Wednesday, November 26, 2008

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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Tuesday, November 25, 2008

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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Thursday, November 20, 2008

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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Thursday, November 13, 2008

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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Monday, November 10, 2008

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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Monday, November 10, 2008

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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Wednesday, November 05, 2008

More evidence on the dangers of modern-day "wealth management"






















In our previous post, we cited two recent articles giving evidence from the current bear market that backs up the core assertions we have made for years about the financial services industry -- specifically, that the idea of "wealth management" from an advisor who rotates his clients amongst varying investment strategies is not a sound model.

We have previously cited studies that we think make that case very clearly. The articles cited in Monday's post can be seen as supporting that case with more recent evidence from the past twelve months.

One detail we cited from Monday's Wall Street Journal article deserves greater examination, and that is the fact that, "following the advice of investment pros" investors had moved heavily into international funds, which are now down an average of 10% more than even the hard-hit US funds.

We believe in the ownership of individual companies, rather than funds (we explain why in this post from December, among other places). But those who rushed to buy international stocks have been similarly hurt.

We have long disagreed with the idea of "international" as an "asset class" that all investors must have. For starters, the idea has its roots in Modern Portfolio Theory, which has taken over the "wealth management" industry (and which it is, in fact, largely responsible for creating) and which we largely oppose, for reasons explained in this post from March.

The Modern Portfolio Theory idea is that owning international funds adds to your diversification. Further, it was seen as a "non-correlated asset" that would potentially go up when domestic stocks were going down. Until the recent crisis, there was much talk of "de-coupling," wherein the other economies of the world supposedly "de-coupled" from the US and therefore provide a level of greater diversification and non-correlation to portfolios.

The recent financial crisis, however, has exploded that notion.

Our other disagreement with the rush to own international investments is the fact that we have always seen them as unavoidably levered to currency bets -- if you invest in a company that reports earnings in another currency, its performance will be boosted when that currency is going up versus the dollar, and depressed when that currency is falling relative to the dollar.

Thus, international investing becomes a form of foreign exchange speculation. "Wealth managers" and "financial advisors" tell their clients "it's time to get into (or out of) international" just as they tell clients that it is time to switch from value to growth, or from small-cap to large-cap, or from biotech to consumer staples. This entire investment philosophy of timing rotation from one sector or capitalization category or country to another is a form of speculation, as we explained in "The drawbacks of sector rotation."

The graph above shows how dangerous such an investment philosophy can be. It is a graph of the US Dollar Index, often referred to as the "USDX," from June 05, 2007 to November 05, 2008.

The index measures the relative strength of the dollar against a basket of six other currencies (the British pound, the euro, the Swiss franc, the Japanese yen, the Canadian dollar, and the Swedish krona). It was set at 100 in 1973, so that values under 100 mean the dollar has declined relative to other currencies since that time, and values above 100 represent relative dollar appreciation since that time.

While the dollar had been on a multi-year slide (hence the steady rise in interest in international investing from investors and their intermediary advisors), actions by the Federal Reserve in the later stages of the crisis, combined with an international rush to hold dollar-denominated securities (particularly Treasuries) when everything else in the world started to look like a bad credit risk, turned that slide around dramatically.

The enormous dollar-rally shown in the dollar index graph translated into severe losses for international funds. An article in today's Investors Business Daily reports that Latin America funds are down 50.57% year-to-date, China region funds are down 56.30% for the year, Pacific ex-Japan funds are down 52.65% for the year, and that MSCI-Barra data indicate that some emerging market funds focused on Hungary, Argentina, Indonesia, Peru, and Russia dropped between 35% and 43% in October alone.

These topics underscore the importance of investing with a time-tested discipline, and one that is based upon fundamental business characteristics rather than speculative calls about this or that sector, market, interest rate, commodity price, or currency.

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Monday, November 03, 2008

The intermediary trap and the current bear market











October 2008 has come to a close, and it was one of the worst on record for the stock market.

Even worse, however, is the fact that during volatile times such as these, many investors themselves experience more damaging rates of return due to poor decisions. A recent article on the Morningstar website reports that, according to Morningstar's Market Intelligence research, investors have been selling their mutual fund investments in record numbers.

Morningstar reports that "a net amount of $49 billion left mutual funds in September alone. We've been tracking redemption data since January 2000, and that's the largest one-month outflow that we've seen to date. Yet, it looks like October is on pace to beat it."

As we have noted many times in the past, this type of behavior has led to the results found in the Dalbar studies which for many years have shown that over long periods of time, "the average investor earned significantly less than mutual fund performance reports would suggest."

In other words, the long-term track record of an investment vehicle is better than the track record of those who jump into it and jump out of it, especially because they often jump out of it at the worst times. The Dalbar studies have also demonstrated that "investors make most mistakes after downturns," and graphs from the 2000-2002 bear market support that assertion, such as those we posted in this previous piece.

This problem highlights a glaring deficiency in the current financial services industry, one that does a huge disservice to individual investors, whether they are small investors or very wealthy families. As we have pointed out, the data in these studies indicates that these well-documented investment mistakes are generally made by investors who are receiving professional advice from "financial advisors", "wealth managers" or "financial planners."

The Wall Street Journal today published an article entitled "No Place to Hide" that points out that, as bad as the returns have been year-to-date for the US market indexes, "The average international-stock fund is down 44.6% so far this year, according to Lipper, 10 percentage points worse than the average U.S.-stock fund." The article also correctly points out that "Following the advice of investment pros, mutual-fund investors had also moved heavily into overseas funds in the past few years."

As we explained in a whitepaper entitled "The Intermediary Trap" that we published in February, 2008, the "investment pros" that the Journal is talking about in today's article were not deliberately trying to sabotage their clients' returns (far from it), but "rather out of good intentions which end up creating long-term damage."

In fact, we went on, "because these professional intermediaries have access to more performance data and more information about new management styles and investment trends, they may be even more prone to chasing performance or switching to a different form of investment than nonprofessionals would be."

This behavior is exactly what the Journal article chronicles when they point out that "Many investors may be tempted to make up for losses by jumping into whatever stock-fund category emerges as the next hot thing, as some were doing with commodities funds earlier this year -- before commodities prices plunged." How many of those investors who flocked into commodities funds when they were going up do you think did so on the advice of financial professionals?

Many nonprofessional investors would not have even known about the latest crop of commodities investment vehicles if they hadn't been introduced to them by the intermediaries. The fact that those intermediaries were "just trying to help" is little comfort to those who were burned by the collapse of commodities and international funds.

Compounding this problem is the fact that intermediaries, because they are not investment managers themselves, often use vehicles such as mutual funds in order to obtain investment management for their clients. As we pointed out in "Some drawbacks of mutual funds" back in May, the pooled nature of mutual funds comes with significant disadvantages. One of these comes when investors panic and sell during a serious bear market, creating a problem for the portfolio manager and for investors who are left in the fund (see the diagram above).

The Morningstar article cited earlier explains, funds typically do not have cash on hand for such mass redemptions so their managers are forced to sell into weak markets, and are prevented by lack of cash from buying even when bargains are plentiful. "If those redemptions force the fund manager to sell securities at lower prices, the investor who redeemed doesn't bear the cost. Rather, it is spread across the entire pool of investors still in the fund."

Clearly, these two problems are related -- the problem of investors selling that Dalbar has chronicled, and the drawbacks of mutual funds which are exacerbated by that selling, which Morningstar describes.

We have long advised investors to avoid the pitfalls of financial intermediaries, and (if possible) mutual funds as well. Sadly, as the recent articles from the Wall Street Journal and Morningstar indicate, the real dangers of such "intermediary" investing are most evident in a bear market environment.

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