Panning for gold during unfriendly business climates

In our previous post, we discussed the "Four Pillars" of tax rates, interest rates, inflation and global freedom, and noted that there are some troubling signs cropping up in all four of those important areas (Global Freedom being perhaps the most positive of the four, with much of the world outside the United States turning towards freer markets and more free enterprise).

No doubt this raises some questions in investors' minds. What should an investor do, if there are potential storm clouds building on the economic horizon?

Does this mean that it's time to head to cash, or gold -- if not immediately, perhaps in the near future? Does it mean that investors should seek out new "alternative" vehicles that are designed to perform well when things turn sour, perhaps investing in "long-short" funds, or "absolute return" funds, or other exotic strategies?

We would answer that during difficult periods -- in which tax rates, inflation, interest rates, or levels of freedom are moving sharply in the wrong direction -- investors should become even more acutely aware of the importance of searching for innovation.

As we have asserted many times before, we believe that investors should always be looking to match their capital with innovation. This is the foundation* during any investment climate. During periods in which tax rates, interest rates, unstable currencies, and government intrusion serve to choke off a lot of potential innovation, the search for tiny nuggets of innovation must become all the more urgent.

A useful analogy might be panning for gold, as depicted in the above photograph from 1916.

During periods in which the climate is conducive to business growth -- in which tax rates are low, inflation is contained, interest rates to borrow capital are not prohibitive, and government restriction of freedom is retreating (all conditions which generally marked the period from the late 1980s through the 1990s) -- innovation and growth may be widespread throughout the business landscape. Investors can experience investment growth with big companies and small companies -- big gold nuggets are literally all over the place, and you have to be careful not to stub your toe on them (many investors may remember feeling that way in the 1990s).

During more restrictive periods, in which the investment climate conspires to restrict innovation, investors must screen for innovation using a much tighter and finer sieve -- similar to the gold miner who sifts through even the smallest pebbles and river silt in search of a few precious flakes.

During these periods, most large companies are not innovating (capital is expensive, due to high interest rates, government regulation and intrusion tangle up their avenues for new business growth, and the reward for marginal innovation success is reduced because the government will tax earnings more heavily). What innovation is to be had will often be found in much smaller companies, companies whose survival and future hinges on overturning the status quo in their market, rather than on preserving it (a very different outlook than the view typical among the larger players in an industry).

We have written before that the 1970s were clearly a period in which the economic landscape was unfriendly to businesses. Examining the Four Pillars of tax rates, interest rates, inflation, and global freedom show that all four were stacked against innovation. In that article, entitled "Return of the 1970s, part 2" we presented historical evidence showing that smaller companies outperformed larger ones during that period by a solid margin.

It is also notable that gloomy periods in which the deck is stacked against innovation often seem to incubate a few highly innovative businesses that completely change their industry and which become real home-runs for investors. Notable examples from the 1970s include Intel in the world of technology, and Wal-Mart in the world of retail**. This phenomenon only serves to underscore what we said above, that during periods when taxes, interest rates, inflation, and government intrusion are against innovation, innovation will likely be far less widespread and the companies where it can be found will be companies whose success is geared towards completely remaking their industry, or forging new ones.

While we believe that the current economic landscape is experiencing the positive effects of a rebound from a financial panic (see for instance the discussion in this previous post), we cannot deny that analysis of the Four Pillars give clear indications that conditions may not be good for widespread innovation and growth over the next few years.

In light of this, we would advise that investors:

• Avoid the temptation to try to time markets by jumping in and out of cash, which is a very dangerous foundation for investment over long periods of time (see for example the discussion in this previous post and this previous post).

• Avoid the products the financial industry is churning out to take advantage of the widespread feeling of discomfort, products such as "absolute return" funds or investment vehicles built on short strategies, almost all of which are focused on markets rather than on business fundamentals (we discuss the problem with such a focus here and here and here, among other places).

• Become even more attuned to the importance of innovation, and to disruptive innovation in particular. We always believe that innovation is the touchstone to an investment discipline built on long-term ownership of growth companies, but during difficult periods the criteria you search for must become even more exacting, because many potential innovations will wither in a climate that is characterized by lower access to capital and greater government restriction and taxation.

• Look for innovation among smaller companies, and be cautious of investing in larger companies, even larger companies that have previously been fairly innovative. We give some examples of this in our discussions on maintaining a proper sell discipline (see here and here).

These are the kinds of adjustments that we believe investors should understand whenever their close analysis of the indicators we discussed in "The Four Pillars" indicate conditions that may squelch innovation and business growth for a period of time. Rather than give up on looking for growth, they should take up the attitude of the old prospectors panning for gold, and become very focused in their hunt for the precious flakes of innovation, which can be found in almost any decade if you just know how to look.

* Unfortunately, much of the investment industry lost sight of this important truth during the advent of modern portfolio theory, which is why their response to difficult climates is to offer investors even more exotic forms of financial engineering.

** The principals of Taylor Frigon Capital Management do not own securities issued by either Intel (INTC) or Wal-Mart (WMT).

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The Four Pillars

For many years, we have analyzed the investment conditions using four foundational criteria that are vitally important for investors to understand.

These four areas are so important that they form the foundation for business growth and investment prospects, and can be seen as the four "pillars" on which everything else depends.

These Four Pillars are:

• Tax Rates.
• Interest Rates.
• Inflation.
• Global Freedom.

Clearly, these four are very much interdependent. Interest rates and inflation are closely interconnected, for example, as we discussed in greater detail in this previous post.

The concept of "Global Freedom," which is perhaps the most important of all of them, includes the other three to some extent. It is a measure of the degree to which people around the world are permitted to seek to fulfill their individual needs by producing and exchanging peacefully with others, and the degree they can be free of the fear of confiscation of their property or their lives.

One resource we use to find data points on the level of "Global Freedom" is the Heritage Foundation's annual Index of Economic Freedom, which provides insight into a variety of components of economic freedom and the level of such freedom around the world.

There has been a remarkable increase in the overall level of Global Freedom over the past three decades, which have seen countries including China and India and many countries in Eastern Europe make dramatic advancements in the level of economic freedom permitted to their citizens.

Unfortunately, intrusive government regulation has been on the rise in the United States, such as the Sarbanes-Oxley regulation enacted at the end of the 2000-2002 bear market, and we would argue that the mark-to-market accounting rules that played such a negative role in the most recent financial crisis were another example of intrusive regulation by government agencies, which is an important factor in the measurement of "Global Freedom" in any given country.

In fact, there are some disturbing signs in the important area of Tax Rates in the US as well, as Arthur Laffer discusses in a recent Wall Street Journal article called "Taxes, Depression, and our Current Troubles."

In it, he argues that many academics and economists, including the current Federal Reserve Open Market Committee, are looking to the Great Depression and seeing only the problems caused by excessively tight interest rates (the second of the Four Pillars) and ignoring the deleterious effect of increased taxation (the first pillar), devaluation of the currency (the third pillar), and the elimination of free trade by the Smoot-Hawley Act and reciprocal tariffs it led to world-wide (the fourth pillar, since freedom to trade is an important component of Global Freedom).

Arthur Laffer's analysis is that we are in danger of making the same mistakes today, based on looming tax rate hikes when the 2003 tax rate cuts expire in 2011, as well as tax hikes that would be necessitated by proposed government healthcare expansions and by proposed cap-and-trade legislation.

While this particular article doesn't specifically mention them, we can also add that recent events suggest both the danger of inflationary Fed policy and the danger of increased restrictions on free trade.

The value of using the Four Pillars to evaluate the business and investment climate lies in the additional clarity that it can provide in making the investor aware of the real situation. We have written before in "Return of the 1970s, part 2" that economically difficult environments may call for subtle changes in the types of companies to which you allocate capital, but that just because such conditions may be on the horizon does not mean that there are no opportunities.

We believe that investors would greatly benefit from taking the time to understand each of these Four Pillars and consciously incorporating an analysis of each one of the "pillars" into their analysis of the overall investment picture.

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For later posts on this same topic, see also:

• "Panning for gold during unfriendly business climates" 09/30/2009.

• "The Consumer" 10/19/2009.

• "The 97-pound weakling" 12/16/2009.

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

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

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

• "Lower tax rates stimulate growth" 07/27/2010.

• "Reducing taxes is the best way open to us to increase revenues" 08/03/2010.

Who are you going to believe -- gold prices or the bond market?

We have previously argued that the Federal Reserve should declare victory and begin to signal that they will begin raising rates from the extremely accommodative target rates (essentially zero Fed funds rates) that they implemented during the financial panic.

The reasoning for our argument is simple: artificially low interest rates lead directly to long-term inflationary pressures which can wreak havoc on the economy (for further discussion see also this previous post and some of the resources linked within that post).

As longtime economist (now retired) Scott Grannis explains in a recent post on his illuminating blog, the Calafia Beach Pundit, warning signs of inflation are now clearly evident in several market-based indicators, including the decline of the US dollar against other currencies, the rising prices of commodities in general, and the rise in the price of gold in particular -- topping $1000 last week.

As he points out in that post, however, the bond market continues to glide along peacefully as if there is no danger of higher inflation on the horizon. When the bond market fears inflation, yields rise dramatically the further out you go on the curve -- reflecting the fact that a dollar you loan today that is paid back in ten years (for example) will be worth far less in terms of purchasing power due to inflation, and therefore lenders will demand higher yields to loan dollars for longer periods.

If longer-term yields suddenly snap upwards, the market price of existing longer-term bonds will fall drastically, because those existing bonds with lower yields will suddenly be worth much less than the newer bonds whose yields have been pushed upwards by the expectation of inflation. Thus, investors have to ask themselves which of these contradictory signals is correct -- the elevated price of gold (signaling strong inflationary pressure), or the relatively low yields of longer-term bonds (signaling a lack of inflation expectations from bond investors).

As Scott Grannis explains in his post, entitled "Why the bond market is so complacent," "The bond market has never been very smart about inflation, and neither has the Fed." The reason the bond markets are failing to signal inflation, in his view, is that they take their cue primarily from the Fed, and the Fed is not concerned about inflation due to their continued belief in the outdated "Phillips Curve" view of the causes of inflation. Mr. Grannis writes, "So the Fed is really the key. If the Fed is not concerned about inflation (and they aren't because of the Phillips Curve), then the bond market isn't."

We've written about the Phillips Curve before, and provided quotations from actual statements by Fed Chairman Ben Bernanke which clearly indicate that he is still in thrall to that outmoded theory, and to its related concept of the "output gap."

If you agree with Scott Grannis, as we do, and believe that the bond market is the one giving the false signal, then you should be very cautious about buying long term fixed-rate bonds right now. If he is right, then the bond market will have a serious correction when it finally recognizes the inflationary pressures that other markets, such as gold, have already picked up.

While these concepts are important for investors to understand and our views are geared towards guarding against an abrupt rise in interest rates, we would also conclude by arguing against trying to invest based on short-term "guesses" on the direction of interest rates, or currencies, or commodity prices. As we have stated many times in the past, such calls are not a reliable foundation for building wealth over periods of thirty years or more. Instead, investors should follow a consistent discipline of ownership of securities issued by well-run, growing companies. Doing so is the way most of the big fortunes in this country have been made.

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

• "The Consumer" 10/19/2009.

• "The 97-pound weakling" 12/16/2009.

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

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

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

The hard-money real-estate sinkhole

Taylor Frigon Capital Management has its headquarters in the beautiful Central Coast town of Paso Robles, California. Located in San Luis Obispo County, we are well aware that this county led the entire state of California in hard-money real estate loan losses in 2008.

According to this recent article from the San Luis Obispo Tribune, investors who gave money to two companies in return for interest payments from real estate development loans lost their entire investment, totaling almost $500 million. Another article covering the damage from the four most notorious county hard-money lending operations put the total at nearly $700 million. In private conversations, we have heard estimates that the losses are as much as $750 million.

It strikes us that this unpleasant situation provides an important lesson in the concept of "malinvestment," which can be defined as the "mis-allocation of capital, often due to an alteration of the market by government incentives or regulations."

We have argued previously that investors should think of the act of investing as the act of matching capital with innovation (see for example here and here). Imagine if that $750 million had been instead allocated to funding innovative start-up companies. Had they placed their funds in a company that invested in promising young businesses run by entrepreneurs, investors certainly couldn't have done much worse!

With $750 million, a venture capital firm could fund seventy-five young companies at $10 million apiece, or a hundred and fifty young companies at $5 million apiece. The possibility that it could find one or two out of that number that could add enough value with their business to later go public or be acquired by another firm for a sum much larger than $750 million is actually quite high.

And yet there remains an almost instinctual aversion towards venturing capital in business opportunities by those who will readily venture it out towards real estate development (even real estate development by those who are unable to get a loan from a traditional bank, and thus must resort to the higher rates offered by so-called "hard money" lenders). This goes along with a belief, very common in the current Baby Boom generation, that real estate is somehow the one investment that can "do no wrong" (this irrational belief has taken something of a hit lately, but it still persists with amazing vitality, even after the carnage of the past two years).

The foregoing observations should not be taken as meaning that we are somehow against real estate investment -- far from it! We have in fact written that families should consider allocating their capital in real diversification (as opposed to the kind of over-diversification within the financial market instruments that the representatives of Wall Street typically preach) consisting of not only financial market assets but also real estate assets and even insurance products, when appropriate. Due to the tax code, real estate is one of the most tax-advantaged investments available in the United States, and it can also experience real appreciation, particularly when businesses in the area add value and thus attract more employees and even pay more in order to compete for talent with other successful area businesses.

But these two positive aspects of real estate deserve a closer look. The very tax codes and government incentives that encourage capital to go into real estate that might otherwise go elsewhere have a very real likelihood of occasionally leading to serious malinvestment, as happened earlier in this decade. A few years back, low interest rates from what we call "Fed oversteering" led to a situation in which if you weren't urging investors to participate in the real estate boom, you were at risk of getting laughed at.

Also, the very point that real estate can appreciate significantly when local businesses do well should cause investors to understand the fact that it is the businesses which drive that train, not the real estate itself. The real estate in California's Silicon Valley experienced some of the most significant appreciation in the world over the past five decades, but that was thanks in large part to the incredible value added by firms that drove the computer revolution which were headquartered and competing for employee talent in that same area. While this may seem obvious, it is amazing how many real estate owners in that area, from the generation that experienced that price appreciation, attribute it all to the miraculous powers of "real estate" rather than to the miraculous business innovations of companies such as Intel, Apple, Google, and the rest that make their homes in the middle of all that real estate*.

Furthermore, while we are on record as saying that real estate can be an important area of capital investment and a form of diversification from investment in financial market assets, the past few years should have taught investors that real estate can have three significant drawbacks: it's not always that easy to sell, it's no longer always that easy to borrow against, and it's not even always that easy to rent out to an appropriate tenant (whether commercial or residential)!

We believe that investors should learn from the San Luis Obispo County hard-money real-estate lending sinkhole, and realize two things: that the real estate experience of the past several decades has almost certainly served to brainwash a lot of people into believing that real estate is somehow less risky than it really is, and that this same history has also served to blind many investors to the overlooked investment opportunities in private equity or direct venture investing. In all the discussion of the "one-year anniversary" of the banking panic, this is certainly a topic worth considering.

* The principals of Taylor Frigon Capital Management do not own securities issued by any of the companies mentioned in this article, including Intel (INTC), Apple (AAPL), or Google (GOOG).

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If Rip Van Winkle took a one-year nap before September 15th, 2008

Just in case you have been taking a Rip-Van-Winkle-style nap, it's been a year since investors awoke to a Monday morning (September 15 fell on a Monday in 2008) in which the financial world as it had existed for decades imploded and came to an end. Lehman Brothers had declared bankruptcy the day before, and Merrill Lynch had hastily arranged to be acquired in order to avoid the same fate.

These events, as well as certain government missteps that followed, set off a banking panic, which triggered a recession. We have argued extensively in numerous places, however, that because of this recession's unusual cause, the recovery could be quite rapid once those unusual conditions (the panic) subsided -- and that is exactly what appears to have happened (see for example the short post with encouraging graphs entitled "A picture is worth a thousand words" from this past June).

Many investors panicked themselves, selling their financial market assets in droves as the market plunged towards new lows -- equity funds alone experienced net outflows of $25 billion in February of 2008 and another $27.5 billion in March of 2008, according to the Wall Street Journal (at about the same time that these investors were fleeing the market, we published a post entitled "Don't get off the train," explaining the real dangers of such behavior).

If, however, you had been invested in a portfolio of well-run businesses in front of fertile fields of growth, such as those contained in the Core Growth Strategy at Taylor Frigon, you could have gone to sleep a year ago and woken up today down about 4.28% after the deduction of management fees* -- a market move not much larger than what you might see in a single day of heavy trading.

Of course, the broader market averages are down somewhat more over the same period (over 16% for the S&P 500), but this just serves to emphasize the assertion we have made many times in the past that which individual companies you choose to own is important. However, the real point is that investors who followed the advice of Wall Street's financial engineers and chased after structured products, commodities plays such as oil, foreign exchange bets, and thirty-one flavors of international investing (which often amount to foreign exchange bets themselves) only wish they had done as badly as the S&P 500 -- because those investments generally hurt investors much more.

Rip Van Winkle is not exactly an admirable character, if you take the time to read the original version of Washington Irving's charming short story, and we do not urge investors to adopt his oblivious attitude towards their actual investment portfolios. The point we are trying to make is that if you follow our somewhat boring and often-repeated advice of matching your investments with solid, well-run businesses in front of fertile fields of growth, then you should be better prepared to weather the inevitable ups and downs of the market and business cycles, and you might sleep better at night too!

On this anniversary of that fateful day in 2008, readers may find it edifying to revisit the following blog posts from the past year:

• "Hurricane hits Wall Street firms" 09/15/2008.

• "Government solutions disintegrate" 09/29/2008.
  

• "Taking stock of 2008" 12/31/2008.
  

• "Managing investments in the new era" 02/18/2009.
  

• "Professor Amar Bhide and his praise of more primitive finance" 02/23/2009.
  

• "Four-letter government words" 04/15/2009.

• "Rip Van Winkle, 2010" 10/11/2010.

* Past returns no guarantee of future performance. Performance results cover period from close of markets on Friday 09/12/2008 through close of markets on Friday 09/11/2009. Taylor Frigon Capital Management complies with the Global Investment Performance Standards (GIPS) for standardized and ethical calculation and reporting of performance. Full GIPS disclosures for the firm are available at the Taylor Frigon Capital Management website at https://www.taylorfrigon.com/TAYLORFRIGON/WEB/me.get?web.websections.show&SCH6022_003.

September 11, 2009

Melanie Oudin, Billy Beane, and the portfolio management process

Today in the Wall Street Journal an article appeared highlighting U.S. Open women's tennis sensation Melanie Oudin and in particular the research and coaching innovations of coach, Brian de Villiers of Atlanta's Racquet Club of the South.

The Journal article notes that Mr. de Villiers' use of extensive analysis of the videos and statistics of opponents is revolutionary in tennis, where: "Thanks to a combination of cost, complexity, the nature of the sport and the weight of tradition, tennis is still in the dark ages in the use of digital-video analysis and statistics."

Although not mentioned in the Journal article itself, this observation reminds us of the insightful 2003 book by former Solomon Brothers trader-turned-author Michael Lewis, Moneyball. That book chronicles the revolutionary coaching of baseball manager Billy Beane of the Oakland A's, and especially his use of a variety of criteria and statistics to analyze players and discover undervalued talent. Lewis describes how Beane's rigorous approach was a stark contrast to the analysis that had prevailed before, in which scouts would rely on a sixty-yard dash time and a "gut-level" analysis of a player's hitting and throwing form.

This storyline, common to both Moneyball and the Melanie Oudin article, has a direct application to portfolio management. The question of what criteria you are looking for in a business -- and how you go about analyzing those criteria -- is critical to money management.

The differences in money management "styles," in fact, can be properly understood as differences in the characteristics that different managers emphasize. A manager who belongs to the "value" school might focus on certain cash flow measurements in order to look for a business whose shares are trading below its actual "intrinsic value," much the way Lewis describes Billy Beane -- who was, after all, assembling a "portfolio" of players on his team. A manager who follows the classic growth investment process which we have described in numerous previous articles might emphasize certain other measurements of a business, such as those we described in this previous post.

This concept is very important for investors to understand. If you manage your own investments (which we have argued previously is a valid approach to building wealth), then you are in the position of a Brian de Villiers or a Billy Beane: you must determine which criteria are most important to focus on, and you must determine how you are going to measure those criteria.

As strange as it is to read about the lack of rigorous fundamental analysis in the high-stakes world of coaching tennis or scouting baseball at the highest levels of the game, it should also go without saying that selecting companies in which to invest significant amounts of capital should not be done by "gut feel."

Another important aspect of this issue is the consistency of the criteria by which you invest your capital over the years and decades. An investor who is managing his own investments, presumably, can keep these criteria consistent through time (after some years of developing his process and deciding what he should be looking for).

However, as we have noted in this previous post, getting a consistent process for years or decades is very difficult if you hire a professional to manage your money. One reason it is difficult is the fact that managers of big funds are often fired or replaced quite frequently, or move on to the next opportunity after a few years of success. The other reason a consistent process eludes many investors is that the intermediary system of investing often leads to the investor being switched from one process to another every few years (extensive research has demonstrated the detrimental effects of this inconsistency).

Investors should thoroughly understand this lesson from the world of sports, and should know the criteria behind their investment process and the importance of keeping it consistent over the years.


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The ETF industry and their promise of easily adding alpha to all

In several previous posts, we have argued that the "intermediary" structure inherent in the "wealth management" industry constitutes a huge problem with respect to long term returns achieved by investors served by the industry.

The crux of the problem is that investors seeking professional assistance typically receive that assistance from an intermediary who does not select individual investments in good businesses himself -- instead, he funnels the investor's capital to someone else who is selecting those business investments (by using mutual funds, separately-managed accounts, index funds, exchange-traded funds, or other investment vehicles where the capital is actually matched to the individual stocks or bonds).

More and more often, intermediaries are relying on exchange-traded funds -- or ETFs -- as their vehicle of choice for the investment of their clients' capital. The reasons for this phenomenon are multiple.

First, ETFs are constructed differently than mutual funds, which enables them to avoid some of the drawbacks to mutual funds which we have noted in numerous previous posts (one of the most important drawbacks of funds to wealthier investors are their tax consequences, which ETFs generally sidestep).

Second, ETFs are mostly constructed to mimic a market index or some portion of a market index. This appeals to those who believe the common argument that "you can't really do better than the index," relieving the intermediary of the burden of arguing against all those studies which show that few active managers consistently outperform their benchmark index (see for example the "performance" link in this presentation from iShares, the first and one of the largest merchants of ETFs). By using ETFs, intermediaries can use "index-fund" arguments while avoiding the drawbacks of the mutual fund structure discussed in the first point.

Third, and perhaps most seductively, ETFs offer the intermediary the promise of "adding alpha" while avoiding the difficulties of actual analysis of individual securities (such as stocks and bonds) -- a process that involves evaluating individual business prospects, balance sheets, earnings reports, management teams, cash flows, and a host of other factors requiring ongoing diligence and research. ("Alpha" is a modern portfolio theory term for the measure of a portfolio's "risk-adjusted return" in excess of the return of the overall market -- we've discussed previously that the modern portfolio theory belief that riskiness can be mathematically quantified and portfolios can thus be evaluated for their "risk-adjusted return" is based on a false premise, such as this post in which we note that this opinion is also shared by the insightful Professor Amar Bhide of Columbia Business School).

We've argued elsewhere that we disagree with the "indexing" argument, which forms an important part of the ETF story. Even more concerning about the ETF phenomenon, however, is the blatant inherent contradiction between the second and third points above.

In other words, the ETF argument contains these two contradictory premises:

1. Active managers who select individual securities cannot "add alpha" consistently enough to make it worth your while.

2. Using ETFs, we can add alpha!

That this is exactly what the growing ETF industry, including the intermediaries who use ETFs, are saying to clients is clear from ETF marketing material. For example, this iShares example shows their "Asset Class Illustrator Tool" with which the intermediary can project the increased returns and "lower risk" that can be achieved by "blending in" a variety of different indexes and market sectors into a portfolio of ETFs. Section number three on the second page of that shows the intermediary how he can show client "Jane Doe" a projection that illustrates her portfolio's increased return and lower volatility (or "risk") versus the index (in this case, the S&P 500 index).

This ability to beat the market (with lower risk) is supposedly accomplished by "overweighting" and "underweighting" different sectors, geographies, and asset classes that are expected to outperform or underperform in the near term (see another description of this concept from ETF marketing material here). It's amazing that the same people who point out how difficult and rare it is for active portfolio managers to beat the market using a portfolio of stocks also argue that they themselves can beat the market using an actively managed portfolio of indexes (it's even more amazing that investors don't notice this contradiction).

We have previously laid out our reasoning concerning the problems with constructing a portfolio by overweighting or underweighting this or that sector (or geography, or growth / value style category, or market-capitalization category, and so on).

There are real tools for evaluating an individual business -- including measuring a host of data from its financial statements, SEC filings, management history and business activities -- while there are no such corresponding metrics for conducting true due diligence on a sector, or an index, or a basket of securities grouped by market capitalization. Thus, the kind of overweighting and underweighting described in ETF literature necessarily relies much more on gut instinct or feelings about what will outperform next than on fundamental business analysis.

Furthermore, empirical research such as this study from index-fund advocate John Bogle illustrates that -- far from adding performance and reducing risk -- investors and their advisors who are using ETFs fall into the same trap that characterizes mutual fund investment behavior and which causes investors to consistently underperform the track records of the ETFs themselves! This finding exactly parallels the problem we discuss in "Investor Behavior . . . or Advisor Behavior?" and it should not surprise our regular readers.

We believe that investors should be wary of the increasingly common pitch for using ETFs instead of investing directly in well-run businesses that have good management teams operating in promising fields of growth.

For later posts on the same subject, see also:

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

• "What a farmers' market can teach us about money management" 01/18/2010.

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

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

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

• "Professor Amar Bhide's latest essay, 'The Judgment Deficit'" 08/17/2010.

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

• "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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"Repeal what remains of the misguided stimulus" -- Allan Meltzer

Today in the Wall Street Journal, distinguished economist, author, and Carnegie Mellon Professor Allan H. Meltzer published an opinion piece entitled "What happened to the 'Depression'?"

In it, he made some excellent points that investors should understand, and which resonate particularly well with assertions we have been making in print on the pages of this blog for many months now.

In it, he points out that many journalists and politicians who are partial to Keynesian theories fall into the trap of believing that government stimulus is helpful -- even necessary -- during periods of recession (a notion we refuted back in January, among other places).

Professor Meltzer demonstrates that the economic recovery that is currently in progress has nothing to do with stimulated consumer spending, but has everything to do with the natural recovery* from what was in fact a panic that was induced by a chain of technical factors, as we have also argued before. He notes that the failure of Lehman Brothers set off a liquidity panic, just as we have been saying since well before the economy and market began to recover (see "It's a panic, not a Great Depression").

Even in the midst of this recovery, Keynesians such as the New York Times' Paul Krugman continue to call for more government stimulus.

Professor Meltzer makes the very important observation that "Keynesian economists always fail to recognize the powerful regenerative forces of the market economy." This is a fact of which investors should be very aware.

He ends his article with the trenchant observation that "The proper response now is to repeal what remains of the misguided stimulus." This advice is exactly what we called for in April's "Four-letter government words," in which we argued that "The remainder of ARRA, TARP, TALF and PPIP are 'four-letter' government activities that, in the words of the late Professor Friedman, could be 'profitably abolished'" -- ARRA being the acronym for the American Recovery and Reinvestment Act, more commonly known as the "stimulus package."

Professor Meltzer, who served in an economic advisory role to both the Reagan and the John F. Kennedy administrations has some authority when he states that the current administration should revise its policy and should begin with "scrapping what remains of the stimulus."

We are gratified to observe such confirmation of our assertions from such a distinguished source.


* We would also add that the recovery from the panic was assisted by emergency doses of liquidity from the Federal Reserve, which did their job but which we have argued should also be removed now.

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

• "The Consumer" 10/19/2009.

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

• "The end of 2009" 12/30/2009.

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

• "Why can't we all just get along (on economic policy)?" 02/08/2010.

• "Zombie economics" 12/23/2010.