Growing the economy, part two: Fix the bad fiscal policy

Above is the full video of the press conference held by Fed Chairman Ben Bernanke held last week -- Thursday, September 13, 2012 -- as he announced yet another in a long line of "unprecedented levels of policy accommodation in recent years" (0:01:46).

In our previous post, entitled "Growing the economy, part one: Get off of a 'War Footing' with monetary policy," we argued that the Fed's unprecedented levels of accommodation over the past four years were inappropriate and in fact harmful. We also promised to discuss why the Fed continues to take this approach, and because the Fed really went "all-in" on that approach last week, it becomes even more important to understand what is behind their actions.

As Mr. Bernanke explains in his opening remarks at the press conference in the video above, the Fed has in its job description something called the "dual mandate," which is to use monetary policy to ensure both price stability and maximum employment.  With government measurements of unemployment still stubbornly above 8%, the Fed is compelled by this second part of their dual mandate to take additional steps to try to reduce unemployment.

In this regard, Mr. Bernanke and the Fed can hardly be criticized: their job description includes taking steps to ensure full employment, and unemployment remains at 8.1%, well above "maximum employment."  Never mind the fact that their control over the tools of monetary policy gives them precious little in the form of tools that can actually create employment -- it is in their mandate, so they have to do something with the tools they have, as inappropriate as that may seem.

To fix that mandate, lawmakers should get rid of it, by amending the Federal Reserve Act (in fact, the dual mandate was only added by Congress to the Federal Reserve Act as recently as 1977).  We have previously published our view that the dual mandate should be abolished (see this previous post, for example).

In his opening remarks, Mr. Bernanke makes reference to the fact that what is really needed in this situation are not monetary tools but rather fiscal tools, and we agree.  All the monetary accommodation in the world will not induce businesses to hire and expand if misguided fiscal policy (set by policymakers in Congress, not the Fed) imposes enormous burdens to hiring and expanding, by increasing the costs of employee health insurance, increasing the regulatory burdens and penalties aimed at businesses, increasing government activity in areas that were previously addressed by private businesses, increasing the taxes on business activity or making the threat of increased taxes seem more likely, and increasing government's spending to the point that future taxes seem even more likely.

Therefore, in order to unleash economic growth (and improve the employment picture at the same time), we need to fix the broken fiscal policy coming out of Washington lawmakers.  As distinguished economist  Dr. Walter Williams points out in his most recent syndicated column, fiscal policy (the power to tax and spend) is the responsibility of the Congress, not the responsibility of the Fed, and also not the responsibility of the President.

In the video below, Brian Wesbury (another economist with whom we agree), explains why he believes the Fed's action yesterday can be called "QE3," why it is misguided, and why it is the fiscal policy that must be fixed if the economy is going to grow:

He also provides some additional thoughts on the reasoning behind the Fed's incredible new tactic of telling the public that interest rates would remain essentially at zero until at least the middle of 2015 (this is what the Fed now calls "forward guidance"), while initiating additional balance sheet activities (often called "quantitative easing" as explained in this previous post) that it will continue until levels of unemployment fall.

At about the 2:30 mark in the above video, Mr. Wesbury points out that -- in addition to trying to fulfill their dual mandate -- the Fed officials may also be trying to correct the difference between the current rate of nominal GDP growth and the rate of nominal GDP growth that had prevailed before mid-2007.  However, as Mr. Wesbury insightfully observes, that is a terrible mistake!  That would be, in Mr. Wesbury's words, "trying to get GDP back to where it was in a bubble time!"  

This brings us to our final point for today's post.  The bubble to which Mr. Wesbury refers was primarily a bubble in housing prices and housing activity, and it was a bubble that was almost entirely created by . . . misguided monetary policy after the previous recession and bear market!  

All of this shows the folly of trying to use monetary policy to "steer the economy," as the 1977 dual mandate  requires by law, and as yesterday's Fed announcements clearly indicate the Fed is trying to do once again.  We have written about the dangers of such "Fed steering" many times in the past. 

As Mr. Wesbury argues beginning at about 1:30 in the above video, the biggest deterrent to economic growth right now is "bad fiscal policy: too much spending, too many regulations, fears about future regulations [. . .], and fears about future tax hikes -- all of that is holding back the economy, and its not a lack of money that is the problem."

We couldn't agree more.

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Growing the economy, part one: Get off of a "War Footing" with monetary policy

As investors return from a three-day Labor Day weekend in the US, much of the talk in the financial media centers around the activity of the central banks, particularly the European Central Bank and the US Federal Reserve. 

Many interpret Fed Chairman Ben Bernanke's comments at Jackson Hole last week as indicating that the Fed is preparing to "do something" at the upcoming Fed meeting on September 13, possibly including the formal declaration of the intent to keep US short-term interest rates at zero through 2015 (rather than through 2014, as the Fed has already pledged to do).

Why does the Fed feel the need to "do something," and why do many investors and pundits continue to argue that the Fed needs to "do something"?  The answer is pretty obvious to anyone who has been paying attention to economic matters at all, which is that unemployment remains stubbornly high and economic growth remains stubbornly low, and many assume that central bank action is part of the solution to these woes.

In this first installment of a short series of posts about how to fix the economy, however, we will make a different argument.  We would argue that when it comes to monetary policy, the best way to allow the economy to experience more robust growth with more jobs is to pursue a stable monetary policy and (equally important) a normal monetary policy.

Unstable monetary policy creates unpredictability and uncertainty that creates obstacles for businesses.  If your business requires purchasing components or ingredients and you don't know whether the prices for those components or ingredients will be going up rapidly over the next few weeks or months, it makes it difficult to plan.  When prices fluctuate wildly, businesses end up spending money trying to hedge against future price fluctuations, and time and talent that could be spent more productively doing something else is instead spent trying to analyze and predict price fluctuations and to plan strategies to lessen the impact of the price volatility.

Unstable monetary policy also creates obstacles to the critical function of supplying businesses with the capital that they need to grow and expand.  If central banks allow massive inflation, for example, lenders may be worried about loaning capital that will be repaid to them later with less-valuable dollars.  To guard against this danger, they may have to charge higher and higher interest rates, or they may become much more reluctant to lend.  Either way, capital can become less available to innovative businesses -- not because those businesses are not promising but because monetary policy is unstable.

Just as important as having a stable monetary policy, however, is having a normal monetary policy. This fact is something that commentators often overlook (especially those who continue to clamor for the Fed to "do something" next week).  The US Federal Reserve has kept short-term interest rates effectively at zero since December of 2008!

A zero interest rate is not a normal interest rate: it is an emergency interest rate, akin to going on a "war footing."  The dramatic cuts to the fed-funds rate that were enacted in 2008 were seen as emergency measures necessitated by a potential liquidity crisis.  Whether the actions taken in 2008 were appropriate or necessary can be debated, but four years later we are no longer in the middle of a financial panic and a potential liquidity crisis.  Why are we still on a "war footing" with regard to interest rates? 

US GDP has been growing at an average of 2.2% annual since the recovery officially began in mid-2009, and at 2.3% in the past year (as economist Brian Wesbury explains here).  While these are not stellar growth rates for GDP, they do not call for a 0% interest rate.  Many economists believe that interest rates are inappropriately low and monetary policy overly loose when they lag below real GDP by even a fraction of a percent.

Keeping interest rates this low may well be contributing to the slow economic growth, and it is certainly inviting dangerous inflation.  The Fed has enormously beefed up bank balance sheets by its emergency actions since 2008 (for an explanation with diagrams of what this means, see this previous post), which certainly alleviates any possibility of a liquidity crisis.  But, as central planners typically do, they are "fighting the last war."  It is no longer 2008!  All that excess money on bank balance sheets has not found its way out into circulation for a variety of reasons, but it certainly could do so and it could do so very rapidly.  If it did, that would have the potential to be enormously inflationary.

Finally, there is an aspect of "self-fulfilling prophecy" in this continued "war footing" mentality.  The US economy acts like it is still in an emergency mode because the Fed continues to enact an emergency monetary policy (and has said that it will need to do so through at least 2014).  

To allow the economy to return to healthy growth, it is time to stop fighting the last war and get rid of these unnecessary -- and harmful -- emergency monetary gimmicks.  A crucial aspect of a healthy growing economy is a stable and a normal monetary policy.

All of this begs the question: "Why is the Fed taking this approach?"  We'll tackle that in our next installment in this series.

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Have you heard of this (boring) company? APH

From time to time, we publish a brief highlight of a company that we own on behalf of our investors, in order to provide an example of the investment philosophy that we practice and that we try to explain to the world in the pages of this blog. In the past, some of the companies highlighted have included:

• EZchip Semiconductor (EZCH)
• Panera Bread (PNRA)
• Tractor Supply Company (TSCO)

and

• ResMed Inc. (RMD)

These short overviews are meant to provide some concrete examples of the investment principles we follow, and to counteract some of the incorrect understanding of "growth stock investing" that began in the 1990s and persists to this day (for more discussion of our understanding of what we might call "true" or "classic" growth stock investing, see previous posts such as this one and this one).

This time, we'd like to briefly discuss a company that may not fit the stereotype of a "hot growth stock" as portrayed by the often-unhelpful financial media, but a company that we believe fits the definition of a true "Taylor Frigon growth company," and that is electronic-equipment manufacturer Amphenol Corporation, of Wallingford, Connecticut*.

Founded in 1932, Amphenol is one of the largest manufacturers of electronic connection products in the world, including fiber optic connectors, busbars, backplanes, specialized cable assemblies, and other parts that enable the ongoing demand for electronics and automation in industrial equipment and automobiles. Many of their parts are designed for harsh environments and the rugged use-cases encountered in the aerospace, mining, and defense industries, often involving waterproofing, vibration-resistant connections, and the ability to withstand high pressure, extreme temperatures, and corrosive materials.

Many Amphenol products (some of which are pictured above) may not be as sleek-looking or ultra-modern in design as the consumer devices that many investors think of first when they hear the words "high-tech," but Amphenol components are critical connections inside many mobile connected devices, fully 50% of which contain Amphenol products in the form of antennas, microphone and speaker connectors, camera sockets, battery connectors, charger connectors, and so on.

Furthermore, Amphenol is a leading provider of electronics solutions that connect the "guts" of the communications networks that make those mobile devices possible, with products that go into cellular base-stations, wireless routers, cellsite antennas, and fiber-optic backhaul interfaces.

And, in case you think that the industrial-strength connections that Amphenol has successfully manufactured for decades are getting ready to be replaced completely by wireless RF connections, Amphenol offers a complete line of RF products which enable connection of devices through wireless RF technology. In fact, Amphenol engineers invented RF technology in the 1940s in conjunction with the US military.

Amphenol has a long history of steady earnings growth (interrupted by periods of earnings declines in 2001-2002 and 2008-2009, each period of decline lasting for about five quarters), and their most recent 5-year operating earnings growth has been at a compound annual rate of 13.3%. Their most recent 3-year operating earnings growth has been even faster, at a compound annual rate of 26.7%. The company's current return on equity (defined as current earnings available to common shareholders divided by common equity) is 21.8%. The company also instituted a modest dividend in 2005, which continues to the present and has grown at an annual rate of about 42.6% in the past five years.

In short, Amphenol may seem on first glance to be a somewhat "boring" company, involved in the unglamorous business of manufacturing the connectors and components that undergird the modern electronic world. In reality, the company is a textbook example of what the late Dick Taylor would call a "stable grower" and what Thomas Rowe Price might have described as a "successful business enterprise which continues to grow and prosper over a long period of years."

We believe that Amphenol exemplifies the kind of company that investors should consider as a destination for investment capital (as part of a well-rounded investment strategy constructed in conjunction with their objectives and constraints), and we highlight it here in order to illustrate the application of some of the general investment principles that we discuss here in the Taylor Frigon Advisor.

Perhaps most importantly, it serves to demonstrate that a "growth stock" may look very different from the companies that you hear being breathlessly ventilated night and day in the financial media.






* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Amphenol Corporation (APH), EZchip Semiconductor (EZCH), Panera Bread (PNRA), Tractor Supply Company (TSCO), and ResMed Inc. (RMD).

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Who is right, Bill Gross or Jeremy Siegel? Answer: George Gilder

Recently, the venerable bond-house money manager Bill Gross of PIMCO published his August Investment Outlook beginning with the attention-grabbing opening sentence: "The cult of equity is dying."

Headlines in the financial media immediately began to proclaim that Bill Gross was ringing the famous "Death of Equities" bell (here's one from the Wall Street Journal, and here's another from CNBC).

The phrase "The Death of Equities" has become legendary in investment circles ever since it was featured on the cover of BusinessWeek on August 13, 1979 (image below).  You can take a trip down memory lane and re-read that cover-story from August 1979 here.

Part of the reason that 1979 declaration of the death of equities has become so famous over the years, of course, is the fact that the stock market of the 1980s and 1990s produced such tremendous returns for many investors, prompting stock-market advocates to pull it out as a warning to all those who would ever dare to call the "death of equities" again. 

The current commentary from Bill Gross is no different, especially because his August investment commentary takes specific aim at the premise of Professor Jeremy Siegel's iconic 1990s investment text, Stocks for the Long Run and its thesis that -- over long periods of time -- stocks outperform all other asset classes.  Many who are rushing to refute the arguments of Mr. Gross and defend the arguments of Professor Siegel are invoking the 1979 cover story, but we think that by doing so they may be missing an even more important point.

Our reading of his Investment Outlook notices two main arguments: 

First, he argues that -- although the long-term real return for stocks is 6.6% when you look at 100 years -- the more recent rate of return for stocks for shorter periods has been far below that, and in fact this is a return to something like a "new normal" because that 6.6% return was the product of an anomalous period of time, "a historical freak, a mutation likely never to be seen again as far as we mere mortals are concerned."

This first argument is the one that makes equity bulls angry, and the one that has them digging up the 1979 BusinessWeek and rushing to the defense of Professor Siegel.  However, in doing so many appear to have missed his second point, which he tells us is the real point of his article (in the first sentence of the section entitled "Got Bonds?").  

His second point is that the long-term returns quoted for bonds are probably just as illusory for future investors, arguing that the long-term bond return has been boosted by the anomalous decades we just went through in which yields for newly-issued bonds fell from ridiculous highs in the 1970s and early 1980s to today's nearly-invisible bond yields.  Based on that fact, and the even more important probability that profligate governments are going to be forced to inflate their way out of their problems, he issues a stern warning to anyone buying bonds that could be remotely categorized as longer term right now.

This point brings him to his conclusion, made in the final sentence of his newsletter: "The cult of equity may be dying, but the cult of inflation may only have just begun."  Inflation of the currency is devastating to the wealth of savers, as we have discussed in numerous previous posts, such as "Stand still, little lambs, to be shorn." 

To be fair to Professor Siegel, he is in agreement with those who point out the damaging effects of inflation, and the likelihood that future inflation could be ugly.  That's why he recommends equities as the only asset class that enables investors to stay ahead of the wealth-destroying effects of inflation.  We agree with him in general, which is why we have linked to his arguments in many of the posts in which we discuss this problem.

Mr. Gross argues that the faith in a long-term real return of stocks in the realm of 6.6% is misguided. He argues that the long-term growth of the US GDP has been about 3.5% over the same period of time that stocks have returned 6.6%.  "If an economy's GDP could only provide 3.5% more goods and services per year," Bill Gross asks, "then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers, and government)?"

This phrasing points to a major flaw in Mr. Gross' understanding of economics.  He is phrasing the question in a zero-sum fashion, as if the gains of one group are always at the expense of someone else, which is the classic formulation of the fixed-pie or zero-sum paradigm.  It isn't that the returns enjoyed by one segment are at the expense of the returns of the others:  government, for example, does not lose-out to the private companies that make up the stock market -- those companies pay for the government and make its budget possible in a very real sense.  Mr. Gross also spends a good deal of his essay arguing that stock returns have somehow been stolen from "laborers," which is another manifestation of zero-sum thinking.

George Gilder explodes this false view in a recently published excerpt from his new prologue to his classic text Wealth and Poverty, entitled "Unleash the Mind."  There, he argues that:

Far from being a zero-sum game, where the success of some comes at the expense of others, free economies climb spirals of mutual gain and learning.  Far from being a system of greed, capitalism depends on a golden rule of enterprise: The good fortune of others is also your own.

George's masterful argument should be read in its entirety, so that the finer points that support this argument can be appreciated.  However, it is clear enough that the growth of the business reflected in a stock return does not come "at the expense" of the laborer as Mr. Gross declares, but rather that the good fortune of the business enables the good fortune of the laborer, whose job and wages are as dependent on the continuing success of the company as they are on the existence of the company in the first place. 

When he raises the specter of inflation, Mr. Gross does not offer any real way out.  Having "dissed and dismissed" both stocks and bonds, he basically tells investors: "If financial assets no longer work for you at a rate far and above the rate of true wealth creation, then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both."  In other words, "stand still, little lambs, to take a haircut."

But we also believe that the faith in "the market" and "stocks" championed by Professor Siegel and his defenders is too simplistic.  Just as there are sub-sets of the overall economy that produce greater returns than the economy as an aggregate whole, there are sub-sets of the overall "stock market" that produce greater returns than the stock market as an aggregate whole.  We have never believed those who argued (based on their reading of the long-term charts) that you should "just index" and everything would always be fine.

This is where George Gilder's insights are so powerful and so revolutionary.  In his essay "Unleash the Mind," he argues that it is not markets that are the source of wealth and growth, but rather innovation, creativity, ideas: the mind.

He argues, "Capitalism is the supreme expression of human creativity and freedom, an economy of mind overcoming the constraints of material power," and "Creativity is the foundation of wealth."

This creativity and innovation is where investors must place their hope for escaping the scenario described by Mr. Gross.  And, while we believe that it is always important to seek out innovative companies, it is even more important to do so during periods in which the obstacles to creativity and innovation are more numerous (such as during the economically misguided period of the 1970s, and indeed during the period since roughly 2000).  This is where the criticism of Mr. Gross of the simple faith in "stocks" and "the market" is on target, especially as we appear to be in a period in which such obstacles will continue to abound.

We have produced evidence that belief in "indexing" tends to fall apart during periods of greater economic stress and malaise, including the 1970s as well as the past several years.  

We believe very strongly that long-term inflation requires ownership of shares of companies in order to stay ahead of inflation, but that just any companies will not do.  Investors must seek out exceptional businesses, creative businesses, innovative businesses -- well-run businesses in front of fertile fields for future growth.

This is a very different message from those offered by either Mr. Gross or Professor Siegel.  We would recommend that all investors check out George Gilder's new book as soon as it is released.

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Milton Friedman

Today is the 100th anniversary of Milton Friedman's birth, born on July 31, 1912.  He was a true champion of human economic freedom, and one of the clearest voices on behalf of the individual's right to choose that the world has ever known.

We have written many times in the past about the importance of Milt Friedman and his arguments for economic freedom, including:

"Milton Friedman, 1912 - 2006"

"Don't Despair"

"Socially Responsible Investing"

"Four-letter government words"

"Freedom and the rescue of the Chilean miners"

"Blocking out the benefits of free enterprise"

"Zombie economics"

and

"Guide the market's invisible hand with a higher principle?"

We have also linked to many of his films and videos, and above is a link to the beginning of his superlative 1980 television series, "Free to Choose," which is well worth watching in its entirety.

Today, there is a powerful essay on the impact of Professor Friedman written by Stephen Moore of the Wall Street Journal's editorial page entitled, "The Man Who Saved Capitalism."  In it, the author notes that there are many who have recently "tried to tie Friedman and his principles of free trade, low tax rates and deregulation to the global financial meltdown in 2008."

However, as we wrote in 2008, that crisis was "A failure of government, not of private enterprise."  Ironically, that quotation -- "a failure of government, not of private enterprise" -- came from an essay that Dr. Friedman and his wife Professor Rose Friedman wrote in 1979 about the Great Depression, in which they noted that the tragic misreading of the Great Depression as a failure of the free enterprise system (when in fact it was a failure of government) led directly to the rise of tyrants such as Hitler and Mussolini (and later Mao as well).  It also led, they wrote, to the conviction among many intellectuals that capitalism was inherently unstable and needed the active and constant intervention of government.

That debate continues to rage to this day, and it is a critically important one that affects us all.  We believe that Milt Friedman was right on this crucial subject, and that the events of the 20th century provide conclusive proof that he was right -- as do the events of the 21st century thus far.

Milt Friedman was truly a champion of human freedom and one whose voice is as important as ever today, one hundred years after his birth.

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