Today's robust GDP number may have surprised the majority of economists, but it did not surprise us here at Taylor Frigon and it did not surprise economist Brian Wesbury, who was predicting a strong rebound before almost anyone else.
Today, he posted a new installation of his "Wesbury 101" video series, entitled "The Conservatives' Big Mistake." We believe it should be "required viewing" for anyone who wants to understand where the economy is right now, particularly in light of the ongoing level of ill-informed economic commentary coming from all directions in the media.
The video above is also noteworthy for another reason. At about 3:44 into the video, Mr. Wesbury outlines what he calls "The moral case for free markets." It is a concept with an importance that far transcends the day-to-day ups and downs of the markets, or even the periodic recessions and recoveries of the broader economy. It is a concept that was eloquently championed by the late Milton Friedman and his wife, and yet one that seems to find fewer champions today.
In his video, Brian Wesbury says: "The moral case for free markets is very simple. Under a free-market system, where freedom reigns and entrepreneurship is allowed, where innovation and creativity create growth, what people do is they're able to find their own God-given best and most-productive use for their life, and if we don't have that there are lots of people who never fulfill what God in fact put them on earth to fulfill. [. . .] It's not government-directed -- it's individual-directed. It has a spiritual nature, and not just a government-bureaucratic nature."
We couldn't agree more, and we applaud Mr. Wesbury for championing the moral case for free markets andfree enterprise at a time when so many seem to have lost that vision.
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Recently, concerns have arisen over the prospect that the government may force banks that received TARP money to raise capital in order to pay their way out.
Doing so would cause the banks to have to issue more shares of common stock, thus diluting the value of the shares currently outstanding, a prospect which yesterday prompted a sharp sell-off in shares of the larger banks.
The irony of this situation, and with the current discussion over the health of the banks, is that nobody seems to be discussing the status of the original "toxic assets" that supposedly necessitated the entire TARP program in the first place.
We have long held the position that the so-called "toxic assets" were really a kind of bogeyman created in large part by the well-intentioned but misguided mark-to-market accounting rules instituted in 2007.
Those accounting regulations caused banks to have to write down the value of assets -- such as mortgage-backed securities -- to whatever the market said they were worth at the time, which during the financial panic was next to nothing. We previously linked to this report from former FDIC Chairman Bill Isaac which gave an illustration from an actual bank which had to write down assets with face value of a billion dollars by a massive loss of $913 million, even though actual losses on the assets were only $1.8 million, with projections of losses of no more than $100 million.
The irony is that now, more than a year later and after the removal of that ill-conceived accounting requirement, those supposedly "toxic assets" have not imploded. In fact, current data would suggest that the main source of bank losses are from straight loans, not from the financially-engineered debt products that (in conjunction with a toxic accounting rule) caused such panic and led to the government forcing banks to accept TARP.
This recent article from Bloomberg shows that the real losses at banks have been from non-current loans that they wrote and kept on their books. As Louisiana State banking professor Joseph Mason says in the article, "While these aren't your giant banks, they are the guys your local strip mall and commercial real estate investors get their funds from." They are local loans that weren't securitized and packaged up into exotic structured products, but the kind of local development loans that have been hung out to dry by the recession.
It is also important to note that, just as in any other business, some banks were less wise in their business practices than others, and are now suffering the consequences. This is yet another reason why we do not advocate investing by "the whole sector" (whatever sector it may be), but rather advise investors to do their due diligence on the individual companies, and commit capital only to individual companies that meet rigorous criteria.
All this is not to say that we take a positive view of the financial engineering that went into the creation of the complicated debt instruments that played a starring role in the devastation of Wall Street in 2008. We have written many times that we take a dim view of the belief that investment risk can be engineered away with complex academic algorithms and theories.
However, the fact that these assets did not contain the level of losses that mark-to-market accounting was forcing firms to value them at raises significant questions. It is entirely possible that these banks never should have been forced to take TARP in the first place, and that the shotgun wedding of B of A and Merrill Lynch (for example) need never have taken place*.
Unfortunately, the repercussions of the over-reaction to the toxic assets that really weren't will echo through the financial system for decades to come.
* The principals of Taylor Frigon Capital Management do not own shares of Bank of America (BAC).
For later posts dealing with this same subject, see also:
Investors who spend much time reading financial predictions or watching the financial media can't help but hear about the powerful entity known as "The Consumer."
This amazing being figures so prominently in conventional economic analysis because many analysts attribute superhuman powers to The Consumer. In their view, The Consumer moves the entire economy, or if not the entire economy, The Consumer moves so much of the economy that there isn't much value in focusing on anything else.
When the economy is moving ahead, in the eyes of these pundits, it is because The Consumer is lifting it. Normally, The Consumer is full of something called "Animal Spirits," causing the economy to grow almost singlehandedly (of course, even the believers do not allege that The Consumer does it all singlehandedly, but they say that 70% or even 80% of the work is done by The Consumer, which is almost the same thing*).
Sometimes, however, The Consumer becomes weakened. The cause of this weakness is never precisely explained (possibly kryptonite), but it appears that The Consumer is prone to bouts of depression, or at least self-doubt, during which the economy either stops growing and stagnates for a time, or even slips backwards into recession.
You can hear or read the opinions of those who believe in the mighty role of The Consumer literally every day in the financial media. One recent example is found in the video clip below from CNBC, in which Harvard professor Niall Ferguson invokes The Consumer:
In the above exchange, particularly the segment beginning around 05:40 into the clip, Larry Kudlow -- concerned that the Fed is keeping rates too low, as we have opined previously -- asks Professor Ferguson, "Will the Fed drain cash, will the Fed raise rates, will the Fed move to an exit strategy? And, I guess -- heaven forbid, Niall -- will we ever stop this explosive borrowing coming out of Washington?"
To this flurry of questions, Professor Ferguson replies, "Well, I don't see any end in sight to the explosive borrowing. We're on a $9 trillion cumulative deficit over a ten-year timeframe and right now I think it's way to early to talk about exit strategy for the Fed. I don't buy the idea that this is a V-shape or even a 'W' -- I think it could be a flatline, given the condition of The US Consumer. So, I don't really see any reason why the combined forces at work here, a huge deficit plus easy money, are going to go away any time soon."
Later, Professor Ferguson adds, "I think they're too scared that this economy could go dipping downwards again and I think they've good reason to be. They also know there's no inflation risk -- you know, they could let the dollar go down another 30% or more."
The problem with this belief in the crucial role of The Consumer is that it is simply false. It is -- as we have playfully suggested in the above paragraphs and images -- a myth, a fable, a comic-book view of reality.
In fact, it inverts reality altogether. As George Reisman, Professor Emeritus of Economics of Pepperdine University, wrote in Capitalism: A Treatise on Economics, this inverted view of the world can be called "consumptionism," which he defines as "the doctrine that the fundamental problem of economic life is how to increase the need and desire to consume in the face of an ability to produce that exceeds them" (543).
In other words, the proponents of this inverted view of reality believe that man's need and desire to consume is fixed and constant, just like the other animals (presumably, dogs and horses do not sit around wishing they had big-screen televisions -- they are satisfied with having their basic needs met). However, because man is able to produce so much more than we need, we are always in danger of having an "output gap" of products and services that exceed the desires of The Consumer, whose desire to consume must then be stimulated somehow.
In this ludicrous view of the world, an endless supply of big-screen televisions can be taken for granted from the production lines of the world -- the real problem is somehow stimulating the lethargic consumer to actually desire a newer and better television than the one he has.
The reason this is an upside-down view of the world is that man, unlike animals, can and does always desire something better. If he secures a newer and larger television, it will not be long before he wants one with even higher definition, or with the ability to connect to his stereo wirelessly, or with the ability to connect to content that is delivered over the internet, in 3-D.
If the above television example does not work for your own particular consumption patterns, you can no doubt think of items for which the above pattern would hold true, whether it be food, housing, cars, surfboards, clothes, travels, or power tools. In short, the desire to consume does not need to be stimulated at all -- it can essentially be taken for granted!
However, the ability to produce goods and services is not automatic. The consumptionist mentality just assumes that goods and services will continue to be produced, often in excess of The Consumer's desire to consume them, regardless of how many obstacles to production are erected in the form of taxes on business returns or regulation of free trade or confiscatory government corruption. Unlike the desire to consume, the desire to produce can be completely squashed by foolish policy. For instance, if you lived in a country where the police did not stop looters from breaking into your store and taking all your goods, you would soon learn not to build a fixed store with inventories of goods and services. This is why in most countries without the rule of law, small-scale stands in open-air markets and bazaars are the norm, rather than larger permanent shops which can take advantage of economies of scale. Generally speaking, in those countries, scarcity is the norm, and sufficient quantities of goods and services to meet the basic needs of all those who desire them are not produced.
For this reason, Professor Reisman says that the consumptionist worldview is completely upside-down. "Instead of taking the need and desire to consume for granted and focusing on the ways and means by which production might be increased, the problem of economic life is now believed to be how to expand the need and desire to consume so that consumption can be made adequate to production" (544).
The problems with the widespread belief in the superhuman role of The Consumer are many. First, predictions about the future of the economy that are based on trying to take the pulse of The Consumer are usually inaccurate. Investors should be very attentive when they hear a talking head on the financial news shows begin to invoke The Consumer, because what follows will likely be driven by the mistaken belief that The Consumer moves 70% of the economy. The widespread nature of such mistaken views, however, has no doubt been responsible for much fear and doubt among the general populace in the past, and will continue to be in the future.
Another negative impact from this consumptionist view is the role it plays in misguided policy, from excessive monetary stimulus at the Federal Reserve to excessive spending out of Washington in its attempts to "stimulate" The Consumer.
The United States often elects consumptionist leaders who believe in the outsized power of The Consumer and miss the importance of the portion of the economy that is responsible for economic activity along the stages of production, and therefore craft policy that penalizes everything else in the interest of The Consumer. We have written previously about ways investors can gauge the degree to which production is being hindered in an economy by these policies, and how investors should adjust when this takes place.
This is a vital concept for everyone to understand -- please share this knowledge with your friends and family.
* The root of the widespread belief that The Consumer is responsible for 70% or 80% of economic activity lies in the way the so-called "Gross Domestic Product" or GDP of any nation is measured: because of the way it is constructed, the GDP formula purposely excludes intermediate goods used in the production of end products, thus artificially increasing the percentage of economic activity attributable to consumer goods. Additionally, GDP is simply one measure of economic activity; there are many more, such as Industrial Production, that give insight into the productive side of the economy.
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Standard & Poor's, a division of the McGraw-Hill Companies*, recently published a piece entitled "SPIVA Scorecard: Active Management Myths." In it, the publisher of bond ratings, investment research, and the well-known S&P series of indexes (or indices) seeks to debunk what they call "enduring investment myths" surrounding beliefs that active management can outperform broader market indexes.
In addressing each "myth," the authors of the study present evidence that active managers did not outperform the S&P 500 index (for large-cap stocks), the S&P MidCap 400 index (for mid-cap stocks), or the S&P SmallCap 600 index (for small-cap stocks), based on data in Standard & Poor's database and from the University of Chicago's Center for Research in Securities Prices (CSRP).
We have been outspoken in our belief that active management -- that is, the effort to select companies for investment based on specific business criteria -- is superior to so-called "passive management" or investment based on ownership of companies contained in indexes. See for example "The active vs. passive debate" and "Would you prefer options linked to your company or to the S&P 500?"
We would argue that the Standard & Poor's study should not be taken as a proof of the weakness of the concept of true active management at all.
First, as we've said before, using the performance of mutual funds as a proof of the superiority of index investing over active investing is fallacious, because mutual funds by their very nature tend to impede the investor's ability to own exceptional companies for a long period of years, as we explain in "Some drawbacks of mutual funds."
Second, we would argue that the Standard & Poor's article misses the true concept of active management altogether. While we believe that the ability to invest in superior companies with superior management teams is the real advantage of active management, the Standard & Poor's article sees the advantage of active management somewhat differently. In discussing what they call the "Bear Market Myth," the authors state that "One of the most enduring investment myths is the belief that active management has a distinct advantage in bear markets due to the ability to shift rapidly into cash or defensive securities." In discussing what they call the "SmallCap Myth" they cite the belief that "the market for smaller stocks is inefficient and therefore conducive to active management."
In other words, they view the supposed advantages of active management as being based upon timing the markets (by jumping in and out of cash), timing sectors (by jumping in and out of "defensive securities"), or exploiting "inefficiencies." We have previously eschewed all three of those so-called "advantages" -- see for example "Ownership of businesses through multiple economic cycles" and also "Drawbacks of sector rotation." We also explained why proponents of index investing often take the zero-sum view that active management is simply about exploiting inefficiencies in "The zero-sum connection."
Finally, we would note that the classification of managers into "largecap" or "midcap" or "smallcap" -- or, for that matter, into "value" or "core" or "growth" -- is of dubious value to investors and results more from Wall Street's desire to create new products to sell than from investment considerations.
In fact, the very heart of what our blog has always been about is our conviction that investment is not the rocket science or mathematical mumbo-jumbo that Wall Street, much of financial academia, and most of the financial media make it out to be.
Into this category of unhelpful Wall Street distractions we would add the constant race to outperform this index or that index (and there are many hundreds of indexes to choose from). If you beat one index one year, it is always possible for someone to pull out a different index and demonstrate that you may have beaten that one, but you didn't beat this one!
Along with all of the other distractions, this pressure to beat every single index all the time only serves to take investors' eyes off of the ball, which is every bit as harmful in the investment world as it is in the baseball batters box. What investors should be focused on, as we have said many times before, is building their financial future on the firm foundation of the great companies that they own.
We were voicing these convictions long before 2008, and we would point out that the events of 2008 and 2009 have borne them out. The performance of the portfolios we manage outperformed the broader market indexes in 2008, and they have continued to do so in 2009 by an even more significant margin. Full performance data as well as GIPS disclosures through the end of the most recent quarter are available on our website's performance page.
While critics might respond that they are not saying that nobody can outperform indexes with active management, just that most do not, we would return to our first point that a study of the overall performance of equity mutual funds does not prove that point, either. Because of the size of most mutual funds, they often end up resembling the broader indexes themselves, as we explain here. In fact, with over $10 trillion in assets according to the latest ICI research, US equity mutual funds practically are the equity market. A study which uses that pool as their sample and then demonstrates that much of it did not "beat the market" is not telling us much of value about the efficacy of active management.
We are concerned that the Standard & Poor's SPIVA study might mislead investors into thinking that the evidence is clear that active management cannot outperform indexes, and that the most recent bear market has proven that yet again. In fact, we believe that the opposite is true, and that the results of 2008 and of the first three quarters of 2009 should show investors that ownership of innovative, well-run businesses is a valid approach and one that can weather even severe financial storms.
* The principals of Taylor Frigon Capital Management do not own securities issued by the McGraw-Hill Companies (MHP).
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The Taylor Frigon Advisor is written by portfolio managers and researchers of Taylor Frigon Capital Management. The investment philosophy of TFCM is directly descended from the classic growth stock theory employed by Thomas Rowe Price and the late Dick Taylor in the 1960’s and 1970’s. For more information on Taylor Frigon Capital Management, please visit our website: www.taylorfrigon.com
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Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC [“Taylor Frigon”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. No amount of prior experience or success should be construed that a certain level of results or satisfaction will be achieved if Taylor Frigon is engaged, or continues to be engaged, to provide investment advisory services. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at www.taylorfrigon.com. Please Note: Taylor Frigon does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Taylor Frigon’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please Remember: If you are a Taylor Frigon client, please contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian.
