Lessons from volatility, October 2008

This month's tumultuous trading has set records for volatility. The enormous swings in the market threaten to "desensitize" investors in the same way that numbing levels of graphic violence in film and video can desensitize viewers.

Until recently, a three percent move in the stock market in one day (in either direction) would have been a significant move. Now, with moves of five percent, six percent, seven percent and even larger percentages following each other in staggering succession, such moves seem to almost lose their power to shock investors.

Above is a chart showing the trading of the Dow Jones Industrial Average during the month of October, so far (click for a larger diagram to see detail). Each vertical bar depicts one day of trading, with the opening value depicted by a horizontal bar to the left, and the closing value depicted by a horizontal bar to the right. The five up days of October are in green -- all the red days represent down days. During the entire month, there have been no back-to-back positive days for the market to date.

Some particularly volatile swings are shown with greater detail in the small boxes that depict the values for the high, the low, the open and the close.

On October 9, for example, the Dow traded up 2.01% from its open before dropping to close down for a loss of 7.37% from the open (a closing level that was down a total of 9.20% from the high of the session).

On October 10, the high was up 3.88% from the open, the low was 8.01% below the open -- a total of 11.45% below the high of the session.

On October 13, a positive day, the high of the session was 11.41% above the open, and the close was up 11.08% from the open.

These stunning one-day swings are driven by many factors -- forced selling driven by margin calls, mass redemptions from hedge funds that are closing their doors, large sales from mutual funds to meet redemptions by investors, and short-sellers who have been enabled to drive stocks downward more easily due to the unexplainable removal of the long-standing uptick requirement last year. Tremendous increases in computer-driven trading and the decrease of the role of the specialist on the floor of the exchange may also play a factor.

Investors are understandably dismayed by this barrage of unprecedented trading movement and volatility. How can they possibly expect to compete with short-sellers and hedge-fund redemptions?

The answer is that they cannot. In the short run, powerful forces can move stocks around the way hurricane winds toss debris. Short sellers can tear down the price of a company regardless of how solid the long-term business prospects of that company.

But investors do have one advantage over such "fast money" -- the ability to wait. Short sellers and other players who rely on leverage and borrowing (such as hedge funds) cannot sell a company short for years on end -- the nature of such trading is necessarily short-term.

It is obvious that during such a flurry of wild market swings as we have seen this month, the only possible response for an owner of shares in a company he believes in is to hold on to those shares and wait for the madness to pass.

This observation underscores what we have always argued and which we wrote about in this previous post: that it is critical to invest with a philosophy of holding good businesses through cycles, rather than trying to time them.

As T. Rowe Price wrote in 1973, the majority of those who made their fortune in the country did so by owning shares in businesses for many years. He observed that "They did not attempt to sell out and buy back again their ownerships of the businesses through the ups and downs of the business and stock market cycles" (emphasis in the original).

Investors should take the giant swings of this month as a great object lesson. It is obvious that trying to time such moves is impossible, and that investing through them is the best course.

This is what we have believed all along, and applies to other temporary cycles as well.

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Another important article from George Gilder

The latest Forbes magazine (cover date of November 10, 2008) contains an important article from George Gilder entitled "The Coming Creativity Boom."

In it, the author highlights the critical role that creativity plays in a successful economy. Creativity is the heart of entrepreneurship, and entrepreneurship is at the heart of the economic success America has enjoyed for over two centuries.

Chris Anderson of Wired magazine recently wrote a post in the Wired blog which shows just how insightful George Gilder has been for over two decades in his vision and his articulation of the direction technology is going and the impact it will have on every area of our lives.

This blog has also called attention to the importance of George Gilder's insights, such as his discussion of "The Exaflood" back in February of this year.

In this most recent article, George points out that "the current crisis is mostly confined to the boondoggles of finance." The important thing to keep in mind is that "The real source of all growth is human creativity and entrepreneurship, which always comes as a surprise to us, especially in the worst of times."

To back up this last assertion, that surprises are often developed by creative individuals and companies during "the worst of times," he links to another excellent post written by Rich Karlgaard last week, which details some of the innovative firms that sprouted during the 1970s.

These things are important for investors to understand, especially at a time when few are focusing on them.

For later posts dealing with the same subject, see also:
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"Great Depression" Update: iPhones selling like hotcakes

The news media is full of stories blaming the latest wild market swings on Wall Street acquiring "recession fears" and fretting about "weak earnings." The New York Times, for example, published a story entitled "Stocks Dive as Crisis Erodes Earnings" and cited weak earnings from Wachovia, Boeing and Merck as "major businesses across a range of industries."*

Few if any are the voices which point out that we have reached a state of irrational pessimism, in which nothing can possibly be good news and everything is interpreted from the viewpoint of certain Armageddon.

It is important to view the current state of the economy accurately. The current credit crisis did not arise because the economy was slowing down. The fall of companies like Bear Stearns and Lehman Brothers did not result from spreading economic malaise in the country which caused home foreclosures to rise and thus drive Bear and Lehman out of business.* Bear and Lehman were brought down by their inability to get lending, due to problematic balance sheets and a death spiral exacerbated by mark-to-market accounting regulations and the removal of the short-selling uptick rule, among other reasons which we have noted in the blog.

This is important. If the chaos caused by the problems in the financial sector actually does eventually receive the "recession" label from the National Bureau of Economic Research (NBER), then you should realize that the direction of the disease was from Wall Street to the broader economy, rather than from the broader economy onto Wall Street. Thus, we believe that the continued dire predictions of "the worst recession since the Great Depression" just around the corner are overblown. In fact, there are hints in the earnings reports coming out this week which bear out this analysis.

Certainly, financial companies in deep distress, such as Wachovia, are going to have bad earnings results. But Boeing's earnings woes stem directly from a machinists' strike and are not symptomatic of the overall economy, the way the New York Times would have you believe.

On the other hand, Apple yesterday released earnings that beat analysts' estimates by three cents a share, and which included Apple iPhone sales numbers that one analyst described as "jaw-dropping."* Apple's Peter Oppenheimer said that they sold nearly 6.9 million iPhones in the September quarter, exceeding the 6.1 million units shipped over the entire lifetime of the first generation iPhone. That was in one quarter. If we are in the Great Depression, it isn't stopping too many people from needing to get their new 3G iPhone.

Elsewhere in the third quarter, Amazon* reported that sales were up 31%! Major League Baseball had record revenues in the just-completed season -- an all-time high of $6.5 billion, and attendance just 1% off from the previous record set the season before, according to this Bloomberg News story.

But of course, the spin on all these stories is how negative things are about to be. Many companies (including Apple and Amazon) issued very gloomy outlooks in their forecasts for the upcoming quarter. Can you blame them, with a regulatory environment in which CEOs are frightened by what might happen to them if optimistic guidance turns out to be wrong? In the Apple story linked above, an astute analyst notes that Apple's low-key sales forecast for the upcoming quarter calls for results that are flat from a year ago and ignores the obvious demand for the latest iPhone. He calls the forecast "comical" and says "It's almost mathematically impossible."

Our advice to investors is, first and foremost, to avoid investment strategies that try to predict economic cycles, as we have explained in previous posts. We advise ownership of good companies through economic cycles -- the same way most of the great fortunes in America have always been made.

Secondly, while we don't try to predict economic cycles, we would advise a healthy dose of skepticism about the current calls for the worst recession since the Great Depression. If we do dip into recession, we believe it will be brief and that recovery will be rapid, mainly because we believe it is clear that the current problems came from the financial sector and not from an economy-wide disease, an important distinction.

When everyone is ignoring any good news and are convinced that all news is bad, it is irrational, just as it is irrational when everyone was ignoring any bad news and convinced that the market would go up forever (a situation that seems like a distant memory, but it really did happen once). We are in such an irrationally negative situation now.

* The principals of Taylor Frigon Capital Management do not own securities issued by Wachovia (WB), Boeing (BA), Merck (MRK), Bear Stearns (BS), Lehman Brothers (LEH), Apple (AAPL), or Amazon (AMZN).

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

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Unleash the armies of accountants!

Over the weekend, the Wall Street Journal published an enlightening interview with economist Anna J. Schwartz, of the National Bureau of Economic Research.

In it, Dr. Schwartz makes the important point that the current situation is not a liquidity crisis, as it is often described in the media.

"The Fed," she says, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem."

It's not that lenders do not have enough liquidity to lend -- it is that they do not have enough confidence in the balance sheets of institutions that want to borrow. The basic problem, she says in the interview, is uncertainty "that the balance sheets of financial firms are credible."

To her credit, Dr. Schwartz had seen the same thing long before the chaos of the past month, and her insights then were published in an interview in a Research Report dated May 18, 2008 from the American Institute for Economic Research.

In that interview, she stated, "liquidity is not the same thing as solvency, which is concerned with a company's balance sheet: Do its assets exceed liabilities? [. . .] Liquidity is not the answer to the solvency problem."

Going further, in that interview she argued that "If the credit market had accurate information on the health of each financial institution, credit paralysis would end."

To that end, she suggested that "One way of dealing with the problem is for a special examination of the portfolios of financial companies that the Fed should require, assigning examiners from the regulating agencies who have been specially trained in assessing the value of exotic collateralized investments that the credit markets have created."

She noted that sending in examiners to inspect the books has a historical precedent of success: "It was used by J.P. Morgan in 1907, when he deputized Benjamin Strong to examine the books of New York City banks to determine which ones merited rescue and which did not. It was used in 1933 after the national Bank Holiday to determine which banks were fit to be licensed by the secretary of the Treasury to reopen and which were to be unlicensed, and then suspended, merged or liquidated. It was used by JPMorgan Chase in 2008 [with Bear Stearns, in March]."

We agree with Dr. Schwartz that the situation calls for an army of accountants to descend upon the books of financial institutions and provide the clarity that the credit markets require in order to unlock the flow of lending.

If Anna Schwartz is correct, and we believe there are excellent reasons to agree with her, then "credit paralysis would end."

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He must've been reading our blog

Yesterday, we published a blog post entitled "The Business of America is Business," in which we reiterated the importance of focusing on the concept of the ownership of shares in a business, especially at a time when the gyrations of the stock market make it almost impossible to remember that the stock price and the business are two very different things.

This morning in the New York Times, Warren Buffett published a very well-written opinion piece entitled "Buy American. I am." In it, he says that he is buying American companies now for his personal accounts, and stated that (while it is smart to be wary of buying shaky or over-leveraged companies) "fears regarding the long-term prosperity of the nation's many sound companies make no sense."

He notes that "In the twentieth century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497." Yet he marvels that, during such a tremendous period of business growth, there were investors who failed to make money because they allowed themselves to be stampeded by the market's wild fluctuations (a topic we have written on at length).

It is significant that such a famous and successful investor would be focusing on the importance of the concept of ownership of business at this time. We obviously found our thoughts turning in the same direction under the same circumstances. This should help validate these truths in the minds of readers who may not have the same background.

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The Business of America is Business

America's thirtieth president Calvin Coolidge (1872 - 1933) once famously stated that "the chief business of the American people is business." Coolidge did not waste words -- his nickname was "Silent Cal" -- and when informed of his death one wit (Dorothy Parker of Vanity Fair) unkindly asked "How can they tell?" So, people should give even more weight to this phrase from a man of few words.

The phrase is appropriate for investors now. At times such as those we are currently experiencing, when everyone is focused on the stock market and its unprecedented volatility, it is critically important to focus on something we have said several times before: investment should be approached as the ownership of shares in a business. It is very easy to lose sight of that fundamental truth, and its importance to investors.

As we have mentioned, T. Rowe Price preserved his convictions about investment in an unpublished 1973 brochure entitled "A successful investment philosophy based on the growth stock theory of investing."

In it, he noted "That 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." Further, he pointed out, with emphasis, that "They did not attempt to sell out and buy back again their ownerships of the businesses through the ups and downs of the business and stock market cycles."

If you look at the names published in the Forbes list of richest Americans in any recent years, you will see that Price's observation (which he made in the early 1930s) is just as true today. Do you think that Bill Gates of Microsoft or Larry Ellison of Oracle or the family members of Sam Walton of Wal-Mart have made a habit of selling their shares in those companies at every crisis over the past several decades and then buying them back again when someone rang the "all-clear" signal?*

It should also be comforting that (unlike much of the opinion being batted about in the financial media right now), Price's observations were actually tested for decades in the markets. He wrote, "The author of this study began to work out a theory of investment [in 1929] [. . .] Since 1934 he has tested the soundness of his theory by applying it to an actual fund." By the time he wrote the quotations cited above about the ownership of business, he had decades of actual results to support the soundness of his observations.

During times of market turmoil, the prices of good companies can be hit just as hard as the prices of mediocre or even below-average companies. For those inclined to buy good companies, this can represent a valuable buying opportunity. For those who are already owners, this can be a real gut-check and can raise all kinds of doubts about the future prospects of those companies.

It is certainly appropriate and important to always evaluate the long-term growth prospects of companies to which you have committed your capital. But, it is also vital to remember that the shares you own represent businesses, and that most of those who have made money in business did not do it by selling their stake and then buying it back again over and over through the years.

This truth may seem to be boring, or hackneyed, but that is because it is a time-tested truth. Unfortunately, although many people give lip service to it during easier times, the number of people who are able to follow it during troubled times are much fewer.

* The principals of Taylor Frigon Capital Management do not own shares of Microsoft (MSFT), Oracle (ORCL) or Wal-Mart (WMT).

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

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The Investment Climate: October, 2008

We recently published "The Investment Climate: October, 2008" in the commentaries section of the Taylor Frigon Capital Management website.

In it, we sum up several of the streams of discussion we have published here over the past months and that have led up to this point.

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

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Bear market anniversary reflections

The current bear market will officially be a year old as of October 09, 2008.

As this chart demonstrates (click chart to enlarge for ease of reading), the Dow Jones Industrial Average reached its most recent peak on October 09, 2007 with a close at 14,164.53. Since that day, it has dropped 34.6%.

During that time, most of the economy actually remained healthy, with most companies (outside of housing and finance) continuing to grow their earnings.

Recently, the stubborn refusal by the SEC to amend or temporarily suspend mark-to-market regulations, combined with a stunning elimination of the independent investment banking industry at the hands of the Treasury and the Fed has caused not just a full-fledged bear market but also a financial panic -- something the country has not seen since the Great Depression.

In the 1979 article by Milton and Rose Friedman cited on this blog recently, the authors asked "But what do the terms 'run' and 'panic' and 'restriction of payments' really mean?" They then defined a "run" on a bank as "simply an attempt by many of its depositors simultaneously to 'withdraw' their deposits in cash" and noted that one bank alone could meet a run by borrowing from other banks -- unless there is a "panic" in which the run spreads beyond the ability of banks to co-ordinate the transfer of deposits to meet the simultaneous runs.

It is clear from the events of the past weeks that the current situation meets the definition given by the Friedmans of a financial panic. Therefore, the Fed's emergency rate cut this morning, in concert with other central banks, is an appropriate response given the circumstances.

At some point, the financial panic will stop, the bear market will end, and the upward move in the market likely will be violent and rapid, as it often has been after previous bear markets depicted in the chart above.

However, it is possible and even likely (as we noted in the post about the insightful Friedman article from 1979) that the fallout of this financial panic will result in exactly the wrong lessons and reactions, just as the fallout of the Great Depression resulted in exactly the wrong conclusions and reactions.

Because of this possible outcome, we are more convinced than ever that the idea of just blindly buying "the whole market" and "all will be well" is wrong. The events of this year have clearly shown that there are very big differences between companies in terms of their quality and their leadership, which can manifest themselves in very different outcomes. We have always believed that those who are able to run their companies and return value to their shareholders and customers will come out ahead. We have written about this issue several times in the past, such as here and here and here.

While a bear market is gut-wrenching, and a bear market combined with a financial panic even more so, it is helpful to keep in mind that the current market drop is in line with those of previous bear markets shown above. We continue to emphasize that ownership of well-run companies through market cycles as part of a disciplined investment process is the best course of action for long-term success, and that bear markets and even financial panics do not change that.

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"A failure of government, not of private enterprise . . ."

In the fall of 1979, fifty years after the Great Crash of October 25, 1929, the Journal of Portfolio Management published a commemorative issue they had been working on since 1977 entitled "The Great Crash: Causes, Consequences, Relevance -- a fifty-year retrospective."

It contained articles by economists such as Paul Samuelson (winner of the 1970 Nobel Prize in Economics), John Kenneth Galbraith, and Milton Friedman (winner of the 1976 Nobel Prize in Economics). There were also articles by economic historian Charles Kindleberger, money managers Arthur Zeikel, David L. Babson and Sidney Homer, Value Line founder Arnold Bernhard, Ibbotson founder Roger Ibbotson, and noted professors James Lorie and Peter Bernstein, among many others.

In that issue of the Journal of Portfolio Management, Milton and Rose Friedman contributed "The anatomy of a crisis . . . and the failure of policy." In it, the authors noted that the Depression directly contributed to the rise of Adolf Hitler, the strengthening of the grip of the military over Japan, and the hyper-inflation in China that allowed the rise of Mao. And in the realm of ideas, the authors noted, the Depression persuaded many that capitalism was fundamentally unstable and subject to ever more serious crises, and that government had to play a more active role to intervene and offset the instability created by private enterprise.

The Friedmans, however, explain very clearly that those conclusions are false. In a sentence they italicize for emphasis (the only italics in the entire article), they state:

"We now know, as a few knew then, that the Depression reflected a failure of government, not of private enterprise."

This fact is vitally important. It is important because schools today continue to teach the opposite, and it is important because the current situation is being framed in the exact same terms.

We believe that it is important to explain that the current situation reflects a failure of government, not of private enterprise.

This past Friday, the Wall Street Journal contained an excellent article by George Mason University professor of economics Russell Roberts. In it, he gives a detailed description of the role played by government in artificially boosting housing demand and encouraging the creation of risky assets derived from the housing boom. The only augmentation of that detailed article which we would offer would be to point out that the Federal Reserve lowered the fed fund target rate all the way to 1.00%, and did not stop at 1.25% in 2003 as it might sound from the wording of the article.

The insights of Professor Roberts, and the insights of Milton and Rose Friedman from 1979, are vitally important right now, and should be explained to the American people from every outlet available. As the Friedmans explained, drawing the wrong conclusions from economic catastrophes led to utterly tragic consequences in the twentieth century.

Please pass these insights on to your friends and family.

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

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Be centered, be still . . . revisited

Back on March 11 of this year, we wrote a post entitled "Be centered, be still" in which we cited research demonstrating that most investors make their most costly mistakes not only during downturns but after downturns. Often, mistakes after downturns come in the form of missing market recoveries, due to an earlier decision to bail out.

The title of that earlier post makes reference to a word that we as portfolio managers believe represents a very important concept in investment management -- the idea of being centered. By centered we mean "remaining within a consistent discipline; not making rash changes that represent a departure from the discipline."

Being centered does not mean "doing nothing" but rather it means continuing to act in line with the principles of an investment process. During times of great turbulence, many are tempted to either abandon their process (if they ever had one) or alter it to suit the "mode of the moment."

Tragically, an abundance of research supports the conclusion that most investors do not have anything close to a consistent process. In fact, as we have argued, the evidence strongly suggests that even most "financial professionals" or "financial advisors" do not have a consistent process, as we explain in "Investor behavior . . . or advisor behavior?" and the other articles linked at the end of that post.

In the absence of a consistent set of principles, investors (and their advisors) become like waves tossed about by the swirling winds, chasing whatever has worked lately. Research has decisively shown that over periods of years, such an approach is very unreliable.

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