"Ships on a Stormy Sea", Willem Van de Velde the Younger (c. 1762) (Source: commons.wikimedia.org)
When clouds appear, wise men put on their cloaks - Shakespeare, "Richard III"
High Tech "State of the Union" Summary
In these last 3 weeks, we've looked at over 8 year's worth of quarterly financial results for 17 leading High Technology companies offering semiconductors, systems and software for a vast range of applications and market segments - the 3 C's of Consumer, Communications and Computing, ISM (Industrial, Scientific and Medical), Automotive and Military/Aerospace. Each of them has their own story to tell, but in today's editorial, we want to come to grips with their collective impact and its implications.
An aggregate earnings chart of the portfolio is of little value, as the comparative revenues of individual companies vary by literally three orders of magnitude. Qualitatively, though, we can fairly lump these sailing vessels on the Seven Seas of High Technology into three broad categories of relative seaworthiness:
Reinagle, "A First rate Man-of-War driven onto a reef of rocks, floundering in a gale", (Source: newscientist.com)
Willem Van de Velde the Younger, "The Gust" (Source: sailingwarship.com)
Eric Bellis, "Cutty Sark Caught in a Squall" (Source: fineartamerica.com)
Adrift and floundering - IBM, HP, Mediatek, Broadcom, Xilinx, Altera, STMicro
Reefing sail and battening down hatches - Cisco, Intel, Nvidia, Google, Lattice, NXP
Sails billowing and colors snapping brightly - Microsoft, Qualcomm, Apple, Infineon
Personally, I'm hopeful that the strategic visions of Intel and Lattice pay off and they move up a notch. Infineon may fall back into the middle category once its revenue bump from the International Rectifier merger levels out, while I anticipate a huge one-time income leap by NXP towards the end of the year when the Freescale acquisition is completed. Despite their current strength and strategic foresight, Qualcomm and Apple are nevertheless at risk because of the increasing stagnation of the mobile computing market.
All in all, Microsoft is the only company at the moment that is growing stronger despite negative conditions in all of its target markets (PC, mobile computing and Cloud.) Satya Nadella is undeniably one of the two or three most capable CEOs in High Tech today.
In the final analysis, a good 2/3 of our portfolio of High Tech leaders are showing flat or declining revenue trends over the long term. Coming off 2014, where the chip industry logged a healthy 9.9% growth (per SIA/WSTS statistics), the start of 2015 is looking decidedly less rosy.
There are further clouds building on the horizon. DRAM prices, a major component of semiconductor revenue gains in 2013 and 2014, are softening markedly. Moreover, the vast China market for smartphones has joined the trend observed in other 1st & 2nd world economies; having reached saturation, it is expected to actually decline in 2015:
Some of you might at this moment be thinking "You're talking out of your a#&, baldie - the NASDAQ is back over 5000! You're just being a sourpuss!" For my part, I wouldn't blame any of you for feeling that way. Silicon Valley denizens in particular might actually question my sanity, as all of you are undoubtedly extremely busy and are surrounded by stressed out, sleep-deprived people everywhere you go. The occasions have been rare indeed where Silicon Valley was not a frenzy of activity and soaring real estate prices, and this is not one of those periods. This begs the question: why would I suggest High Tech's fortunes are heading towards a dimmer year than last?
The world is still deceiv'd with ornament,
In law, what plea so tainted and corrupt,
But, being season'd with a gracious voice,
Obscures the show of evil? - Shakespeare, "The Merchant of Venice"
Let's start the discussion by looking at a favorite Silicon Valley measure of success and prosperity: stock price performance. It is true that the NASDAQ has reached a new high. Nonetheless, there are several critical reasons why this record index level is, in fact, a chimera. Take a look at this April 24th report from FactSet on the S&P 500:
FactSet provides a smorgasbord of market data and is reasonably good at avoiding contamination from positive or negative bias in its reporting. Note in particular the following phrase in the "Week Ahead: Apple" section of the report:
"The blended (combines actual results for companies that have reported and estimated results for companies yet to report) for the Information Technology sector is 0.7%. Excluding Apple, the blended earnings growth rate for the sector would fall to -5.1%. The blended earnings decline for the entire S&P 500 is -2.8%. Excluding Apple, the blended earnings decline for the S&P 500 would increase to -3.9%."
Stated differently - Apple's performance is the keystone of the vault holding the NASDAQ aloft. To complicate matters, Apple has also juiced its own valuation and, consequently, that of the NASDAQ as a whole thru its stock buyback program - already huge in 2014 and set to expand tremendously in 2015:
From previous editorials, many of you likely remember exactly what my position is on today's corporate stock buyback practices and we'll revisit the topic later in the discussion. Let's transition now to a broader analysis of the global economy to give us more insight into what sort of business environment High Tech is likely to confront over the next 12-18 months. Mounting to the crow's nest with telescope, compass and sextant in hand, what can we discern gathering on the far horizon?
The Big Picture
What experience and history teach is this — that nations and governments have never learned anything from history, or acted upon any lessons they might have drawn from it. - Hegel
2007 was an augural year on a worldwide scale. Apple released the first iPhone in June of that year. At about the same time, the entire subprime mortgage industry in the USA began to turn from a slowdown into a rout, leading directly to the worst financial crisis since the Great Depression by mid-2008.
The iPhone, followed by the iPad in 2010, began a new wave of creativity and engineering achievement in chip and system level hardware & software which, even as unit sales of tablets and smartphones roll over and decline this year, is still sending shockwaves across High Tech, with side effects branching out fractally and individually picking up steam in areas such as the IoT, AI, new semiconductor process technology and many other technologies that we've covered in previous articles. The ripples and reverberations from these shockwaves will reshape our world much more dramatically over the next 4-5 decades than either the first industrial revolution of the mid-18th to mid-20th centuries or the second that lasted from roughly 1947 (when Shockley and his Bell Labs collaborators in Murray Hill, New Jersey developed the first transistor) to 2007.
The world's financial arena will also undergo revolutionary change during the next several decades. I think most of it will, in the end, be enormously beneficial for both our children and, especially, our grandchildren. But I also have no doubt that it will be a painfully bitter pill to swallow, at least in the short and medium term.
There was a prologue to the 2008 financial crisis. The popping of the Dotcom bubble in 2001 was followed by a deliberate attempt by Washington D.C. to 'inject' cheap credit into the US economy thru artificially (US Treasury and Federal Reserve-driven as opposed to market-driven) suppressed interest rates. Banks stocking up on US Treasury securities could deposit them at the Federal Reserve, earn interest on them and use them as assets against which they could extend low interest loans.
Underwritten by Fannie Mae/Freddie Mac (essentially a government institution that was an unintended byproduct of FDR's New Deal programs during the Great Depression of the 1930's), banks could issue mortgage loans risk-free to consumers regardless of credit risk and be guaranteed to make money. Thus was the Housing Bubble of the first decade of the 21st century born.
"Nescire autem quid ante quam natus sis acciderit, id est semper esse puerum."
Not to know what happened before you were born is to remain forever a child. - Cicero
The folly of debt-financed prosperity of the post-WW1 1920's was being repeated, yet anyone who had been on Wall Street during that time and experienced its terrible aftermath had either passed away or left Wall Street and the Financial industry by the 1970's. Even if some Methuselah had been present to sound the alarm, though, it's unlikely anyone would have listened. The US Government could finance massive deficits for both 'guns & butter' spending while pretending to serve the public interest, mollified by the fantasy that resulting economic stimulus could easily increase tax collections to neutralize the debt growth over the long term. It was from this that the infamous Dick Cheney "Deficits don't matter" proclamation sprang (and, folks - no matter what end of the political spectrum you may be on, you have to admit that this statement was perhaps one of the two or three stupidest things ever said in the history of humanity.)
Concurrently, bankers could issue zero-down, zero-interest-for-the-first-5-years housing loans like there was no tomorrow without even bothering to weigh counterparty risk. Since Uncle Sam was ultimately footing the bill, financiers could act as if their was no risk at all, moral hazard be damned.
When the bill came due in 2007 and bum creditors began walking away from their essentially free housing loans in droves, the 2008 financial crisis bloomed, dragging down a couple of Wall Street giants. Lehman Brothers was dumb enough to hold onto its subprime mortgage portfolio and found itself without a chair when the music stopped. Credit insurer AIG, who had issued derivatives packaged as insurance policies against defaults of these and other sorts of financial instruments ("credit default swaps on collateralized debt obligations"), became insolvent and had to be bailed out to the tune of $85B by the Federal government.
What was Europe doing during the 2001-2008 period? At first, the outlook was rosy. The European Union officially launched the Euro on currency markets in January of 1999 and began issuing physical currency in January of 2002. The elimination of numerous sources of commercial friction from intercontinental border tariffs, customs controls and protectionism fired healthy growth.
Part of the Euro pact, of course, included restrictions on national central banks from being too free and easy with their management of local financing conditions and sovereign debt support. In fact, though the EU encouraged annual government deficits to 'stimulate' growth (a pseudo-Keynesian concept that John Maynard Keynes actually rejected during his lifetime), there was an agreed upon upper limit of 3% to annual government debt-to-GDP growth. Unfortunately, most members cheated, and some grossly so. These states effectively rode to one degree or another on the coattails of a perennially productive German economic powerhouse during this period, their gross fiscal malfeasance hidden by the general increase of prosperity and accounting fraud.
And China? The Middle Kingdom has been the real driver of growth in the global economy since 2000. By pegging the yuan to the USD, China was able to protect its position as a low cost manufacturing base and drained an enormous amount of industrial plant to its shores from its trading partners. Few nations found ways (or even made the effort) to protect their domestic economies from such intrinsic value loss - Germany, Switzerland, Taiwan, Japan and South Korea being the exceptions.
Contemporaneously, though, Beijing spent staggering sums on infrastructure improvement thru provincial government agencies. And, after a half century of highly centralized authoritarianism, this spending spree was plagued by rampant corruption at the local level, with empty cities built in the middle of deserts, a multitude of 'bridges to nowhere', widespread graft, cronyism and budget fraud.
Unfortunately, the 2008 crisis did not serve to wake central governments up to confront the errors of their ways. In the USA, a new presidential administration and Congress instead decided that doubling down on failed economic dirigisme was a brilliant idea, especially as it ensured that certain sources of bountiful campaign contributions and post-civil service employment would be well cared for. Europe (with the notable exception of Iceland) also concluded paradoxically that even more debt would extract them from the problems that too much debt had created. Beijing's apparatchiks, on the other hand, determined that nominal 9% annual GDP growth was a bragging right they did not want to relinquish, nor did they dare face a potentially destabilizing popular backlash from a sudden worsening of economic conditions and loss of growth momentum.
When thou attended gloriously from heaven,
Shalt in the sky appear, and from thee send
Thy summoning archangels to proclaim
Thy dread tribunal. - Milton, "Paradise Lost"
The results over these last 7 years have been uniformly negative. Some bleak statistics starkly illustrate the quandary:
1. In the first three quarters of 2014, America's S&P 500 companies reported total net income (not revenues) of $945B. However, 95% of that was repurposed not for PPE expansion, R&D and new product development but for stock buybacks and dividends.
2. From the 2008 crisis to March 2015, the S&P 500 has spent $4T (yes, you read that right) on buybacks and dividends - 85% of their total earnings for that 7 year period.
3. Again, from the 2008 crisis to March 2015, the S&P 500 has leveraged their assets by taking on $3T in ultra-low interest debt, primarily to finance stock buybacks (with Apple leading the charge in the last year, as described earlier in this editorial.)
4. America's economy today has 2M fewer jobs than in 2007. Remember: America's population grew by 18M during the period. It doesn't take a math genius to figure out that the current 5.4% unemployment figure is a farce.
5. The workforce participation rate in the USA continues to be at a near four decade low at 62.8%. It has been at that level now for one full year.
6. In line with observations regarding the nature of jobs that have been created since 2008 (dominated by part-time and minimum wage work), the average age of a minimum wage worker today is 36, and 37% of minimum wage workers are over 40.
7. Normalizing with official CPI inflation figures, mean household income in the USA in 2014 is 4% less than it was in 2007. This is a truly damning indictment of government economic policy, as a consumer spending-based economic recovery is simply impossible under such conditions.
8. Total public and private debt in the USA (including local, state and federal debt along with corporate and consumer debt) in 2000 was $28T, or 2.6x GDP. In 2014, it topped $60T and 3.5x GDP. (NOTE: these are cash numbers, not GAAP, which would be much higher.)
From the above, one can plainly see how, over the last 7 years, a record high 18,000+ in the Dow, 2,100+ in the S&P 500 and 5,000+ in the NASDAQ have been reached in the teeth of a net worsening of economic conditions for the vast majority of consumers. These stock price gains are obviously not driven by an improving economy, but by extremely low interest financing channeled into equity markets. It is also evident from the above that a global economic revival cannot be driven by the US economy.
This leaves us to look towards Europe or China for future short and medium term growth. Unfortunately, neither geography is in noticeably better shape. Both eastern and western european countries are saddled with huge debts - total debt (public + private) in every country on the continent exceeds 3x GDP, and several are over 4x. From a $2T economy with $2T total debt in 2000, China has grown to a $10T economy with $28T total debt.
It's clear where all this is leading. Central banks and governments will feel compelled to protect the liquidity of their financial sectors thru continued sovereign deficit spending and concurrent interest rate suppression while hoping that by some magic stroke of luck things will get better on their own if they keep pushing on the same rope long enough. Yet this has proven to have no positive effect on productive investment in the economy and will only continue fueling the speculative bubble in equity markets.
These 'free money' policies have likely reached their limits, though. A critical indicator of this is the S&P P/E (price/equity) ratio, which has now surpassed 20x. Economic history buffs will recognize this as a clear "red sky in morning" event. Moreover, there is simply no further room to materially lower interest rates. Many sovereign debt issuances pay such low interest that when discounted by inflation, their yields are effectively negative.
A Pause for Reflection
I was very hesitant to write the section above because of how negative and potentially upsetting such news can be. After all, most of you, dear readers, are employed in High Technology. High Tech workers are a group of people who have sweated through years of sitting in the campus library on saturday night until the wee hours, struggling to earn a STEM degree and then working ferociously to build their careers so as to provide and build a future for themselves & their families. To hear that after all that dedication of time and effort that the near term future offers nothing but increased difficulty and hardship is bound to turn more than a few folks off.
So: let's forget for a moment all of the data presented above. There are certain sources of information that are untouched by the hands of government bureaucrats - rather simple measures that provide unvarnished and transparent indicators of economic activity. We've used these benchmarks before: the Baltic Dry Index (BDI) which is an index of cargo shipping rates from the major global ports, and the Commodity Research Bureau (CRB), a 'thermometer' of commodity market prices for a broad range of metals, textiles and agricultural products that is far superior to the highly massaged and contrived data of the CPI.
First we'll glance at the BDI.
The above is a 5 year chart. The BDI peaked in May 2008 at roughly 11,800.
Notice how there is a Q4 'spike' almost every year, reflecting the holiday season. None of the holiday seasons over the last 5 years have been considered successful by retailers, with 2012 and 2014 noted as particularly poor. Of special note is the fact that the BDI has just bounced off its historic low of 509 on the 15th of February.
Here's a BDI chart that goes back to 1/1/2000 up to today. The 828 number at the end is actually from a rolling average; today's number should match up with the 634 in the graph above. My eyesight isn't as good as it used to be, so if someone can see the evidence for recovery after 2008 so heavily espoused by talking heads in the mainstream media, please point it out in the Comments section. ;-)
Now let's look at the CRB index. This is the classic CRB (not the Thomson Reuters/Jefferies index), which tracks pricing for 23 commodities, listed here:
China has been the driver of the CRB for the last 15 years because of its demand for steel, zinc, copper, wheat, concrete and everything else needed to rapidly bring an economy out of the crushing poverty of marxist collectivism and central planning to very nearly 1st world status in just a decade and a half (and I say 'very nearly' only because though many of China's urban centers have modernized with spectacular swiftness, many rural areas have yet to catch up - no offense intended to my Chinese friends and readers.)
Here is a CRB chart with a loooong historical tail.
From comparing the above to charts in earlier editorials, one thing is obvious - since early 2014, commodity prices have been in freefall.
Implications to the High Technology Sector
Never let the future disturb you. You will meet it, if you have to, with the same weapons of reason which today arm you against the present. - Roman Emperor Marcus Aurelius
It was 480 BC. Leonidas and his 300 Spartans had fallen at Thermopylae in a defense of such heroism that it would echo across the gulf of Time for thousands of years.
The Persian army was a horde of millions, an irresistible flood. The Spartans regrouped with their allies to the south at the Isthmus of of Corinth. Xerxes directed his forces to finish the conquest of the province of Boeotia, intending to then focus his wrath south on Attica and the hated city of Athens.
The Athenians sent a delegation to Delphi. To the venerated priestess they posed a question: should they stay and fight, defending the city and the Acropolis, protecting the Parthenon with its statue of their patron goddess Athena, or should they flee en masse to Italy or Sicily and start over?
Apollo had granted the Pythia the gift and curse of prophetic visions. Sometimes they were simple and clear, but were more often obscure and sometimes ensnaring.
The Pythia received their offering and stood over the sulphurous vent in the temple, seeking from the fumes that swirled at her feet the trance that would give her inspiration from Apollo for her divination.
At length the Pythia spoke.
"Why sit you, doomed ones? Fly to the world's end, leaving home and the heights of your city circles like a wheel. The head shall not remain in its place, nor the body, nor the feet beneath, nor the hands, nor the parts between; but all is ruined, for fire and the headlong god of war speeding in a Syrian chariot shall bring you low. Many a tower shall he destroy, not yours alone, and give to pitiless fire many shrines of gods, which even now stand sweating, with fear quivering, while over the rooftops black blood runs streaming in prophecy of woe that needs must come. But rise, haste from the sanctuary and bow your heads to grief."
The Athenian envoys despaired, as the gods had told them their world was about to end.
At this moment, Timon, a noted citizen of Delphi, suggested they employ a different tack. Gathering themselves to try again with the Oracle, the Athenian delegation followed Timon's suggestions to the letter and, approaching the Pythia as supplicants with olive branches in hand, they begged Apollo directly thru his priestess for help, and if none was forthcoming, they would remain the temple until they died.
The Pythia then spoke again.
"Not wholly can Pallas (Athena) win the heart of Olympian Zeus, though she beseeches him with many prayers and all her subtlety; yet I will speak to you this further word, as firm as adamant; though all else shall be taken within the bound of Cecrops (the mythical half human, half dragon first king of Attica) and the fastness of the holy mountain of Cithaeron (a mountain forming part of the northern border between Attica and Boeotia), yet Zeus the all-seeing grants to Athena's prayer that The Wooden Wall only shall not fall, but help you and your children.
"But await not the host of horse and foot coming from Asia, nor be still, but turn your back and withdraw from the foe. Truly a day will come when you will meet him face to face. Divine Salamis, you will bring death to women's sons when the corn is scattered or the harvest gathered in."
The delegation returned to Athens, whereupon Themistocles, a leading Athenian political figure and commander of the combined Greek allied fleet, discerned the meaning of the Delphic soothsayer. He met with the captains of the various allied contingents and proposed that the fleet engage the Persian navy in the confined spaces of the strait between the coast of Attica and the island of Salamis.
At this juncture, the ancient Greeks took up their favorite activity - they began to argue. Things reached a point where one of the commanders threaten to assault Themistocles if he persisted in defending his proposal, whereupon Themistocles yelled "Strike, if you will, but hear!"
Upon uttering this phrase, the commanders fell silent. For a man with the standing of Themistocles to offer himself up for injury and abuse if he could just argue the merits of his plan convinced everyone to give it full consideration and, in the end, approval.
Athens evacuated its entire population to Salamis. 500 amazingly courageous Athenian hoplites remained behind, determined to defend the Acropolis and Parthenon to the last. The Persian host approached and burned the city to the ground. The Acropolis was overrun and put to the torch, the hoplites slaughtered and the sacred Olive tree, said to have sprouted when Athena struck her spear on the rock, was broken.
Xerxes still had not sated his appetite, however. Upon hearing of the Allied Greek fleet in the straits of Salamis, he ordered the Persian navy to pursue and destroy it. In anticipation of finally obliterating the Athenians, Xerxes seated himself on a high bluff overlooking the straits in order to fully savor the spectacle.
The allied navy numbered slightly less than 400 triremes, half of them Athenian. Persian forces were at least 600 ships and may have been double that.
At dawn, the Persians drove into the strait but quickly found its confines awkward to navigate and hurriedly redressed their formation into a depth of three lines. The Greeks appeared to be withdrawing to the south and the Persians redoubled their pursuit in some disarray. It was at this opportune moment that the Greeks turned to attack, joined by a larger force that had hidden behind a spit of land from Salamis and taking the Persian fleet full in the left flank.
The Wooden Wall of Greek triremes annihilated the invader's navy, leaving 400 supply ships supporting Xerxes' land forces completely defenseless. These ships turned tail and headed back north at all speed, anxious to put distance between themselves and the Greek ships.
The Athenians returned home. Their hearts were heavy as they beheld the smoking ruin of their home. Yet some who climbed the Acropolis to search for the 500 hoplites who had stayed behind discovered Hope, as the stump of the sacred olive tree had sprouted a new, delicate green branch.
With a sense of bitter frustration, Xerxes sent the overwhelming bulk of his army immediately north to cross the Hellespont and retreat into Persian -controlled Asia Minor, leaving behind 180,000 soldiers under the command of Mardonius, a longtime collaborator and Greek mercenary general, and Artabazus, a Persian provincial governor and favorite court lackey of Xerxes. Doubling the size of the army over the following year by conscripting troops from subject territories in northern Greece, the Persian force, under a divided command and split loyalties, met a combined Greek force of perhaps 60,000 under joint Spartan and Athenian leadership on the plain of Plataea, whereupon the Persian army was shattered and dispersed.
While there's life, there's hope. - Cervantes, "Don Quixote"
With great ingenuity and stalwart hearts, the Greeks defeated a heretofore invincible foe. Slaying giants (at least of the engineering kind) is something we do in a busy afternoon in High Tech.
While the semiconductor industry grew by 9.9% last year, global growth rates in 2014 were much less impressive:
USA - 2.4%
China - 7.4%
Euro area - 0.88%
I feel very safe in suggesting that High Technology, though plainly vulnerable to general macroeconomic conditions, is somewhat protected from general downturns by the fact that High Tech companies are masters of producing Value. This will serve us exceptionally well in the coming trials.
With the global economy almost certainly headed into another recession and worldwide debt loads combined with moronic economic policies that serve a very limited spectrum of entrenched interests continuing to hobble genuine growth, business will get harder for us. But it won't become impossible. Sure - things will get tougher for a number of years. But knowing is half the battle.
Microsoft and Google are developing Machine Vision, Voice Recognition and AI for the Cloud. Apple and Qualcomm are leapfrogging them to create the same on smartphones. Lattice, Nvidia and CEVA are developing silicon products and IP to support these same purposes. Intel, NXP and Mediatek are pursuing the IoT market purposefully and energetically.
I think we should collectively hoist the Jolly Roger and sail the Spanish Main in search of prizes in the IoT or AI. And that's not the only loot to be taken on the seas of High Tech. There's an incredible number of other things being worked on, and I'll begin exploring some of those in the next blog post.
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