Happy New Year!

As 2007 comes to a close, many investors prepare to enter 2008 with some trepidation regarding the outlook on the economy.

Economists are widely quoted in the media predicting recession. Today's online Wall Street Journal features a video clip with the Chief Economist of Nomura Securities saying the economic activity in the first half of 2008 will be "flirting with recession" (although he goes on to predict that the second half will return to growth and that "we'll avoid a recession, although it will be a very close call").

Last week's InfoChoice Weekly Banking Bulletin (emailed weekly to subscribers in the banking industry in Australia and parts of Asia) led with a story entitled "Australia should be concerned about US economy" which cited former Morgan Stanley Chief Economist, now Morgan Stanley's Asia Chairman, Stephen Roach asserting that the US is heading into a recession in 2008 (this is not new: Mr. Roach has been predicting recession for some time).

Earlier that same week, economist and former Clinton Treasury Secretary and former President of Harvard University, Larry Summers, gave a speech entitled "Risks of Recession, Prospects for Policy" in which he stated that, "In my view it is almost certain that we are heading for a period of heavily constrained growth, quite likely that the economy will experience a recession as technically defined and distinctly possible that we are headed into a period of the worst economic performance since the stagflation of the late 1970s and the recessions of the early 1980s." Happy New Year, indeed! Not only does he throw around the R-word, but tosses in the 1970s and stagflation for good measure!

A constant barrage of predictions like these have investors in some doubt about welcoming in 2008, and have many scurrying for cover. Yet these predictions keep coming from the same sources that have been predicting the demise of the economy for seven years. They have been dead wrong!

As we have pointed out previously, we believe the current recession drumbeat is yet another false alarm, one reason being that recessions rarely arise when everyone is concerned about a recession but are much more likely when few expect a recession and businesses spend bullishly and mistakenly build up huge inventories. Or even more likely, recessions occur because of bad policy decisions, both monetary (too easy or too tight money) and/or fiscal (tax increases).

Further, as we have also discussed in earlier posts, many in the media and many economists have a demand-side mentality which attributes more weight to the consumer as the driver of the economy. This view has led to consistent underestimation of the strength of the economy for the past seven years. It also ascribes a greater ability of the housing sector to derail the rest of the economy than it has in reality. Almost all of the predictions of recession heard in the news predicate their recession predictions on spillovers from the housing sector.

However, housing only makes up 4.5% of the overall GDP. Even though that sector has been in serious contraction for several quarters, GDP growth has continued to be positive, indicating that the rest of the economy continues to post expansionary numbers in spite of the drag from housing. In fact, the third quarter GDP number (the most recent we have) came in at 4.9% after its final revision. In spite of the assertion of well known bond manager Bill Gross, who stated that we are already in a recession, some supply-side economists predict the current quarter's GDP growth will be above 2%.

The difference in these two views is that demand-side economists believe that housing woes will spill over to the rest of the economy because the consumer is disproportionately impacted by housing market fluctuations, while supply-side economists include the very real problems in the housing sector in their calculations but believe that the production of goods and services (more than 95% of which are not part of the housing sector) continues to grow.

They also point to the strong productivity numbers posted by the current economy. Earlier this month, Q3 productivity was revised upwards from 4.9% productivity growth to 6.3% productivity growth. As we have stated before, our decades of experience have shown that it is the production side (often called the "supply side") rather than the consumption side (or "demand side") that actually drives the economy, and supply-side economists have consistently been more accurate in their assessments of the economic growth than the more numerous demand-side economists (only about 15% of economists are supply-siders).

While the current and upcoming quarters will likely show slower growth than the exceptional third quarter, we believe that prospects for growth continue and that the current recession predictions are overblown.

The prospects for a happy 2008 are not as bleak as the news is making them out to be!

for later blog posts dealing with this same topic, see also:

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

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

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

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It's time for year-end charitable contributions

It's the time of year for posting any contributions to charities and organizations working towards causes you care about. Typically, those donations must be received by the charity by December 31st in order to count towards your tax year for 2007.

However, as Steven Malanga details in this article in the most recent edition of City Journal, many charitable organizations (including, increasingly, religious ones) are actively involved in bashing the capitalist system which enables the creation of the very wealth that they receive from their contributors.

For example, the article quotes the co-president of Interfaith Worker Justice as saying that America must save itself from "its own arrogance, its selfishness and its greed" and as speaking out against those "wallowing in an obscenity of massive unearned wealth." The Executive Director and Founder of the same organization is quoted as saying that America needs "redistribution" to "shift wealth from a few to working families." That same organization (Interfaith Worker Justice) receives funding and financial support from over 100 religious organizations, including the National Council of Churches of the USA (NCC) and, the article notes, some key members of the NCC including the Episcopal Church, the Evangelical Lutheran Church, and the Presbyterian Church USA (PCUSA) "are particularly active."

The article also cites a quotation from Father Robert Sirico, the President of the Acton Institute, which (according to its website) promotes "integrating Judeo-Christian truths with free market principles." He states that if religious leaders targeted by groups such as Interfaith Worker Justice (in this case, seminarians) don't have an economic background, it's easy for them to fall into the fallacy "that our economy is a zero-sum game that demands conflict between business owners and workers."

We've written about the fallacy of the zero-sum mentality on this blog before, such as in this post and this post. It is sad that those who benefit greatly from the wealth creation enabled by a mostly free economy are often tricked by the rhetoric of those with a zero-sum view of the world.

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Holiday Wishes

This giant sequoia (sequoiadendron giganteum) is the General Grant Tree, in Sequoia and Kings Canyon National Park. Discovered in 1862, it was named the General Grant in 1867.

In 1926, President Calvin Coolidge designated it the Nation's Christmas Tree and each year since park rangers have held a ceremony at the tree on the second Sunday of December.

In 1956, President Dwight Eisenhower designated it a National Shrine and a living memorial to those who have given their lives in wartime in the service of the United States of America.

Seasons Greetings from all of us at Taylor Frigon Capital Management!

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Anatomy of "style drift"

Previously, such as in this post, we have discussed the problem that is common to "mass-managed money" which is the fact that as they grow larger and larger, they are forced to own more and more securities -- and if they invest in equities, they are forced to own shares in larger and larger corporations.

The fact is that most investors in the United States, including ultra-wealthy investors, get their exposure to equities through what we call mass-managed money (money managers who are managing portfolios that exceed $5 billion dollars). In other words, the primary way that these investors connect to the ownership of businesses is through vehicles that are forced, by their sheer size, to own shares in hundreds of businesses, and to own shares in a very specific type of business: LARGE businesses.

This is because mass-managed money is not just a mutual fund phenomenon. Many wealthier investors use managed separate portfolios -- a form of managed money that does not pool the investments of different account-holders into one fund, but keeps them separate. We explain some aspects of separate portfolios in our publication Separate Portfolio Advantages, available here. But although the separate portfolio structure has many advantages over the mutual fund structure, especially for wealthier investors, most of the managers of separate portfolios are huge mutual fund companies who offer separate portfolios that may have more dollars under management than their mutual funds do! Many well-known separate portfolio strategies have upwards of $10 billion under management.

The diagram above is an illustration of what can happen inside a portfolio strategy (whether it is a mutual fund or a separate portfolio strategy) when it grows into the tens of billions of dollars in assets. The diagram shows the famous Fidelity Magellan fund, from mid-1982 through early-2000, and graphs its holdings by the SIZE of the assets. The different colors on the chart represent percentages of the holdings that are in stocks characterized as small-cap value or growth, and large-cap value or growth. This chart can be found on the internet in a Barclays Global Investors research paper entitled "In Pursuit of Performance: the Greatest Return Stories Ever Told" (see page 18 of the document).

Note that in the early years of the fund, before it began to grow to massive proportions, the portfolio was primarily composed of stocks characterized as small-cap growth:


















In this part of the graph, the lightest-colored section (making up more than 50% of the holdings) designates small-cap growth stocks, while the darker blue section above it represents small-cap value stocks, and the gray at the bottom represents large-cap growth stocks. This is the composition of the fund at the left side (earlier years) of the portfolio.

Fifteen years later, however, the right side of the timeline shows a radical change in the composition of the fund:


















Note that by the end of the period under consideration, large-cap stocks (the gray area at the bottom of the diagram) have grown to consume over 80% of the portfolio's stock holdings. Small-cap growth stocks, the lightest of the four colors in the graph at left, used to be the largest portion of the portfolio, but by this slice in time they have been squeezed down to a sliver, and by the end of 1999 they were entirely absent from any meaningful role in the portfolio. By the very end, the lowest color band on the chart (large-cap growth) and the second-lowest band (large-cap value) make up almost the entire portfolio, except for the thin (and shrinking) band at the very top representing the remaining small-cap value stocks. In other words, the record shows a very strong migration of the portfolio from owning stocks in smaller-cap companies to owning almost entirely stocks in large-cap companies. What happened in the intervening years that caused such a transformation in the types of companies that investors held? The fund grew enormously. This X-ray of a "mass-managed" fund emphasizes the points we made in our previous posting (linked at the beginning of this post) about larger funds (or portfolios) being forced into larger stocks. It also reveals the fact that investors may have the same investment vehicle for many years, but that does not mean that they are getting the same portfolio management consistently for all those years: the management team may change their style, or the management team may leave altogether! In short, these diagrams present a picture of "style drift" that is forced upon many investment vehicles as they grow larger and larger. Investors need consistency not just for a couple years but for many decades (the chart covers almost twenty years -- most investors don't think about it, but their need for exposure to equities over their investing lifetime will be usually be even longer than twenty years). Consistency is very difficult to find in today's landscape, which is dominated by mass-managed money and Wall Street salesforces which use mass-managed money as their main investment tool for their clients.

For later posts on this same topic, see also:

• "So when do you fire a manager?" 02/01/2008.
  

• "The same thought process for 30+ years" 03/31/2009.

• "Invest like Mr. Howell" 05/18/2009.

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

• "It's all about the thought process" 07/29/2010.

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

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A portfolio manager's perspective on Fed critiques

As we have explained several times in various posts (such as the first one on this blog), our investment philosophy is based upon the long-term health of successful businesses (choosing good companies), rather than upon the shaky foundation of attempting to time market cycles or predict fluctuations of currencies, commodities, or interest rates -- including those controlled by the Fed.

The current market volatility has been widely blamed on recent decisions by the Fed and disagreement by market participants as to what the Fed should actually have done or not done.

Are they right? What should the Fed do? There are excellent economists whose works we have read for years who are at complete disagreement over the proper course of action. In fact, any position you can name right now will generate heated opposition on this subject.

However, although many in the media are pointing (as they have for several years now) to the specter of the 1970s and "stagflation" (a stagnating economy coupled with rising inflation), it is safe to say that whatever actually develops will not be the same thing that the conventional wisdom expects. In fact, an honest comparison of the fundamental economic scenario of the 1970s and the economy that we have today can lead us to conclude that whatever does develop, the 1970s are not it.

We would also argue that, as we have stated in previous posts such as this one from over a month ago, what is really troubling the markets may not have as much to do with the threat of inflation as it does with the threat of taxation. Although not everyone who participates in the market understands the ins and outs of monetary theory and what does and does not cause inflation, everyone understands that when taxes go up you have less money left. Taxes are pretty clear about what they will do to your returns. They give you an exact number of what they will take, unlike inflation which economists can debate all day long.

That said, we do not dismiss inflation's damaging potential by any means, and in a fiat-money system (currency not tied to an objective store of value), inflation is almost always present to some degree. We believe this is yet another argument for ownership of businesses.

All this is why we believe that the best investment philosophy is one that focuses on selecting sound businesses with management teams who are able to navigate through unpredictable fluctuations, whether those are caused by the banking system or by other factors.


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

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

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

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