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:

• "If Rip Van Winkle took a one-year nap before September 14, 2008," published on September 14, 2009.
• "Rip Van Winkle, 2010," published on October 11, 2010.

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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Investment Climate commentary, April 2013





We recently published our latest quarterly commentary, which includes some discussion of the "growth hole" that we have noticed in the market over the past several months (corresponding to a phenomenon that stretches all the way back to the bear market of 2000 - 2002), even as some of the major stock market indexes make new highs.

Check out "New Highs! Again, and Again," at the Taylor Frigon website.  Other commentaries from previous quarters are archived here.

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