Dear Friends,

The first quarter of 2014 saw an uptick in stock market volatility as a change in Fed leadership and Russia’s annexation of Crimea caused some investors to rethink investment and trading positions. The Dow Jones Industrials finished the quarter -0.72%, the S&P 500 +1.3% and the Nasdaq 100 was +0.54%.

Meanwhile, after a poor showing last year, bonds bounced back in Q1, outperforming equities. The Barclays Aggregate Bond Index finished the quarter +1.97% while the Barclays Municipal Index saw gains of +3.32%.

Though these movements are not large, there have been significant moves in particular sections of the market. In 2013, certain internet and biotech stocks rose to excessively optimistic valuations, but 2014 has seen particular weakness in these names. We believe this indicates the broader market is nervous to some degree about growth prospects with many participants taking profits in what they perceive to be the weakest and most speculative names.

The dramatic events in Ukraine have also jittered investors, particularly those exposed to Russian assets or consumption. The risk of rising tensions and economic sanctions against high-spending foreigners has depressed luxury goods makers and brought a chill to higher end real estate in major global metropolis. At the same time, we have seen Chinese investors and companies spooked by falling demand and regulatory actions in China.

January saw Janet Yellen officially step into her new role as Fed Chair, replacing the departing Ben Bernanke. In March, she held her inaugural press conference, which seemed to go well, until she was asked a follow-up question about when she expects interest rates to be raised. She had used the term “a prolonged period” which a reporter asked her to clarify.

Unlike her predecessors, who would have either ignored the follow-up question or provided a maddeningly vague answer, Yellen, in what may have been an attempt to shed light on the traditionally opaque Fed, answered “It’s hard to define but, you know, probably means something on the order of around six months.” US stocks immediately sold off on this comment, as investors interpreted this to mean that the Fed’s easy money policy would end sooner than originally thought.

This incident reinforces our view that markets have become far too reliant on the Fed’s easy money policy. We expect risk assets (namely stocks) will continue to be under pressure as the Fed winds down its stimulus program.

High frequency trading has been in the news over the past several weeks with the release of a couple of high profile books that delve into the guts of the equities marketplace. The steady demise of physical trading floors and the advancement of technology has moved virtually all trading volume onto electronic venues. Inevitably, the vast sums at stake have led to an arms race amongst trading firms. We’ve known for some time that major market-makers have been doing their utmost to gain physical proximity to exchange computers so they can see orders as quickly as possible. The exchanges (which have over the past fifteen years transformed themselves from member-owned organizations to for-profit publicly traded corporations) have not been shy in tapping this new revenue stream. In our view, this is not any different from the old days when traders who participated in the market would buy an exchange membership so they could walk onto the floor and be in the middle of the action. There was an informational advantage to seeing the activity of the actual participants on the floor, this advantage still exists, but the venue is electronic. Most investors will never have cause to consider high-frequency trading or being part of the market on an exchange floor. This is highly specialized activity requiring very specific skills, which is why exchange memberships were limited, and why there are only a few successful HFT firms.

The move to electronic market-making has been largely beneficial for investors. Costs to execute transaction have fallen. Investors who would pay brokerage commissions in the hundreds of dollars now pay a handful of dollars for the same. But the far larger impact has been on bid-offer spreads, the difference between the price at which the market is willing to buy and sell a particular stock. With decimalization, these have fallen from one-eight or one-sixteenth of a dollar down to a cent or less in most cases. Most individual investors will not generate orders that are the target of HFT algorithms since they are too small to generate predictable patterns.

What has changed, and does concern us, is that some exchanges are changing rules at the behest of HFT firms. There has been a profusion of order types for interest, the vast majority of these are not used by the average investor (of any size). They’re exclusively used by the programs run by HFT shops to discover what market participants are doing without running afoul of securities regulation. In a sense, the exchanges have been responding to customer demand, since much of their revenue now comes from HFT firms, but this is short-sighted. The true clients of stock exchanges are the investors and listed companies (and by extension the investment advisors and brokers who represent them). Prior to de-mutualization, leadership at exchanges knew this and balanced the interests of their members (who were on the floor every day trading and making markets) and those of investors and corporate issuers. It seems this balance has been skewed and some electronic exchanges may have become captive to the interests of the firms who generate the most revenue for them. This short-term thinking, and the belief that obeying the letter, rather than the spirit of our laws (which broadly aim for investor protection) is what worries us.

In other news, we recently hired a new intern named Daniel Sobajian. Daniel comes to us from Columbia University where he’s majoring in political science. Daniel is also founder of Studentsdo.org, a non-profit he started while in high school that provides school supplies to needy students in southern California.

Louis recently published an article on the website greentechmedia.com. The article investigates the risks of investing in crowd-sourced clean energy projects, specifically Solar Mosaic. You can read the article by logging onto greentechmedia.com and running a search for Louis Berger.

Louis Berger                                                                    Subir Grewal