A Phillips-curve Fed?

Back on March 4, we pointed out a troubling quotation by Fed Chairman Ben Bernanke, in which he indicated his opinion that slowing economic growth could lower inflation and moderate energy prices.

In light of the market turbulence in the wake of this week's Fed decision, that post from March 4 is worth a second review. In it, we stated that a belief by the Fed that slowing growth or, more specifically, rising unemployment will dampen inflation -- a connection called the "Phillips curve," shown in the drawing above from 1950s economist A. W. Phillips -- threatens to destabilize the dollar. We pointed out that the Phillips curve has been resoundingly proven wrong in the fifty years since its introduction, and that it was economists such as Milton Friedman who rebuked that theory and helped lead the way out of the stagflation of the 1970s. Mr. Friedman also taught us that inflation is a monetary phenomenon caused by too much money chasing too few goods. The Fed is being loose with money creation now (too much money) and that is creating the rise in prices for commodities like food and oil (not enough available).

Recently, Steve Forbes lamented the damaging effects of "the excess liquidity the Federal Reserve has created since 2004" in this opinion published on June 16. In particular, he argues that the Fed's most recent loosening from 5.25% to 2.00% on the target Fed Funds rate is directly responsible for oil's rise from $70 a barrel in August to today's record prices, which is a point we also made in this post from June 4. Tellingly, Mr. Forbes asserted in that article his belief that "the Federal Reserve is still in thrall to the Phillips curve."

The editorial staff of the Wall Street Journal today analyzed yesterday's dramatic market sell-off and blamed it on concerns that the Fed will continue to let inflationary pressures rage and the dollar collapse, pointing for evidence to the fact that gold and oil both shot up sharply yesterday (see here for their article).

The Federal Reserve's statement from Wednesday said "The Committee expects inflation to moderate later this year and next year." Exactly how do they expect inflation to moderate? Do they believe it will moderate all by itself, based on the fact that, as they noted, "labor markets have softened further"? Does this confirm that the Fed is indeed still in thrall to the Phillips curve?

Economist Brian Wesbury noted that the Fed's statement is much more hawkish than their April statement, raising hope that the Fed is keenly aware of the inflation danger and that they stand ready to correct the monetary situation and begin moving to stabilize the currency.

We agree that the Fed must tighten rates in order to stop the problem, which will not go away by itself, and the sooner the better. We hope that a mistaken belief in the Phillips curve doesn't cause them to wait for inflation to moderate on its own. That could well be a long wait!

For later blog posts dealing with this same topic, see also:

• "The Fed drops the mask" 08/25/2008.

• "Stand still, little lambs, to be shorn!" 06/03/2009.

• "Milton Friedman, 1912 - 2006" 07/31/2009.

• "The Consumer" 10/19/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "Still in thrall to the Phillips curve?" 03/15/2010.

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On any given day in the markets . . .

Richard C. Taylor had a saying that "On any given day, one percent of the owners of a stock set the price for all the other owners."

He was advising owners of shares in good businesses not to become flustered by the market moves of their stocks in the short term, because those moves are driven, on any given day, by only a very small percentage of the total ownership base of those businesses.

Too many investors view "The Market" as the final say on what a business is worth from day to day: all those other shareholders out there "must know something" -- the implication being "they must know more than you do!" Financial media coverage tends to reinforce this perception. So does modern portfolio theory and its efficient market hypothesis, which we have discussed in this previous post.

Instead, investors should realize that even on days with exceptionally heavy volume, only a very small percentage of shareholders in any given issue actually trade their shares. Thus, only a small percentage are speaking for everyone else on any given day, and what that small percentage says about the value of the business should be viewed as the opinion of a very small minority.

For example, comparing the average daily volume of shares traded over the past three months and dividing that by the total shares outstanding listed in the most recent annual reports filed with the SEC for ten different well-known public companies, the average percentage traded per day was 1.67%. So, we could be a little more precise and say that "On any given day, about 1.67% of the shareholders of a company set the price for everyone else." But the general point is very important for investors to understand.

It is also important to realize that during periods of lower volume, even fewer voters than usual get to set the price for the stock. We have previously stated that lower volumes (which are typical of the upcoming summer months) will probably keep the markets fairly volatile but indecisive until this fall and the November elections, when greater certainty will bring greater volume to bear.

The important takeaway from this insightful saying of Mr. Taylor's is that those who believe in the importance of owning businesses should focus more on what those businesses are doing and saying, and less on the distraction of the markets, which function on a daily basis as a kind of "Greek chorus" of commentators who may have some valuable points, but who make up a tiny slice (a hundredth or two) of the total community.


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A hawkish Fed or a dovish Fed? There can only be one. . .

Two weeks ago, on June 9, Fed Chairman Ben Bernanke indicated that the Fed would get tough on inflation, in a speech we discussed in this previous blog post, which also contains a link to the full speech by the Fed Chairman.

Since then, doubts have arisen as to whether the Fed is serious about actually pulling the trigger, based on dovish statements by other Fed officials, including Vice Chairman Donald Kohn.

The week of Mr. Bernanke's hawkish statements, the markets had a positive week, ending at 12,307 on the Dow and 1360 on the S&P. Gold fell to $873 by that week's end. Since then, however, the Dow fell back to 11,842 this past Friday June 20, the S&P fell to 1317, and gold moved back to close the week at $903.

This week, the FOMC meets Tuesday and Wednesday, announcing their target rate decision on Wednesday, and no one expects them to actually hike this week, although the tone of the Fed statement will be very important to see if there are indications of increased hawkishness against rising inflation pressures.

As we have stated in numerous previous posts, we do not advise investors to buy and sell securities based on whether they think the Fed will raise or lower rates this meeting versus next meeting, or any other short-term barometer. We believe in a foundation of ownership of well-run, growing businesses through many economic and market cycles.

However, we have also argued previously that the building inflationary pressure, including the severe run-up in the price of oil, is yet another consequence of easy Fed policy dating back to 2003 which had a hand in exacerbating the housing problem as well as excessive CDO underwriting.

Therefore, we would like to see the Fed remove the excess stimulus it provided earlier this year and get back to focusing on providing a stable currency, which is of paramount importance to businesses and to investors in securities -- both stocks and bonds.

While the conventional wisdom is that the markets hate Fed rate hikes, we believe that some tough and aggressive inflation fighting would actually be good for the market. And, even though the Fed probably won't do it this week, those hikes may come sooner than expected for those who still think it's a good idea to bet on continuing increases in the prices of gold, oil, and other commodities. This may be a good juncture for them to ask themselves the famous line from Dirty Harry: "Do you feel lucky?"


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For future posts dealing with this same subject, see also:

• "Still in thrall to the Phillips curve?" 03/15/2010.

• "Inflation is a monetary phenomenon" 03/07/2011.

Managers who hate their own cooking

It should go without saying that the money manager you entrust with the task of managing your money should believe in the investment process he uses to manage your portfolio.

In fact, we would go further and say that he should be convicted that the investment discipline he is following is the very best process that he could possibly use for the objectives, mandates, and constraints of that portfolio.

One indication of such conviction is whether that manager actually places his own money in the securities that he selects for the clients investing in his portfolio. Doing so is commonly described as "having skin in the game" or as "eating his own cooking."

However, a recent study from Morningstar, published this week, reveals that an astonishing percentage of money managers do not have a single dollar invested in the portfolios that they manage. According to the preliminary data which encompassed approximately 6,000 mutual funds, 47% of the managers of US stock funds report no management ownership, 61% of foreign stock funds report no management ownership, and 71% of balanced funds (investing in both stocks and bonds in the same fund) report no ownership.

The author of the article linked above, which is found on a Morningstar site, notes that there are some special circumstances which would dictate that a manager not invest alongside his investors, such as if running a muni bond fund composed only of bonds from another state (and fully 80% of muni bond fund managers had zero ownership in their funds) or if the manager is from a foreign country that bars investment in fund domiciled in the US, but that beyond those two special circumstances, it's a mystery "why anyone would invest in a fund that its own manager doesn't invest in."

From our perspective as money managers, we can add the comment that, if you deeply believe that you are pursuing the very best investment discipline that you possibly can, why wouldn't you want to invest at least some of your own money in that very same process?

Furthermore, academic studies which look at the level of management ownership (as well as director ownership by members of an investment company's board of directors) confirm the common-sense hypothesis that skin in the game matters. For example, this 2006 academic study looked at director ownership and found benefits to their ownership, and this different 2006 academic study concluded that "future risk-adjusted performance is positively related to managerial ownership, with performance improving about three basis points for each basis point of managerial ownership."

We also noted in our February 1 post entitled "So when do you fire a manager?" that a portfolio manager's level of investments in his own portfolios is an important indicator of his conviction to the merits of his strategy and that he should "eat his own cooking."

This discussion is particularly timely in light of today's news in which federal authorities indicted two hedge fund managers. Among the allegations are that one of the managers began to remove about a third of the $6 million of his own money he had invested in the hedge funds that he managed, without notifying investors, nearly three months prior to the collapse of the funds in June, 2007.

We strongly believe that investors should view management ownership of portfolios in which they invest as an important indicator of conviction, and caution that management's removal of their own money -- or failure to invest in their own portfolio at all -- should be viewed as a major red flag.


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A critique of The Big Switch, by Nicholas Carr

Nicholas Carr's The Big Switch: Rewiring the World, from Edison to Google (Norton: New York, 2008) is a well-written and fascinating analysis of the enormous paradigm shift taking place in technology, one that he rightly observes will have enormous sociological ramifications beyond merely changing corporate data centers and the business models of enterprise software (although the consequences of those changes are significant in themselves).

In support of Mr. Carr's book, his invocation of the paradigm shifts that took place around the introduction of electricity at the beginning of the twentieth century is outstanding in its attention to the details of a world-changing transformation that we citizens of today -- who have never known a world before electricity -- take completely for granted.

Indeed, the fact that we barely notice the ways in which our lives are shaped by the consequences of that shift to electric power underscores his argument that the changes the internet has already brought, and the changes that the impending computer revolution will bring about, cannot help but profoundly alter the way we live and even the way we think.

His examination of the shift from on-site electric dynamos and mill-work to the utility electric grid around the turn of the last century, and the parallels he makes to the changes taking place in computing (as well as important differences between the electricity analogy and the networked computer) are important observations for investors to consider, and something we have also discussed in previous posts such as this one, this one, and this one. We would even argue that the economic disruptions at the beginning of the last century had political echoes that manifested themselves in similar political arguments to the ones that are being thrown around today, as discussed in this recent post.

And yet for all its important insights, The Big Switch displays a general attitude towards business that we feel is wrong-headed, and worth discussing because it is a common one among many in journalism and academia. It's not that we don't believe that there can be negative consequences to new technologies: clearly there can be, and attempts to foresee those (such as Mr. Carr's book) are valuable and necessary. But The Big Switch puts forth the common pseudo-economic arguments (popularized primarily by Keynesian economists and especially the late John Kenneth Galbraith) that businesses bend societies to do their bidding, enslaving consumers and forcing them to spend to the detriment of those consumers and to the detriment of society in general.

For example, in discussing the changes brought about by electricity, Mr. Carr complains that because of the new capabilities in ironing and cleaning that electricity enabled, consumers (especially women) in the twentieth century actually became enslaved to the new electric regime. He says: "Clothes had to be changed more frequently, rugs had to be cleaner, curls in hair had to be bouncier, meals had to be more elaborate, and the household china had to be more plentiful and gleam more brightly" (99).

But this line of argument is disingenuous. It ignores the basic fact that businesses make money by providing value to their customers, not by coercing their customers into doing things they don't really want to do. If technology made it possible to have neater and cleaner clothes, businesses would only be able to build a business model selling such a capability if in fact customers wanted that capability. In other words, providing bouncier curls in hair would not be a value proposition for a manufacturer of electric curling irons unless customers actually valued bouncier curls.

And while writers of the Keynesian school like Galbraith would say that nobody really needs bouncier curls, the very fact that people have the luxury to worry about bouncier curls and to exchange money and time in pursuit of bouncier curls is evidence of the progress in standards of living that free-market economies (in other words, capitalism) brings about. It is true that nobody worries about bouncier curls if they are starving to death, but the progress brought about by free economies means that people can pursue more and more things that they value beyond the basic necessities of living -- things like the cleaner rugs, fancier meals, and bouncier curls that Mr. Carr catalogs above.

The Big Switch takes the exact same approach to the new luxuries afforded by the bandwidth revolution, for example in his discussion of YouTube and other sites that enable "user-generated content." Carr writes, "Look more closely at YouTube. It doesn't pay a cent for the hundreds of thousands of videos it broadcasts. All the production costs are shouldered by the users of the service. [. . .] In a twist on the old agricultural practice of sharecropping, the site owners provide the digital real estate and tools, let the members do all the work, and then harvest the economic rewards" (137-138).

But, again, if a business does not provide something that people value, it does not make any money. Nobody holds a gun to anyone's head and forces them to buy an iPod: if a consumer buys an iPod, it is because he judges what he gets in exchange for his money to be more valuable. If the founders of YouTube have a lot of money, it is because they created a service that provides value to a tremendous number of people. And, just as in the discussion above concerning the pursuit of bouncier curls and more neatly-pressed clothing, the very fact that people have time to create user-generated content is irrefutable evidence of the progress enabled by the very free-market economies that critics like John Kenneth Galbraith distrusted so deeply and criticized so vigorously.

We would advise all investors to read Nicholas Carr's The Big Switch. But we would caution that many of the conclusions that it draws err due to a pervasive Keynesianism, and that awareness of this error is important, as it is sadly widespread even today.


For later posts dealing with this same subject, see also:

• "Big changes coming -- part II" 07/08/2008.
  
• "The unstoppable wave" 01/12/2009.
• "Clayton Christensen, disruptive technology, and your portfolio recovery plan" 02/04/2009.
  
• "Revisiting the 'New Economy'" 05/06/2009.
• "The Unstoppable Wave: Revisited" 12/22/2009.
• "Was the decade lost?" 01/14/2010.
• "Exaflood update" 06/01/2010.
• "What battles of the tech titans tell us about investment theory" 09/08/2010.
• "Another wake-up call" 11/29/2010.

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Two important data points to be aware of from this week

One week ago, the non-farm payroll report sent the unemployment rate higher by 0.5% to 5.5%, sending the markets into a steep dive and reviving cries of recession from the demand-side pundits and economists who were having a hard time supporting such talk recently.

Since then, two important positive pieces of information deserve note: one is the Fed's public recognition on Monday of the inflation they have created, and a signaled willingness to increase rates to relieve that inflation, and the second is a strong retail sales report showing growth in retail sales at twice the rate expected by the consensus of economists.

We have already explained in previous posts on the Taylor Frigon Advisor that the Fed's attempts to steer the economy often have serious economic consequences, and that the most recent example is the inflationary pressures left over from too-easy money since the end of 2003 (likely the primary factor in the painful increase in oil and gasoline costs).

The good news is that, since the era of the Volcker Fed, we have known how to prevent runaway inflation, and Bernanke's comments earlier this week indicate a willingness to use proven tools to contain it, saying the Fed "will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation" (text of the speech is available here).

The other noteworthy data point was the retail sales data for May, shown in the Census Bureau graph above. Total sales for the period of March 2008 through May 2008 were up 2.6% over the same period one year ago. Retail sales in May 2008 were up 2.5% over retail sales in May 2007. Retail sales in May 2008 also increased 1.0% from April 2007, while the consensus had been forecasting an increase of only 0.5%.

The main talking point for the recession crowd has been that the consumer was going to fall off a cliff, sending the US into a recession. The strong retail sales figures totally crush the theory that the consumer is causing a recession. We have explained in many previous posts that the fears of a consumer-driven recession which have played endlessly in the media since last fall are overblown -- see here and here for example.

The main rebuttal we have been hearing is that these retail sales numbers from May are primarily the result of the government rebate checks. The very first of these checks hit accounts around May 2nd. However, on the same day that the May retail sales numbers were released by the Census Bureau, the retail sales figures for the March 2008 to April 2008 period were also revised upward, from -0.2% to +0.4%. This upward revision for March and April derails the argument that the May growth was simply about rebate checks. Further, only about a third of all the checks have even gone out to date, which also diminishes the argument that the retail number was primarily due to the government "stimulus" checks.

Not surprisingly, the media continues to warn of a consumer-led recession, in spite of the developments of this week. However, we would tell investors to focus in on the two important positive data points discussed above as confirmation of some of the arguments we have made on this blog over the past several months, which will help amidst the barrage of noise and opinion that floods in from all sides in the modern information age.

The markets themselves will no doubt be bumpy for several months, due to fears about Fed rate hikes and uncertainty over when they will begin, uncertainty over the upcoming Presidential elections, lower summer trading volumes that can exacerbate mood swings, and other unforeseen factors. However, the picture for growth in the underlying economy became clearer this week, for those who are able to read the signs.


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An economist looks at populism

Economist Brian Wesbury's comments in the editorial page of today's Wall Street Journal describe the current condition better than anything we have seen lately.

His analysis reveals that we must be careful in our choices. While it is easy to follow a path towards dismay, the most important point he makes is a positive one: thanks to the dawning of what he calls "Internet Time," it is less likely for bad policy to continue for as long, when its consequences "become visible almost in real time, creating real political pain."

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Wall Street firms back at the well

This week, Wall Street brokerage firm Lehman Brothers* announced that they will be seeking an additional $6 billion in capital to shore up their balance sheet.

This is in addition to the $4 billion they raised just over two months ago. Just prior to that March capital raise, the firm's CFO had stated that the $1.9 billion they raised in February of this year had taken care of the firm's capital needs for the rest of the year.

This underscores the fact that even the CFOs and CEOs of those firms do not have a clear picture of the conditions of their own balance sheets; other big Wall Street firms have announced similar additional write-downs this year after what were supposed to be the final write-downs.

The reason the big Wall Street investment banks have this balance sheet problem right now is that they were underwriting a variety of debt-based instruments over the past five years (in order to collect underwriting fees, which is a primary source of revenues for these firms). During the recent period of unusually low interest rates (the product of over-steering by the Federal Reserve, as we have discussed in previous blog posts such as this one), there was a frenzy of such underwriting because of the heightened levels of borrowing and packaging of debt that the low interest rates induced.

When these investment banks could not sell all of the underwritten debt instruments through their sales forces, they took them into their own inventories. But, the accumulation of such instruments has wreaked havoc with their balance sheets, particularly in light of the accounting requirement to "mark to market" daily, and the end result is the situation today where the balance sheets of the biggest Wall Street investment firms are so full of questionable debt instruments that they have to go looking for capital to shore them up, even if they just finished saying that they have raised all they need for the year.

It's as if the manufacturing arm of a business kept cranking out boxes of product even after the sales force was screaming at them that the market was saturated and they could no longer sell any more, but the assembly lines just kept on turning it out, and so the excess was stuffed into the warehouse. So much was stuffed into the warehouse, in fact, that management inspections keep turning up more of it squirreled away in dark corners and underneath old shelves in the back, and a lot of it has been discovered to be rotten.

Those in the salesforces at these big Wall Street firms must be asking themselves how many times the capital market side (the "manufacturing" side in the above analogy) has to ruin things for them, by trying to pile up the underwriting profits during whatever craze is gripping the markets at any given time, setting the stage for yet another downfall. It wouldn't be as big an issue if it weren't such a recurring event (Latin American Debt, Orange County, Long Term Capital Mangement, Asian Currency Crisis, etc.).

In fact, it seems that investors might be better served if these large advisory divisions -- a relic of a bygone era when those firms needed a salesforce to distribute the stock of companies they took public -- separated completely from the big investment banks and became independent. Perhaps in the future the current arrangement of advisory arms at big Wall Street investment banks will be a thing of the past.

* The Principals of Taylor Frigon Capital Management do not own shares of Lehman Brothers (LEH).

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A hard look at the current price of oil and gasoline

Everyone's talking about the price of oil, and why not? With gasoline prices above $4 per gallon in many parts of the country (this photograph was taken this week at a gas station in the San Francisco Bay Area), the cost of driving has increased tremendously in a few months.

With crude oil futures contracts currently above $135 a barrel, many consumers are blaming the oil companies, while many investors are tuning in to dire prognostications about "peak oil" and reasoning that a dwindling supply in the face of rising demand will send oil prices on a continual upward spiral. But before you decide that oil is the one investment that will "always go up and never go down," remember that just a few years ago many people were saying the same thing about real estate, and consider whether the current situation might just be related to the the credit and housing speculation that recently collapsed with such disastrous consequences.

Skyrocketing oil prices are related to skyrocketing gasoline prices, which create a cost that people cannot ignore, since they have to fill up about every week or two weeks. The cost of driving has risen by $890 per year for the average driver of a Ford Explorer or Toyota 4Runner logging 20k miles, according to the AAA's annual "Your Driving Costs" report, up about 23.4% for drivers since 2007 and up about 40% over the past two years.

Congress, fearing a groundswell of resentment from their constituents, promptly pounced on the oil companies, grilling oil company executives recently in Washington and telling them they "apparently have no ethical compass about the price of gasoline" (in the words of Senator Diane Feinstein). Senator Dick Durbin asked them, "Does it trouble any of you when you see what you are doing to us, the profits that you are taking, the costs that you are imposing on working families, small businesses, truckers, farmers?"

But ire directed at the oil companies is misplaced: oil companies want nothing more than to deliver more oil (and oil refined into gasoline) to consumers, because by doing so they make money. The record clearly shows that Congress has imposed excessive regulation on their industry and erected barriers to the ability of private companies to operate, including the placing of vast areas of land and territorial waters off-limits to exploration and drilling, restricting the construction of pipelines and refineries, and mandating wasteful programs such as ethanol requirements. In 1995, Congress did pass legislation opening up the Arctic National Wildlife Refuge for exploration and drilling, but the President at the time vetoed the bill.

Further, government taxes per gallon of gasoline have risen sharply, and are currently at about 14.7% of the price per gallon for regular gasoline pictured above (Federal and state combined). As others have noted, this percentage is higher than the profit margins of the oil companies that the Senators were excoriating and calling unethical.

The real culprit in the current price of oil has been excessive Fed easing, which has lowered the purchasing power of the dollar dramatically over the same period that the price of oil has been rising. While this latest run-up has unleashed a chorus of pundits who argue that we have reached "peak oil" and begun the inevitable decline into oil shortages and higher prices, we would point out that the recent advance of oil prices has corresponded to a period of remarkable Fed easing, beginning with the reduction of interest rates to 1% for thirteen months from 2003 to 2004, and followed by the current easing period.

We discuss the mis-allocation of capital that Fed over-steering has caused in the past ten years or so in previous posts, such as this one. We would caution that the current price of oil (and of gasoline) is a by-product of the same Fed policy that has caused dollars to shrink rapidly (see this previous post for further discussion of that subject).

As we have stated many times before, we advocate building the foundation of your future wealth upon the same bedrock that has proven to be responsible for most of the big fortunes made in this country over the past one hundred or more years: the ownership -- for a period of years -- of shares in well-run businesses that are positioned in front of fertile fields of future growth. Trying to "play" the run-up in oil, which is caused by political and monetary factors that have little to do with the long-term fundamentals of business and which can reverse rapidly, is a shaky foundation for building long-term wealth and one we would strongly caution against.


For later posts on this same topic, see also:

• "What about commodities -- revisited" 09/02/2008.

• "The intermediary trap and the current bear market" 11/03/2008.

• "Taking stock of 2008" 12/31/2008.

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "The best defense is a good offense!" 12/03/2009.

• "The 97-pound weakling" 12/16/2009.

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The zero-sum connection

In our most recent post, we outlined some significant developments investors should be aware of, developments that will likely initiate a paradigm shift not just in technology-related industries but also in many other areas of life.

As professional portfolio managers, we would be foolish to publicly share such specific ideas on a blog -- or even outline some of the specific underlying fundamentals and critical metrics used in our investment philosophy -- if active money management were indeed all about the "ability to predict consistently the appearance of new information" and use it to advantage before others do, as efficient market theorists describe it (the quotation cited here to describe active management comes, in fact, from Eugene Fama's famous 1964 dissertation which was the founding document of the efficient market hypothesis; published in the January 1965 Journal of Business, citation is from page 40).

In other words, if money management were only about exploiting temporary inefficiencies in the market before other people noticed those inefficiencies (as passive management advocates say that it is, in their arguments against active management), then it would be foolish for any money manager to ever publish a blog!

This important point reveals that the world-view of the advocate of passive investing is, generally speaking, a zero-sum world-view (we discuss the zero-sum concept in several previous posts, such as this one). He believes that the only way to outperform the market is to exploit some superior information before others do so (a zero-sum outlook).

He then arrives at the superiority of passive investing (such as indexing) by a similar zero-sum argument: since efficiencies are quickly reduced, no one can consistently "beat the market." Therefore, returns are basically a fixed pie (the return of the market), and in this zero-sum world, the best thing to do is get as much of that fixed pie as possible (by owning the market for the lowest fee possible). You can see that this is exactly the line of argument presented by index-fund magnate John Bogle in his 1994 book, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor.

But it is a false premise to assert that the totality of the market (all existing publicly-traded businesses) is the limit of what an investor can achieve. Some businesses are well-run businesses in front of fertile fields of growth; others are poorly-run, and others are operating in fields that are dying out or contracting. Even an indexing advocate would have to admit that he could, with the benefit of hindsight, assemble a portfolio that would deliver returns far in excess of the total market, if you asked him to select thirty or forty superior companies at any given time over the past ten years, even if you told him he had to hold each company that he chose for not less than three years. This exercise alone proves that the returns of the total market are not the fixed pie of returns which all investors must squabble over, as the zero-sum world-view would have you believe.

Mr. Bogle, in fact, has explicitly stated his zero-sum view of the world in many statements since then, such as his statement that "The market as a whole is simply a gambling casino where investors as a whole try vainly to outpace the market. Beating the market is a zero-sum game, but only before costs are deducted" ("The Wall Street Casino," 1999). More recently, he told a graduating class from Georgetown's McDonough School of Business that "we're no longer making anything in this country, we're merely trading pieces of paper, swapping stocks and bonds back and forth with one another" -- a starkly zero-sum view of the American economy, and one that is patently incorrect (from speech delivered May 17, 2007).

In contrast, the classic growth stock theory of investing that forms the foundation of the investment management we advocate takes a profoundly positive-sum view of business and investing (true investing, as opposed to speculation or gambling). We believe that good businesses add new value into the system that was not there before, and that the history of the growth of the American economy in general and the history of specific companies over the past hundred years is so full of examples that support this assertion that it is hard to argue otherwise.

The exponential growth in the U.S. GDP (for example, from $9.6 trillion in 2000 to over $14 trillion today) is not simply a result of more vigorous "swapping stocks and bonds back and forth with one another" but rather is the result of real value being created by real businesses. Our investment philosophy of building wealth on the foundation of the ownership of well-run businesses operating in fertile fields of growth is based on the recognition of this undeniable fact, and on the recognition that most real wealth in this country has come from the ownership of a company or companies which produced real value for a number of years.

The passive investment argument, by all accounts including those of its adherents, did not arise in the business world or in the world of money management, but rather in the world of academia. For a variety of reasons, this is understandable. The academic arguments in support of it rely heavily on mathematical demonstrations -- and mathematical formulas are almost by definition "zero-sum" (what is added to one side of a formula must be subtracted from the other: an equation is a closed system in this sense). Furthermore, the tenure system is itself a sort of zero-sum system, in which only a certain number of professors can hold tenure at any given time, and for one to be added another must generally leave. While many mistakenly believe that this is the same way that the business world operates, the reality is actually the opposite in a free market economy (for a more thorough discussion of this subject, see this previous post and the article linked in the post).

The connections between the passive investment arguments and the zero-sum world-view are not widely understood, but they are very important.

for later blog posts dealing with this same subject, see also:

• "Stock Market Guessing" 12/01/2008.

• "Beware of the witch doctors of modern finance" 12/15/2008.
  

• "Lessons from the Madoff Scandal, part two" 12/29/2008.

• "New Year's Resolution: swear off snake oil" 01/05/2009.

• "Professor Amar Bhide and his Praise of More Primitive Finance" 02/02/2009.

• "The dark side of zero-sum thinking" 04/20/2009.

• "Another black swan?" 05/13/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

• "The dance of the hippos" 08/10/2010.

• "Lawlessness in California" 12/16/2010.

• "The growth theory of investment works" 01/14/2011.

• "Don't confuse free enterprise with a questionable theory about securities markets" 01/19/2011.

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