Hundredth Anniversary of the Federal Reserve: We "get by" IN SPITE

On December 23, 1913, one hundred years ago yesterday, Woodrow Wilson signed into law the Federal Reserve Act, which had been passed in the House on September 18th the same year by a vote of 287 - 85 and which had been passed in the Senate on December 18th by a vote of 54 - 34. 

The creation of a central bank in the US meant that the supply of money could now be controlled by a central planning body, in contrast to the previous basically laissez-faire systems (the US had experimented with several different systems with varying levels of government interference during its history prior to 1913), in which money and credit were not directly under the control of the government and banks could issue their own notes, and during some periods could issue their own scrip in exchange for deposits. 

The contrast between central banking and free banking is admirably contrasted in Breaking the Banks, by Richard M. Salsman, published in 1990 and available from the American Institute for Economic Research.  He characterizes central banking as follows:
[. . .] we describe central banking as any and all forms of government intervention in the banking system, specifically a legal tender monopoly on the issue of bank notes, a lender of last resort, mandatory deposit insurance, and the regulation and/or ownership of banks.  16.
The ramifications of the creation of the Federal Reserve have been profound.  One of the most important negative aspects of the central banking system has been steady erosion of the purchasing power of money, which over time has had a catastrophic effect on the people's ability to trust their money as a store of value.  The long-term impact of this erosion of purchasing power has been far greater than most people recognize, as we discuss in several previous posts, most notably in "Stand still, little lambs, to be shorn!" which itself is the title of a study published periodically by the AIER.

Perhaps not coincidentally, 2013 is also the one hundredth anniversary of the establishment of a federal income tax in the United States, via the ratification of the 16th Amendment to the Constitution in February of that year.  After the Constitution was changed to allow an income tax, Congress got to work writing income tax law, which was enacted in October of that year.
Both the income tax and the erosion of the purchasing power of the money in the US have together caused tremendous harm to the individual's ability to keep his or her own property and to increase it through productive labor.  It is very important for investors to understand the history and impact of both the income tax and inflation / loss of purchasing power on their money and ultimately their wealth.
Further, the creation of the income tax and the establishment of the central bank led directly to the ability of the federal government to grow tremendously in size and scope since 1913.  While a thorough critique of the performance of the Federal Reserve since its founding is beyond the scope of this writing, there can be no doubt that the ramifications of the existence of such an entity has been significant in its impact on the US and global economy.  While it can can be argued by reasonable people (certainly Milton Friedman was one) that the benefits of central banking outweigh the negatives, it is our view that the concentration of such power into the hands of a few must be handled very carefully and well articulated "rules of the road" must be followed in order to limit such power.
Regardless, here at Taylor Frigon Capital Management, we have always believed that individual men and women, as well as the country at large, have gotten by in spite of what we believe to be  often questionable actions by the bankers at the Fed.  See for example the previous post entitled, "We get by in spite," published December 23, 2009. 
And on that positive and hopeful note, we wish all our readers a very Happy Christmas and a Prosperous 2014!
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Back from the New Telecosm Summit, 2013

We recently attended the New Telecosm Summit, which was the latest in a series of Telecosm Conferences inspired by the vision set forth by author and thinker George Gilder.  This year's event took place on December 3rd and 4th in New York City.

The concept of the "telecosm" refers broadly to the world unleashed by abundant information-processing capability coupled with abundant networking capability: the technologies which make information processing and sharing so inexpensive and plentiful that massive amounts of high-definition video data can be shared almost anywhere, even while mobile (not requiring people to use devices that are tethered to the network by a physical cord).  

The possible applications for such super-abundance are literally unlimited, since the human imagination is essentially unlimited, and we have all seen the impact of the creative applications that people have found for these new capabilities over the past ten or fifteen years, and the ways they have transformed numerous aspects of human life.  These transformations, and the technology that makes them possible, constitute the concept of "the telecosm."

This year's Telecosm conference featured talks on the progress of this paradigm, and some of its far-reaching ramifications as we can envision them today, as well as presentations by some of the individuals and companies who are working on ways to apply the capabilities of the telecosm to different areas of human life (including medicine), or on ways to expand those capabilities to new heights.

Of course, event chairman and Telecosm pioneer George Gilder gave the opening keynote, and during his remarks he laid out the powerful vision that he believes underlies the entire paradigm.  He notes that the incredible advances in information processing and information sharing on global networks during the past several decades was made possible by the "information theory" articulated primarily by Claude Shannon, who declared (in George's words during the talk) that "information itself is surprise, and creativity is surprise."  

This concept underlies the inevitable gravitation of information towards the electromagnetic spectrum, because the waves of energy in the electromagnetic spectrum behave in a very unsurprising and predictable way, making them an ideal carrier for information (unexpected blips in the predictable spectrum can then be used to carry coded information, in just the same way that puffs of smoke signals against a clear sky can be used to carry coded information).

George then explained how this concept has ramifications that go to the heart of the profound question of how economies grow and how innovation and creativity can flourish (these are both the same question, of course).  Most of those who have tried to examine this question of how to enable innovation, creativity and growth have focused on incentives of some sort, whether those incentives came in the form of government "stimulus" (a typically "Keynesian" or "demand-side" approach) or in the form of reducing penalties or obstacles to growth such as taxes or regulations (the typically "supply-side" approach), but George explained that the application of Claude Shannon's information theory to this question came as an epiphany to him, and enabled him to see that innovation and creativity are actually forms of surprise, and therefore forms of information!  

This insight enabled him to see that a healthy economy that enables the always-surprising creativity and innovation of individuals is really a knowledge system (because it is based on information), rather than an incentive system, in which those in power try to provide incentives to behavior as if they were guiding a chicken in a Skinner Box.   George explains that trying to manipulate humans using the Skinner Box method has failed miserably, but that by realizing that knowledge accumulates in very specific ways, and by seeing the economy as a knowledge system or a learning system, we find an entirely new perspective that has not been appreciated before.  

"A learning system operates differently from an incentive system," he said in his talk.  Specifically, learning and knowledge are accumulated through a series of "falsifiable experiments" -- and in the world of business innovation this means a series of "entrepreneurs creating falsifiable experiments" that may succeed or they may not.

George develops this important new approach to understanding creativity, innovation, and economic growth in his most recent book, Knowledge and Power.

Unfortunately, the temptation of those in power is and has always been to interfere with the critical series of "falsifiable experiments," by picking winners and losers.  One of the sub-themes of the conference this year was the degree to which the unpredictability and interference introduced by government officials and their cronies in various areas of business has created major disruptions to the promise of innovation and creativity over the past two decades.  

Thus, this year's Telecosm presented a tempered message that was balanced between the promise of innovation and creativity -- which in many ways have reached tremendous heights -- and the caution and uncertainty which still threaten both the telecosm and the wider economy.  We believe these concepts are very important for investors (and all participants in the economy and wider society) to understand and consider carefully.

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"The crisis facing fixed-income investors"

Here's a link to an important article entitled "Bonds' future fortunes are flagging," by Simon A. Lack, who is also the author of a recently-published book entitled Bonds Are Not Forever: The Crisis Facing Fixed Income Investors.

In the article, the author points out the many daunting problems facing bond investors today.  Most investors are probably aware of the main problem: interest rates are at historic lows, as they have been for years, and have been held artificially low by the actions of central bankers (mainly the US Federal Reserve), and probably will remain artificially low in the foreseeable future.  This drives down the income return for bond investors, and makes their purchases subject to the possibility of loss in market value when interest rates finally do begin to rise.

However, Mr. Lack's article articulates aspects of the situation which many investors may not fully appreciate.  He explains that "Much of the return [for bond investors] of recent years has been fueled by capital gains through falling yields on long-term bonds" but that (as even the least-engaged bond investor should now realize) "Today's yields are close to, if not at, the point where further capital gain is not possible."

He then argues that bond investment returns from interest yields alone (without possibility of capital gains) "will turn out to be confiscatory" for three reasons:

1.  Transaction costs for the retail buyer are now (and have always been) too high, with investors paying a markup representing "an unacceptably big chunk of the possible return."

2.  Nominal yields on government and investment-grade credit will not stay ahead of inflation, let alone inflation plus taxes. 

3.  Even if yields were to stay ahead of inflation plus taxes, those planning retirement have to deal with costs which will rise faster than the measured "official" rate of inflation, and because they are generally on "fixed incomes" they will be even more vulnerable (unlike those who are still working and can hope to increase their incomes to keep up).

Again, these obstacles to bond investing are not new developments: the current situation has been building for over a decade, and many are aware of the general issue (although perhaps some of the nuances which Mr. Lack explains will reveal new sides to the problem for some readers).

The most significant aspect of his article, in our opinion, is the solution that Mr. Lack proposes for investors.  While many professional investors who have recognized these long-term problems with bond investing have turned to all kinds of structured vehicles engineered to try to address the problems described above, and while individual investors are being sold all sorts of "alternative" investments supposedly designed to create stable income streams with "less risk," the article actually proposes something which we think makes more sense.

Mr. Lack asks: "So where should investors go in their search for more-reliable ways to preserve the purchasing power of their savings?  The answer is equities.  US common stocks come in many flavors, provide growth opportunities and also offer an extremely fair deal to investors in terms of transaction costs."  Many stocks offer dividend yields that are much more attractive than the income possibilities of bonds, as well as offering attractive dividend growth rates.

To offset the greater potential for volatility (and even loss) which stocks present to the investor, Mr. Lack recommends holding greater percentages of cash than might otherwise be the case.

This strategy is actually one which we have been pursuing in our income strategy investing for some time, and we believe it is sound advice in the current environment.  We believe investors should clearly understand these issues, the serious problems facing bond investors, and the different courses of action which are available to them in the situation that has developed over the past several years.

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The importance of embracing risk

Economist and technology analyst Bret Swanson published an important essay earlier this year entitled "Long Live the Risk-Takers."  It examines the vitally important subject of "risk," particularly from the economic perspective. 

While acknowledging that seeking to identify and prevent (or at least avoid) future problems is a valuable and necessary endeavor, the essay then asks:
What happens, though, when we develop a hyperfocus on shortcomings and potential losses?  What happens when we seek a public policy remedy for every perceived problem?  This kind of obsession with [eliminating] risk, danger and downside may be counterproductive.  It may exacerbate known problems and unleash dangers never dreamed of.

The danger, Bret Swanson argues, stems from the fact that in the real world, "Entrepreneurship is more likely than centralized economic management to produce innovation and wealth."  Entrepreneurship requires conditions which allow decentralized citizens, acting on their own initiative, to pursue their own goals, dreams, and creative impulses.  This kind of decentralization can be scary and unpredictable, and it will necessarily entail some failure.  In short, it is risky.

However, the article goes on to say that such risk is not merely a byproduct of innovation and growth -- it is a key component of innovation and growth, and it is in fact a beneficial part of the process.  Mr. Swanson writes:
Wealth is about creating new ideas.  New ideas can only emerge through experiments of science, technology, and enterprise, all of which must be capable of failure in order to generate newness.  Failure flushes away bad ideas and points us toward good ones.  The failures may at times harm individuals and waste resources -- people lose jobs and investments can be lost.  The larger effect, however, is to lift the economy to a higher plane of knowledge, efficiency, and resilience.
Central planners may be tempted to try to protect citizens from risk by implementing public policies that make it next to impossible for people to lose their jobs, but doing so can lead to a situation in which entrepreneurship is stifled and new businesses, new innovations, and new jobs are never created, all of which might have been created if conditions had been less stifling.  

As Bret Swanson's essay points out, this scenario is not hypothetical: many European economies have tried to do away with "risk" over the past several decades, only to throttle the ability of decentralized citizens, acting on their own initiative, to pursue the risky path of innovation and growth.  By trying to eliminate risk, danger, and downside, these countries have made their economies less diverse, creative, and resilient -- and now their citizens are suffering because of it.

In his most recent book, Knowledge and Power, visionary author George Gilder takes this observation even further, arguing that the expansion of wealth comes "through the conduct of the falsifiable experiments of free enterprises".  He explains: "Crucial to this learning process is the possibility of failure and bankruptcy." 

His book explores the importance of information and knowledge, and the fact that information is inherently decentralized -- meaning that dispersed individuals will always possess more information about certain subjects than even the most efficient central planners, and that therefore decentralized citizens must be allowed to act on their own initiative, and pursue their own goals and dreams using the information at their disposal.  In fact, in his book, he defines information at its most basic level as "surprise," which goes a long way towards explaining why central planners, even at their most efficient, can never corner the market on information and knowledge.

This subject, of course, has profound implications for the investor.  For one thing, we have long argued that investors should view their investing activities as the allocation of capital to businesses, and there are many ways that they can use the insights of George Gilder and Bret Swanson discussed above to seek out businesses that are creating "surprise" in their field.

Investors should become concerned when they see central planners moving in a direction that inhibits the ability of businesses and individuals to create surprise and (in Bret Swanson's words) "generate newness" -- a process which can only happen when there is a possibility of failure.  There are signs that, for a variety of reasons, central planners in many parts of the world (including the United States) are implementing policies that try to eliminate risk, even though such policies in reality only create bigger problems in the long run.

While investors may not have much control over the direction taken by policy-makers, they can and should consider the above discussion on the subject of risk, and realize that the temptation to try to eliminate risk can actually be more hazardous than embracing risk.  We have written on this subject in the past, such as in our article from June of this year discussing the dangers of municipal bonds (which many investors consider a sort of nearly "risk-free" investment), or this reflection from four years ago this month examining the reason investors think of venture capital investing as inherently more "risky" than real-estate lending, when in fact the opposite may be true.

In short, we believe that both Mr. Swanson's article and Mr. Gilder's book deal with an extremely important subject for investors to ponder deeply, and that both should be considered "required reading."  It may be understandable that at this point in history, elected officials and the investing public at large are reluctant to embrace risk.  Nevertheless, we believe that a correct understanding of the concept of embracing risk has never been so important.

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Don't Get Caught Up in the Fray!

As the calendar turns from summer to autumn the dreaded months of September and October, historically the weakest months for the stock market, are facing investors, there is plenty of outside news to make even the most steely market veterans queasy.  On the minds of most citizens in the United States, let alone investors, is the question of whether or not there will be an escalation of U.S. military involvement in the Middle East.  As of this writing, the Obama Administration is heavily lobbying the U.S. Congress to approve a strike against the Assad Government in Syria, apparently as "punishment" for the regime's use of chemical weapons against its own population.  We have no expertise in handicapping what the response of the Congress will be, and even less with respect to what the Obama Administration will ultimately choose to do, irrespective of the vote in Congress.   We will also not opine on the merits of such an "activity".

What we can say is that history is fraught with military endeavors and the market has either initially sold off only to recover shortly (1991 Iraqi invasion of Kuwait, Afghanistan War in 2001, Iraq War 2003), or it has ignored the actions altogether (U.S. and British bombing of Libya in 2011, NATO bombing of Yugoslavia in 1999).  For sure, the more prolonged a military conflict becomes, the more likely the market will react sluggishly, at best, or negatively, at worst.  It seems likely that any action taken by the U.S. against Syria will be short-lived and limited in consequences, at least in the short to intermediate term.  Therefore, we would expect the effect of any action on the market will also be short-lived.

The problem that this current pending military engagement presents is that it comes after a dozen years of prolonged conflict that the U.S. has been involved in both in Afghanistan and Iraq; and the citizenry, including the "investor", is weary of the danger that another prolonged conflict could be in store if action in Syria should go poorly.  It is very important that we make the point here that we believe war is NOT good for the economy, which is contrary to what many often believe.  Besides the obvious human tragedy that war encompasses, it strains the economy in that resources which would normally go towards investment in productive, entrepreneurial activity are instead redirected towards destroying things and killing people.  Sure, the defense industry may benefit, but this is the ultimate "zero-sum game".  We would argue that much of the reason that the market has struggled over the last dozen years is at least partially due to the enormous economic AND emotional cost of the wars in which the U.S. has been embroiled.

This is not an indictment of the defense industry.  Yes, there have been many technologies that have emanated from research and development in defense and have ultimately been commercialized, thereby aiding economic growth.  However, the most valuable of scalable technological advancements have come from private investment in areas such as microprocessors, software, and bio-pharmaceuticals.

What is most important to recognize is that while war may well have served to suppress the economy and market in recent years, the economy has managed to grow in spite and many more advances in technology have occurred in mobile, 3-D printing, biotechnology, etc.  And while the market has made little progress over the past dozen years, it is that very fact that likely means any significant downturn is less likely to happen, or to last long if it were to occur at all.  Therefore, as events unfold in the Middle East in coming weeks, regardless of what transpires, it would be wise not to get caught up the the "fray"!

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The boy who cried wolf: Economy growing in spite of monetary policy, not because of it


Recently, the Federal Reserve issued a statement in which the members of the committee downgraded their description of the expansion of economic activity in the US from "moderate" to "modest" and reiterated their intention of keeping the zero interest-rate policy in effect for "a considerable time."  They also kept in place their ongoing quantitative easing policy, known as QE3 (sometimes nicknamed "Q-Eternity").

While the stock market response to this ongoing dovish sentiment from the Fed has been generally positive, we believe that the continuation of what were originally billed as "emergency measures" to address the 2008-2009 financial panic is unhealthy for the economy and the markets.  

We have written many times previously that the Fed should not be attempting to "steer" the economy.  Most recently, we discussed this problem in a blog post published towards the end of June, which contained links to the many previous posts which warn against the dangers of Fed "over-steering."

Even if the Fed does not decide to get out of the business of trying to steer the economy, we also believe that continuing to steer the economy as if it is in the middle of a major financial panic is inappropriate and potentially dangerous, just as it would be inappropriate and dangerous to drive your car as if you were always in the middle of an action movie car chase rather than simply going to work or going out to get coffee.

We have written about this problem before as well, such as in this post from last year entitled "Growing the economy, part 1: Get off a 'war footing' with monetary policy."  We know that central planners and policy-makers generally like to act as though we're always in the middle of an existential crisis (like a war): witness the "War on Poverty" and the "War on Drugs."  Such a mentality can induce the people to accept greater levels of intrusion into their lives from the governing bodies.  However, if such behavior is used all the time, it becomes a serious distraction to the normal, healthy functioning of individuals and businesses who are just going about their business and leading their lives.

At the risk of adding one too many metaphors, it's like the story of the "Boy who cried wolf."  After a while, the farmers got tired of dropping whatever they were doing and running to save the little boy's sheep from a wolf that wasn't really there.  All that running around took them away from their own business of the day.

While some would argue that the US economy has been in need of life support since 2008-2009, and that in such dire straits an endless "emergency status" is appropriate, we believe that the economic numbers have shown and continue to show steady, if painfully slow, economic growth.  We would also point to the analysis of professional economists whom we respect, such as Brian Wesbury, who argue that monetary policy gimmicks are not the way to grow the economy, and don't address the real issues that have been stunting economic growth in the US.  

In a recent note published on July 31, Mr. Wesbury wrote:
As we have written many times before, QE3 is simply adding to the already enormous excess reserves in the banking system, not dealing with the underlying cause of economic weakness, including growth in government, excessive regulation, and expectations of higher future tax rates.
Mr. Wesbury has coined the term "plow-horse economy" for the slow but steady progress that the economy has been making since 2009, and recent economic data such as the latest ISM manufacturing number and data showing continued gains in employment rates appear to support such a description.  The main reason the "plow horse" is not moving faster is that government has been weighing it down with additional regulation and costs, and these cannot be addressed with monetary policy from the Fed.

In fact, inappropriate "emergency" monetary policy actually acts as another load that weighs down the plow horse.  As another economist, Scott Grannis, writes in a post published on August 1 and entitled "A decent manufacturing report trumps QE," recent economic data:
casts serious doubt on the assumption that many observers have made that the Fed has been artificially lowering interest rates and in the process distorting the capital markets and artificially stimulating the economy.  As I've asserted for a long time, the Fed's QE program has been designed not to stimulate the economy but to accommodate the world's intense demand for money and cash equivalents.  And not only has monetary policy not been stimulative, but fiscal policy has been acting like a headwind to growth, since its emphasis has been on redistribution, huge new regulatory burdens (e.g., Dodd-Frank, Obamacare), and higher taxes.  In short, what we are seeing is that the economy has been growing in spite of monetary and fiscal policy, not because of it.
We believe these are very important insights from economists to whom investors should pay close attention.  Their analysis supports the assertions we make above that the Fed's continued zero-interest-rate policy and quantitative easing are inappropriate "oversteering" and that the sooner these policies end, the better.

Investors should also note that many stock market participants wrongly believe that the Fed's ongoing "emergency measures" are a good idea.  When those policies are finally removed, there may well be some serious negative reactions in the stock market.  However, we believe that any tantrums the market throws when the Fed finally ends these inappropriate policies will be outweighed by the longer-term benefits of getting these policies out of the way of real growth.

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Federal spending drops sharply in the US, leading to a budget surplus for June 2013

Recently, economist Scott Grannis published a post on his Calafia Beach Pundit blog entitled "Budget outlook improves dramatically."   In his post, he notes that:
especially in the last 12 months, there has been a dramatic improvement in the federal budget outlook.  Revenues have grown at double-digit rates of late, while spending has slumped.  As a result, the budget deficit has plunged, both in nominal terms and relative to GDP.  Almost two-thirds of the decline in the burden of the deficit since 2009 has come from the spending side, and that is good news since it leaves more room for the private sector -- the source of most productivity gains -- to expand.
His post contains some important charts which track the federal budget in terms of revenues (chiefly from taxes) and spending.  The charts show that while spending still exceeds receipts, the gap has narrowed significantly due to some recent spending cuts (including the government "sequester").  Other charts on his post show that federal spending has fallen as a percentage of GDP, from over 25% to 21.4%.  

The specific breakout of government spending outlays can be found in the US Treasury Department's most-recent Monthly Treasury Statement (MTS) which shows data through the end of June 2013.  The charts above, from the June MTS, show federal receipts in the top chart and federal outlays in the bottom chart.  While the outlays were generally higher than the receipts in most of the past twenty months, in June spending took a sharp turn lower and receipts took a sharp turn higher, leading to a surplus of $116.5 billion for the month.  Scott Grannis notes that the total spending for the twelve months ending this past June dropped 6% over the previous year -- "by far the biggest one-year decline in the past 43 years."

Brian Wesbury, another economist whose analysis like that of Scott Grannis we believe to be valuable, has commented on the June surplus in a recent piece entitled "Deficit?  What Deficit?"  There, he breaks down some of the components of the June spending drop (including some that are not really spending cuts but that the Treasury counts as spending cuts anyway), and notes that the overall federal budget deficit will probably drop to about 4% of GDP this year, down from over 10% in 2009.  Note that the deficit is the difference between spending and revenues -- that number is down to about 4% of GDP.  In contrast, spending by itself is a larger number than the deficit number -- that number is down to 21.4% of GDP.  It's important to keep those two different measurements straight, if you're not used to looking at these kinds of budget numbers.

We believe this development is actually very positive, and one that is not very well known by the general public or the investing community (Scott Grannis calls it the "most under-appreciated news that I am aware of today").  While there are of course aspects of the situation that could be much better, the fact that spending as a percentage of GDP has come down from over 25% in 2009 is very encouraging, since at that time it looked as though spending might continue to head towards an even higher percentage of GDP rather than coming down.  

It is also encouraging that the US economy (which drives tax revenues for the US government) has continued to grow, even if at a rate that is slower than we would like to see.  Brian Wesbury calls it a "plow-horse economy," as opposed to a race-horse economy.  At least it is still plodding forward.

In an environment in which many people are very nervous about the economy and in which positive economic news is not always widely reported in the media, we believe this development is extremely important and one of which investors should be aware.  

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Investment Climate July 2013: Have Interest Rates Bottomed?

We recently published our quarterly Investment Climate for the end of June, 2013.  It is entitled "Have Interest Rates Bottomed?"
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"A high-entropy, bull-in-the-china-shop distortion"

Here's a link to a recent article by John Tamny of Forbes entitled "All eyes are on the Federal Reserve, and that's the problem."  We believe it should be required reading for anyone who either chooses to invest in market securities or is in any way impacted by the monetary policy of the United States central bank (which is to say, just about everyone).

In the article, Mr. Tamny puts forward the thesis that "the Fed’s machinations have served as a massive barrier to a true bull market."  We agree with this assessment.

In fact, we have been saying pretty much the same thing for years.  We recommend a quick trip down memory lane to the following posts on this subject:

Mr. Tamny's article is also important for contrasting the excessive Fed focus with what investors should be focusing on: business, and particularly successful and innovative businesses.

He writes:
Rather than judge companies on their individual merits, investors must waste valuable time playing junior Kremlinologist in order to divine the future actions of the second rate economists who populate the Federal Reserve. Investors aren’t doing this because our central bankers have any useful knowledge to impart, but because what should be a low-entropy monetary input has become a high-entropy, bull-in-the-China-shop distortion whose actions must be priced.
Far from a driver of positive economic evolution, a Fed that we all have our eyes on has become an economy-shrinking distraction that forces us to consider the macro over the all-important micro. Instead of focusing all of our attention on commercial ideas not yet hatched but that need investment, on existing companies that simply need new direction, not to mention healthy companies that would grow even larger and healthier if entrusted with more funds, investors must, in the words of George Gilder, spend inordinate amounts of time so that they can “predict the exercise of government power” over predicting which technology highflyer will become the next Apple*, or which corporation is best suited to cure cancer.
This contrast is the most important message in the article.  We believe it goes right to the core of investing, and that investors should keep this message at the forefront of their thinking at all times.
* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL).
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Municipal bonds

In the classic 1988 film Bull Durham, the frustrated manager throws a staged tirade in order to turn his team around, a tirade which includes the immortal lines:

"This is a simple game.  You throw the ball.  You hit the ball.  You catch the ball."

In spite of all the mystique that for some reason surrounds the world of finance (including the numinous world of "high finance"), our opinion is that finance is a simple game as well:

"You invest capital.  You hope to get your original amount back.  You hope to get something in addition to that original amount to compensate you for your trouble and the use of your capital." 

That's it.  Not quite as eloquent as the manager of the Durham Bulls, but simple nonetheless.

If the arrangement is a loan, you hope to get back your principal plus interest.  If the arrangement involves equity in a business, you hope that the value of your equity stake grows enough to return your original investment plus some capital gains.  You may also get dividends.  If the entity asking for the capital is well-connected politically, it might be able to offer you interest that is not subject to taxation.

Other more complex capital structures might involve debt that returns your principal plus interest plus a chance to convert into equity.  There are really no limits to the way the investment can be structured -- theoretically you could craft a deal that would promise to return your principal plus one pizza a month for twenty years, if you really wanted to.

However, if you decide to enter into this business and you want to have any hope of seeing your original amount come back to you, let alone anything extra, you might want to do a little bit of analysis of the entity to whom you are giving your money.  After all, if you walk into a bank and ask them for a million dollars in financing, they won't usually just hand it over to you -- they will typically want to ask you a few questions about your income, your other debts, your credit history, etc.  Investors would be wise to do the same before they get into the business of financing.

That's why at Taylor Frigon Capital Management, when investing capital on behalf of our clients, we exercise extreme caution with regard to investment in municipal bonds.  Not only do we feel that many of them have terrible answers when it comes to their income, other debts, and credit history, but there have also been examples of municipalities being slightly less than forthright in their answers to those questions (in other words, making their answers sound better than the actual situation would suggest is the case).

Recently, the US Securities and Exchange Commission charged two borrowers with securities fraud for allegedly deceiving those considering the loan of capital to them.  Those borrowers were municipalities: Harrisburg, Pennsylvania, and South Miami, Florida.  As municipalities, they borrow money by issuing municipal bonds.  States in the US also borrow money by issuing municipal bonds (when the federal government borrows money, they issue Treasury bills, notes and bonds).

In an article entitled "The Many Ways Cities Cook their Bond Books," Steve Malanga of the Wall Street Journal explains that the SEC has previously charged states with making "material omissions" and "false statements" in their municipal bond documents, including the state of New Jersey in 2010 and the state of Illinois in March of this year.  The article explains that:
With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."

The article explains that such fraudulent activity in misleading potential and actual investors is nothing new in the municipal bond market.  It notes that when Stockton, California, filed for bankruptcy, the city's new financial managers found evidence that Stockton had been hiding "significant costs, including the real cost of employee compensation and retirement obligations," and that after San Bernardino, California, filed for bankruptcy, some observers alleged finding evidence that the city "had been filing inaccurate financial records for nearly 16 years."  Just read that last quotation again slowly in order to let it sink in.

All of this is related to the issue that we have called "The question of our time," which is the fact that "retirement obligations" (as in pensions for government employees) and other government benefits (including health insurance programs) have been promised far in excess of what government incomes can sustain, not just in US cities and states but in fact all over the world (Japan and Europe are two other examples recently in the news). 

Those who decide to loan money to a government entity should conduct a thorough examination of such obligations and the income that is supposed to be supporting those obligations, before committing capital.  As the article points out, however, it is always more difficult to do that when the entity asking for the loan is deliberately falsifying their books.

In the end, financing really is a very simple business.  If you intend to offer your capital to some entity, in the expectation of getting it back some day with "something extra" (whether interest payments, dividends, capital gains, or some combination), it would be wise to consider the potential for growth of that entity's incomes and financial obligations.
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Rip Van Winkle, revisited

Here's a link to recent commentary entitled "Still Bullish," from one of the most insightful economists we know, Brian Wesbury.

In it, he proposes a mental exercise, asking readers to imagine that they had gone to sleep on October 09, 2007 (when the major US stock indexes were making record highs, but just before they began their decline towards what became one of the deepest and most gut-wrenching bear markets in history), and just woke up this week.  In this exercise, he explains, our modern-day Rip Van Winkle would have slept through 67 and 1/2 months, nearly six years.  

He then asks readers whether, knowing where equities are today and where they were at that time, they would have chosen to buy equities or not before this long nap.  If the answer had been "buy," then even though the economy suffered a violent recession and the markets were ravaged in the interim, Rip would have awakened this week to find the Dow Jones Industrial Average 8.4% higher than when he started his nap back in October of 2007. 

We believe investors should carefully consider the implications of Mr. Wesbury's article, and the data he provides to support his arguments.  In fact, we used the very same Rip Van Winkle analogy in two blog posts in the past, both of which are worth revisiting today:
In those articles, we pointed out that this analogy is helpful, but only to a point.  We obviously do not advocate simply ignoring one's investments under the mistaken belief that things "always turn out for the best."  Many who have not read Washington Irving's actual tale do not realize that his Rip Van Winkle was not exactly a sympathetic character, but instead was one described as having an "insuperable aversion to all kinds of labor," and one who would rather "starve on a penny than work for a pound."

We also don't advocate the idea that investors are best served if they just "own the market" rather than spending energy evaluating individual companies to find superior destinations for investment capital.  While Rip would have been better off had he bought all the companies in the S&P 500 before his nap than if he had left that money in cash, he would have been even better off if he had been able to buy the shares of a smaller number of truly exceptional companies instead.  Note that in the "nap interval" selected by Mr. Wesbury, the thirty-name Dow Jones Industrial Average outperformed the 500-name S&P index by a fairly wide margin.

However, the main point of the Rip Van Winkle exercise is to highlight the fact that for the vast majority of investors, investing in equities must be a long-term decision, appropriate for assets that one can afford to leave invested for many years.  When that is the case, then investors can afford to take the longer view, and avoid over-reacting and potentially causing self-inflicted wounds during the intervening period.  Like the hypothetical investments of Rip Van Winkle in the illustration of Mr. Wesbury or in our blog posts above, the markets can go through all kinds of gyrations in the intervening years, but none of that matters if your investments are worth more in the long run than they would have been worth had you made a different choice.

This is a very important point to keep in mind during times of turmoil.

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Crossing the chasm to IPO becomes even more difficult


Here is a link to the website of Renaissance Capital of Greenwich, Connecticut, which shows U.S. IPO volume by capital raised for the past decade, beginning in 2003 and showing each year up through the year-to-date figures for 2013.  The graph below shows the status as of the publication of this post, May 16, 2013:
Clearly, the total volume of capital raised has yet to return to the levels reached prior to the meltdown of 2008-2009.  IPO volume reached $48.7 billion in 2007, before being cut in half in 2008  to $21.8 billion, and declining from there in 2009 to $21.8 billion.  Although the volumes have rebounded since 2009, they have yet to reach 2007's watermark.

The above chart begins in 2003, which was the first year of recovery after the previous market meltdown of 2000-2002, and that year the total volume was only $15.2 billion.  In 1999, the final year of the roaring bull market and accompanying IPO mania, volume reached an all-time high of $69.1 billion in capital.  Clearly, nothing in the intervening years has come close.

It strikes us that this dearth of IPO volume is not a healthy sign for free enterprise.  While it is certainly possible to argue that the 1999 IPO market became distorted on the upside, with some of the volume made up of companies who had no business going public, in general the emergence of new businesses is healthy for competition and innovation.  

But, the capital volume figures do not even tell the entire story.  The same Renaissance Capital website also shows charts for IPOs by number of filings.  This data is even more revealing.  Again, the chart showing the status through the date of publication of this post is shown below:

This chart reveals that the number of filings has been dropping since 2004, dropped precipitously in 2008 and 2009, and is still well below the numbers reached in 2007 and 2004.   The number of IPO filings in 2004, numbering 314 filings, was still well below the whopping 541filings recorded in 1999!

In the previous chart, capital raised for 2012 was above the capital raised in either 2011 or 2010, but in this chart it is clear that the capital raised in 2012 was done with far fewer IPO filings than in either 2011 or 2010.  This comparison reveals that the capital raised is coming from fewer, larger IPOs.  The capital volume is being boosted by mega-IPOs, such as Facebook (May 18, 2012).*

We believe that these charts highlight a very unhealthy trend: fewer companies are able to make it to IPO, and those that do are much bigger when they finally do go public.  This situation is unhealthy in several ways.  First, it means that fewer companies are shaking up the status quo in any given industry.  The entrenched incumbents have less to fear.  Less competition often means higher prices and lower quality than might otherwise be available, as complacent incumbents have less to fear.  More competition often means lower prices and greater improvements in quality.

A second negative consequence of the mega-IPO trend is the fact that the average investor has less opportunity to participate in a growing company in its early years.  By the time Facebook went public, it had already reached a valuation of over $104 billion.  If it had gone public at an earlier stage, smaller investors could have been along for the ride before it reached that valuation.  As it was, only the insiders and others with access to private shares in the company were able to participate prior to the company's reaching of that lofty valuation.

Even more disturbing, however, is the fact that the trend towards fewer and larger IPOs means that venture investors who fund companies looking to "cross the chasm" between start-up and fully-fledged, independent public company will become even more selective, holding out to fund only the companies that can become big IPOs.  Valid businesses, which might never have a chance of being "the next Facebook" but which in an earlier era might have had a smaller IPO and become a successful independent player, might be passed by and never get the funding they need to cross that chasm.

In fact, we believe that the bridge across the chasm from start-up to IPO has been blown out in the years since 1999, and especially since 2008-2009.  While it was never easy to make the perilous crossing to an IPO, nowadays the funding is even harder to come by, especially in the "middle parts" of the bridge.  Companies might be able to find angel investors and early-stage investors to get them launched, but unless they are looking like "the next big thing," finding funding at the middle sections of the journey has become much more difficult.  Many now languish in the middle sections, and some will die there.  The successful ones are more likely to be scooped up by existing companies in their industry (the incumbents) than to make it all the way across to an IPO of their own.

This is an important phenomenon for investors to understand.  There are probably many causes, including increased government regulation and increased skittishness on the part of venture investors in the wake of the two meltdowns mentioned earlier. 

Another probable contributing factor has been the pied piper of "green" projects that collectively seduced many of the Silicon Valley venture firms during the decade that followed the 2000-2002 tech meltdown.  Leery of tech investments after the crash, and yet flush with investor dollars that needed to be invested somewhere, many venture investors turned to green energy start-ups, possibly lured by the various state and federal incentives that were being dangled in front of companies in that field.  This recent article in Forbes magazine highlights the woes of one famous venture firm during the period, and contains a quotation in which its founder calls one of those investments the "most tragic venture-capital-backed debacle in recent history."

Articles like that one are a clear indication that the venture capital world is waking up from their trance, which is a good sign.  If government loosens the stranglehold of some of the regulation that was put in place as part of the backlash against the economic disruptions of 2000 and 2008 (much of which serves as only a minor annoyance to the huge incumbents but which can effectively choke out the start-ups who could become potential competitors to those incumbents), we expect to see the situation improve.

Then, healthier levels of traffic across the chasm that stretches from start-up to IPO would no doubt return.  In the photograph at top, an intrepid individual makes his way by rope across a blown-out section of the old bridge over the Blue Nile river near Amhara in Ethiopia, clutching a walking stick in one hand as he does so!  This bridge was replaced in 2009 with a new suspension bridge through the philanthropy of charitable individuals, and the new bridge now services about 500 travelers crossing the canyon every day.  It is almost certain that traffic was lower than 500 travelers per day when the only way across was by rope!

* As of the date of publication of this post, the principals of Taylor Frigon Capital Management do not own securities issued by Facebook (FB).
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Unstated assumptions about government stimulus

Here's a link to a Yahoo video of former Wall Street analyst Henry Blodget declaring that "The Economic Argument is Over -- and Paul Krugman Won" in which Mr. Blodget asserts that government stimulus is the way to help economies grow, and that anyone who argues to the contrary has now been silenced by a recently-discovered spreadsheet error.

The spreadsheet error to which he refers is found in a 2010 study arguing that government deficits stifle growth after reaching 90% of GDP (the paper, authored by Carmen Reinhart and Kenneth Rogoff, was entitled "Growth in a Time of Debt").  The paper was widely cited by the so-called "austerians," or those who argue for government "austerity."  

The term "austerity" usually means a set of policies which force a government to spend less and -- often -- to tax more at the same time.  

Since the error in the 2010 paper went public last week, supporters of  government stimulus have been rejoicing and declaring victory, just as Henry Blodget does in the above-linked video.  He has been on record as a supporter of government stimulus packages for some time -- here is a video of him praising Paul Krugman's calls for stimulus from 2009.

Of course, just because "austerity" defenders have been embarrassed by a spreadsheet error does not mean that government stimulus is beneficial for an economy.  We believe that government "stimulus" represents a misallocation of capital, in that the government first takes money through the threat of force (taxation) and then spends it where government officials decide is the "best" place for that capital.  Instead, we believe that the decisions of the original owners of that capital, freely allocating their own capital for themselves, will always be better than the decisions of government officials allocating money that they have taxed from someone else.

Here is a previous post in which we linked to a video full of evidence that stimulus is actually harmful, not helpful.  Many authors have been surfacing lately who have been crediting the entire economic recovery, slow as it has been, to government stimulus.  But if stimulus is actually more detrimental than beneficial, then the recovery has been in spite of government stimulus, not because of it!

The whole problem with the Reinhart and Rogoff approach, in our view, is that those who use it as an argument are tacitly accepting the idea that stimulus is beneficial.  The "austerians" have basically been saying, "Yes, stimulus might be helpful, but you can't have too much of it, or the government will rack up enough debt to counteract the helpful aspects of stimulus."  The Reinhart and Rogoff study put that "harmful point of debt" at 90% of GDP, but below that at least some of them seem to think that stimulus is A-OK.

Now that the mathematics behind the 90% number has been shown to contain "spreadsheet errors," many government stimulus fans are dancing a jig, and saying that this proves that stimulus is great, and that there's no upper limit to how much of a good thing an economy can handle.  But the spreadsheet error doesn't prove a thing about whether or not government stimulus is actually good, at all.  We believe it is harmful, and quibbling over whether it stops becoming helpful at 90% or some other number is nonsense if it is actually never helpful in the first place! 

For plentiful historical evidence that stimulus is not helpful but harmful, please go back and re-visit the Dan Mitchell videos which we have linked in posts going back as far as 2009, such as this one and this one.

Furthermore, we have written about the problems with the "austerity" mantra in previous posts, including this one and this one.

Finally, Brett Arends at the Wall Street Journal has written a good article analyzing the current brouhaha over the Reinhart-Rogoff article, entitled "Why everyone is wrong about austerity."  In it, he makes some excellent points, including the point that backwards-looking studies such as that of Reinhart and Rogoff are inherently flawed from the outset. 

Analysts that appear on the financial media often hold unstated assumptions which inform the analysis that they present for their viewers.  Often, one of these unstated assumptions is the idea that government stimulus is positive for an economy.  Even those "austerians" who seem to be on the other side of the argument sometimes hold this view.  We believe it is a mistaken assumption, and we believe investors should be very aware of the evidence which call that assumption into question. 

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The gold sell-off

In our previous post discussing Cyprus, we noted that governments in general have three choices when they run up debts beyond what their income can support.

One option, of course, is to increase their income.  Governments can try to raise income by raising tax rates or, a far better option, by encouraging economic growth which will lead to greater tax revenues even if tax rates stay the same or go lower.

A second option for governments is to borrow further.  Governments do this by selling bonds.  If they do too much of this, however, it can cause their borrowing rates to go up and their credit rating to go down.  

A third option is to print more money in order to pay for their expenses.  Because a big part of those expenses are interest payments on their debt, this option is also known as "monetizing the debt."  It is  also known as inflating the currency.

One of the consequences of inflating the currency is that it takes more dollars to buy the same amount of the same thing, and one of the places this effect can be most easily seen is in the number of dollars it takes to buy a fixed amount of gold.  Since a gold bar of equal weight and equal purity made in 1970 is no better and no worse than a bar of the same weight and purity made today, the difference in the price of the same gold bar in 1970 and today is primarily a function of the inflation of the currency. 

When governments inflate a currency, the price of gold and other commodities go up in relation to that currency.  When people expect a lot more inflating activity in the future, many of them will start to buy gold or other commodities in the anticipation of the rise in commodity prices.

Gold has been on a nearly unbroken bull run since 2001, but since the publication of the previous post on Cyprus something very significant took place in the gold market: the price of gold, which had been settling slowly after reaching all-time highs in August of 2011, plunged 25% during the week of April 8th through April 12th, and then continued to plummet on Monday, April 15th with a drop of over 9% in a single day -- the biggest one-day drop in thirty years.  The price of gold ended last week just above $1400 per ounce, down more than 25% from the high of $1,900 reached in August, 2011.

Does this drop signal the end of something, or is it just a big head-fake in a landscape that has not changed?  Arguments that nothing has fundamentally changed and that the reasons for buying gold remain intact are well summarized in this article entitled "Gold Down: What Now?" by Frank Seuss, published in the Daily Bell.  In that article, the author argues that: 
Fundamentally, all of the reasons that made gold an ever more attractive asset over the past years are still fully in place, and increasingly so. The recovery story is really just that: a story. All the reasons to buy and hold gold as a medium- to long-term crisis hedge and for portfolio diversification are fully intact. The only difference is that now, or in the next few weeks, we can buy at a much better and more reasonable price.
In other words, he believes that the economic recovery is a "myth, a word he uses earlier in the article.  While this article does not give the authors reason for calling the economic recovery a myth, many who are in that camp argue that any growth the economy has experienced since the crisis of 2008-2009 has been the product of easy money from central bankers and stimulus spending from central governments.  Those in this camp note that such policies inevitably lead to more inflating, which will inevitably push up the prices of commodities including gold.  Some in that camp also believe that the situation could get so dire that it could lead to an outright collapse, in which case fiat currencies would become worthless while tangible stores of value such as gold would not.

Although we adamantly oppose inflating the currency, we believe the arguments of those in the "myth" camp are mistaken.  

One of the primary problems with the argument is the idea that the economic recovery is all a product of emergency government spending and central bank easing.  We believe this view gives far too much credence to the healthful powers of government spending and easy money.  In fact, we believe government spending and excessively easy money are harmful, not helpful, and that the recovery has taken place in spite of such actions, not because of them.  We suspect that without such obstacles, the recovery would have been much stronger over the past four to five years.

Secondly, there may have been some other factors at work fueling gold's spectacular 12-year bull run than simply fears of inflation and speculation of more government spending and monetary expansion, although those certainly contributed.  In this important blog post entitled "Gold is re-linking to commodities," published last Monday April 15, retired economist Scott Grannis argues that the surge in the demand for gold corresponded to a decade of explosive growth in China, which caused China to increase their foreign exchange reserves at a rapid pace.  

Holding foreign currency exposes a country to foreign exchange market risk, and a common move is to use those reserves to buy commodities, including oil and gold.  In his posts on this subject, Scott Grannis presents some excellent charts showing a very strong correlation between the increase in China's foreign currency reserves and the steep climb in the price of gold, beginning around the year 2001.  He explains: "This came to an end in early 2011, as net capital inflows to China approached zero, and shortly thereafter gold peaked.  Both forex (foreign exchange) purchases and the price of gold increased by many orders of magnitude over roughly the same period."

These arguments contradict the idea that "Fundamentally, all of the reasons that made gold an ever more attractive asset over the past years are still fully in place, and increasingly so," as those in the camp of the "recovery myth" believe.  

Trying to predict the next move in the price of any commodity is extremely difficult, and we believe that doing so correctly year-in and year-out for long periods of time is next to impossible.  We have always argued that it is much wiser to invest capital in businesses which can be analyzed based on their business plan and management team than to speculate on the ups and downs of commodities, including gold.

The indisputable history of governments with fiat currencies over time is to inflate those currencies.  The question is how investors should protect themselves against such depredations.  While ownership of gold is a well-known strategy in this regard, speculating on the price of gold is fraught with peril, especially because the price of gold can be influenced by numerous factors, some of which are unknown to the general public.  We believe this is a very important subject for our readers to understand.

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