Taking stock of 2008

Well, 2008 is finally coming to a close, and there were definitely some fireworks this year, although not the kind that most businesses were happy to see.

One year ago, we noted several financial commentators who were predicting a recession in 2008, and why we felt their assumptions were incorrect. We agreed with the obvious assessment of the state of the housing market, but did not believe it would spill over into the broader economy, and ended with the conclusion that "The prospects for a happy 2008 are not as bleak as the news is making them out to be!"

While we were wrong about that, it has always been our assertion that investors should not attempt to time cycles and that we do not base our portfolio management process on an ability to make short-term calls about the direction of the economy, interest rates, or market movements. We have repeated that assertion many times on this blog, including in first sentence of our second post ever, and more recently in posts such as "Stock Market Guessing."

Furthermore, we believe there is ample evidence that the problems in the housing market and financial companies that unwisely overindulged in housing-related financial products would not have spilled over into the broader economy if it had not been for a stubborn adherence by regulators to two very damaging "good ideas": mark-to-market accounting and the removal of the uptick rule for short-sellers in July 2007.

We wrote of the dangers of over-reliance on mark-to-market accounting as early as Friday, March 14, prior to the stunning disappearance of Bear Stearns over the weekend. There were others who had been sounding the alarms on mark-to-market before that, and yet the nation's leaders have continued to ignore the problem. Had this accounting problem been corrected back then, and had the time-tested uptick rule been reinstated, it is very possible that the spectacular implosion of Wall Street in September and October could have been avoided.

We maintain that it was the violent downdraft of all asset values this past fall that finally shocked the rest of the business world to such a degree that they basically came to a stand-still; we called it a case of "jaw-dropping, screen-staring amazement." In the aftermath, corporate budgets were hastily rewritten, and plans for business activity were drastically cut back.

It is important to have the correct perspective on the events of 2008, because -- as we predicted back on October 6 -- many will want to interpret them as a failure of the entire idea of free market enterprise.

In fact, today there is an article in the Wall Street Journal from the consistently anti-business Frank Thomas entitled "The 'Market' isn't so Wise After All" in which the author happily concludes that the carnage of 2008 should show everyone except for the most dogmatic ideologues that the idea of "the market and its fantastic self-regulating powers" is a dangerous illusion.

But while that article is full of snide jabs, it has little substance. Pointing to the recent meltdown and saying "I told you free markets don't work" should not convince anyone. While painful, the recent events do not prove that free-market capitalism is a system that fails. In fact, the past hundred years have decisively proven the opposite.

Elsewhere in 2008, our business-focused perspective enabled us to warn readers about the significant bubbles in oil and commodities before they deflated with a collapse that was bigger than the collapse in stock prices.

For instance, on March 31 we wrote a post entitled "What about commodities???" in which we warned against the chorus of voices which had been advocating commodities since they began their most recent upward journey in February 2007. Since that post was published, the commodities index has dropped about 47% in nine months.

On June 4, we published a post entitled "A hard look at the current price of oil and gasoline," in which we noted that crude oil futures were at $135 and rising, and that many pundits were talking as though oil prices had become "the one investment that will 'always go up and never go down.'"

We warned that "the real culprit in the current price of oil has been excessive Fed easing" and advised investors that "trying to 'play' the run-up in oil, which is caused by political and monetary factors that have little to do with the long-term fundamentals of business and which can reverse rapidly, is a shaky foundation for building long-term wealth and one we would strongly caution against."

Since then, the price of oil futures has dropped more than 70% in less than seven months.

It must be repeated that we did not make these timely observations because we have some kind of extraordinary ability to tell you what direction markets will move next. That goes against everything we believe in. On the contrary, we were able to sound a note of caution about those former "flavors of the month" because we believe in building the foundation of wealth on the long-term performance of well-run businesses operating in fertile fields of growth, rather than on an ability to "play" the current hot ticket.

As we have said many times before, most of the big fortunes in this country were made by men who retained shares of exceptional businesses through market cycles -- even through market cycles that were as dramatic as those we experienced in 2008. Bill Gates, for instance, didn't become one of the world's wealthiest men by selling his position in Microsoft every time he thought the market was going to have a bad year, and then buying it all back again.*

At the end of 2008, our most important piece of advice to investors is exactly the same as it was at the beginning of 2008: entrust your long-term financial well-being to the ownership of well-run businesses that are positioned in front of substantial opportunities for future growth.

We look forward to discussing some of those opportunities with you in 2009. Happy New Year!

* The principals of Taylor Frigon Capital Management do not own securities issued by Microsoft (MSFT).

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Lessons from the Madoff Scandal, part two

The discussion of the Ponzi scheme perpetrated by Bernard Madoff is likely to continue for a long time, and it raises several issues that are worth discussing, including many important issues concerning regulation and the SEC.

However, there are at least two issues that the Madoff scandal exposes that are absolutely vital for all investors to understand, whether you are investing millions (or even billions) of dollars, or whether you are investing sums less than those lost by Madoff.

1. The intermediary trap.

It has been noted that most of those who lost money with Bernard Madoff did not invest directly with him, but did so through an intermediary. Some of those that he robbed of their savings were his personal friends, including people he had known for decades, but even more were robbed because they gave their money to "middlemen" who charged a fee themselves, and then farmed the management out to other managers -- in this case, to Bernard Madoff.

Over the weekend, the Wall Street Journal published the story "Madoff Feeders under Focus," (follow the link and then click the title of the story at the Digg website) which shows that some of these "middlemen" charged significant fees, even though they were not actually managing the money themselves but were only funneling the money to other managers. One apparently charged a "1 and 20," meaning 1% per year and 20% of any upside, while another charged an exorbitant 4.5% per year. These fees were for the middlemen; Madoff himself apparently made money by brokerage commissions on the trades he made (as well as by siphoning money from clients, which will now apparently result in a cost of 100% to most or all of them).

This arrangement, of paying a middleman who does not actually manage the money but rather farms it out to someone else, is actually a very common arrangement in the financial services industry -- in fact, it is the arrangement that the entire industry is built on. We have explained extensively why we believe it is a bad arrangement in previous posts, including "The Intermediary Trap" back in February of 2008. The diagram above, from that post, shows the "middlemen" in circle "B" -- they are often called "financial advisors" or "wealth managers."

To be sure, most middlemen do not farm the money out to managers who turn out to be fraudulent criminals. The reason this setup usually leads to substandard returns -- and extensive data over many years supports this assertion -- is not that the manager (or the middleman) are in any way nefarious, but rather that the manager's long-term returns ("point C") end up being better than what the original investor ("point A") experiences, because along the way the middleman ("point B") decides to do "something better" and short-circuits the manager.

However, the reason that the middleman tends to short-circuit the process is that the middleman is very focused on one-year performance numbers. When he sits down with his clients, he is very aware of "how manager X did in 2008, how manager Y did in 2008," and so on. This short-term focus (short-term compared to the business prospects of a well-run growing company, which can take a few years or more to realize its full business potential) is what leads investors -- and their advisors -- astray, according to studies on the matter.

This focus on the one-year performance numbers is a common trait of middlemen, and it certainly was a factor in the Bernard Madoff scandal, in which middlemen and their investors were clearly attracted by what they thought were consistently good one-year performance numbers.

The fact that the middlemen in the Madoff scandal did not believe he was actually stealing investors' money is fairly clear from the fact that many of them invested their own funds in his program as well. This is related to the discussion of "eating one's own cooking" which we have examined previously.

In this context, however, it highlights the extent to which these middlemen were unable to actually understand the investment management they were putting their clients into, which is another problem with the intermediary trap even when fraud is not involved.

The entire premise of the intermediary structure is that the intermediary doesn't get "bogged down" in the demanding job of actually making calls on individual securities in the portfolio -- let the manager do that. This supposedly frees up the middleman to be better at "wealth management" and the evaluation of managers.

We have always questioned that premise, and wondered why anyone would want to have someone giving them advice about investment management who is not actually in the trenches themselves and does not know how to be. We discussed this issue over a year ago in a post entitled "Don't hire a journalist to coach your team." The Madoff scandal demonstrates very clearly that even the most apparently successful and sophisticated middlemen in the world are still just middlemen. Better to have your investment manager be the one who actually understands the strategy on which your life savings depends.

This lack of transparency brings us to the second critical lesson that the Madoff scandal illustrates:

2. The zero-sum connection.

Madoff's apparently world-class returns were billed as the product of a sophisticated trading strategy, one that could exploit market inefficiencies. The Wall Street Journal story cited above contains an investor presentation claiming that the strategy involved something called an "approximate notional put hedge," among other things (just how "notional" it would turn out to be no doubt came as a surprise to everybody).

Several news articles since the scandal surfaced, such as this one, note that many sources report that "if current clients asked Madoff too many questions about how he invested, he kicked them out."

"Secret" trading strategies that must remain secret in order to work should raise a red flag.

Many in the general public have been led to believe that investing is all about finding out some secret information before everyone else and then profiting from it. However, that is only one type of investment strategy, and one that is antithetical to the investment philosophy practiced at Taylor Frigon Capital Management.

It is true that arbitrage strategies and many of the strategies followed by hedge funds are based on secret (or, more commonly, "proprietary") methods of exploiting inefficiencies, such an approach is necessarily a zero-sum game. One side of the trade benefits at the expense of the other side in such a strategy.

On the contrary, we advocate a strategy that is based upon the ownership of well-run businesses that are positioned in front of major growth opportunities. Such a strategy is not dependent upon keeping a secret or moving at lightning speeds -- instead, it is dependent upon having the discipline to do the homework to identify those companies, and then having the discipline to stay with them through the various cycles that come along on their way to realizing their business potential.

This is almost the exact opposite of secret or proprietary trading strategies -- an investor in such a strategy may even find himself in the position of telling others how good a company's prospects are, but people will not want to listen because the cycles are against that company at that particular time. In other words, he doesn't need to keep it a secret the way someone running a zero-sum strategy does.

That's because the classic growth strategy is a positive-sum game -- it is based upon the principle that enterprising companies can and do actually add new value that was not there before. Such a strategy aims to allow investors to participate in such new value creation, and thus it is the opposite of the zero-sum approach which many mistakenly believe is the heart of what it means to be an investor.

We have discussed the difference between zero-sum trading strategies and the classic growth investment philosophy in the past as well, such as in this post from June of 2008.

The Bernard Madoff scandal is a despicable episode and one that has apparently resulted in the robbery of billions of dollars of wealth from hundreds of families, foundations, and institutions. Investors should carefully consider the two important issues that it exposes in a dramatic object lesson.

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Seasons Greetings -- including to Mr. Grinch

Here for your holiday listening pleasure is the delightful 1966 song "Mr. Grinch," sung by Thurl Ravenscroft (also the original voice of Tony the Tiger until his death in 2005). Due to its creative metaphors, the song never seems to get old (who can resist "You're a three-decker sauerkraut-and-toadstool sandwich, with arsenic sauce"?).

Lest anyone object that such fare is too light for the season, it should be pointed out that Dr. Seuss's 1957 classic, How the Grinch Stole Christmas, is a sort of modern Christmas Carol, in which the main character experiences a radical change in heart.

Furthermore, with the 3rd quarter GDP down 0.5%, and with the fourth quarter likely to be down 6% or more due to the "grinding halt in the economy that took place in September through November" that we described in the previous post, the grinning Grinch seems an appropriate image this year.

On the financial news stations and in the wider media, pundits are regularly raising the specter of "deflation," while others warn of Argentina-like "hyperinflation" (see the link to the video in the previous post referenced above). It seems that the Grinch is going to be busy this year!

However, as economist Brian Wesbury explains in the "Wesbury 101" video below, entitled "No Deflation, No Hyperinflation," the monetary supply situation may not currently be either deflationary or hyperinflationary:

We believe Mr. Wesbury provides significant evidence to cry "humbug" at the current deflationary chatter in the media. Perhaps there will be an opportunity for a Grinch-like change of heart for some of the pessimists in the future.

In any event, we wish all our readers a very joyous holiday and seasons greetings from all of us at Taylor Frigon Capital Management.

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The best perspective comes from a business focus

Many pundits are arguing over how far in to the economic crisis we are and what is the correct direction for investors to take. Many are predicting far worse catastrophes yet to come, while others believe a bottom has been put in and things are beginning to turn.

If there is a central point to all the posts we make on the Taylor Frigon Advisor, it is that investors must remain focused on the foundation of investing, which is businesses.

We continually try to draw people's attention back to the fact that investing is about providing capital to businesses, whether you are investing in common stock or whether you are searching for yield through ownership of bonds, preferreds, or other income securities.

The reason that a large percentage of investors lose sight of this fact is that it is quite the opposite of what Wall Street has been selling them, which is that there is some kind of magic to investing, and that there is a caste of those on the inside who can "read the tea leaves" and on whom you must rely to tell you what is going to happen next.

We categorize this approach as snake oil, and we have written about it recently in "Beware of the witch doctors of modern finance" and in "Stock market guessing."

Investors who have been taken in by this concept, as well as those who haven't, should look to the foundation concept of "investing in businesses" as they try to determine what they should do at this juncture.

We argue that it is critical to place your financial foundation firmly upon the ownership of shares in well-run, growing businesses. If you own income-producing securities, such as bonds or preferreds, you should be equally critical in your analysis of the business fundamentals of the issuer -- its cash flow, its balance sheet, its leadership, and its future business prospects.

If the market price of the securities of a good business go down during hard times, it is important to remember that wealth is not made by bailing on your business in hard times. Those who have built a successful small business can attest to the truth of that fact. It is probably safe to say that there is not a successful small business owner who has not faced hard times and resisted the temptation to give up.

However, it is also true that many of those successful business owners did something more than just hold on through the hard times: often they succeeded because they positioned themselves during the bad times to be successful on the other side, and to take advantage of the opportunities presented by the exit of some of their competition or other new circumstances.

Likewise, investors should now be positioning their investments during the bad times to be ready when there is a turnaround.

Although this current crisis is a dire set of circumstances, it is by no means unprecedented. In fact, it is no more dire than situations the economy has faced in the past. We have had equally dire threats in the past and survived them.

Some pessimists are claiming that America is economically on its way to becoming a "banana republic," heading for economic disaster because it has thrown away its industrial base and is just a "phony service-sector economy."

Many are listening to such rubbish because those who are pushing such views "predicted" the financial panic of the past months. This is just another example of the "snake oil" discussed earlier, and those who feel tempted to follow this or that new witch doctor should go back and revisit the two articles linked above.

In fact, America's industrial base produces significantly more manufacturing output than at any time in previous history. Look at the chart of manufacturing industrial production above, which shows that even with the downturn of the past few months, current manufacturing output is far above that of ten years ago and dwarfs the output of previous decades.

Over the next few months, economic data will continue to come out that will look bleak, reflecting the grinding halt in the economy that took place in September through November. But economic data is backwards-looking.

We would urge investors to force their focus onto business fundamentals, to not bail on those businesses that are actually well-run companies positioned in front of promising opportunities for growth, and to make necessary changes wherever they have allocated capital without a good look at the businesses underneath. By doing so, they can avoid the siren call of the snake oil salesmen at the same time.

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Lessons from Madoff and his Ponzi scheme

With last week's announcement of the largest Ponzi scheme of all time it is important for investors to understand that for a Ponzi scheme to work, the operator has to take the money from one investor and give it out to another.

In order to do that, the first investor must lose visibility of his money. In other words, he must be unable to see what is actually happening in his account, either because he does not get regular account statements every month, or because he gets false account statements every month.

In the case of the Madoff fraud, the investors were receiving false account statements every month. For this to happen, the custodian of the assets (where the accounts are held) must be part of the scheme. In the Madoff fraud, Madoff's own broker/dealer firm was acting as the custodian for his clients.

The Wall Street Journal today published an article explaining ways investors can avoid falling into such a situation. Most important of the recommendations is the sentence "If your adviser manages your investments, but the funds are actually held at, say, Charles Schwab or Fidelity, it's almost impossible for him or her to run a Ponzi scheme." That is because it is extremely unlikely that a separate custodian firm, especially a large and well-known firm, would enter into an agreement to commit fraud, or that such a firm would be able to hide such a fraud.

Ultimately, we believe that it is wise for clients to get their investment advice from a source that is separate from the custodian who holds their assets and trades their accounts.

In fact, the larger general lesson that investors may draw from this scandal is that the advisory business, including asset management, should be separate from the brokerage/custodial business -- and the investment banking business as well. We have made a similar point in the past, such as in this post.

Investors whose assets are currently held with a large reputable custodian who is separate from their investment advisor are much less vulnerable to the kind of fraud perpetrated by Bernie Madoff.

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Beware of the witch doctors of modern finance

In 1974, towards the end of the biggest and most sustained bear market since the Great Depression up to that point (see this chart for historical perspective), something very significant happened in the world of portfolio management.

Theories that had been developing for two decades in academia were widely adopted by many investment management professionals who had previously ignored them or dismissed them as a bunch of "baloney." Specifically, academic work by economists such as Harry Markowitz, William Sharpe and Eugene Fama tried to quantify the concept of risk and mathematically incorporate it into the construction of portfolios.

That same year, investment manager Peter L. Bernstein founded The Journal of Portfolio Management to explore, discuss, and disseminate these new ideas. Bernstein later said, "The market disaster of 1974 convinced me that there had to be a better way to manage investment portfolios. Even if I could have convinced myself to turn my back on the theoretical structure that the academics were erecting, there was too much of it coming from major universities for me to accept the view of my colleagues that it was 'a lot of baloney'" (quoted in Hagstrom, The Warren Buffett Portfolio, page 28).

In the very first issue of that new periodical, Nobel laureate Paul A. Samuelson wrote an article entitled "Challenge to Judgment" which opened with a depiction of this new tectonic shift in money management:

"Once upon a time, there was one world of investment -- the world of practical operators in the stock and bond markets. Now there are two worlds -- the same old practical world, and the new world of the academics with their mathematical stochastic processes."

Between that 1974 bear market and the current bear market, the second of the two worlds identified by Samuelson grew at an exponential pace, while money managers of the old school became harder and harder to find.

We have made it as clear as we possibly can, in several places on this blog going back to our very first post, that we believe in the classic, pre-1974 approach to money management, which we characterize as being based on both practical experience and a disciplined fundamental analysis of the companies that issue market securities like stocks and bonds. Our portfolio management process is directly descended from that used by Richard Taylor and Thomas Rowe Price when they managed money together in the 1960s, before the great shift of 1974.

We have also made clear our view that there are serious drawbacks to what Samuelson calls "the new world of the academics with their mathematical stochastic processes" (in particular, we outlined several in this previous post). We would disagree with Peter L. Bernstein that what was coming out of major universities couldn't be "a lot of baloney." To the contrary we think it was!

We also believe that 2008 may well be a year that causes reconsideration of the investment world's rush to embrace "academic mathematical stochastic processes," or at least it should. If you are a client of the mainstream financial services industry, you are probably very familiar with the current products of this post-1974 approach: quant strategies, "black box" strategies, "130/30 funds," "negatively correlated assets" that turned out not to be negatively correlated at all, "portable alpha," asset beta, risk-free assets, and the litany could go on and on.

We say that the current year should cause the investment world to ask if some of the products of that "new world" might actually be "a lot of baloney" after all, but at least one famous market observer thinks that is probably too much to hope for.

Nassim Nicholas Taleb's bestselling 2007 book The Black Swan: The Impact of the Highly Improbable introduced a graphic new term to describe what he calls "large-impact events with small but statistically incomputable probabilities." A black swan is an event that blows up the models because it is unanticipated. Before the discovery of a black swan in Australia in the 1600s, nobody in Europe would have been able to tell you the probability that a black swan existed, because in Europe they do not, and in fact the assertion that "all swans are white" was used as a truism in texts teaching logic.

In a notable interview from earlier this year, Professor Taleb answered a question about why Wall Street does not seem to learn from past catastrophes, saying:

"Let me blame business schools and the financial economics establishment - they have a vested interest in promoting models and devaluing common sense. I worked on Wall Street for close to two decades in trading and risk management of derivatives. I noticed that while portfolio models got worse and worse in tracking reality, their use kept increasing as if nothing was happening. Why? Because in the past 15 years business schools accelerated their teaching of portfolio theory as a replacement for our experiences. It looks like science, and they have been brainwashing more than 100,000 students a year."

He also added, "The problem may also be the Nobel in economics that gave a stamp to these junky theories. Someone needs to make the Nobel committee account for this, for the damage to society - and I hope to do so."

We heartily agree. It has been our observation that the current monolithic financial services industry is built upon a false pretence of having access to some secret knowledge about what is going to happen next with interest rates, or the price of oil, or the performance of one market sector versus another sector.

As we wrote in "Stock Market Guessing," "it is a rare member of the advisory profession who will admit that it is impossible for them to know any more than you do about what is going to happen next." The financial services industry in general, and their sister industry the financial media, have become a kind of class of witch doctors, claiming access to knowledge of the next moves of the market that the ordinary individual cannot possess. In the case of quantitative strategies, the computer models or "black boxes" become the witch doctors, able to predict something that mere mortals cannot.

Our message continues to be that there is no magic to this, and that investors would do well to stop relying on the witch doctors of the financial world. We advocate that investors apply common sense and rigorous analysis to finding "well-run companies in front of fertile fields of growth," as we have explained several times before (such as in this post).

We believe investors should look for fertile fields of growth in areas where paradigms are changing, as we have also explained previously. No mathematical model or algorithm can tell you what previously unknown company is going to innovate next. It is quite possible for ordinary investors to identify good investments, given the time and the inclination to do so, and the discipline to persevere through gut-wrenching twists and turns.

The current bear market enables investors to realize the power that a crisis can have in changing the direction of an entire industry, and better appreciate how the 1973-1974 bear market gave an opening to what Paul Samuelson (who supported the new theories) called "the new world of the academics with their mathematical stochastic processes." In this bear market much of that academic mumbo-jumbo has turned out to be quite harmful (several hedge funds based on quantitative models blew up, and supposedly non-correlated assets such as international funds and commodities trackers caused investors to have bigger losses in their portfolios instead of smaller losses).

But there is an alternative, that most of the financial services industry turned its back on in 1974, that we believe is just as valid today as it was when the world rushed into the "new world of the academics."

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Understanding the uptick rule can help you see the big picture on the current economy

Yesterday, Charles Schwab, the founder and CEO of financial services firm and broker/dealer Charles Schwab & Company*, published an opinion in the Wall Street Journal entitled "Restore the uptick rule, restore confidence."

In it, he argues that it is time to restore the uptick rule, which prevents selling stock short until after the price of a trade moved up relative to the previous trade (called an "uptick").

Mr. Schwab notes that the SEC removed the uptick rule, which had been in place since 1938, after a brief study in July of 2007, a study which only examined stock market movements between 2005 and the first part of 2007, a period of exceptionally low volatility. He argues convincingly that the removal of the uptick rule removed an obstacle to bear raids and market manipulation characterized by short-sellers "betting heavily on lower prices and triggering panicked investors to sell even more."

We have long argued that the SEC could have prevented the disastrous chain reaction on Wall Street , which led to a credit panic and which has now impacted the entire economy, by the simple regulatory steps of removing the mark-to-market rule and restoring the uptick rule. In fact, the day before Mr. Schwab's article was published, we said it again in this post (see here).

Like Mr. Schwab stressed in his article, we do not have any problem with the institution of short selling in general. Taking a bearish position on stocks is an important check on stock prices and a self-correcting force within the markets, and helps the markets perform their function as one of the world's most efficient processors of information (economics texts often call them a giant "price discovery mechanism"). Even though at Taylor Frigon Capital Management we discourage short-term speculation and encourage investment in businesses with a long view of their business prospects, we published a post back in August entitled "Give the traders a break" in which we made that very point.

The larger point in the context of the continuing financial unrest is that we believe there is ample evidence that the great panic of 2008 was a self-inflicted wound, rather than a collapse of capitalism caused by a system-wide failure by Americans to save enough, or their desire to just spend money they didn't have and never do anything virtuous or productive.

Certainly there were imprudent decisions made in some sectors of the economy, but the inexplicable failure of regulatory bodies to remove or suspend the disastrous effects of mark-to-market accounting and to reinstate the time-tested uptick rule has allowed a problem in one small subsection of the overall mortgage market to metastasize into a world-wide problem.

With the proper perspective on the cause of the current economic difficulty, however, investors are better able to make decisions for the future and to better assess the exaggerated predictions of those who believe we are witnessing the end of our economic system as we know it.

* The principals of Taylor Frigon Capital Management do not own securities issued by Charles Schwab and Co. (SCHW) .

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Thoughts on the NBER's identification of a current recession

The National Bureau of Economic Research declared last week that the US has been in a recession since December 2007.

Real GDP is the broadest measure of economic activity, but the GDP is not measured on a monthly basis, and the NBER has clearly based their dating of a recession on employment numbers. The graph above from the Bureau of Labor Statistics clearly shows unemployment rising beginning in December of last year.

The NBER looks at employment levels, industrial production indicators, manufacturing trade sales, and personal incomes. Out of these four, employment levels are the broadest monthly indicator (the least restricted to a specific sector of the economy or the population) and the NBER gives them the most consideration in its determinations. For example, in the official NBER release last week declaring the beginning of a recession, the third paragraph states that "The committee believes that domestic production and employment are the primary conceptual measures of economic activity" and the following paragraph tells us "This series reached a peak in December 2007 and has declined every month since then."

However, the GDP data for the first and second quarters of 2008 showed expansion, including a 2.8% expansion in the second quarter. The NBER release cited above notes this GDP growth during 2008 (without citing the actual strong numeric growth rates) but then concludes that because the GDP went down in the fourth quarter of 2007 before going up the first two quarters of 2008 and then down again in the third, "the currently available estimates of quarterly aggregate real domestic production do not speak clearly about the date of a peak in activity."

Our own view of the matter is that the implosion of the financial sector in September of this year caused a nationwide panic that included a near shut-down of activity from the end of September through November, and that it was this extraordinary freezing of business activity that led to the temporary contraction of GDP. Since then, consumer spending in the first part of the holiday shopping season have suggested that the extraordinary panic of those months may be unlocking.

We do not believe that this recession follows the pattern of previous recessions, in which companies have been over-optimistic, built up their inventories, hired too many people, and then were caught flat-footed when the economy suddenly slowed. This pattern did take place in the housing sector, and to a degree in the parts of the financial sector linked to housing, but not in the rest of the economy.

As we have written before, the final spectacular collapse that ultimately created the shock that brought down the rest of the economy was preventable and could have been avoided by the removal of two regulatory and accounting mistakes -- the mark-to-market accounting requirements of FASB 157, and the ability to short stock on a down-tick (which reversed a rule that had been in place since Joseph P. Kennedy implemented it as the head of the SEC in 1938).

Finally, the most important point we would make during this current cycle is the same point we have made repeatedly on The Taylor Frigon Advisor: the importance of owning well-run, growing businesses through multiple economic cycles. Historically, solid businesses end up surviving.

The flip side of this most important conviction is the conviction that those people who tell you they are able to predict the next cycle are selling a very dangerous delusion. There are figures appearing on the financial media and the internet right now receiving all kinds of credit and accolades for "predicting" this all along. The implication is that you should follow the advice of those who are able to call bear markets or recessions before they happen, and benefit from their special ability to predict cycles.

Nothing could be more dangerous. This kind of thinking is a perfect example of the "persistent delusion" that Professor Henry Dunn spoke of in 1939. In that address in 1939, Professor Dunn noted that such "systems may at times have appeared to work fairly well for periods just long enough to mislead the unwary."

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"Stock Market Guessing"

Today, the American Institute for Economic Research published a Research Report entitled "A Persistent Delusion," which contained selected quotations from an earlier bulletin that the AIER had published in 1962.

The AIER was founded during the depths of the Great Depression in 1933 by Colonel E. C. Harwood (1900 - 1980), a graduate of the West Point Class of 1920 (pictured above).

In September 1962 he published an address given by Professor Henry W. Dunn of the Harvard Business School, with a preface declaring that "The principles emphasized in Professor Dunn's address are as important to an investor's education and to the public welfare today as they were when it was delivered." The entire 1962 address, along with Colonel Harwood's preface, can be found on the internet in the AIER archive for 1960 - 1970, under the title "A Persistent Delusion."

Speaking just ten years after the Stock Market Crash of 1929, Professor Dunn wanted to combat "what I have chosen to call the persistent delusion: that coming moves of the stock market can be successfully guessed, bringing greater rewards to those relying on that procedure than are obtainable through the adoption of any other policy."

He called this delusion an "intoxication," and indicted as a culprit the financial services industry which "finds the source of its intoxication and the chief support of its activities in never ceasing efforts to predict, by one means or another, the direction and timing of the next intermediate movement." Astonishing as it may seem, this intoxication is every bit as widespread today as it was seventy years ago -- perhaps even more widespread, as it is now reinforced by the twenty-four hour financial news cycle on television and the computer, whereas in 1939 it had to make do with printed financial publications that could only be published generally once a day.

A brief examination of any of the major financial media channels will reveal a parade of guests being asked about their opinion of the next move in oil, or in the dollar, or in the financial sector, or in the central bank's interest rates, and the best stocks or other investment instruments to buy in order to profit from the predicted move.

Professor Dunn categorized all such behavior under the excellent phrase "stock market guessing." He noted that believers in stock market guessing did not necessarily believe that it could be done "with 100 per cent of accuracy, but enough of the time, and with a high enough percentage of accuracy, to make buying and selling stocks on such judgments the most profitable way to employ money."

We would agree completely with Professor Dunn's observations, and with E. C. Harwood's 1962 remarks that the passage of decades has done nothing to diminish the importance of combatting this "persistent delusion." In fact, just as Professor Dunn observed, we have said that the financial industry has fostered this very delusion, and that "financial advisors" like to wrap themselves in a cloak of superior knowledge about upcoming cycles, and that it is a rare member of the advisory profession who will admit that it is impossible for them to know any more than you do about what is going to happen next.

Indeed, we have previously noted Wall Street Journal articles pointing out that many such advisors, based on their "market guessing," recommended clients overweight commodities and international stocks in 2007 and early 2008, with disastrous results. This is just one recent manifestation of what Professor Dunn was describing in 1939. We have previously described these issues in a series of posts about the "intermediary trap" problem, here, and in discussions of "sector rotation" such as this one.

It may come as a shock to some, to hear professional money managers admit that no one can predict the next market cycle. What does someone in the money management business do, if not some form of stock market guessing?

The answer is: fundamental research on good companies and other appropriate investment vehicles. Rather than focusing on the unpredictable moves of market cycles, we believe in focusing on the business elements of the companies that issue stocks and bonds (and preferred stocks, and commercial paper). These business elements can be analyzed in order to discover well-run businesses operating in fertile fields of growth, as well as to predict when a company no longer fits into that category.

We firmly believe that this approach is far more reliable than "stock market guessing." Professor Dunn ended his address with a call to "all members of that profession" to "make clear their own position with no hesitation or compromise" -- in other words, to declare that stock market guessing is a delusion -- "and second, to consider all possible means by which they may effectively aid in spreading more widely what I have attempted to define as the true investment gospel." It is in this second capacity that we have published this post, and the rest of the content of the Taylor Frigon Advisor, and ask your help in passing it along to others who would find it beneficial.

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Happy Thanksgiving to All

This year, Thanksgiving comes during a time of economic fear and uncertainty.

Market drops have been as brutal as any in the past hundred years, and dire economic commentary can be heard on the news around the clock.

Bearish commentators are having their day, taking credit for predicting the current crisis. Now many are using their media platform to predict further doom and the end of America's economic prominence.

Peter Schiff, for example, says that "the growing imbalances in the U.S. economy, its twin budget and current account deficits, its lack of domestic savings, and the erosion of its industrial base, have now reached a point where a severe recession, culminating in a substantial decline in the over-all American standard of living, is imminent." Jim Rogers in an interview yesterday said "I hope you're worried . . . the demise of the UK as it went from being a great power to a declining power -- I'm afraid it's happening here."

The bears are having their day now, but Americans should not let themselves be talked into believing that our system is ready to collapse. The American economy remains the greatest example of the incredible blessings of freedom and free-market capitalism in the world. In spite of the imperfections and encroachments on freedom present in the system, America remains among the freest economies in the world in terms of protection of private property and the right of the individual to participate in the economy in whatever legal manner he decides to do so for his own economic improvement.

At Thanksgiving, it is appropriate to take a step back and see the big picture and the incredible advances that this economic freedom has enabled.

At the turn of the last century (just over a hundred years ago), for example, the life expectancy for male infants was just 32.5 years for non-whites. For white males it was a few years longer: 38 years. Those who survived to the age of ten had a longer life expectancy -- to an age of between 42 and 48 years old.

The free market has enabled tremendous advances in medicine that explain much of the incredible increase in life expectancy from those amazing early 1900s statistics. But medical advances are not the whole story -- free-market capitalism has enabled incredible advances in food production and distribution, in the distribution of electricity to homes and businesses, and the ability of homes to have indoor plumbing, to the point that having water delivered right to a tap in the kitchen instead of being pumped by hand from a well is now taken for granted by almost everyone in society. The widespread availability of air conditioning and central heating have also played a role in lengthening lifespans, as have a century of technological advances that have made greater productivity possible with less physical danger than in centuries past.

Free markets mean that you are not restricted from entering the market to sell your goods or services based on your race, or your religion, or your sex, or your country of origin. Those who seek to restrict economic activity on those grounds (as well as on the fear that you may take away their business by offering a better product or better value than what they are offering) are acting against free markets. There are generally far fewer of such barriers to participation in markets today than there were in 1900, and this fact is also part of the story of the incredible increase in opportunity and prosperity that we have seen in this country and that we can be thankful for.

That it is still very possible in this country to start with an idea and turn it into a business that does a billion dollars in annual sales (or more) is evidenced by the entrepreneurs who come to Silicon Valley from all over the country, and all over the world, to try to do it -- and by those who have and continue to successfully do so, not just in Silicon Valley but in other parts of the country as well.

The advances of the past hundred years -- from the introduction of the Ford Model T to the introduction of the Apple iPhone, and countless other ideas before and since that have added value to our lives -- were made possible by a system that is very much still in place.*

The current economic chaos has given an opening to those who say that the American system is ready to fade into history, and that standards of living are doomed to suffer a horrendous collapse. We can be thankful that these reports are, as Mark Twain would say, "greatly exaggerated."

Happy Thanksgiving to you, from Taylor Frigon Capital Management.

* The principals of Taylor Frigon Capital Management do not own securities issued by Ford (F) or Apple (AAPL).

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Stimulus package, revisited

Today in the Wall Street Journal, Stanford University economist John Taylor explains why the first "stimulus package" didn't work, and why a new and larger one won't either. John Taylor is the author of the so-called "Taylor Rule" for fiscal policy which is cited in virtually any economic textbook you can find.

In an opinion piece called "Why permanent tax cuts are the best stimulus," Professor Taylor includes a revealing graph which shows that the stimulus package of May of this year had little or no effect on personal consumption expenditures.

Back when that "stimulus package" was passed (in February of this year) we wrote a blog post entitled "Where is the leadership?" In that post, we noted that "in the face of market turbulence and howls to 'do something' no leader arose to call for action that would really have an impact beyond shuffling dollars from one taxpayer to another in a shell game."

Yesterday, in an interview on Bloomberg (see below), former FDIC Chairman Bill Isaac repeated his call to end the mark-to-market accounting rules that have played such a role in causing the crisis in the banking system, and which continue to cause havoc:

In the interview, Mr. Isaac says that the simplest thing for the government to do would be to "simply call the Chairman of the SEC over to the White House and say 'knock it off' -- get rid of this mark-to-market accounting. You're costing the financial system hundreds of billions of dollars and the taxpayers are having to replace it."

Again, back in the first half of March, we published a post entitled "It's not worth zero, but if the market says it is . . ." in which we made the same assertion. Mark-to-market accounting is an attempt to price assets more transparently, by using the changing market price for that asset. As Mr. Isaac explains in the interview above, however, it totally ignores any fundamental analysis of the cash flows of the asset and instead uses "the market" as a shortcut for that analysis.

Respected economist Brian Wesbury made the same point in a research report yesterday, a point which he has also been making since early this year. His metaphor at the top of the second page of that two-page report explains why mark-to-market has fanned the flames of a financial industry brush fire, causing it to spread out of control to the rest of the economy.

The economic insights that are necessary to put out this problem are out there and available to Washington leaders, and they have been available since before the problem got out of control. Why they have not taken advantage of these insights is inexplicable and inexcusable.

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Change -- The Investor's Only Certainty

The markets have been going through a protracted and agonizing testing of the lows they reached in October 2008. On an intraday basis the S&P 500 today broke those lows and briefly touched the closing lows of the previous bear market reached on October 9, 2002: S&P 776.

There are few investors alive today who have gone through markets as ugly as the current one. No bear market since World War II has been down as much as this market is now down from the peaks it reached in October 2007. The S&P 500 index is down 48.5% from its peak reached in that month, as of yesterday's close, surpassing even the bear market of 1973-74.

The current crisis meets the definition not only of a bear market but also of a panic, as we noted in this previous post. Selling has reached irrational levels: the market is priced as if there has been no value added since 2002. This is irrational.

However, markets are forward-looking, and they represent the sum of what investors feel about future value. As such, it is reasonable to conclude that many investors right now are acting as though the entire system is going to fail, or at least experience a contraction unlike anything since the Great Depression.

During times like this, our first point is that we do not believe the system is going to fail. In fact, the seeds of recovery have already been sown, as we have pointed out in this post and will discuss further in future posts.

Nevertheless, it is also true that "change is the investor's only certainty." Forty years ago, in June of 1968, Thomas Rowe Price wrote a short pamphlet entitled "The New Era for Investors." The late Dick Taylor, who managed portfolios with Mr. Price and from whom the investment process used at Taylor Frigon Capital Management is descended, kept a copy of that bulletin, which contains insights that are valuable today.

In particular, that pamphlet contained a paragraph which reads:

"Keep in mind that forecasting the future is always a very difficult task. Opinions are bound to be only partly accurate because of the unforeseeable and unpredictable events which change the normal or expected trends which appear logical at the time. This is why hindsight is always much easier than foresight. By way of illustration, it is almost impossible to foresee such events as wars, assassinations, and nature's catastrophes, such as floods, droughts, famines, etc. Also, inventions and changes in personal leadership influence the course of history. A forward-looking investor must be able to reasonably assess and evaluate the currents and the tides and be prepared to reckon with winds or storms, which are unpredictable. He must be constantly alert. He must stick to the basic concepts which have proven sound over a period of centuries, be flexible of mind and be willing to change opinions, change tactics, and not stubbornly stick to old opinions and buck new trends, or try to swim against the tides."

This tension between the dictum "stick to basic concepts which have proven sound" and the requirement to "be flexible of mind" is something we have written about before, for instance in the January post "Remaining calm without being blind or obstinate."

The most important lesson from this voice from forty years ago is that massive change is nothing new or unique to the present time. In fact, in the 1968 bulletin, Mr. Price refers to a 1966 bulletin he wrote entitled "Change -- The Investor's Only Certainty."

The frame of mind described in the paragraph above -- that the investor "must be constantly alert" and "willing to change opinions" -- is clearly valuable today. The upheavals of the 1960s and the 1970s, which Taylor and Price experienced, were not the end of American capitalism -- far from it.

The future will not look exactly like any previous decade; in fact, as the paragraph above reveals, current opinions and predictions will no doubt turn out to be "only partly accurate." But the attitude of holding to proven principles while remaining alert is an important lesson from a professional investor who lived through the 1920s and the 1930s, and who survived and succeeded by following those tenets.

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Some perspective during gut-wrenching markets

The stock market is going through a grim period, with market declines that have rivaled those of any bear market since World War II (see the chart of bear markets in this blog post, and click on the chart to enlarge).

As the markets test the lows that they reached about a month ago, many investors are understandably dismayed. It seems there is little to no good news in sight, and the relentless, grinding market drops will never end.

We like to refer to the historical bear market chart because it is so helpful in providing perspective -- it reminds us that this is what happens in bear markets. How long it will continue is impossible to say, but it is important to understand that the current market swoon is not the first such situation in history, and as we have witnessed in past bear markets this one will also pass.

Larry Kudlow recently published an excellent piece entitled "Mustard Seeds," in which he noted a few pieces of positive data in important areas. It is worth a read, especially by those who are ready to conclude that nothing will ever be positive again, or at least not in their lifetime. As Larry references in his article and we note in the chart above on retail gasoline, there are some positives trends that are developing however minor they may seem at the moment.

Bear markets are gut-wrenching. However, an investing lifetime that spans several decades (as it does for most investors) inevitably encounters bear markets. It is important to keep perspective during such periods and to process all the data that is available, not just the data that is front-and-center in most media outlets.

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Gerry Frigon on Peninsula TV's "The Game"

Taylor Frigon Capital Management's President and Chief Investment Officer Gerry Frigon was recently asked to be a guest on the San Francisco Bay Area's Peninsula TV show "The Game." Here are three segments from that show.

Part two:

Part three:

Video services courtesy of Gallagher Video, Paso Robles, CA.

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Your portfolio recovery plan

In our most recent posts, we have noted that the current bear market has revealed the deep problems in the existing structure of "wealth management" that we have long been aware of and warned about (long before we ever started a blog).

We have noted articles appearing which give evidence of the damage that the "intermediary" system can give rise to, in which well-meaning "financial advisors" or "wealth managers" outsource investments to third-party investment managers. In an attempt to funnel their clients' money into asset categories that were "working" when everything else wasn't, these financial intermediaries steered many investors into commodities and into international investments during 2008, often with catastrophic results.

We have also pointed out that because they do not manage the money themselves, "wealth management" professionals are forced to rely on money managers at large investment management companies which provide mutual funds or separate accounts for those clients. We noted that there are many structural drawbacks to mutual funds, in this post from December called "The further you are from owning individual companies . . ." and this one from May entitled "Some drawbacks of mutual funds." We have also noted that even separate accounts that some advisors use instead of mutual funds can fall prey to some of the same drawbacks as mutual funds, as explained in another post from December entitled "Anatomy of 'style drift'".

Investors who are now realizing the truth of some of these assertions, or who are facing losses from investments that have been hit harder than even the overall market, may be thinking of making changes to their portfolios going forward.

To investors in that sitaution, we would offer the following advice: "Beware of knee-jerk reactions." We would offer the same advice to those who ask us what changes, if any, should be made in the wake of the recent US presidential election.

Even if you are considering a major change to your investment structure (getting away from mutual funds, for example, or international investments), the dramatic price drops will turn around at some point for many investments, providing a major rally. That will be a better time to make necessary changes, rather than at the current depths. (Obviously, individual companies that are likely to go bankrupt would not see a rally, and such advice does not apply in those situations).

In the meantime, investors should be researching and preparing so that they are ready to move when the time is propitious.

This is the way we approach portfolio investment changes as professional portfolio managers, and one we believe is prudent for individual investors as well.

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