don't know what systemically important means, as we randomly suggest that it applies to insurers like Met Life and to asset managers.

Because of the cynical way in which Dodd-Frank was passed, the regulations that will be at the heart of the future evolution of the system and the source of shocks, are being written away from the eyes of the electorate by anonymous lawyers and policy wonks, all aided and abetted by their favored activists and lobbyists.

The final problem facing central bankers is the IMF's incessant clarion call for national central banks to make their decisions in "a global framework."  This sounds like an innocuous platitude, leading to many meetings at tony locations with lots of papers and meaningless declarations. John Cochrane adds that the real motive may be to pool together all the lenders of last resort and to spread the costs of carrying the weaker players among the stronger players. Our Federal Reserve and the taxpayers certainly doesn't need to take on that burden too.

Central bankers need to be independent of politicians and of Wall Street gunslingers, and their measured, predictable tweaks to the economic engine which enhance growth, moderate cycles and preserve the value of the currency are their most valuable contribution to Main Street.

Thursday, April 3, 2014

The World Won't End Without HFT!

In 2011, we wrote about the notion of a 'click tax' on high frequency trading. Re-reading that post today, all the arguments still seem pretty sound.

We have the biggest, deepest, most efficient markets globally in areas like large capitalization stocks that are the the bellwethers of institutional portfolios by value. What's the incremental efficiency worth and to whom? Cliff Asness of AQR Capital Management is a hedge fund manager and quant who knows his way around the world inhabited by HFT firms. Surprisingly, he doesn't come out unambiguously in favor of high frequency trading.

His firm uses HFT, and he says that his analysis, which I can attest from reading his papers would be very quantitative, suggests that HFT lowers his firm's trading costs.  Attributing his firm's cost savings to HFT alone is a leap of faith.  Here's what Dr. Asness writes,
"It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve."
Further, hedge funds love to trade in instruments where illiquidity and informational inefficiency are always present.  Where else would significant incremental returns be found?   Certainly not in trading Microsoft. So even for traders who have large proportions of their volume in these instruments, the benefits are not demonstrable.

Exchanges and specialist firms still produce what some would call "licenses to print money."  But, these folks argue that spreads have come down consistently over time, and since markets are ultimately social constructs, then certain costs for providing reliable, fraud-free, and efficient markets are monies well spent.

Traditional institutional traders have embraced electronic trading with each other for decades. Perhaps these platforms aren't the the Gumperts of high speed trading, but if they are fast enough, anonymous enough and comfortable enough for their markets participants, why innovate incrementally for unknown, higher risk benefits?

"Real work is necessary to improve and safeguard a complex and still reasonably new system," Asness writes. Why spend the money?  Incremental efficiency isn't worth it for everybody.  Put a tax on HFT and see where it goes, and find other ways to make the markets more transparent and incrementally efficient without legitimizing and indemnifying some wealthy geeks in back rooms with their computers.