However they spin today's data, it's no Great Depression

Don't look now, but the Bureau of Economic Analysis at the U.S. Department of Commerce has revised their advance estimate upward and now estimate that the real GDP growth in the second quarter of 2008 was an above-average 3.3%.

Commentators who for one reason or another are invested in putting a negative spin on this blatantly positive news will no doubt find some way to explain away the naked fact that the economy is growing strongly.

Whatever mitigating circumstances they offer, there is no way to square this data with the conventional wisdom that the economy was entering the "worst recession since the Great Depression." Just a few months ago, the media was full of quotations to this effect, repeated so often that anyone who said otherwise was liable to be viewed as delirious.

However, we have been critical of the media's recession drumbeat since last November (see for example our posts here, here, and here). There has of course been a crisis in the financial sector, the long-term causes of which we have dealt with in posts such as this one and this one, but today's GDP number shows that the rest of the business world has generally continued to grow, and recent quarterly earnings reports tend to support that view as well.

The most important lesson from this entire episode in our view is the conviction that you should not base your investment strategy upon trying to time the economic cycles. As we have written before, doing so can cause you to try to "recession-proof" your portfolio or make other erroneous portfolio moves based on the shaky predictions of economists and media pundits. We strongly believe that the best core foundation for a long-term investment discipline is the ownership of well-run, growing businesses whose leadership you trust to make the right decisions for the various economic situations that come along.

For later posts dealing with the same topic, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.

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The Fed drops the mask

Back in early March, we noted a troubling quotation indicating that the Chairman of the Federal Reserve, and possibly many other members of the board, believed that slower growth reduces inflation and faster growth increases it.

We noted that this discredited notion held sway through the inflationary 1960s and 1970s until Paul Volcker put into practice the theory advanced by Milton Friedman -- that inflation is strictly a monetary phenomenon and will not melt away by itself when economic growth slows unless monetary policy is also corrected -- and ended stagflation. The very existence of stagflation argues that slowing economic growth does not automatically contain inflation.

After the June Fed meeting, when the Fed's statement indicated that "The Committee expects inflation to moderate this year and next year," we wrote a post entitled "A Phillips-curve Fed?" The Phillips curve was the 1950s-era concept that lower employment would lead to lower inflation, and higher employment would lead to higher inflation. It was hard to believe that anyone still believed in that concept, which had caused so much inflation in the decades before 1980.

Now, however, we are forced to conclude that the Fed is, as Steve Forbes argued in June, "still in thrall to the Phillips curve." On Friday, August 22nd, Ben Bernanke gave a speech to the Federal Reserve Bank of Kansas City's Annual Symposium in Jackson Hole, Wyoming.

Coming during a week in which the inflation data was worse than at any time since 1982, Mr. Bernanke stated that moderating commodity prices and "a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate this year and next year."

This is sheer Phillips-curve thinking. It is difficult to doubt any further that the Federal Reserve is indeed under the belief that slower economic growth will of itself cause the current inflationary pressures to subside.

Instead, as we have argued previously, stable monetary policy will create the environment for business growth, while inflationary policy (such as the Fed has been pursuing for at least a year) will hinder it. By subscribing to the outdated Phillips curve, the Fed can cause the very "weakening outlook and downside risks to growth" that they think will contain inflation.

It is true that commodity prices have dropped sharply, but this is probably due to the unwinding of the speculation that was riding on the back of the actual inflation dragon. That underlying inflation is still there, and our belief that it is a monetary phenomenon means that only monetary policy can tame it.

All of this points to the fact that an investment philosophy which relies on timing the Fed, or playing the resulting moves in commodities, should not be the core of a long-term plan for building wealth. We believe that ownership of innovative, growing, smaller companies in a portfolio help weather the inevitable inflationary flare-ups. Even in troubled or inflationary times, unless you think the economy is going to shut down completely, it will often be the smaller, more nimble companies with a product or service providing new value that will be the engine of growth.

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

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

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

• "The 97-pound weakling" 12/16/2009.

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

• "Avatar and long-term inflation" 03/02/2010.

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

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

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The long shadow of the Y2K bug

Remember the concerns during the years before the end of the twentieth century about the "Y2K bug" that threatened to cause airplanes to drop from the sky, nuclear plants to melt down, and electronic data systems and power grids around the world to fail, leading to riots, confusion, and chaos?

It seems almost laughable now, but if you were a bank employee or a member of the Federal Reserve (which has oversight of banks), your recollection of Y2K would be that getting ready for it was no joke. The Fed took the threat of y2K problems very seriously, and conducted extensive preparation for the event in the months and even the years leading up to January 1, 2000.

You might think that Y2K came and went with no ill effects, but you would be wrong. That's because, as we have written before, the effects of Fed oversteering on the economy are enormous.

Look closely at the graph above, which shows the Federal funds target rate in red, superimposed on a graph of the NASDAQ Composite Index in blue, from the middle of 1995 to the present. During the year 1999, the Fed lowered rates dramatically.

To a casual observer, the rate cuts of 1999 may not look that dramatic -- especially in light of the truly historic rate cuts that follow later in the chart -- but if you understand that even a small move of 0.25% in the Fed funds target rate is a major event on Wall Street and the broad economy, with a huge impact on lending and investment and business activities, you will realize that the successive rate cuts of 1999 were actually very significant -- especially because they came at a time when the economy was already on fire and dot-com mania was blazing.

The significance of this excessive money creation is graphically shown by the reaction of the NASDAQ Composite Index on the same graph. Dramatic Fed easing typically results in "malinvestment," or the misallocation of capital due to an artificially altered perception of risk. When money is made too cheap and too plentiful, excesses occur which are commonly called "bubbles." In 1999, as everyone knows, that bubble was in speculative companies found mainly in the NASDAQ Composite. The Fed's 1999 rate cuts poured gasoline on the fire, ending in the NASDAQ flaring to 5048.62 on March 10, 2000.

We believe that this should never have happened -- it was the Fed's ill-timed panic over Y2K and attempt to flush the system with extra cash in advance of it (see for example this article or this article from May and June 1999, with the Fed banks "stocking the vaults" with seven to eight times normal cash amounts, and saying they "stand ready to lend" as necessary) which resulted in a rush of speculative buying in what was hot at the time (telecom and tech-related companies).

Alarmed by the dramatic bubble that they created, the Fed rapidly and excessively tightened rates, resulting in an even more dramatic collapse of the bubble. Unfortunately, the tightening (far beyond the level rates had been before the cuts) came at a time that the economy was beginning to slow, resulting in the biggest deflation since the 1930s, decimating the overleveraged telecom and overextended tech sectors (exacerbated by the previous excessive loosening).

As we have said before, it is this volatile monetary policy which has created the extreme boom-and-bust cycles that have continued since 2000 and resulted in what many are calling a "lost decade" for stocks (major indexes in 2008 are roughly where they were in 1998).

Since then, the Fed has continued this pattern of dramatically oversteering, leading to the housing and mortgage bubbles, which also clearly took off after a period of dramatic Fed easing just as the NASDAQ bubble did, this time beginning with the thirteen-month period when the Fed held their target rate at 1%, seen at the lowest portion of the red line in the graphs above.

The housing and mortgage collapse is still reverberating through the financial sector. In response to its ill effects, the Fed has rushed to the "rescue" just as they did after the NASDAQ bubble, with the most recent series of rate cuts (seen at the right end of the red graph).

This latest overreaction is responsible for the commodities bubble and high gasoline prices of 2008, as well as the inflation that is becoming harder and harder for "inflation doves" to deny. The speculation occurs in whatever asset is hot at the moment -- from 2003-2006 it was real estate and mortgage securities; today it is in commodities.

The Fed's excessively volatile monetary policy destroys the stability that is most conducive to business growth and economic progress. The technological advances that began prior to the NASDAQ bubble and which characterized the growth of the late 1990s are continuing today, but not with the same kinds of benefits and progress we might have seen by now if the Fed had provided an environment of stability instead of the chaos created by their oversteering.

This is the real legacy of the all-but-forgotten "Y2K bug" fever of 1999, and a pattern that we hope future Fed Chairmen will realize and reject.

For later posts on the same topic, see also:

• "Revisiting the 'New Economy'" 05/06/2009.

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

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

• "The Bandwidth Revolution" 07/29/2009.

• "What Rube Goldberg could teach us about economics" 12/08/2009.

• "The 97-pound weakling" 12/16/2009.

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

• "Was the decade lost?" 01/14/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Great minds think alike!" 03/19/2010.

• "Why do we want the Fed to steer the economy?" 09/01/2010.

• "Likelihood of Fed over-steering increases" 01/25/2011.

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"Win and keep your uniforms clean . . ."

Today, the producer price index (PPI) came in up 1.2% for the month of July, twice the increase expected by economists in general.

At the same time, economist Brian Wesbury this morning has an excellent piece in the Wall Street Journal entitled "Inflation is a clear and present danger."

In it, Mr. Wesbury decisively explains why those who argue that inflation is not a threat (for example, because commodity prices have recently dropped, or because "core" CPI is significantly lower than the headline number) are wrong.

"Much like the 1970s," he notes, "there is a widespread denial that inflation is a problem today."

Most importantly, as we have asserted in previous posts, Mr. Wesbury demonstrates that the Fed's attempts to "steer the economy" in addition to its other mandate of providing a stable currency is at the root of the problem.

He uses one of the best metaphors we've heard to explain this problem:

"The Fed's 'dual mandate' -- to keep the economy strong and prices stable -- serves to support this mistake. In contrast, the European Central Bank has a single mandate: price stability. No wonder the dollar has been so weak relative to the euro. Imagine two football teams. One with a single mandate: win. The other with a dual mandate: win and keep your uniforms clean. It's clear that the one with the single mandate will have more success in achieving its goals over time."


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

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

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

• "Why do we want the Fed to steer the economy?" 09/01/2010.

• "Likelihood of Fed over-steering increases" 01/25/2011.

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The Fed is NOT in a "tight spot"

Here is a graph of the Consumer Price Index, from economic and business database specialists Haver Analytics. The graph shows better than words the stark reality that the Fed's excessive easing has introduced unacceptable inflationary pressures into the economy.

According to the July data released by the U.S. Bureau of Labor Statistics yesterday, the CPI is now up 5.6% over the past year. At that rate of inflation, your money will lose half of its purchasing power every thirteen years. If you have a million dollars today, it would have the purchasing power of just $500,000 by the year 2021. If you have a five-year old child now, your dollars when he enters college at eighteen will purchase half of what they will purchase today (at least in terms of room and board: college tuitions have been rising at more than the CPI for several years now).

Many media observers are spinning yesterday's inflation readings as putting the Fed in a "tight spot," because they know that the Fed is supposed to provide price stability, but believe that the Fed cannot afford to raise rates because it would "hurt the economy."

For example, the New York Times yesterday ran a story saying, "The Federal Reserve can try to choke off inflation by raising its benchmark interest rate. But such a move would also make it harder for businesses, banks and households to obtain loans, which could cause a further slowdown in the economy. Investors now expect the Fed to hold rates steady until at least the end of the year."

We strongly disagree. We have argued in previous posts, such as this one and this one, that if the Fed would concentrate on providing a stable currency it would help the economy, not hurt it.

Contrary to the argument from the New York Times quoted above, raising rates and choking off inflation would actually help businesses, banks, and households. As economist Larry Kudlow explained in an insightful blog post a week ago, inflation ripples through the entire economic system, and inflation relief does the same.

Inflation relief can help households on the margin of being able to make their home payments to avoid falling over the edge, which would mean fewer foreclosures, and lower the level of problems inside the collateralized debt instruments held on the balance sheets of various financial institutions.

Businesses would be helped far more by the Fed providing a stable currency than by providing lower rates. Inflation is extremely damaging to businesses that have to purchase more expensive materials or components, and can cause compressed margins as they are forced to either raise prices or eat the difference.

Finally, banks would also benefit from the Fed getting the Fed funds rate back up where it belongs, as we explained in this July post entitled "The dark side of 'making hay while the sun shines.'"

In short, we believe that the people who are calling for more Fed cuts are failing to see the threat posed by inflation, and that those who are saying that the Fed should cut but now will have to hold steady are also misguided. Inflation does not moderate all by itself. We believe that the Fed should raise rates immediately, and agree with Dallas Fed President Richard Fisher who dissented from the majority in the last two Fed meetings, voting for a rate hike in each of them. He also voted in April that the Fed should not have lowered again, although he was outvoted in that meeting as well.

In the meantime, we would argue that the Fed is not in a tight spot at all: they should stop trying to steer the economy, which only creates problems, and stick to providing stability in prices. An inflation reading of 5.6% makes it extremely clear they have work to do.


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Drawbacks of sector rotation

Here is a diagram showing the composition of the market, as represented by the Standard & Poor's (S&P) 500 companies, and divided into the ten sectors categorized by S&P's Global Industry Classification Standards (GICS).

The sectors are shown in their relative size, by the combined market capitalization of the companies which make up each sector. For example, at current market prices, companies in the Energy sector make up 14% of the market capitalization of all the companies in the S&P 500 index. Companies in the Financial sector make up 15%.

The way you often hear sectors discussed is via speculation as to which sector or sectors are about to do better, relative to the other sectors, and which sector or sectors are about to do relatively worse. Much of the "mass-managed money" world of big mutual funds manages money through the same approach, "overweighting" one sector and "underweighting" another, based on their assessment of various macroeconomic and other criteria.

We have previously made the observation that this is essentially "timing" sectors, such as in this post from March, 2008. It underscores the distinction between ownership of businesses and ownership of markets -- or in this case, slices of the market. There are several reasons why we believe that ownership of businesses is superior to ownership of markets.

First, the analysis of businesses is a mature field with a long history and a well-established body of knowledge. Financial statement analysis has been going on for decades. You can find out real, concrete evidence about a company through its balance sheet, income statements, cash flow statements, filings with the SEC and other real measurements, as well as through visits with the management teams and employees of the companies themselves.

However, the same body of knowledge for the evaluation of one sector versus another is nowhere near as well-developed. How do you compare the management teams of all the companies in the Utility sector versus the management teams of all the companies in the Energy sector? It simply cannot be done. Consequently, when someone is saying "It's time to move out of utilities and into financials," it is hard to justify as anything more than an opinion.

Secondly, as a close examination of the sectors themselves reveals, assigning a company to a sector is sometimes clear-cut, but in many cases the decision is ambiguous. For example, there are companies which could easily be classified as either Information Technology or Telecommunications, because their technology is critical to telecommunications infrastructure or because they are operating in the convergence of those two sectors. More and more sectors are converging as we move forward.

Perhaps the most important reason we do not follow an investment process that is based on sector rotation, however, is the fact that ultimately wealth is made and grown through the ownership of great businesses, not through the ownership of sectors. We would rather own great businesses in the Industrials sector, such as II-VI or MSC Industrial*, than own the Industrial sector itself. Where the Industrials sector is down over 13% year-to-date, shares of II-VI and MSC Industrial are up over 53% and 25%, respectively.

Neither of these companies are actually members of the S&P 500, but they are included in many industrial sector index funds. The point is that ownership of II-VI or MSC Industrial is ownership of shares in a business, rather than ownership of something vague, like a sector. Some might argue that ownership of a sector is actually ownership of a large number of individual businesses, and that is true, but the argument we are making is that the approach to owning a sector is an approach that is much more based upon owning the market or a sector of the market, not owning a business.

We discussed the distinction between owning companies and owning markets (or slices of the market) in our previous discussions contra indexing, such as this one and this one. Although most of the arguments used by proponents of indexing have to do with "just owning the market," in practice investors who index usually end up being sector rotators.

Investors should consider building their financial foundation on a discipline of owning businesses, rather than on a system of rotating through sectors.

* The principals of Taylor Frigon Capital Management own shares of II-VI (IIVI) and MSC Industrial (MSM).

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

• "Ownership of businesses through multiple economic cycles" 09/04/2008.

• "More evidence on the dangers of modern-day 'wealth management'" 11/05/2008.

• "Stock market guessing" 12/01/2008.

• "Don't be hasty, young Jim Cramer" 05/21/2009.

• "A conversation with Gerry Frigon" 08/10/2009.

• "What 'sell in May / go away' has to do with the 'persistent delusion'" 08/11/2009.

• "The ETF industry and their promise of easily adding alpha to all" 09/04/2009.

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

• "Solid convictions versus snake oil" 01/08/2010.

• "News flash! Computer model enables you to beat Wall Street!" 06/10/2010.

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

• "Investors fleeing equity funds for bond funds" 08/25/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

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Return of the 1970s?

We argued in our previous post that the paradigm-shift coming in technology is more important for investors than the continuing turmoil from the financial sector.

However, there are advisors out there who believe that the recent bear market (defined as a 20% drop in the market averages) is just part of a "secular bear market" -- fifteen to twenty years of sideways movement, such as that experienced in the 1970s. Here is an article from a recent issue of Investment News in which one advisor argues that we are in a secular bear market with another seven to twelve years to go, meaning that investors should look for returns in foreign currencies, managed futures, and especially "all types of commodities plays" rather than stocks.

We have explained before that ownership of shares in well-run, growing companies is a better long-term foundation for wealth than commodities and other supposed "secular bear market" strategies (see the historical data given in links at the end of this previous post on inflation, for example).

Further, we would argue that the underlying premise of those calling for a secular bear market is flawed. Periods of extended economic stagnation such as the 1970s are a result of government interference, not weather patterns that just blow in by themselves that you have to put up with until they go away. Businesses tend to try to grow and to make more money when given the freedom to do so, which results in continuing progress and expansion in free economies, except during periods in which freedom is somehow restricted.

In the 1970s, excessive government taxation discouraged committing capital to entrepreneurship and innovation: if your venture failed, you took all of the losses, and if your venture succeeded, the government could take up to 70% of your profits (the top income tax rate in the US was 70% prior to the election of Ronald Reagan in 1980 -- see the tax tables on pages 98 and following of this document). We have explained in previous posts such as this one how the marginal tax rates are a critical factor in suppressing the natural tendency of businesses to try to add more value into the economy and thereby make more money.

Also in the 1970s, monetary policy was excessively loose -- government was essentially inflating the currency and destroying the purchasing power of money, following the discredited Phillips curve theory. Both inflation and excessive taxation can be seen as threats to freedom and property rights, and act as tremendous drags to economic growth. Thus secular bear markets are not simply cycles that appear out of thin air -- they are caused by government interference.

Although there are concerns about existing monetary policy and tax rates, the fact is that we are a long way from the situation that existed in the 1970s, and there is little likelihood that tax rates of 70% or inflation rates of that decade are going to return in even the most far-fetched scenarios. Even given recent missteps, the Federal Reserve knows how to prevent the kind of runaway inflation we had in those years. Advisors who are predicting a ten to twelve year bear market just because we have had them in the past have little to back up such predictions.

Furthermore, it turns out that while the 1970s were marked by economic stagnation caused mainly by excessive taxation and inflation, they were also a tremendous time for some companies. In fact, maybe the 1970s weren't that bad after all. As we have written many times before, we emphasize owning businesses, not owning markets. In any economic environment, some companies grow faster than others. During the 1970s, companies not listed on the NYSE but listed on the NASDAQ began the transition from being outcasts to being important companies. Think of owning companies such as Intel, which had its IPO in 1971*. In fact, the 1970s were a golden age for small-cap investing as described in this July Forbes article, although most investors are unaware of that fact.

We don't give much credence to those who are calling for another economic period like the 1970s just popping up out of the blue. On the other hand, we believe that even in difficult economic environments, the best foundation for long-term investment is the ownership of good, growing businesses, rather than the rush into speculative instruments such as commodities and forex.

* The principals of Taylor Frigon Capital Management do not own shares of Intel (INTC).

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

• "Another important article from George Gilder" October 27, 2008.

• "Ownership of businesses through multiple economic cycles" September 4, 2008.
• "Return of the 1970s, part 2" February 17, 2009.

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

• "Dangerous media distractions" 07/07/2009.

• "Index of Economic Freedom Released; US Slips" 01/27/2010.

• "Does a rising tide really lift all boats?" 07/20/2010.

• "Gold versus Apple" 10/25/2010.

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

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"Video is clearly the killer app here . . ."

Yesterday afternoon Cisco Systems* gave an earnings call which underscores several major points we have discussed on this blog previously, points which are very important for investors to understand right now.

Firstly, Cisco's earnings beat analyst estimates, continuing a trend of earnings growth by bellwether companies we have pointed out previously -- a trend which defies the "Great Depression" drumbeat the media has been pounding out for several months.

More importantly, Cisco's CEO John Chambers gave some answers to analyst questions which reveal the enormity of the changes coming -- changes with huge investing significance that are being largely ignored amidst the frantic headlines about financial firms, oil prices, and recession alarms.

Indicating that the proliferation of video capabilities over the internet will be a paradigm shift with far-reaching consequences, Mr. Chambers said, "For the first time that I can remember as a CEO, you talk to other CEOs and they can actually give an advertisement for me on collaboration with TelePresence, in terms of saying: 'This is changing the way I do business,' 'This is the direction that we're going,' et cetera."

When the heads of corporations say that something is changing the way they do business, it is a fairly clear indication of something with a paradigm-shifting impact.

We have pointed out in several previous blog posts (such as this one) that the changes already beginning around computing and video are going to have serious and significant transformative effects over the next five to ten years -- ushering in changes to business and society equivalent to the changes brought about by technology between 1980 and 2000.

If you can look back in hindsight and see business opportunities and investment opportunities created during that period, then you understand that the advent of the next paradigm shift is enormously important for investors to understand. Again, this paradigm shift is still largely ignored by the short-term focused financial media and the equally short-term focused "wealth management" community.

To grasp the truly amazing capabilities being developed, take a look at the video embedded above, in which Cisco's CEO demonstrates holographic TelePresence with Martin De Beer. As Mr. Chambers said in the Q&A for yesterday's call:

"Video is clearly the killer app here, and when you think about the loads currently going on networks, these are largely downloads that are occurring today -- or one person to one person. If you begin to take concepts like TelePresence, where you have ten different locations into a single meeting -- which I do pretty regularly now -- as an example, and you begin to think about that occurring not only in the area of business, but also to the home [. . .] you begin to see our view of at least what we believe will be in loads on the networks."

This brings us to a final point that the Cisco call revealed which investors should internalize, which is the different time focus of corporations versus the short-term focus of most individuals. The changes which technologies like TelePresence will bring about are not going to happen in the next couple of weeks or even the next quarter -- these are changes which will take place over the next few years.

In our 2007 commentary, "What Hasty Investors could learn from an Ent," we discussed the importance of having the right time perspective when it comes to participating in the revenues of a business that may not realize its full potential for several years. In response to an analyst question yesterday, Mr. Chambers uttered a statement which every investor should memorize. He said, "I make no decisions by the quarter and very few by the year. I make all my decisions three, five, seven years out."

It has been pointed out that during the 1990s, there were financial crises such as the "Asian contagion," the Latin America debt crisis, and the collapse of Long Term Capital Management, but if you were to ask whether those were more important than the changes brought about by the internet, there would be no comparison.

Yesterday's Cisco call highlights the truth of that statement with regard to the importance of the big changes coming over the next several years versus the lingering financial turmoil of the moment.

* The principals of Taylor Frigon Capital Management own shares of Cisco Systems (CSCO).

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

• "The Unstoppable Wave" 01/12/2009.
  

• "Clayton Christensen, disruptive innovation, and your portfolio recovery plan" 02/04/2009.

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "Was the decade lost?" 01/14/2010.

• "Exaflood update" 06/01/2010.

• "Have you heard of this company? HITT" 07/06/2010.

• "Have you heard of this company? IIVI" 08/05/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "On the verge of something important" 09/29/2010.

• "Another wake-up call" 11/29/2010.

• "Have you heard of this company? EZCH" 12/09/2010.

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Give the traders a break!

We have previously written about the folly of short-term trading and speculating on rumor and innuendo with respect to how "investors" deploy their hard-earned capital. This time, however, we are coming to the defense of traders and speculators.

Much has been made of the move in oil prices this last year. Many have blamed "speculators" as being at the heart of the problem and only if they can be stopped we would see a return to "normalcy" in the price of oil and other commodities. This nonsense emanates mostly from Washington D.C., so perhaps we should recognize the source of such commentary and act accordingly. Yet, while we are not suggesting there is investment merit in making what amounts to a bet on what the price of oil will be tomorrow, we want to emphasize the importance of traders and speculators in the market every day.

We stick to our beliefs that one should not base his investment decisions on what traders are doing at any given time, but without those traders there would be no market. Trading activity (both short and long) provides the liquidity investors need in order to raise cash from their long-term investments when the need arises or when the determination has been made that the investment in question has reached full value.

In addition, the practice of shorting stock (borrowing stock one does not own and then selling it in order to buy it back later at, hopefully, a lower price) serves another purpose of keeping the management of public companies honest about how they run their operation. The self-correcting force of those who short stocks acts as a barometer of management's effectiveness. If management stumbles for any reason, the short sellers are there to trounce the stock and send it down in a hurry, creating a situation that the management of most firms surely hope to avoid. Certainly the pain can be drastic, in the short run, and often good companies and management teams can be unfairly judged by the sellers. However, the benefits to the market and investors in the long run outweigh the negatives a lower stock price can bring about.

However, while recognizing the benefits of trading and in particular of shorting stock, there is a disturbing trend that has been identified lately which worries us with respect to short-selling stock. The act of shorting itself, which requires the seller to borrow stock and then sell it, seems to have been distorted by those who are fraudulently shorting stock before they borrow it (a legal practice called "naked shorting") and then failing to deliver the stock they have sold. This is a very serious problem if allowed to continue unchecked. A 2007 Bloomberg News piece, here, highlights the pervasiveness of this activity and asks some crucial questions as to why this has not been dealt with more harshly up to this point.

It may well be that companies are being targeted by these unscrupulous traders and -- more significantly -- if there are broker-dealers that are complicit in this practice, they need to be handled immediately and without sympathy, as it is activities like these that undermine the fabric of the free enterprise system.

More on this as the story develops but, meanwhile, we need to give honest traders who play by the rules a break. Stay tuned . . .

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For later posts relating to this same topic, see also:

• "Understanding the uptick rule can help you see the big picture on the current economy" 12/10/2008.
  

• "Being short is not automatically evil" 04/27/2010.