Government solutions disintegrate

In a dramatic turn of events, the wheels came off the government "bailout" plan today when the House of Representatives defeated the proposed legislation by a vote of 228 (nay) to 205 (yea).

While the government is temporarily unable to address the situation, the private sector has been busy recapitalizing the banks in its own free-market way: stronger banks are looking at the assets of weaker banks and other financial institutions and buying them up -- often at very attractive prices!

Could it be that the free market will be able to accomplish what the government cannot?

The Wall Street Journal ran a timely opinion piece by Gordon Crovitz this morning (before the legislation fell apart) entitled "Calling J.P. Morgan," noting that in the Panic of 1907 the capitalist titan called the nation's top bankers into his library, opened their balance sheets, and in an all-night session, "decided which financial institutions had to go and which would live."

Something similar has been taking place over the past weeks and months.

Not mentioned in the Journal's article is the fact that many politicians were so shocked that the resolution to the crisis had been accomplished by a lone capitalist outside of the halls of government that they began working to ensure that it would never happen again. Morgan's legendary meeting was the impetus for those who argued for the creation of a Federal Reserve Bank.

We have argued that the current crisis was not caused by free enterprise (as many are asserting) but rather by government (starting with Fannie Mae, Freddie Mac, Congressional legislation such as the CRA, and the Federal Reserve itself, among other players -- including many of those Congressmen pretending the most outrage now).

The biggest concern now is that as a result of the dramatic events currently unfolding, government will become even more emboldened to interfere with the free-market system, just as they did after 1907.

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

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

• "Big news on mark-to-market accounting" 03/13/2009.

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

• "The end of 2009" 12/30/2009.

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An important distinction

Last week was a week of enormous consequence in the financial world. The events were so dramatic that they will be analyzed, discussed and debated literally for decades. It is no exaggeration to say that Wall Street as we knew it is no more, with the news today that Morgan Stanley and Goldman Sachs agreed last night to be converted into traditional bank holding companies.*

Across America and indeed the world, last week's turmoil is being seen as final proof that we really are in the greatest disaster since the Great Depression.

But there is a very important distinction to be made between the crisis on Wall Street and the economy at large.

This distinction is one that most observers are overlooking. They are tending to "conflate" or blend together the situation on Wall Street, where one venerable firm after another fell like dominoes last week, and the situation in the economy in general. They are not one and the same and should not be confused with one another.

It was not weakness in the broader economy that caused real estate related assets on the balance sheets of firms to plummet in value. Yes, there have been loan defaults and home foreclosures, particularly on loans that clearly were irresponsible. But the rate of foreclosure and default did not jump off the charts and drive Wall Street into bankruptcy. The latest data from the Mortgage Bankers Association shows the current foreclosure rate at 2.75% (up 1.35% from a year before) and the delinquency rate at 6.41% (up 1.29% from a year before). It should be noted that in the Great Depression the delinquency rate for homes which had a first mortgage was 43.8% (in 1934) and for homes with a second or a third mortgage the rate was 54.4%, according to statistics reported in the Federal Reserve Bank of St. Louis Review for May/June 2008.

The main catalyst for the financial meltdown, which has been brewing for over a year, was the effect mark-to-market accounting had on the balance sheets, credit ratings, and borrowing capabilities of financial firms, as we pointed out in a previous post. Economist Brian Wesbury uses a great analogy in his outlook for this week, in which he asks you to imagine that your neighbor has to sell his home under exigent circumstances at a fire-sale price, and because of that your banker declares that you must now mark your own home's value to the "new market" and that you must immediately give the bank $80,000 in new capital in order to keep yourself at the loan-to-value percentage set by the bank.

But that is a Wall Street problem, and although it is true that the financial sector impacts every other business that uses financial instruments (such as currency and credit cards and money market funds and bank accounts), it does not mean that the economy is in the same state of affairs. Most businesses not in the financial industry are not impacted by these specific mark-to-market rules, because businesses outside of the financial sector do not generally need to "borrow short and lend long" as part of their business model.

It may be hard to believe, but the true situation is that the underlying economy is actually solid. We have been saying that for months, and the numbers continue to bear it out. Recently, the Bureau of Labor Statistics released revised productivity data for the second quarter of 2008 which determined that non-farm productivity increased at an annual rate of 4.3% sequentially and 3.4% year-over-year.

Productivity is one of the most important economic measurements there is, although this healthy productivity number did not get much media attention this month. In a 2003 speech, Federal Reserve official Cathy Minehan noted that "rising standards of living are almost solely a function of productivity growth."

The fact that productivity is currently increasing at 3.4% is significant. From 1947 through 1986, for example, productivity grew at an average annual rate of 2.3%.

You won't hear too many commentators in the media explaining to you that, based on numbers such as corporate earnings, GDP, and productivity, it is reasonable to believe that the economy is fundamentally sound, despite the financial sector turmoil. But that is because very few of them are aware of the important distinction between the situation on Wall Street and the economy at large.

* The principals of Taylor Frigon Capital Management do not own securities issued by Morgan Stanley (MS), Goldman Sachs (GS), AIG (AIG) or Lehman Brothers (LEH).


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This week is not an indictment of free markets

Around the world, proponents of greater government control of economic activity are arguing that the emergency measures taken by the Treasury and the Fed this week, and the financial-sector turmoil which led to them, repudiate the credibility of the market economy.

For example, in this article from the New York Times this week, French lawmaker Bernard Carayon is quoted as saying that for "evangelists of the free market, this is a painful lesson."

Former EU antitrust commissioner Mario Monti is quoted as saying that critics can now say "that even the standard-bearer of the market economy, the United States, negates its fundamental principals in its behavior."

The tendency to frame the financial-sector's problems as a case of free markets vs. government control is widespread in the media reporting of the events of the past two weeks.

For example, an NPR story from today is titled "Do Federal moves take us back to the New Deal?" In it, Clinton-era Treasury Secretary Larry Summers is quoted as saying that the idea that the government should "stand back and let the private sector sort these problems out" is "the kind of thinking that made the Depression 'Great'."

Elsewhere, an interview on the CNBC "Stock Blog" from early Thursday, before the huge rally that accompanied the first indications of a comprehensive Treasury plan to take over troubled mortgage assets, was posted under the sensationalistic title "Is This The Death of Capitalism?!"

The important point to keep clearly in mind during this week's dramatic culmination of a situation that has been building for years is the very clear role that interference with free market principles played in creating the problem.

This interference took several forms, and we and many others have pointed out these forms several times over the past months. One of the most important of them was the creation of an unprecedented amount of easy money by the Federal Reserve under Alan Greenspan, which we outline in detail in "The long shadow of the Y2K bug" as well as in earlier posts that are referenced in that piece.

Another critical but little-understood contribution was the change in accounting rules to a system known as Fair Value Accounting, which took place in the early 1990s. We pointed out how serious this problem was in a blog post on March 14, prior to the collapse of Bear Stearns.

In it, we noted that assets with real value, paying real interest, were being valued as though they were virtually worthless, because the market for those assets had frozen up. That isn't a drawback to the free market: if nobody wants to pay what you think something is worth, then in a free market you can simply decide not to sell until demand for your item returns to a level you agree with.

However, due to well-intentioned accounting changes enacted in 1991, financial firms can have a very serious problem in such a situation, because they are now forced to mark those assets to the market, even if the market has temporarily gone away. This phenomenon can easily turn into a vicious cycle, and it is exactly what happened to the financial titans that now lie in ruins after the events of the past seven days.

Two recent articles in the Wall Street Journal detail the role of this accounting regulation in the financial sector's crisis. The first is "Bad Accounting Rules Helped Sink AIG" and the second is "How to Save the Financial System."

We are not suggesting that the actions of the Federal Reserve or the decision to force mark-to-market valuation of financial assets were motivated by anything besides good intentions -- they were clearly well-intentioned efforts to respond to crises that were pressing at the time. But that is exactly the point a free-market economist would make: well-intentioned government intervention often seems like a good idea, but ends up leading to unintended consequences. Some of those consequences can turn out to be catastrophic.

The earth-shaking events of this week are not an indictment of free-markets -- they are an indictment of intervention. However, that is not the interpretation you are likely to hear from most observers.

For later posts on this same topic, see also:

• "Guide the market's invisible hand with a higher principle?" 02/26/2009.

• "How your view of 2008-2009 impacts your understanding of today's big events" 02/03/2010.

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

• "The political winds are swirling" 09/15/2010.

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Don't jump off the ship in the middle of a hurricane

Here are two revealing diagrams, one which we posted back in January showing the three successive market lows during the bear market of 2000-2002, and one which is beginning to look very similar to it from today.

In the first diagram, we marked with red arrows the three successive sharp bottoms, each lower than the one before, which look like someone took an axe and whacked the market three times, each one harder than the last.

As we pointed out back in January, long before the market downturn had become an official bear market, "this type of diving three or even more times as the market tests for the final bottom is not unique to the chart above -- you can see it in other significant corrections, for example between the dates of January 1, 1981 and December 31, 1982."

After the final bottom in October 2002, the stock market rallied strongly in the first quarter of 2003, although many investors were so shell-shocked from the effects of that bear market that they missed that significant move. We know that many investors missed it because the historical data (which we also presented in that January post) show successively larger investor inflows into bonds and out of stocks during those successive "axe blows":








The similarities to today's situation are striking. Yesterday, for example, the amount of money flowing into three-month Treasury bills was so large that some investors were bidding for the bills at almost 0%. Much of the frantic buying was a result of fear that money market funds and other cash instruments would not be safe, leading to a rush to buy a bill that would pay no interest but was sure to be paid back.

From a portfolio manager's perspective, the important thing to remember in the current storm is to remain centered and not panic. We have already recommended that investors not hold large amounts in bank CDs or savings account, which we discussed in our post entitled "The bond market rules the world." Money market accounts may temporarily see some turmoil, but they are still diversified and a better alternative for cash, and they pay dividends.

Additionally, as the comparison of the current market chart above to the market chart from 2001-2002 shows, we appear to be heading into a situation which looks similar to the market bottom of October 2002. It is a fact of history that when the upward movements finally take place, they are so rapid that it is very hard to catch them unless you are prepared in advance. It is fairly widely known that a 1994 study found that 95% of the stock market gains between 1963 and 1993 occurred on just 1.2% of the trading days.

As we have pointed out in a series of in-depth examinations of the ramifications of years of Dalbar studies, ample evidence supports the conclusion that "investors make most mistakes after downturns." It is easy to conceptualize the idea of not jumping off the ship in the middle of the hurricane, and yet that is what a large percentage of investors do time and again.

Baron Rothschild is credited with the expression "The time to buy is when there's blood in the streets." It is easy enough to say that when things are going well, but you have to be in the kind of environment we are currently experiencing to absorb the full impact of that idea. The late John Templeton was known for his philosophy of investing at "the point of maximum pessimism." And the famous money manager Peter Lynch has written that "In many ways, the key organ for investing is the stomach, not the brain."

These are important truths to remember during weeks such as this one. Our view is that the financial system is undergoing a serious challenge, but that the overall economy is nowhere near as bad as it is being portrayed, and that investors should not confuse the two. Finally, we have stated many times our philosophy that it is dangerous to try to time economic and market cycles, and that it is much wiser to follow a disciplined investment process which is based on ownership of well-run businesses in front of fertile fields of growth.


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For later posts on this same subject, see also:

• "Be centered, be still -- 2011" 03/17/2011.

The Fed shows some backbone

Yesterday, the Federal Open Market Committee voted unanimously to hold their target funds rate unchanged at 2.00%.

Wall Street was urgently calling for yet another rate cut. Fed futures in the days leading up to yesterday's decision indicated a climbing percentage of bets that the rate would be cut by .25%, with an 88% probability indicated the day before the Fed's meeting. Many futures participants were even betting for a .50% rate cut.

Such a rate cut would have been in keeping with the volatile Fed policy that came to characterize the final years of the Greenspan Fed, as we have explained in greater detail in our August 22 posting, "The long shadow of the Y2K bug."

The howls of protest from some market pundits typifies the old Wall Street view that the Fed should jump to lower rates whenever it would serve their short-term interest.

That unhealthy pattern of giving Wall Street emergency cuts led directly to the severe turmoil wracking Wall Street this week -- events which have in fact just altered Wall Street as we have known it and probably ended the era of the big independent investment banks.

In light of that, it is a very positive sign that the Fed stood up to the demands for rate cuts and stood firm rather than cutting again.

The emergency cuts that started a year ago have not staved off the crisis that has engulfed AIG, Lehman, and others.* On the other hand, they have led to dramatically higher prices for businesses and consumers.

The CPI numbers continue to rise at an unacceptable rate. This week, the Bureau of Labor Statistics released August CPI data showing an increase of 5.4% over the index from a year ago. Many observers are acting as though the inflation threat has subsided, since the number shows a deceleration, mainly because gasoline prices came down significantly during the month of August, although the BLS report points out that gas prices are still up 35.6% from their August 2007 level.

But the "core" CPI, which excludes food and energy, is not only increasing but accelerating in its rate of increase. It's ironic that when the headline inflation number was going up more rapidly due to rising oil prices, inflation doves were pointing to the core CPI number that factors out food and energy. Now that the headline number is down but the core number is accelerating, the same voices are pointing to the headline number and ingnoring the core number!

In sum, the Fed did the right thing by refusing to lower rates again.

As for the rescue of AIG by the Federal Reserve late Tuesday, we are less enthusiastic. We can only point out that back in May we used that company in a post as a negative example in our discussion of why any doubts about the capability of the management of a company is a reason to avoid investment in the securities of that company.

* The principals of Taylor Frigon Capital Management do not own securities issued by AIG (AIG) or Lehman Brothers (LEH).


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Hurricane hits Wall Street firms

The weekend's momentous events saw the end of investment bank Lehman Brothers as it filed for Chapter 11 bankruptcy.*

As the assets of Lehman are sold off to meet their obligations to their creditors, other firms holding similar assets will potentially see the market value of assets held on their own books revalued, probably downward.

For some of them, this latest shock to their balance sheet would likely be enough to push them over the brink as well, and therefore they will have to find a firm with stronger capitalization to buy them, or share Lehman's fate.

As we explained in July in the post entitled "The dark side of making hay while the sun shines," the proximate cause of this wreckage was hedge-fund style behavior by some departments within Wall Street investment banks.

The management teams of these firms allowed bankers to rake in more and more banking fees by putting together more and more securities composed of or related to mortgages: see this graph illustrating the surge of CDO issuance beginning in 2003. In doing so, they knowingly or unknowingly were betting the firm in order to make outsized profits during the mortgage-boom years.

Those bankers and their managers made big bonuses during the mortgage boom; those who worked in other parts of their firm are now the ones who are paying the price, as they watch the value of their shares in the company plummet. In the case of Bear Stearns, in which fully 31% of the company's shares were owned by employees of the firm, the drop was to $10 a share. In the case of Lehman Brothers which had a similar percentage of employee ownership, it will be to zero.

In this regard, the crisis among Wall Street firms this weekend resembles the devastation of the weekend's other major disaster, the landfall of Hurricane Ike. Unlike that storm, however, many of the employees at firms such as Lehman were endangered by the decisions of their firm's leadership, and will now be left with nothing.

Among the lessons of this financial storm: Be careful about owning shares in companies that have complex balance sheets (and don't be too ready to loan them money either). As evidenced by the numerous cases this year of firms saying they didn't need more capital right before they needed more capital, it is evident that even the leadership of those firms didn't always know the depth of their own balance sheets.

On the other hand, one false lesson that many in the media and many politicians will want to draw from this entire disaster is a supposed need for "more regulation." As we explained in a posting back in March, shortly before the Bear Stearns fire sale, government regulation helped create the problem in the first place. Excessive Fed over-steering, described in "The long shadow of the Y2K bug," as well as Congressional interference in mortgage lending practices (such as laws that encouraged banks to loan to people who may not have been ready to own a home) created the situation that investment banks exploited to their own long-term detriment. In light of that, perhaps the best news to come out of this weekend was the fact that the government representatives from the Fed and Treasury opted not to back up bad assets with taxpayer dollars in order to facilitate a sale.

Unlike a physical hurricane, this disaster was man-made, and preventable. Like a real hurricane, the damage will be widespread and have an impact that will be felt throughout the economy.

For individual investors, one further lesson might be what we hinted at the end of our post "Wall Street firms back at the well" -- the widespread consumption of "wealth management" services at firms with active investment banking departments is really a relic of a bygone era, and a model with more disadvantages than benefits for the management of a family's wealth.

Yet, as we have also stated before and continue to believe today, there will be opportunities presented from this financial storm to those who are patient and have capital available to put to work.

* The principals of Taylor Frigon Capital Management do not own securities issued by Lehman Brothers (LEH).

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

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

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

• "If Rip Van Winkle took a one-year nap before September 15, 2008" 09/14/2009.

• "Rip Van Winkle, 2010" 10/11/2010.

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September 11, 2008

"Soldiers of the 148th Ohio: I am most happy to meet you on this occasion. I understand that it has been your honorable privilege to stand, for a brief period, in the defense of your country, and that now you are on your way to your homes. I congratulate you, and those who are waiting to bid you welcome home from the war; and permit me, in the name of the people, to thank you for the part you have taken in this struggle for the life of the nation. You are soldiers of the Republic, everywhere honored and respected. Whenever I appear before a body of soldiers, I feel tempted to talk to them of the nature of the struggle in which we are engaged. I look upon it as an attempt on the one hand to overwhelm and destroy the national existence, while, on our part, we are striving to maintain the government and institutions of our fathers, to enjoy them ourselves, and transmit them to our children and our children's children forever.

"To do this the constitutional administration of our government must be sustained, and I beg of you not to allow your minds or your hearts to be diverted from the support of all necessary measures for that purpose, by any miserable picayune arguments addressed to your pockets, or inflammatory appeals made to your passions or your prejudices.

"It is vain and foolish to arraign this man or that for the part he has taken, or has not taken, and to hold the government responsible for his acts. In no administration can there be perfect equality of action and uniform satisfaction rendered by all. But this government must be preserved in spite of the acts of any man or set of men. It is worthy your every effort. Nowhere in the world is presented a government of so much liberty and equality. To the humblest and poorest among us are held out the highest privileges and positions. The present moment finds me at the White House, yet there is as good a chance for your children as there was for my father's.

"Again I admonish you not to be turned from your stern purpose of defending your beloved country and its free institutions by any arguments urged by ambitious and designing men, but stand fast to the Union and the old flag. Soldiers, I bid you God-speed to your homes."

-- Abraham Lincoln. August 31, 1864.

The wages of socializing, revisited

The biggest news of the day, and probably the week, is the historic seizure by the government of the two entities it originally created, Fannie Mae and Freddie Mac.

This sorry episode should be a clear warning to all observers of the wages of socializing.

The concern is that many commentators and members of the media will portray it as a failure of free markets and a need for greater government control of various industries. For example, an article on page A15 of today's Wall Street Journal entitled "U.S. Poised for Bigger Role: Mortgage Bailout Marks the Return of Federal Activism" states, "The struggle between market forces and government control is as old as the country," as if Fannie and Freddie represent market forces.

This is completely false.

As we wrote in July in "The wages of socializing" (part one), the dangerous excesses of Fannie and Freddie were a direct result of their status as a government creation: because of the perception that the government implicitly stood behind them, they could borrow more money more cheaply and leverage their bets more aggressively than a regular private corporation would ever have been able to do.

They also lobbied vigorously through the years to prevent any limits to the size of the bets they were making. The supposed justification for these so-called "government-sponsored enterprises" was that they served "a public purpose" (see the Fannie Mae logo above, which describes the entity as "a Shareholder-Owned Company with a Public Purpose"): helping more Americans own homes. As studies linked in our earlier blog post reveal, the percentage of Americans owning their own homes barely changed in the decades since Lyndon Johnson moved Fannie Mae out of the federal government in 1968, increasing by only two percent over the next thirty years.

Because they were seen as just as safe as U.S. Treasury debt (because of their implicit backing from the same source) but paid a slightly higher rate, agency bonds issued by Fannie and Freddie are favored by many conservative investors, from retirees to foreign governments*. Treasury's seizure of Fannie and Freddie and placing them in conservatorship should ensure that those lenders will be protected, and our view is that this outcome is correct: Congress has basically been allowing this "government-sponsored" relationship for forty years (thirty-eight in the case of Freddie Mac, which Congress created in 1970).

On the other hand, shareholders of Fannie and Freddie will probably be wiped out, and this outcome is also as it should be. They were the ones who benefited from the upside when these entities made their aggressively-leveraged bets using borrowed money, and they should be the ones who pay when the bets go the other way.

However, because of the fact that these were government-sponsored entities and not private entities, there is a real possibility that every American taxpayer will also pay -- an outcome that is called "socializing the losses."

According to Treasury Secretary Hank Paulson's plan, as described in his press release yesterday, Treasury has received senior preferred equity and warrants in the conserved entities, and will be paid before the common stockholders if they are able to privatize later at higher valuations, which is certainly possible, thereby saving taxpayers from having to pay for the mess.

Ultimately, the entire "housing crisis" is an indictment of government's attempts to steer the economy (including through the actions of the central bank, and by high-handed Congressional legislation such as the Community Reinvestment Act) rather than an indictment of free markets and private business, as many commentators want to portray it.

Those who are critical of the current situation should realize that it is part of the wages of socializing.

* The principals of Taylor Frigon Capital Management do not own securities issued by Fannie Mae or Freddie Mac, either stocks or bonds.

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

• "Guide the market's invisible hand with a higher principle?" 02/26/2009.

• "How your view of 2008-2009 impacts your understanding of today's big events" 02/03/2010.

• "Bubble alert!" 06/07/2010.

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Ownership of businesses through multiple economic cycles

An important aspect of the Growth Stock Theory of investment as envisioned by Mr. Thomas Rowe Price in the early 1930s is the concept of owning companies through the ups and downs of business and stock market cycles.

This approach distinguishes the genius of Mr. Price's discipline from almost everything else that you hear from Wall Street and the financial media.

Since at least the early 1860s, when Clement Juglar (1819 - 1905) began publishing his observations that economies pass through predictable up-and-down cycles every seven to eleven years, this so-called "business cycle" (sometimes called "Juglar cycle") has become a fixture in economic textbooks and the general consciousness, and investors have sought to make money (or avoid losing money) by timing their investments to various predictors of the next shift in the cycle.

Major financial services firms dole out analysis and advice on what the latest job report or retail sales number means in regards to where we are in the business cycle at any given moment, and what sectors or assets you should be switching to next. Do the business cycle indicators mean that you should switch from small-cap stocks to large-cap stocks now? From value to growth? From stocks in the Energy sector to those in Consumer Staples?

In contrast to all of this, Mr. Price wrote that by the early 1930s, after ten years experience in the investment business, he had learned that "most other people, including various stock market services, were unable to predict the market over an extended period of time." He made the important observation that "the various systems usually failed at crucial turning points in the market" ("A Successful Investment Philosophy based on the Growth Stock Theory of Investing," T. Rowe Price, 1973).

Price's response was to reject the endless attempts to time the various cycles. Instead, he sensibly observed (as we have discussed at length in several previous posts) that "most of the big fortunes of the country were made by men retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years."

A vitally important point that he makes about the owners of such successful businesses is that "They did not attempt to sell out and buy back again their ownerships of the businesses through the ups and downs of the business and stock market cycles" (emphasis in the original).

The concept of holding a company based on the growth of the company, rather than its market value within the ups and downs of the business cycle, was a totally different approach. The very term "Growth Stock Investing" suggested a focus on criteria other than the business and market cycles followed by other investing methodologies.

In the same discussion of his theory, Mr. Price cautioned "That a stock is considered to be a growth stock is no assurance against a decline in earnings, dividends or market values during a downtrend in the business cycle when earnings and dividends of many companies decline." This fact no doubt creates a strong temptation to try to respond when such declines begin to hit, but Price's observation from the 1930s, that systems of cycle timing "usually failed at crucial turning points" continues to hold true today (recent failures of such systems at well-known hedge funds, by respected and experienced traders, provide additional proof, if any is needed).

However, as we have also discussed previously, this rejection of the timing of economic cycles does not translate into a blind or obstinate "buy and hold" mentality of never selling any business once purchased. The hallmark of the growth theory is that it recognizes that corporations themselves, "like people, pass through a life cycle of growth, maturity and decline," as Mr. Price put it.

Instead of trying to time the ups and downs of the business cycle, we recommend instead looking for companies that are in their growth cycle. In fact, as we have noted previously in last month's "Return of the 1970s?" posting, companies that are in their own growth cycle can provide exceptional returns, even during a time period which is atrocious in terms of the overall business cycle, such as took place in the 1970s.

This is a crucial concept. Unfortunately, it is little understood today, seven decades after Mr. Price first began to explain it to the public.

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

• "Return of the 1970s, part 2" 02/17/2009.
  

• "Beautiful Growth Companies, part III" 05/14/2009.

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

• "The importance of a proper sell discipline" 05/27/2009.

• "Seeing beyond a huge false dichotomy" 07/13/2009.
  

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

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

• "S&P takes aim at active management" 10/07/2009.
  

• "If Rip Van Winkle took a one-year nap before September 15, 2008" 09/14/2009.

• "Would you sell your successful local restaurant because of a debt hiccup in Dubai?" 11/30/2009.

• "Another black swan?" 05/13/2010.

• "Market-timing and train-timing" 05/25/2010.

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

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

• "Glenn Beck is an economic butterbar" 11/04/2010.

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What about commodities -- revisited

Back in March of this year, we wrote a post entitled "What about commodities???" in which we noted that the steep rise in commodities prices had been generating the predictable interest in commodities that always arises when the stock market has done relatively poorly relative to commodities (the same phenomenon occurred in 2005).

As we noted then, commodities by their very nature have no value added to them -- that's why they are called commodities -- and therefore they do not increase in real value over time. Because of this basic fact, there is no real value to buying commodities "for the long run" -- they go up and down based on a variety of influences, but do not appreciate at a very significant rate over decades.

We have emphasized repeatedly (as we did in the March post on commodities) our conviction that long-term strategies for building and preserving wealth should be based on ownership of businesses that are consistently adding value, rather than on speculative calls on the relative market value of one asset versus another.

We made a similar point in our June 4 post on oil prices, "A hard look at the current price of oil and gasoline." In it, we argued that "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." At that time, when oil was at $122 a barrel on its way to $145, anyone who said that oil would drop to $100 or less before it hit $200 would have been scorned by the pundits spouting dire oil predictions on all the financial media outlets.

Since then, the CRB has retreated about 17% from its July 3rd peak, and crude oil futures settled today down more than 23.5% from its July 3rd close.

As we have stated in a previous post, we believe that the Fed's easy policy since September last year has been the underlying cause of most of the rise in oil and commodities, and speculators noting the trend added more fuel to the fire. Since July and the possibility of a lift on some of the drilling bans in the U.S., much of the wind has been taken out of the sails of the speculators, although the underlying loose monetary policy is still a problem.

All of which is vindication for our observations at the time (when oil and commodities could "only go up and never go down") that playing that game is closer to Russian roulette than to anything that can be called "investing." In fact, not long before the July 3rd peak we noted in a June 23rd post that "this might be a good time for them [those who still think it's a good idea to bet on continuing increases in the prices of gold, oil, and other commodities] to ask themselves the famous line from Dirty Harry: 'Do you feel lucky?'"

For later posts on this same subject, see also:

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

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

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

• "Gold versus Apple" 10/25/2010.

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