2010: the year in review

The year is rapidly drawing to a close, and what a year it was. Many important issues came into the spotlight in 2010 -- too many in fact to cover in a short post, so we've selected three to discuss which we believe include some of the more important lessons investors can carry with them from 2010 into the years ahead.

• The world is waking up to the folly of endless taxpayer-funded pension systems. We called this "The question of our time" and it dominated headlines from Greece to California this year. After World War II, many governments instituted pension payments for retirees that were funded by the taxes levied on those still working. At the time, life expectancies were much shorter (men often worked past 62 and the average life expectancy was only 65), and as the Baby Boom of children born after the war grew up and entered the workforce, these pension ideas seemed to work. In some places, the benefits became more and more generous and the retirement ages at which retirees could draw them became younger and younger. This year was the year in which many around the world woke up to the fact that this system is unsustainable. See also "Greece and California."

• The "Unstoppable Wave" rolled on with a vengeance. The other half of the solution to foolish government entitlement programs is economic growth. While some pundits looked at the budget crisis in European countries such as Greece and in US states such as California and argued for an "austerity" solution of higher taxes and fewer entitlements, the real answer is higher economic growth rates and fewer entitlements. We've argued that the best recipe for economic growth is for government to ensure that it does not discourage innovation. We've also pointed out that the "Unstoppable Wave" paradigm shift taking place is so powerful that even ordinary-grade government ineptitude will be unable to derail it. The year 2010 provided all kinds of examples of the kind of transformative innovations that exponential increases in bandwidth can have on various industries, from the explosion of online retail shopping after Thanksgiving to the proliferation of smartphones and tablets, particularly their application to businesses but also even combat operations. Some of the best investment performance during the year came from businesses involved in this paradigm. See also "On the verge of something important" and "Another wake-up call."

• The "experts" who wrote off the economic recovery were as wrong as those who wrote off the San Francisco Giants. Conventional wisdom going into 2010, and during much of the year, was that the rebound after the crater of March 2009 was just a big head-fake, and that the economy would probably slide back into "years of treading water" or even replay the worst that had gone before with a "double dip." It was fashionable in the media to say we were still in a recession, long after the recession had officially ended. In July, the UK's Telegraph published a story entitled "With the US trapped in a depression, this is really starting to feel like 1932" and opened with a quotation from Robert Reich declaring that "The economy is still in the gravitational pull of the Great Recession. All the booster rockets for getting us beyond it are failing," despite the fact that the economy (as measured by Gross Domestic Product) had been showing steady expansion since June 2009. Since then, the economy has continued to expand, embarrassing the critics who had written off America's ability to grow. Incidentally, we've argued that it would have grown even more without the harmful and wasteful government "stimulus" plans. We pointed out the similarities between those who confidently wrote off the economy and those who confidently wrote off the World Champion San Francisco Giants, and cautioned investors to beware of the conventional wisdom they hear on the financial television shows, even if it is coming from the mouths of impressive-looking economists with PhD's. In fact, we think that the Giants victory might well be one of the most important things for investors to remember from 2010, and recommend that our readers (even those who aren't Giants fans) revisit this post on the subject!

And on that happy note, we'd like to wish all our readers a very Happy New Year and a prosperous 2011!

Google and Groupon

P Morgan Brown has a noteworthy article discussing Groupon's decision to spurn Google's $6 billion buyout offer and raise more cash themselves to expand.*

Beyond the specifics of the Groupon story itself, the article provides plenty of food for thought on important subjects such as acquisitions, the importance of management teams, different management styles, paradigm shifts and the interchange between the "engineer viewpoint" and the "salesforce perspective."

We believe these are important topics for investors to consider, and would recommend readers also look at few of our past posts on related subjects, including "The koi pond analogy of investing" and "Capable, dynamic management operating in a fertile field for future growth."

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Google (GOOG).

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Seasons Greetings and Warm Wishes

Seasons Greetings and Warm Holiday Wishes from all of us here at Taylor Frigon Capital Management!

The photo above shows this year's wreath-laying ceremony at the General Grant sequoia in the Sequoia and King's Canyon National Park.

Zombie economics

The New York Times recently published an op-ed by columnist Paul Krugman entitled "When Zombies Win," in which the author laments that the extension of lower tax rates are a puzzling example of the triumph of "free-market fundamentalists" (as an aside, we prefer the term "free enterprise") whom, he declares, "have been wrong about everything."

He goes on to say that such ideas (like the idea that lower tax-rates encourage growth) are "zombie economics" which he defines as "doctrines the crisis should have killed but didn't."

As evidence, he offers this startling sentence: "How, after the experiences of the Clinton and Bush administrations -- the first raised taxes and presided over spectacular job growth; the second cut taxes and presided over anemic growth even before the crisis -- did we end up with bipartisan agreement on even more tax cuts?"

While Mr. Krugman's own biases are so obvious to anyone who is familiar with his writing that such statements will probably come as no surprise, we believe it is worth pointing out that in this sentence he is completely and utterly wrong on his economic history.

It's true that the (also somewhat biased) Nobel prize committee awarded Paul Krugman a Nobel prize in economics, but he seems to have missed the fact that it was only after Bill Clinton and the first GOP-controlled Congress in forty years enacted spending restraint in 1996 enroute to a capital gains tax rate cut in 1997 that economic growth took off in the latter half of the 1990s! See the chart below, showing quarterly GDP growth as a percentage, and note the presence of GDP growth above 6% (in chained 2005 US dollars). Note that the roaring GDP growth rates began after the 1996-1997 changes (first red arrow on the left side of the X-axis).

















And, while we have several issues with some of the economic moves of the Bush administration, it is also true that US GDP went from around $11 trillion to over $13 trillion (in chained 2005 dollars) under the lower tax rates that George W. Bush enacted in his first term (see GDP chart in this previous post). Note also in the chart above that GDP growth of 6.9% was seen in Bush's term in 3Q2003, in conjunction with the enactment of his tax rate cuts (second red arrow on the right side of the X-axis). Growth rates of 3.0%, 3.5%, and 4.1% in 2004 and 2005, and of 5.4% in the first quarter of 2006 (which can also be seen in the chart above), can hardly be described as "anemic."

If we wanted to, we could also go back and look at growth after the JFK tax cuts (which he proposed in 1962 and which were enacted in 1964, after his death), when GDP grew at quarterly rates of 10.2% (1Q1965), then another 5.5% (2Q1965), then another 8.4% (3Q1965), then another 10.0% (4Q1965) and another 10.2% on top of all of that (1Q1966)!

Is Mr. Krugman ignorant of these simple facts of economic history, or is he trying so hard to prove that "free markets" are a failure that he can't let such trivial details get in the way of his larger argument?

We propose that it is Mr. Krugman's view of freedom as a failure that is the dead idea that should have been laid to rest long ago. Perhaps the issue was not settled yet in 1968, when the seminal zombie movie Night of the Living Dead was released, and the United States and the Soviet Union were involved in a space race to prove which economic system -- one based on free enterprise or one based on central government control -- was more viable, but four decades later it is inexcusable for an economist of Krugman's stature to pretend otherwise. We all know how the race to the moon turned out, as we wrote on the anniversary of Apollo 11 last year.

The question "Do lower tax rates and other economic policies that enhance the freedom of individuals to start businesses and employ their talents as they themselves see fit promote growth or not?" has been decisively settled by history as well -- we invite readers to view previous posts on that subject such as "Why can't we all just get along (on economic policy)?", "Growth is the answer: the primacy of human creativity," and "'Reducing taxes is the best way open to us to increase revenues."

Even better, we would recommend readers listen to another Nobel laureate economist, and one who had a much better grasp of history: Milton Friedman. For starters, we have linked to some of Milt Friedman's discussions on these important subjects in previous posts such as "A failure of government, not of private enterprise," and "The healthcare black hole."

Another excellent resource is the extensive interview of the late Professor Friedman from 1999 which was recently published on Youtube here.

It is amazing that the events of the twentieth century did not settle this issue once and for all, but as long as publications such as the New York Times continue to give a platform for the dissemination of arguments against free enterprise, the intellectual fight against zombie economics must continue.

Andy Kessler: "Spectrum Scarcity? Hardly."

Andy Kessler has an excellent article on his website entitled "Spectrum Scarcity? Hardly." We've referenced his writings previously, such as in this post. In this article, as well as in a subsequent interview on Tech Crunch, he is discussing the concept of "net neutrality" -- or, more precisely, the role of government in regulating commercial practices on the internet.

We recommend listening to Mr. Kessler's views in conjunction with our previous posts on the subject, including this one.

We also recommend Bret Swanson's commentary on the recent developments at the FCC regarding this issue, which he published in RealClearMarkets here. Along with George Gilder, Bret Swanson is the author of "Unleashing the 'Exaflood,'" an important article we have referenced before and which we discussed here.

It is clear to Mr. Kessler (and to us) that the bandwidth paradigm shift currently underway is the most important economic development impacting businesses and future innovation today and for the coming decade. We also agree wholeheartedly with his arguments that government must not stifle competition and innovation in this critical field (and with his argument that incumbents typically lobby hard for legislators to preserve the status quo at the expense of potential newcomers).

However, we are also encouraged that recent developments, while not perfect, appear to reduce the chances for some of the most onerous initiatives proposed by those in favor of increased government regulation. We'll take that as a mild positive, while continuing to agree with Mr. Kessler that more competition for the delivery of bandwidth would be even better.

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Noteworthy article: "iPhone added $2 billion to trade deficit with China"

We've called our readers' attention before to Carpe Diem, the excellent blog by Dr. Mark J. Perry, professor of economics and finance at the School of Management in the Flint campus of the University of Michigan (see for instance here and here).

Professor Perry recently posted a noteworthy analysis entitled "iPhone added $2 billion to trade deficit w/China." In it, he demonstrates that the entire retail sales price of an Apple iPhone is considered a Chinese export to the US for the calculation of the trade statistics cited by the government and by economists, even though only 1% of that retail price goes to the cost of the assembly in China (the rest goes to various chipmakers and other component suppliers, including the company that designs, engineers, and markets the phone -- Apple).*

The information presented in Professor Perry's post is a powerful argument against protectionism (for more on the problems with protectionism, see here and here).

It also should be a powerful wake-up call to those who have fallen for the alarmist rhetoric that the US is in danger of losing its economic sovereignty to China, or is in danger of having China suddenly refuse to buy any more US Treasurys.

We would advise all investors to read Professor Perry's complete post, and to remember it the next time they hear a politician or an economist bewailing the "trade deficit."

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL).

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Lawlessness in California

Classical scholar, university professor, and author Victor Davis Hanson has a new article entitled "Two Californias" chronicalling some of his on-the-ground observations from the great Central Valley of California, one of the most productive agricultural regions in the world. He reports some dismaying developments, but ones which are not surprising to those who have grown up in the state and spent a lot of time in the Valley over the years.

His observations during his travels by bicycle in and around the small agricultural towns north and south of Frenso carry a common theme of growing lawlessness stemming from the state's total abdication of its responsibility to enforce existing laws, including but not limited to immigration laws.

As a matter of economic principle, we are 100% in favor of immigration and believe that every human being should be seen as a potential contributor to the overall value of society. This position is in contrast to those who hold a zero-sum (or "demand side") view of the world, which sees others as potential threats who are competing for shares of a "fixed pie" of wealth.

People who hold such a view typically believe that foreigners, or people of other races, or women in the workforce, or people working in other countries, or even robots and machines employed on assembly lines are taking away jobs at the expense of others. On the contrary, we believe that more productivity (whether from robots and machines or from the participation in the economy of groups and regions that did not contribute previously) is good for everybody, and makes the "pie" bigger.

This is exactly what has happened in the history of California, as immigrant groups from all over the world have contributed to create one of the most vibrant economies in America (or anywhere else).

What is most disturbing about the article from Professor Hanson is the element of lawlessness that is introduced as a result of government abdication of its most basic responsibility to enforce the laws written by the representatives of the citizens. Without the rule of law, innovation and economic growth cannot take place. Individuals cannot contribute to the economy because private property is not respected or protected and in the resulting unpredictable (and dangerous) environment, it does not make sense to build and add to a business.

As we wrote towards the end of our post entitled "The Consumer" in October of 2009:

"Unlike the desire to consume, the desire to produce can be completely squashed by foolish policy. For instance, if you lived in a country where the police did not stop looters from breaking into your store and taking all your goods, you would soon learn not to build a fixed store with inventories of goods and services. This is why in most countries without the rule of law, small-scale stands in open-air markets and bazaars are the norm, rather than larger permanent shops which can take advantage of economies of scale. Generally speaking, in those countries, scarcity is the norm, and sufficient quantities of goods and services to meet the basic needs of all those who desire them are not produced."

This is the environment that California's failure of leadership is creating in some parts of the state, and matches that described by Professor Hanson in his personal travels through the Central Valley. The problem is related to California's incredible increase in entitlement spending (which really accelerated exponentially during the 1990s) to levels similar to some of the worst offenders in Europe, which we discussed in posts such as "Greece and California" and which Chapman University Fellow Joel Kotkin described with great insight in "The Golden State's War on Itself" earlier this year.

These are extremely important economic principles of which every citizen should be aware, but which many do not understand or choose to ignore. For those of us who live in the great state of California and who yearn to see it continue its long history of innovation and growth, we can only hope that this plight will be recognized and corrected.

Please share this information with your friends and family.

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Noteworthy article: "How the bond market vigilantes work"

Here is an excellent article from economist Scott Grannis entitled "How the bond market vigilantes work." We recommend all investors interested in understanding the current situation with the bond market and QE2 read it carefully.

We have been concerned about the inevitable snap upward in bond yields (and corresponding drop in bond prices) for some time, and have sounded cautionary notes about the recent flood of investment dollars into bonds, in posts such as this one and this one.

The chart above shows that there has been quite a bull market in bonds for the past year (yield line trending downward) but that may have ended quite decisively in the past couple of weeks.

Scott Grannis explains exactly what is going on, and why yields will likely continue to trend higher in the months ahead.

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Noteworthy article: "Netflix everywhere"

Here is a noteworthy article from Wired magazine entitled "Netflix Everywhere: Sorry Cable, You're History," written by Daniel Roth.*

We recommend it for several reasons. First, it is an excellent illustration of a "paradigm shift." We have discussed the importance of this concept in numerous places, such as here and here.

Second, it relates to the "Unstoppable Wave" paradigm that we believe all investors should understand. Recent posts on this topic can be found here and here.

Further, it illustrates the point we made back in February 2008 in this post, in which we pointed out a New York Times article whose author declared: "downloadable movies require high-speed Internet connections - and only about half of American households have them. That number won't change much for years."

We used that article back then as an example of failing to appreciate how rapidly things can change -- in other words, failing to appreciate the power of a paradigm shift, even one that was well under way in 2008. This is a very important lesson for investors.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Netflix (NFLX).

Noteworthy article: "The Democracy Recession"

Here is a noteworthy article from today's Wall Street Journal opinion page, entitled "The Democracy Recession."*

We believe that investors should read it in conjunction with our previous posts, "The Four Pillars" and "Does a rising tide really lift all boats?"

We would also point out the distinction between "democracy" and true economic freedom, discussed in this post from July of this year.

These trends are important for investors to keep an eye on.

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* Readers who are not subscribers to the Wall Street Journal can read that article by going to this search result page and clicking the top search result, which goes to that story.

Noteworthy article: "The puzzling assault on for-profit colleges"

Here's a noteworthy article discussing entitled "The Puzzling Assault on For-profit Colleges,"* and it is one with which we agree. The article discusses the latest government ideas for increasing regulation of the for-profit higher education industry.

We believe that investors should read it in conjunction with our previous posts, "Intellectual affluence" and "Bubble alert!"

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* Readers who are not subscribers to the Wall Street Journal can read that article by going to this search result page and clicking the top search result, which goes to that story.

Have you heard of this company? EZCH

We've spent some time discussing what we believe is the biggest transformation affecting both the business landscape and our day-to-day lives: the enormous increase in the amount of data that can be sent rapidly and inexpensively from place to place. We would advise readers to go back and visit our recent post "Another wake-up call" and look at the graph depicted in the image on that post, and watch the video linked in that post discussing that graph, if they have not already done so.

We would also recommend going back to a post to which we often refer, "The Unstoppable Wave," in which we link to a 1996 article by George Gilder. In that article, George explains his very compelling definition of a "paradigm shift," and foresees the paradigm shift taking place right now, saying: "To grasp the new era, you must imagine that bandwidth will be free and watts scarce."

The rapid increase in bandwidth (the amount of data per second that can be sent through the network) and the rapid decrease in the cost of bandwidth that George describes and that we have been living through in recent years has led to transformative changes in our lives and in many industries, and these changes will only accelerate.

Video is now easy to upload and download for free. People can watch premiere sporting events online, some free and some for a small fee, typically less expensively than through cable TV or satellite. Some readers may remember the days when sending or downloading a file of a few megabytes would tie up their data connection on their computer for hours!

EZchip Semiconductor is an innovative fabless semiconductor company which designs processors used in the equipment that moves the increasing volumes of data flowing across the networks. These network processors are built into switches, routers, and other networking equipment designed by companies such as Juniper Networks, Alcatel-Lucent, Ciena and others.** See the EZchip diagram above, which shows where in the network such equipment resides.

EZchip's network processors incorporate functions that previously required several different chips (such as processing engines, classification engines, and traffic managers). By incorporating the functions that formerly required several chips into one chip, network equipment designers can save both space and energy use in their products, which are extremely important considerations. Equally critical is the fact that EZchip's processors provide higher bandwidth throughput capacity than chips offered by other merchants or chips designed by the network equipment companies themselves.

EZchip is headquartered in Israel, where a tremendous amount of innovation is taking place right now, and many of the executives and engineers at the company are graduates of the prestigious Technion Israel Institute of Technology.

Amazing as it may seem, many in the investment world are unaware of the importance of the paradigm shift described above, and of the specific value-add that EZchip network processors bring to the companies which make the equipment that must handle the rapidly swelling tide of data being sent over the web. We believe that some on Wall Street are just now beginning to notice this company and taking positions in the stock.

We believe that EZchip meets the definition of a Taylor Frigon growth company that we've described in numerous previous posts (see some of the criteria discussed in this post, and some of the examples provided in previous posts such as this one or this one). We would advise investors to analyze EZchip for themselves, and to understand how it and companies like it fit into the larger paradigm underway.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by EZchip Semiconductor (EZCH).

** At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Juniper Networks (JNPR), Alcatel-Lucent (ALU), or Ciena (CIEN).

The "wealthiest" tax rates matter to everyone

The debate over extending the current tax rates is raging, and we believe that the most important economic consideration is being left out of the argument by both sides in this debate.

Currently, the argument is being framed something like this: one side proposes the extension of the current lower rates for "the middle class," but letting the lower rates expire "for the wealthiest Americans" (this group considers those earning over $250,000 in income per year wealthy), while the other side is arguing that the lower rates should be extended for everyone.

Those who believe lower rates should be extended for everyone generally put forward the argument that many small businesses could see their taxes raised, and that "we can't raise taxes on small business in a fragile economy". This simply ignores the fact that while the economy is not growing as fast as one would hope, the economy is expanding and has been since roughly June 2009.

There are several problems with this argument. First, it assumes that raising tax rates is fine, as long as we are not in a fragile economy or a downturn! We would argue that low tax rates are critical for growth and innovation at all times (see here and here for previous posts on that subject).

The bigger problem is the inability to explain why raising marginal tax rates on the highest income levels hurts everyone. Even if small businesses were somehow excluded from the increase in rates for those earning more than $250,000 per year, the impact of the tax hike on upper income brackets would be crippling to growth and innovation. This is true because, as Art Laffer points out in an article we've linked to previously, "one should expect a greater supply-side response with a change in the highest tax rate than with any other rate."

In other words, if the rates were raised for all dollars earned above $250,000 and someone earned $250,001 in a particular year, the higher rates would only be applied to that extra one dollar (the lower rates would be applied on all the dollars earned up to $250,000). On the face of it, this fact makes it seem like an increase in the rate charged on that final one dollar is not such a big deal -- but on the contrary, it proves the point Art Laffer is making above. If the government is going to take a bigger percentage of that final one dollar, but not as large a percentage of the previous two hundred fifty thousand dollars, then people are less likely to work harder for that last dollar.

The choice to try to make more or not is intensified at the highest bracket. When the marginal tax rate on the highest bracket goes up, people who are in the position of making that one extra dollar dramatically scale back their decisions to do so -- it is perfectly logical cause-and-effect.

While this might not seem like such a big deal when those people are described as "millionaires and billionaires" popping thousand-dollar bottles of champagne every night with their dinner, it is a fact that innovative businesses that create new jobs are overwhelmingly financed by those who are making this very decision on whether to pursue those marginal extra dollars or not.

As we wrote in this post almost three years ago:

"If you are a venture capitalist and you know that if you risk $2 million in a start-up business which may pay back $12 million in a few years, but which may also go to zero if that start-up fails (as many start-ups do), you might be willing to risk that $2 million if you get to keep 85% of the gain (even though there is a risk that there will be a total loss). But if the government tells you that they will tax the gain at 50% (instead of 15%) you may calculate that it is no longer worth risking the total loss of $2 million for the possibility of making only $4 million (after taxes) instead of $8.5 million. In that case, you may not fund the entrepreneur at all, and a business will not form that (under a less onerous tax rate) might have blossomed and added great value (and many jobs) to the world.

"Changes in tax rates cause immediate changes in the decisions of those who are allocating large amounts of capital for the formation of new businesses and the expansion of existing businesses. In fact, even the prospect of taxes rising within two or three years will have a big impact on the allocation of capital right now -- in the example above, that venture capitalist may very well have to wait at least two years before any tangible results come from his investment, so he is making his calculation based on his assessment of the future tax rates that will hit his potential capital gains. The prospect of higher tax rates in the future will have a big impact on the very important allocations of large amounts of capital today. These large allocations of capital, the productionist or supply-sider argues, are the engines which actually drive the economy."

If those who finance innovative businesses decide not to pursue that "extra dollar" (or extra few million dollars), then new drugs and cures will not be funded (take a look at the recent movie Extraordinary Measures for insights into how new medical advances are financed), advances in consumer technology will not be what they could have been, and in general the economy and quality of people's lives will be retarded.

This is the argument that is being overlooked by both sides. One side is saying that "millionaires and billionaires" don't need a tax rate cut at all, while the other side is arguing that the rate cuts should be extended to everyone, because of small business or the fragility of the economy. While small business is important, it is not the main reason that marginal rates in the highest bracket are critical to everyone.

Sadly, very few people in the US understand this argument, as evidenced by this recent Gallup poll, which shows that, while 40% want the tax rate cuts extended to all, the percentage zooms to 83% when the tax rate hikes are withheld from "the wealthiest Americans," with some of the additional 43% setting that "wealthy" limit at $250,000 and some setting the bar higher, such as for those earning over a million dollars.

It's not really their fault -- nobody on either side ever cares to explain this to the American people. Nobody ever takes the time to explain how critical financing is to things that make a real difference in people's lives, and how critical the highest marginal tax rate is to those big-dollar financing decisions. Please pass this post on to your friends and family as a way to shed some light on this critical subject.

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