The Inflationary Fed

Here is a picture of inflation: two tickets to a lower box seat to see the San Francisco Giants, the first (on the left) from 1985 and the other from 2005.

The price of the lower box seat ticket in 1985 is $8.00.

The price of the lower box seat ticket in 2005 is $31.00.

What changed? Granted, the Giants got a new ballpark, but the seats are not any bigger. What changed was the dollar itself got a lot smaller. It used to take eight dollar bills to cover one lower box seat, in 1985. By 2008, it took thirty-one bills to cover a seat of similar size.

The dollar shrank in size by a tremendous factor. In fact, if you calculate the annual rate of inflation of lower box seats between 1985 and 2008, the inflation rate for lower box seats to see the SF Giants works out to be over 7% annually.

Always remember that when someone talks about "the inflation rate" that rate is different for every specific good and service. The CPI or the PPI are looking at specific goods and services in order to try to measure inflation in a more general sense. Giants tickets have clearly been inflating at a higher rate than the CPI over time; college tuitions have been inflating at an even higher rate.

In general, the fiat money system instituted in this country with the initiation of central banking (and the Federal Reserve) in 1913 has resulted in an inflationary monetary regime. The level of inflation has increased and decreased over time: one of the primary factors in the positive growth of business and innovation from 1981 to 2000 was a more predictable level of inflation than had existed in previous decades.

Currently, inflation numbers have been rising at more alarming rates, in response to Fed measures to prevent a "impending recession" that (as we have written previously) we do not believe was actually impending (and the credit crisis that caused the angst in the first place was directly related to earlier inflationary behavior by the Fed).

So what is the best protection for the purchasing power of your assets given the nearly unbroken decades of history of an inflationary Fed?

While a traditional response has always been to run to gold or other commodities, there is a better (although perhaps less glamorous) answer: invest in businesses.

Well-run businesses that are providing value can deal with adverse situations that arise, whether the problem is a shrinking dollar or some other problem. In the case of higher costs from their suppliers, for example, a business can take one of many courses of action (including passing those costs along to their clients or customers), but if they are a well-run business in front of a fertile field of growth and they can continue to grow their earnings, you have an excellent ability to stay ahead of inflation by owning shares in that business.

In fact, ownership of common stocks has an unsurpassed track record of outpacing inflation -- there has been no other asset class when comparing any thirty-year period since 1872, or any twenty-year period since 1929 which comes close to the performance record of common stocks, and that includes gold and other commodities (see statistics discussed here; for a more recent comparison against real estate you can see statistics posted here).

For later blog posts dealing with the same subject, see also:
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Build your house of bricks

cartoon copyright 2004 by Patrick Hardin. used by permission.

We've written before about "deworsification" and included a scholarly graph in a previous post.

Here is an all-time classic cartoon which drives the point home perhaps more effectively than any graph you will find in a business-school text.

The wolf is advising the pigs against "putting it all into bricks." As we said in the earlier post on the subject:

"Diversification is an important concept in investment management. However, the marketing machine of Wall Street has taken an important investment concept and used it, in some cases, to convince people that they need to own more different products, and thereby more holdings, than they actually need."

In this cartoon, the wolf may well have an ulterior motive for recommending "sticks and straw as a hedge."

In real life, an advisor may not have an ulterior motive at all, but may be doing what he thinks is best, without even realizing that sticks and straw and all the other "hedges" created by the financial industry are not as good as simply sticking with the bricks.

Because advisors generally don't even pick stocks anymore, finding an ever-wider variety of instruments for clients is almost the typical advisor's automatic instinct (which we wrote about in several places, such as this post).

We reiterate the lesson that Rowe Price first observed in the early 1930s, and which he emphasized again four decades later in 1973: "most of the big fortunes of the country were made by men retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years."

Financial market assets do not need to be as complicated as the financial industry makes them out to be. Reasonable diversification from solid stocks and solid bonds should form the majority of the foundation. When the big bad wolf is huffing and puffing, we'd still rather own good old-fashioned bricks.

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

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Must-read: Unleashing the Exaflood by Bret Swanson and George Gilder

Today's article, "Unleashing the 'Exaflood'" by Bret Swanson and George Gilder in the Wall Street Journal Opinion page is a must-read.

Here is another article this week in the New York Times by someone who does not see what is coming, entitled "Web Movies Show Why DVDs Sell."

George Gilder has seen it coming since at least 1990, when he wrote Life After Television.

If you are trying to invest in businesses in front of fertile fields of growth, you need to be able to analyze what the business landscape will look like over the next four to six years.

The Swanson and Gilder article embodies that ability. They cite several graphic examples of the exponential growth and changes to internet data traffic over the past few years.

The New York Times article embodies the opposite of that ability. It takes conditions today and projects them into the future in a static fashion. For example, the author says, "downloadable movies require high-speed Internet connections - and only about half of American households have them. That number won't change much for years."

If you believe that the way most Americans have built big fortunes over the past few decades, or the past hundred years, is to own shares in well-run businesses in front of fertile fields of growth for a long period of years (see this previous post, among others), then you should understand the differences in these two mindsets, and you should read Swanson and Gilder's article very carefully.

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

There is a new Taylor Frigon commentary available which ties together arguments we have made previously about the detrimental effects of the rise of a class of financial intermediaries between the investor and the money manager.

In the diagram above, the investor (A) can be an institutional investor or an individual investor. He typically focuses on the performance record of the money manager (C), which can take the form of a mutual fund, a separately managed account, a closed-end fund, or many other vehicles.

Very few people realize that the performance experienced by the investor (A) can be very different from the manager (C) due to the timing and behavior of the investor in putting funds into C and taking them back out of C. Measuring the performance of A is much more difficult than measuring C, but studies such as the Dalbar Quantitative Analysis of Investor Behavior (QAIB) have done so for years and shown that the performance of A has been terrible.

Lost in this analysis has been the fact that the intermediary (B) may well be contributing to the problems of the investor (A). These intermediaries are often called "financial advisors" or "financial planners" in the individual sector and "investment management consultants" in the institutional sector. They are not money managers (C), and their track records are generally not easy to examine, as are the records of the managers.

Click here to read "The Intermediary Trap."

To read our previous blog posts on the subject, click here(1) and here(2) and here(3) and here(4).

For later blog posts dealing with the same topic, see also:

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Washington's Birthday (Feb 22, 1732)

Today the markets are closed for the federal holiday marking Washington's Birthday. Since the elimination of a holiday on his actual birthdate in 1971 following congressional action in 1968 to move certain mid-week federal holidays to Mondays, the holiday (now on the third Monday in February) never falls later than February 21st .

Although Congress has never officially changed the name of the holiday from Washington's Birthday to President's Day, many calendars, schools, advertisements and media outlets now refer to it as such, causing many to believe that an official name-change has taken place. Moreover, some states have changed the title of their state holiday to President's Day, including California (states can create whatever holidays they want, and are not required to follow the federal model).

Presidential scholar Gleaves Whitney laments in this piece in today's National Review Online that the disappearance of Washington's Birthday has left Americans less educated about the qualities of the first president, and the selflessness for which he was well known. Particularly noteworthy was Washington's willingness to hand over the reigns of power after accomplishing his mission. For this he was widely known as the American Cincinnatus (Cincinnatus was a Roman farmer appointed supreme commander during the early republic, and returned to his farm sixteen days later after defeating the enemy).

Had Washington not possessed his admirable restraint and a belief in a limited government, the new nation might have wound up like the many states around the globe today headed by military dictators, and there would have been no markets to have been closed today in honor of his birthday.

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Where is the leadership?

Well, we have a new "stimulus package," signed into law today by President Bush, who called it "a booster shot for our economy."

Washington leaders in the White House and in Congress have decided that they needed to do something, and the sooner the better, so they rushed legislation through that would give at least $300 and up to $600 to people who file returns in 2007 (even if that person doesn't make enough to actually pay any taxes), as well as $300 for dependent children.

The government payments (which of course find their ultimate original source in taxes collected from taxpayers) will phase out for filers beginning at an annual income of $75,000 for those filing single or head of household. By the time he reaches an annual income of $87,000 a filer who is single or head of household and has no children will get no government payment.

In other words, the stimulus package is basically a transfer of money from those who pay the vast majority of the federal taxes to those who make less.

Instead of this charade, which adds nothing to the GDP (simply shuffles dollars from one taxpayer to another), real leadership would have taken the opportunity to stand up and argue for making the current tax rate reductions permanent and to lower the corporate income tax rates as well, which would have had an immediate and lasting impact on the growth of the GDP, as we have argued here and here.

The uselessness of the measures in the so-called stimulus plan are demonstrated in this article published today by Art Laffer in the Wall Street Journal. In fact, he argues that they will be worse than useless, by virtue of the fact that they take from one group and give to another, thus more than making up for any positive effects in the damage that they inflict.

These facts and people who can explain them are available to our elected government politicians.

But, in the absence of leadership from our elected representatives, the tax rate uncertainty continues to drag on and on. We have stressed several times that this continued uncertainty remains a major factor in the unstable condition of the financial markets (see here and here).

The market will rapidly and painfully price in the effect of the tax rates lapsing when it becomes clear that they will not be renewed at their current levels. Or, the market (and the economy) will quickly respond positively if the tax rate cuts are made permanent, or improved by the lowering of corporate tax rates as well. But 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.

Leadership is not a popularity contest. In this situation, the elected politicians on both sides of the aisle chose to throw a sop to the masses instead of tackling a less popular but infinitely more effective course of action.
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A paradigm shift in the way you get information

Here is a link to a story in today's Wall Street Journal by Esther Dyson entitled "The Coming Ad Revolution" which discusses major changes in advertising that have been on their way for years but which few people today even see coming.

The article outlines an impending paradigm shift in the way people find information, which will have a tremendous impact on the advertising business and those that support it.

But this revolution in the way that people find information will impact more than just the ad industry. We wrote about some of the potential implications in the world of search two months ago in a post entitled "What is the future of search?" And there are thousands of other ways in which the kinds of changes that Dyson is discussing in this article will impact business and life beyond business.

George Gilder predicted these very same revolutionary forces in his 2000 book Telecosm: How Infinite Bandwidth Will Revolutionize our World. In chapter 18, "The Lifespan Limit," he wrote:

"The supreme time waster, though, is television. Many people still have trouble understanding how egregious a time consumer, how obsolete a business model, how atavistic a technology, and how debauched a cultural force it is. [. . .] For as much as seven hours a day, on average, consuming perhaps two thirds of your disposable time, year after year, all in order to grab your eyeballs for a few minutes of artfully crafted advertising images that you don't want to see, of products that you will never buy.
[. . .] In the future, no one will be able to tease or trick you into watching an ad. Your time is too precious and you are too powerful. Advertisements will truly add value rather than subtract it" (247 - 252).

The value of your trusted circle of friends, family, colleagues, and various networks to which you belong or with which you associate may become much easier to tap into to help you with decisions than ever before, diminishing the power of old-fashioned advertising as Gilder foresaw years ago and as Dyson describes in today's article.

You may well make purchasing decisions based on these existing networks, as well as based on new networks which arise to provide you with access to what products other consumers like you find valuable.

Based on this outlook, the tremendous valuations for companies like Google, whose revenues are based upon a very primitive version of tying advertisements to what you are looking for, may be something of a house of cards. If the paradigm is truly shifting in the ways that are foreseen by Dyson and Gilder, there are new opportunities few see now, and the companies most dominant today may become examples for future discussions of the topple rate (which we discussed in this previous post).

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

For later posts on this same topic, see also:
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"I think we're actually talking ourselves into this slowdown . . . "

Yesterday's quarterly earnings call from Cisco Systems (CSCO) featured some insightful comments from CEO John Chambers. Most telling, perhaps, was his answer to the final question of the call, from a Bear Stearns analyst, which is contained in the clip above (total run time for that question and the answer is 2 minutes and 32 seconds).

The analyst asks, in effect, if Mr. Chambers thinks that CEOs he's spoken with are changing their budgets based on what they hear on CNBC.

Mr. Chambers says it's an excellent question and says "I think we're actually talking ourselves into this slowdown."

He gives the anecdote of his own daily run on the treadmill in front of a broadcast from "one of these media organizations in the morning" and that, although he felt pretty good about his business when he got started, by the time he's absorbed the media pessimism he's so put off that he's had to stop his run early!

Earlier in the conference call, Mr. Chambers said, "If it is gonna be a slowdown, you've never seen businesses in such a good a shape as they are."

We've said in many previous posts that the current recession drumbeat is overdone. You can see some of those posts here and here and here.

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At least the rats and mice are happy

Here's a link to an incredible story on the recycling mandates imposed by the government on citizens in Sweden. The author (who is from Sweden) is currently studying for his PhD in Economics at the University of Missouri. While we don't know much about his other political and economic beliefs, his description of the exasperating system being forced upon his countrymen is a warning to those who think it could never happen outside of Scandinavia.

He describes the situation in Sweden, where putting out your "garbage" has now been eliminated and you must sort everything and put it into its own category (aluminum, non-aluminum metals, newsprint, other types of paper, colored glass, clear glass, plastics, and so on). You must also clean your own garbage so that it will be accepted, and even remove labels from your soup cans!

The waste collection companies have lowered the number of times they will collect, and the government has established waste collection centers where citizens have to take much of their trash in order to turn it in (properly sorted). The government's regulations have thus led to a mis-allocation of resources -- including, ironically, gasoline which is being used by citizens to drive their trash around town, instead of the more efficient situation in which one garbage truck picks up garbage for dozens or even hundreds of citizens.

Citizens are now complaining about the filth and the vermin (such as rats and mice) that go along with this forced recycling program. In a true free-market economy, a situation that made so many people unhappy would be a tremendous business opportunity for an entrepreneur who wanted to offer an alternative.

Of course, in Sweden, there is a government-imposed monopoly on the waste business. What's more, aspects of this inefficient and unpleasant situation could very easily be exported to the US. There are even many citizens here who (misguidedly) think that greater government regulation to force recycling would be a good thing.

The current state of affairs in Sweden should be a caution to those who think so. Government interference with the free market always leads to greater inefficiency and mis-allocation of resources. Of course, if an entrepreneur wanted to set up a business to make it easier and less expensive for people to sort and recycle their trash, and could show that they could save money on their garbage bill or even eliminate their garbage bill by doing so, then the entrepreneur should be allowed to do so.

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Don't Panic

Worth a read (perhaps worth two reads) is Brian Wesbury's recent Testimony to the House Budget Committee from one week ago today.
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Still not a recession

While we don't base our investment discipline on making short-term calls about the direction of the economy, we do pay close attention to what is taking place with economic data, and we continue to note an absence of data which would indicate that a current recession has begun or even is imminent.

As we stated in blog posts in November (you can see those here and here), we believe the recession drumbeat which was growing towards the end of 2007 (and reached a crescendo about a week and a half ago) was overdone.

For a while, it was hard to find anyone who wasn't stating confidently on the media that we were already in a recession. However, the kind of data that would indicate a recession remains absent, and people may be beginning to change their minds as to whether a recession is as much of a foregone conclusion as they thought.

One reason the markets stampeded lower as the recession talk grew louder is that so many money managers are "sector rotators" -- they will rapidly shift money from one sector to another depending on cyclical trends in the economy. When they perceive a recession seems likely these types of managers will rapidly move out of sectors that tend to perform well when the economy is expanding and shift assets into defensive sectors that they believe will perform even if the economy is contracting.

These shifts from sector to sector happen extremely rapidly and with large amounts of money. Like a herd of wild horses which at the least sign of danger will run first and ask questions later, money managers, in the aggregate, don't wait for a recession to actually be confirmed before they shift their allocations.

However, while recent data has been mixed, signs indicate that a recession continues to be unlikely. One notable data point from last week was the very low inventory levels reported in the Q42007 GDP number last Wednesday, which argues that businesses are not going to be caught off-guard with overly-optimistic inventories, a factor which has been present in previous recessions and does not seem to be present right now (we pointed this out in our December 31 post as well).

Other supply-side indicators such as durable goods orders and the ISM manufacturing index have been strong, while demand-side indicators such as the jobless numbers have been bad, but we believe the demand-side indicators are usually overplayed by the media and economists with a demand-side bias, and point out that Labor Department jobless numbers are very volatile and often subject to positive revisions (for a discussion of demand-side versus supply-side views of the world, see this previous post).

In short, it is important to be aware that the much-hyped recession has so far failed to materialize, and indications are that economic growth will continue, although always at a faster or slower pace from one quarter to the next. The most important point to be made is that these constant economic ebbs and flows should not shake you from hitching your own future growth to the ownership of well-run businesses that you can continue to own for many years.

For future posts dealing with this same issue, see also:

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So when do you fire a manager?

Our previous post demonstrated that research on institutional managers suggests that the same sort of performance-chasing manager-switching that hurts individual investors also hurts the performance of institutional investors.

Based on the conclusion that this switching of managers has led to demonstrably unsatisfactory results, the natural questions that follow might be, "What is the alternative?" and "When should you change managers, then?"

We would argue that the results of the separate studies that we have cited argue for investing directly with a money manager, and not relying on the advice of a third-party who is not a money manager but rather "hires and fires" money managers. The other alternative is to manage the money yourself, but many people do not have the time or inclination to do that, and when they are investing substantial amounts the cost of mistakes can be significant.

We have long advocated finding a money manager who has a consistent investment process and has been using that investment process for a period of many years, and has an infrastructure around him, but who isn't too big. We believe that a manager's level of investment in his own portfolios is also an important indicator (he should "eat his own cooking").

The results of the studies that we have cited in previous posts suggest that investors should not be hasty in abandoning a manager if they have carefully examined his process for fundamental soundness and for consistency of execution.

We pointed out in an essay entitled "What hasty investors could learn from an Ent" that there is a helpful metaphor from Tolkien's famously un-hasty characters in the Lord of the Rings. A longer "time perspective" is helpful when evaluating the market movements of businesses or of portfolios composed of the stocks and bonds of businesses. The day-to-day gyrations of the markets cause many investors to focus on a much shorter time frame than they should.

Other research demonstrates that underperformance by a manager for periods as long as three years do not necessarily indicate that an investor should fire that manager. A study published in 2006 and authored by Baie Netzer and Melissa Wedel of Litman/Gregory found that almost every manager who outperformed over a ten year period trailed his benchmark for three years by a percentage of 2% or greater at some point during those ten years.

But the average investor, who holds onto a manager for a period shorter than three years, would probably abandon a manager after a couple years of underperformance. This is where the motto, "Do not be hasty," becomes important. To the average investor, waiting as long as three years does not seem to be "hasty," but in fact it may take longer than that for a portfolio manager's companies' potential to be realized, which is why the Ent metaphor is so appropriate.

However, there remains the fact that it is appropriate to leave a manager for valid reasons. The fact that most people hurt themselves by switching too often does not mean that investors should be blind or obstinate (as we explained regarding actual stocks in an earlier post).

One valid reason for leaving a portfolio manager is if the portfolio becomes too big. Successful money management attracts more new dollars, and when the flow of new assets becomes an avalanche, the very size of the portfolio can cause the investment process to change. You can see this very process graphically illustrated in the history of the Fidelity Magellan fund, which we wrote about in this post.

Another reason to leave a portfolio is if the manager himself leaves. If you have evaluated a manager's process and the consistency with which he applies that process, then when he leaves the basis for your evaluation of those factors has changed. Money manager turnover industry-wide is actually much higher than most investors may realize. An S&P research study in 2007 found the average portfolio manager tenure to be only 5.6 years.

Certainly, any indication of a lack of integrity would be cause to leave a manager.

While there are valid reasons to change managers, research indicates that most investors would do well to be less hasty in doing so.

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