Two prominent economists note the role of food inflation in global events

Two economists whom we respect recently pointed out a very important aspect to the current situation in Egypt and the Middle East, namely the role that inflation (particularly inflation in the cost of food) plays in the larger picture.

Rising food prices can be the straw that breaks the camel's back (so to speak), increasing the pressure on the public with every single meal, and creating a catalyst for action against other forms of government oppression.

Economist Larry Kudlow recently wrote a noteworthy post on this subject, entitled "Food riots: is Bernanke partially to blame?"

Economist Brian Wesbury sounds a similar note in his most recent weekly outlook, entitled "Egypt, dollars, and history." He points out that the Fed's easy monetary policy has contributed to a 66% rise in the Goldman Sachs Agricultural Index over the past six months, the most for any six-month period since 1974. He also notes that the disastrous revolution in Iran in 1979, which led to the establishment of the far-more oppressive tyranny that still grips that country, took place during the hyperinflation of the 1970s.

As Larry Kudlow writes, "a region-wide revolt against the autocrats may be healthy if it leads to greater democratization and liberalization," but that outcome is by no means certain or even likely.

It is important to recognize that seemingly-esoteric economic issues, such as the over-steering of monetary policy by the Federal Reserve -- as well as the decision to subsidize and mandate the increased use of food as fuel -- impact people all over the world, with numerous unintended consequences, some of which can be deadly.

Mark Cuban declares Wall Street is for suckers; Maclean's of Canada agrees

Here's a recent article from Maclean's of Canada entitled "'Wall Street is for Suckers'." It lays out a litany of reasons why, in the words of the article's author, "something is very wrong with Wall Street" -- including the allegation that "the stock market has become very disconnected from its primary function of uniting growing businesses with large numbers of long-term investors."

Many of the examples cited in the article are phenomena that we have discussed previously in this blog, including the issue of Facebook's private capital raise, and the tendency towards owning stocks for shorter and shorter periods of time (tying the results more to market moves than to longer-term business success or failure).

It also touches on the fact that a much larger percentage of the public is now participating in the stock market in one way or another, a subject we discussed in "Invest like Mr. Howell."

The article centers around the assertion of entrepreneur and businessman Mark Cuban that "Wall Street is for suckers." We find that quotation somewhat ironic, since Mr. Cuban's wealth is directly a result of his decision to own shares in businesses that he built, and then to sell those shares through the capital markets collectively referred to as "Wall Street."

And, while we agree that all of the changes that the article discusses are important for investors to be aware of, we disagree with the conclusion that things are somehow "broken" now, or that Wall Street was somehow more virtuous in the mythical past.

We point out that Thomas Rowe Price, Jr. wrote in 1973 (in a paper to which we have referred several times in the past) that in the 1930s, after ten years in the investment business, he had an epiphany that led him to forsake the kind of short-term market-based speculating that dominated Wall Street even then, and instead to seek out long-term ownership of successful business enterprises that could grow and prosper "over a long period of years."

We would argue that this is still a valid recipe for success, and that the fact that few investors on Wall Street are following it today creates more of an opportunity for those who do, just as it did in Mr. Price's day.

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Likelihood of Fed over-steering increases

In the past, we've compared the Fed's extreme interest-rate swings to a driver of a car going out of control, and we believe the image is a helpful one.

Like an inexperienced driver going too fast on a road with little traction, the Fed's overzealous turns on the steering wheel can lead to a damaging wipeout, especially when one overcorrection is followed by another even larger overcorrection in the opposite direction.

We have argued that the promising technological innovation of the late 1990s was not an illusion but that the real companies creating progress during that time period were caught up alongside companies that were nothing but hype. When the Fed's easy-money policy leading up to the year 2000 created a bubble, the Fed over-corrected for that easy policy with a rapid round of tightening, culminating in a round of deflation. This unfortunate turn of events wiped out many telecom/technology-related companies that had financed their investment plans using debt.

After the disastrous impact of that tightening became evident, the Fed became overly-easy again, leading to a real estate bubble, which further diverted capital from tech investment and led to the cataclysm of 2008-2009.

Technology has been getting back on track again following that almost ten years on "pause," with potentially huge improvements being applied to virtually every aspect of life and business. We have called this phenomenon the "Unstoppable Wave" and have written about it extensively -- even arguing that it is such a powerful paradigm shift that government ineptitude would have a hard time derailing it.

However, one concern we have is that the Fed could blunder in almost the same way they did ten years ago by keeping their foot on the accelerator for too long. This danger is evident in that they have held the Fed funds rate at zero for over two years now. This could mean they have put themselves in a predicament that would force them to spin the wheel wildly to the tighter side when the wall of rising inflation suddenly looms into view.

We believe the likelihood of another oversteering scenario is depressingly possible, with the Fed and many pundits thinking that inflation is unlikely as long as unemployment remains high (a view we think is suspect, at best, and can be traced to the influence of the Phillips Curve). Unfortunately, to use another automobile metaphor, inflationary pressures often act like an overheating engine radiator: pressures build up under the surface and suddenly blow without warning.

One difference between today and 1999 is the fact that many of the leading companies today (especially tech companies) generally have tons of cash and low or no debt. While the continued possibility of Fed oversteering is unfortunate, and may make growth and progress slower than they otherwise could be, we are not bailing out on the "Unstoppable Wave" thesis. We are simply pointing out the likelihood of future Fed over-tightening to make up for the over-easy policy of the past two years, and recommend investors be cautiously optimistic as they allocate dollars in their portfolio.

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

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

Don't confuse free enterprise with a questionable theory about securities markets

We've written about our insistence on using the term "free enterprise" rather than "free markets" in previous posts, such as this one and this one.

While this may strike readers as a somewhat cranky or esoteric distinction, we believe that in fact it is an incredibly important distinction, but one that people overlook all the time.

The problem arises when people confuse a certain theory about the efficiency of securities markets with the system of free enterprise capitalism (often referred to somewhat confusingly as "free market capitalism" or simply "free markets"). The two are simply not one and the same, and yet proponents of the efficient market theory often act as though they were!

We believe the efficient market theory is hogwash. As we explained in this recent post, a popular way of explaining this theory is that a blindfolded chimp throwing darts at the stock pages is as effective as selecting stocks using dedicated fundamental analysis. Efficient market theory proponents believe blindfolded chimps are just as effective because their theory says that the market is so good at pricing securities, nobody else should bother questioning its pricing decisions. This theory, or some modification of it, forms the foundation of all of so-called "modern portfolio theory," which we believe to be largely hogwash as well.

Proponents of the efficient market hypothesis, however, often use the success of free enterprise as a supporting argument, even though the two concepts are not at all the same. For example, one modern portfolio theory supporter said in a debate that the only people who don't agree that "markets work" are "the North Koreans, the Cubans, and the active managers." By saying that, he is conflating those who disagree with free enterprise capitalism (the rulers of North Korea and Cuba) with those who disagree with the efficient market hypothesis (the active portfolio managers, who don't believe that blindfolded monkeys can do it just as well).

We have rebutted this argument several times, including here, here, and here. Perhaps the best way to clear up the issue, however, is to simply point out that there is a very real distinction between securities markets (which serve a very important function of allocating capital and providing liquidity, but which sometimes get prices very very wrong) and the system of free enterprise (which enables people to innovate and add value to the best of their ability and which has brought about tremendous advances for humanity wherever it is tried).

The only real connection between the efficient market theory and the concept of free market capitalism is in the word "markets," which is why we prefer the term "free enterprise" (another reason is that it puts the emphasis where it belongs, on entrepreneurial innovation). When you look at it that way, it isn't a small distinction at all.

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The growth theory of investment works

At the beginning of the year, we cautioned against becoming too obsessed with annual performance numbers, because what really matters for most investors is performance over periods of time much longer than one year.

That said, we would like to point out that the principles of classic growth investment theory which we discuss on this blog do work. In fact, we would argue that the cold hard record of investment performance is one way of validating the opinions somebody tells you -- in the investment world, if someone is full of hot air, the market often has a way of exposing that in the end.

Above, we show a graph and table of the performance record of the portfolios we manage according to the investment discipline we discuss on this blog. We have presented many arguments in the past against those who take aim at active management, calling it a waste of time (or worse).

Perhaps the best counterargument against those theorists are the track records of active management that has invested capital in above-average companies, and have the results to prove it.

This performance record only shows the period of time since we founded Taylor Frigon Capital Management. We've been at this for twenty-five years now, but regulations do not allow linking this record to the previous record. Nevertheless, we can say with great conviction that we firmly believe in active management, and the investment process that we use and discuss with you the reader.

The ideology of modern finance

For investors looking for a good New Year's Resolution for 2011, may we suggest this one: swear off the ideology of modern finance.

Andrew Redleaf and Richard Vigilante have published their insightful view of the financial crisis of 2008-2009, which they encapsulated in an article last year entitled "It's not the size that counts: the problem isn't that banks are too big. It's that they're too opaque."

What strikes us as important for all investors to consider carefully is the connection that Mr. Redleaf and Mr. Vigilante see between the panic of 2008-2009 and what they call "the ideology of modern finance," which is built upon what they describe as "a dogmatic worship of securities markets" and the belief that "it is dangerous even to try to out-figure the all-seeing market on price or value."

Investors may be most familiar with this modern financial ideology that they are describing through the famous quotation of Burton Malkiel, a Princeton professor and one of the leading proponents of the so-called efficient market theory, who said that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one selected by experts."

In other words, the proponents of this modern ideology hold as their most cherished principle the belief that markets are all-knowing, and that it is useless to try to apply individual analysis to investment securities: an expert who spends all his time analyzing the choices would still do no better than a blindfolded ape.

The notable insight of Mssrs. Redleaf and Vigilante is their connection of this worship of "efficient markets" with the financial crisis. Gripped by this belief, they argue, institutional investors moved decisively away from fundamental analysis and blindly trusted their mathematical models (models based on the tenets of modern portfolio theory), ultimately with disastrous results.

As the authors explain in the article referenced above, "Under the reign of modern portfolio theory, too many Americans, especially institutional investors, have been investing almost blindly for decades." Because of this, Mr. Redleaf and Mr. Vigilante argue, "moving mortgages onto securities markets put investors with none of the expertise or information available to mortgage bankers in charge of pricing. First the mob priced them too high; then it panicked and priced them so low the banks appeared to be broke."

While this topic is crucial to the entire banking system, investors should immediately see that the central thesis has enormous implications for money management as well.

First, they should realize that the financial implosion of 2008-2009 was directly related to the rise in prominence of this new ideology of modern finance that slowly took over the professional investment world beginning in 1974 (we have written about this phenomenon previously, in previous posts such as "Beware of the Witch Doctors of Modern Finance" and "The Judgment Deficit."

Second, investors should realize that -- even though the recent crisis should have dealt a death blow to this dangerous modern ideology of finance -- modern portfolio theory and the negative investment behaviors associated with it still dominate the professional investing landscape.

This presents investors with a choice, and an opportunity.

The situation is very much like the one described in the joke we talked about in July 2009, in which two economists see a $100 bill in the street and conclude it can't possibly be real, or somebody else would have already picked it up! They believe that no great innovation could possibly be left to be made -- if anything were really worthwhile, somebody would already have done it. Investors can choose to listen to the learned professors who argue that nobody can find exceptional companies and not to bother trying, or they can instead reach down and pick up the figurative $100 bill that according to the theory should not even exist!

The real world is full of innovative individuals and companies creating new value where it did not exist before. Take a look at some of the biggest stock gainers of 2010 (or any other year) and you will find plenty of examples.

This fact presents real investors with a tremendous opportunity, to seek out innovative and well-run companies that have an opportunity to grow faster than the average company for the next several years. In this fresh new year, we recommend that investors get back to the due diligence and focus on fundamentals that the "modern ideology" teaches are irrelevant, but which actually matter more than ever.

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Scott Grannis provides some excellent structural analysis of current wall of worry

Retired economist Scott Grannis published a noteworthy post yesterday on his Calafia Beach Pundit blog. We believe all investors should tune in to his blog for all his analysis, but yesterday's post, entitled "Rosenberg's Six Walls of Worry," is especially noteworthy for his clear and insightful discussion of six concerns voiced by economist David Rosenberg.

There's an old saying on Wall Street that the market "climbs a wall of worry" -- in other words, that market gains are actually sustained by concerns and worries (often global political or economic concerns). This saying has some merit, in that these concerns can act to keep money on the sidelines which comes in later on when the feared outcomes do not materialize, driving the market higher and sustaining the upward progress. (Note that we have cautioned investors about ascribing too much value to Wall Street truisms in past blog posts, such as this one and this one).

In the above article, Scott Grannis responds to six "major things that the bulls aren't appreciating" according to Rosenberg, as reported in this Business Insider article by Joe Weisenthal.

What's particularly noteworthy about the Calafia Beach Pundit's analysis of the former Merrill Lynch economist's arguments is the way in which it highlights the distinction between a supply-side approach to economics (from Scott Grannis of Calafia Beach) and a demand-side approach (from David Rosenberg of Gluskin Sheff, formerly of Merrill Lynch).

We believe this is a very important distinction for all investors to understand, and we have written about it in many previous posts, such as this one from two years ago. It can also be described as a distinction between production (the supply-side) and consumption (the demand-side), and an obsessive focus on "The Consumer" is usually a dead giveaway that you are dealing with an adherent of the demand-side / consumption-driven approach to economics. These two schools of thought are so diametrically opposed that economists from the two different camps will typically interpret one event or possibility in entirely opposite ways.

Note, for example, how Scott Grannis deals with David Rosenberg's worry number #3, that a newly-elected GOP Congress might enact spending cuts, which Rosenberg believes would hurt the economy and slow down GDP growth because of the decrease in government stimulus. Mr. Grannis writes, "It is amazing to me that so many economists and commentators automatically accept the proposition that a cutback in federal, state, and local budgets will hurt the economy.
[ . . .] Indeed, there are good reasons to believe the stimulus spending probably hurt the economy, since it a) drained significant resources from the more efficient private sector, b) spent those resources wastefully and inefficiently, and c) created real fears of a surge in future tax burdens, thus discouraging private sector investment."

Similarly, he deals with Rosenberg's worry over rising oil prices by focusing more on the production side of the economy (factories, projects, and investments) than the consumption side of the economy (as Rosenberg does, stating that as gasoline prices rise, we should "expect the consumer to sputter").

We're not saying that investors should not keep their eyes open at all times to the global macro economic and political situation -- on the contrary, we devote a large amount of time each day to such analysis. However, the approach to economics that one brings to such analysis is extremely important, and we believe that the recent post by Scott Grannis (with whose approach we generally agree) highlights the contrast between the two major approaches in a very helpful way for investors.

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"There are some things that are just too important to be left to the free market"?

Yesterday, NPR aired a story about the increasing price of onions in India, up 40% due to heavy rains spoiling recent onion crops.

The story featured quotations from those blaming "middle men" or "market mafias" who manipulate prices even further by holding back supplies until prices rise, and then brought in a professor of economics from Nehru University in Delhi, Jayata Ghosh, who says:

"You know, I think there are some things that are just too important to be left to the free market, and food is one of them, because food is essential. You have to feed your population; you can't say, 'Well, too bad, if you don't have the money you can just starve to death.' So food has to be managed."

Professor Ghosh sounds like a very charming person, but we must take exception to her statement that "there are some things that are just too important to be left to the free market," and point out that by framing the issue in this manner she is committing the error which Friedrich Hayek warned about in his famous text, Road to Serfdom, of assuming that the free choices of individuals does not constitute "managing."

As we pointed out in a previous post in response to a similar quotation made by a public official in this country, both sides in this debate want goods (in this case, food) distributed by the best method possible -- the question is whether distribution is best managed by a central body of governing officials or whether it is best managed by the free choices of individuals who are left to themselves to pursue their own interests.

As Hayek put it: "it is not a dispute on whether we ought to employ foresight and systematic thinking in planning our common affairs. The question is whether for this purpose it is better that the holder of coercive power [i.e. the government] should confine himself in general to creating conditions under which the knowledge and initiative of individuals are given the best scope so that they can plan most successfully; or whether a rational utilization of our resources requires central direction and organization of all our activities according to some consciously constructed 'blueprint'" (41).

Professor Ghosh goes from the assertion that "you can't just say, 'Well, too bad, if you don't have the money you can just starve to death'" (and we would agree with her that free governments cannot say that) to the assertion that therefore "food has to be managed."

Hayek also agreed that, as he says later in Road to Serfdom, "there can be no doubt that some basic measure of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody" (148). But he makes a distinction between "security against severe physical privation" (of which food stamps are an example in the United States) and the idea of having government become responsible for feeding the population, as Professor Ghosh says, or of entering the market to "provide critical foods at reasonable prices in order to dampen the effect of speculation," as the commentator in the NPR story puts it.

If "middlemen" are actually manipulating onion prices in India by withholding onions from the market, this would create a business opportunity for other middlemen to sell their own onions for lower prices. Of course, if the government has not created an environment where those new sellers can be assured that they will not be threatened with violence, beaten, or killed for doing so, then it is really a lack of free markets that is causing the problem, not "free markets" themselves.

In fact, rising food prices and scarcity can often be traced back to governments failing to actually provide the environment for free market activity, or (even worse) directly interfering in the market and causing even more disruption (such as government mandates that Americans burn food in the form of corn ethanol in their automobile engines). Do listeners to NPR really think that food in this country or any other would be better distributed if it were "managed" by the government? The Soviet Union, in spite of its tremendous resources, was unable to adequately feed its citizens in spite of its best efforts at central planning, and even today those countries in the world with economies based on central management depend heavily on food supplies from those that allow "free markets" (as an aside, we make an important distinction between free markets and free enterprise, which we discuss here and here).

We agree with Friedrich Hayek that in free societies, government can and should use tax dollars to provide security against severe physical privation. When Professor Ghosh says that governments can't just let people starve to death if they don't have enough money, we agree with her. But, we would change her statement to read, "there are some things that are just too important to be managed by the government, and food is one of them."

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Facebook and Wall Street

Today, the Wall Street Journal has two noteworthy commentaries on the recent news of the private capital raise by Facebook.

The first, by the opinion page editorial board, is called "Friending Private Capital"* and it asks the question "Why submit to Sarbox if Facebook can raise money without an IPO?" The authors make the case that fewer companies want to go public in the United States of late, due to the exponential increase in regulation enacted by Sarbanes-Oxley and other laws since the dot-com implosion, and that this trend "has consequences for the health and shared prosperity of American capitalism."

The second, by Holman W. Jenkins, Jr., is entitled "The SEC vs. Zuckerberg"* and it argues that Facebook is wisely delaying an IPO until its young CEO is ready for the scrutiny that comes with running a public company.

While some who heard the news about Facebook and Wall Street this week may take a jaded view that they are not interested in Facebook's funding drama, or the investment-banking activities of big Wall Street banks, the Journal's editorial board is correct when they assert that the mechanism that provides access to capital for companies in this country is an incredibly important subject that affects all of us.

Andy Kessler (who is writing a lot of noteworthy articles these days) pointed out the importance of Wall Street as an alternative to government taxation as a source of capital in a recent article also published in the Journal. In his "How videogames are changing the economy" he notes that many technological advances in the 1940s, 1950s, and 1960s were driven by military spending, but no longer.

"So why has the military been displaced?" he asks. "For one, capital formation. Governments had the unique capacity to raise (read: tax) the enormous capital required to fund state-of-the-art projects. But a fully functioning stock market can raise billions for productive commercial applications, bypassing the military connection. Hate Wall Street all you want, but it's now better than wars at driving progress."

This observation is very insightful, and an important one for all Americans to understand. It is also the reason that the recent news about Facebook, and the implications discussed in the two articles above, are important for investors to consider.

* Subscription required to read them online. Due to an agreement with search engine companies, it is possible to read these stories from a search result. For the three articles mentioned, go to the following search pages and click on the top result: here, here, and here.

And now a word about annual performance numbers

It's a new year, and portfolio managers everywhere are reviewing their numbers from calendar year 2010 and looking ahead to 2011, which is off to a roaring start in its first day of trading.

The financial media is busy covering equity managers who beat the market in 2011, and investors and their advisors are dumping managers who did poorly to move their money over to those who did well.

While we ourselves had a third year in a row of solid outperformance from the equities of the companies we own (validating the principles we espouse in this blog of conducting fundamental research on the business prospects and management ability of companies), we would like to point out that the focus on the calendar year is an arbitrary measurement, and one that can easily lead investors astray.

We also believe it is important to point out that (as we have said before in whitepapers such as "What hasty investors could learn from an Ent") investors should have a long perspective, because what really matters to most investors is performance over many years and even decades.

The way that investing works, those investors who outperform over long periods of time will always have shorter periods within which they do not perform as well and actually underperform the broader market.

We believe this is because it sometimes takes several years for a company's business prospects to become realized within the business landscape -- often, a company must build towards a change that is underway but has not actually taken place, akin to Wayne Gretzky's famous line about "skating to where the puck is going to be." Because of this fact of business reality, investors in those companies that are "skating to where the puck is going to be" must often endure periods when the stocks of those companies are out of favor on Wall Street and when the "hot money" is chasing something else, creating intermediate periods when their investments do not do as well.

In fact, extensive research bears out the fact that almost all managers who outperformed their benchmark over ten-year periods endured at least three consecutive years of relative underperformance within that ten-year period!

To illustrate the importance of this concept, we offer the track record (shown above) of the late Bill Ruane, as quoted by Warren Buffett in his famous address at Columbia Business School in 1984 entitled "The Superinvestors of Graham-and-Doddsville."

In the table, the annual performance of his portfolio is shown in the left-hand column of numbers, and the performance of the S&P 500 with dividends reinvested is shown on the right. Years in which his portfolio underperformed the S&P are shown in red. It is clear that his portfolio outperformed the S&P by a staggering amount over the years, but it is also clear that his investors had to stomach some gut-wrenching years of underperformance in order to get there.

This is particularly notable in the first four years of the record cited by Buffett, the years 1970, 1971, 1972, and 1973, when Mr. Ruane first took over the investment partnership. In those years, his performance lagged every single year, in some cases by a wide margin. In fact, in the first three years it lagged the S&P but at least had positive returns; in 1973 the markets experienced a severe bear market but Ruane's portfolio was down even more, by almost ten percentage points worse than the S&P.

How many investors today would have held on through such a period of underperformance? And yet, according to Mr. Buffett, from the time he took over to the most recent quarter available when he gave the speech in 1984, Ruane's investment process returned a cumulative gain of 775.3% versus the market's 270.0% over the same time period. In terms of annual return, Ruane's investors enjoyed a compound annual growth rate of 17.2% versus the market's 10.0%.

Investors inevitably focus on the annual calendar returns, and the media reinforces this obsession, but Ruane's record shows that what really matters is the long run. We like to emphasize this critical investment truth especially during periods like this one, when our annual performance numbers are very good. Investors should understand that, while annual numbers may be less arbitrary than quarterly or daily performance numbers, they are still shorter periods than real investors with long time horizons should be focusing on.

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