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:

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  1. You state, "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," yet later you quote a Forbes article stating that the '70s were the golden age of small caps. Which was it? If the "excessive government taxation" was so discouraging, then why did small caps do so well? You're incongruent. . .

  2. The point is that even under situations with less overall freedom (such as those characterized by excessive taxation and inflated currency), investment in good, growing businesses is your best foundation for the growth and protection of your capital. Even in less-free situations, businesses will continue to try to operate. If you followed the link to the supporting evidence that showed small-cap outperformance during the 1970s, you will see that small-cap stocks in fact outperformed large-cap stocks during that period of economic stagnation. But that does not defeat our argument that the 1970s were characterized by government taxation and inflation which discouraged innovation and business growth! The question you should be asking is: how much MORE would those companies have been able to grow, if they didn't have to contend with such artificially oppressive conditions? Just because they did well doesn't mean they couldn't have done better. We're never incongruent . . . we're not triangles . . .

  3. Follow-up for anonymous:

    Today's blog post (September 4, 2008) may shed some more light on your question. You asked why, if the government did so much to damage the overall business environment, did small caps do so well? In today's post titled "Ownership of businesses through multiple economic cycles" [ ] we explain why: you are focused on the business cycle (as is most of the "investing" world), but instead you should focus on the individual cycles of individual companies.