Be sure to head over to the Quarterly Investment Climate section of our website, where the latest Investment Climate (July 2014) has just been posted.

This quarter's commentary is entitled "Zero Interest Rates are not normal!"

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The "passive" investing myth

image: Wikimedia commons (link).

Over the course of three decades in the professional investment business, we've heard our share of arguments for so-called "passive investing," the idea that investing in securities designed to mimic the broader market represents the safest, least expensive, and most certain way to achieve the best possible investment outcomes for the largest number of people. But is there really such an animal as "passive investment" at all? Our opinion on the subject is similar to our opinion on the existence of Bigfoot: we agree that there are many people who claim to have seen such a creature, and we remain open to seeing the evidence, but so far we have not seen enough evidence to believe in the existence of either one (Sasquatch or "passive investing").

The arguments in favor of passive investment are almost always coupled with equally passionate criticisms of "active management" (actively selecting investments in an attempt to provide a better return than the broader market). These arguments usually center around cost (active managers charge more than passive investing vehicles), performance (the allegation that the majority of actively-managed investment vehicles fail to achieve the performance of the broader market over time), theoretical soundness (many passive investment advocates believe that it has been academically proven that it is impossible to beat the performance of the broader market over time, due to the efficient market hypothesis in one of its three main variants), and motive (because passive investment advocates believe that it is almost certainly impossible to beat the performance of the market, they often attribute nefarious motives to anyone who continues to try to do so, usually involving the desire to make money at the expense of all the poor suckers who have not yet accepted the dogma of the passive investing evangelists). 

Occasionally, the commitment of active investment practitioners to ideals such as human freedom and self-determination are even called into question, such as in the inflammatory arguments of Rex Sinquefield, who in a debate on the subject argued that "only the North Koreans, the Cubans, and active investment managers" have failed to accept the premise that "markets work." Sinquefield thus equates faith in the system of free enterprise with the belief that no one within a free enterprise system should evaluate individual businesses within that system prior to investing capital in those businesses: unless you give money equally to all the businesses in the market, you might as well go take up residence in Cuba or North Korea. This strikes us as a singularly nonsensical assertion.

We have written on this subject many times in the past, in previous essays such as the one linked above in which we quote Mr. Sinquefield and demonstrate that his arguments are incorrect (see "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital"), and in other examinations of the issue including "The active vs. passive debate," "The emperor's new index fund," and "S&P takes aim at active management." 

In those previous writings, we argue that we put more faith in individual businesses (which can be analyzed for their soundness and their business prospects using methodologies which have been developed over the course of nearly a century), than in "markets" (which cannot), and give sound reasons why investors should as well. Today, however, we are going to take a step back in order to question whether "passive investment" exists at all.

Passive investment is defined by Burton Malkiel in his book A Random Walk Down Wall Street (first published in 1973) as "simply buying and holding an index fund" (9th edition, page 345). But what is "an index fund"? The term is broad enough to include securities which are structured as an open-end mutual fund (the first and still most well-known index funds took this form) as well as exchange-traded funds (which can be traded like stocks through brokers for commissions, can be sold short, and avoid some of the tax drawbacks inherent in the open-end mutual fund structure). However, in either case, the term refers to a portfolio which has been assembled by someone (we won't call that someone a "manager" in order to avoid offending the passivists) in order to replicate the performance of some segment of the securities trading in a market.

But an index itself is a portfolio, and it is assembled based on a variety of criteria. If you want to be a passive investor in equities, then you can choose from funds designed to track the venerable S&P 500 (descended from the first cap-weighted index created in 1923), a plethora of other S&P indexes (such as the S&P Composite 1500, the S&P MidCap 400, and the S&P SmallCap 600), the Dow Jones Total Market Index, the various Russell and Wilshire indexes, the MSCI equity benchmarks, and hundreds of others -- just to name some associated with US equities. 

Because there are actually over 10,000 publicly traded companies in the US equity markets alone, each one of these indexes which contain fewer than that number of securities is actually a portfolio, constructed by some manager, according to some criteria with actual decisions being made regarding what to do when new companies enter the overall market (when Facebook went public in May of 2012, for example, it took some time before the name was finally added to the portfolio of companies included in the S&P 500, near the end of December, 2013).* Each one consists of a list of securities and a weighting of the securities on the list -- which is the definition of a portfolio (just like the lists created by active managers, who may use different criteria but are doing the exact same thing). There have been literally thousands of such indexes (that is to say, portfolios) created as the "passive" craze has gathered steam, just as any market tends to fill up with various products designed to offer consumers choices and to compete for their dollar.

So, passive investors are using portfolio managers just like anyone else who decides to outsource the selection of the securities they buy instead of selecting those securities themselves. We don't think there's anything wrong with this (after all, we also create portfolios for those who have decided that they themselves don't want to select the securities in which to invest). We happen to believe that there are other criteria by which securities can be best selected for inclusion in a portfolio in addition to those typically utilized by those who construct portfolios that they call "indexes" (for example, we evaluate various aspects of the management team, and various aspects of the potential for future growth in the company's market, neither of which are typically evaluated by those who construct indexes), but they are obviously using criteria to decide what gets into their portfolios just as we are (otherwise, why did it take Facebook over a year to gain access to the S&P 500, and why do different indexes created by different companies such as Russell or Wilshire contain different names from those created by Standard & Poors or Morgan Stanley?).*

We believe that the criteria we use to assemble a portfolio are valid criteria which have stood the test of time and which have produced valuable results for investors in those portfolios -- better results, in fact, than were obtained by investors in most other portfolios assembled by other criteria (whether those portfolios were labeled "active" or "passive" or some other label). But, we don't bash the professionals who are assembling portfolios using methodologies other than our own, and we certainly don't label them "communists" or "crooks" or the other unfortunate sobriquets sometimes employed in this debate.

If they want to label what they do "passive," that's their own choice and their own marketing strategy, but investors should consider how accurate that label really is. Nowadays, investors following a so-called "passive" strategy actually have two or more layers of management that could arguably qualify as "active." 

First, of course, there is the active management of those who are assembling the indexes themselves: who are deciding upon the criteria, and then -- when new companies such as Facebook enter the market -- are deciding whether and when to add those companies to their list or not. Because the markets are always changing, with new companies issuing new securities (and new debt instruments, in the case of bond indexes, etc), this is a constant process, and one which could very well be classified as active to some degree. 

Second, there is evaluation which takes place at the "securitization" level, in which financial services firms create the open-end mutual funds or the Exchange Traded Funds (ETFs) which investors can actually buy and sell through a broker-dealer or an investment advisor. Here again, some level of management must take place on a fairly constant basis (you can label it "active" or "passive" if you want, but it is obviously a full-time job for a lot of people). Creating these vehicles involves choices as to how many of the names in the index being tracked will actually be included in the investment vehicle (giving rise to greater or lesser levels of something called "tracking error"). When changes are made in the list that is the index, the curators of these vehicles must decide whether or not to include those changes in their own securities, and if so, when and how to make those changes.

Then there is the level of management involved in selecting a mix of securities appropriate to a particular investor, whether that investor is an individual, a family, or an institution such as a foundation, a university, or a state employees' pension and retirement fund. This mix of securities will be based to some degree upon goals, timelines, and a philosophy about the best mix of investments to reach those goals, just as with any other investment. If an individual or family decides to make those decisions for themselves, then they are acting as their own "advisor" in that case, while still hiring the two levels of advisors already mentioned. Nowadays, however, there are a whole host of advisory companies offering their services in the arena of constructing a portfolio of "passive" investments best suited to an individual or family's goals, timelines, and risk tolerances (and at the institutional level, nearly 100% of these decisions have been delegated to a professional class of investment advisors for decades). 

We call this level the "intermediaries," because they stand between the end-investor (the individual or family or institutional client) and the portfolio manager. In this case, the portfolio management is split between two groups -- the big firms such as Standard & Poor's and Russell which make the index lists themselves, and the firms that assemble the index funds or ETFs designed to mimic the lists created by S&P or Russell, and who make decisions at their own level about which securities on the list will get into the ETF or open-end fund that they are managing. 

Again, we're not saying that there is anything inherently wrong with this set-up, although in practice there can be problems if the intermediaries frequently change strategies in mid-flight. However, we believe it is disingenuous to paint such services as qualitatively different from the rest of the investment advisory world, and to paint those services as somehow more "pure" and "wholesome" because the portfolios and securities selected use "index-style" criteria rather than "business-style" criteria (and to cast aspersions upon anyone who selects securities based on business-related criteria). It is true that such service providers typically charge lower fees than those managing securities based on business evaluations, but they are usually trying to make up in volume what they give away with lower fees. They are not working for free (nor do we argue that they should be, since they are performing services which their clients find valuable and are willing to pay for).  However, this is just another argument which shows that their activities are not "passive," since true passivity would imply a lack of activity and a hence a lack of any fee.

In addition, most of these "intermediary" advisory services also perform rebalancing activities, after they are finished with their initial "portfolio assembly" activities. We would argue that there really is no way to characterize rebalancing decisions as passive. Rebalancing necessarily involves a host of "active"-type questions, such as: When do we rebalance? Based upon what criteria? How "out-of-tolerance" must a position in a portfolio become before it warrants trades designed to bring it back in line with the general model weight? These are all decisions over which different managers could debate with various merits, and whose answers will differentiate the management style of one manager from another. 

In short, "passive" investing is really a myth, or an illusion, or a marketing ploy which enables some financial services professionals to say, "I'm passive, but I get to change what names I own when I decide to do so (just like an active manager), and I get to decide when to buy and sell and how much to buy and sell (just like an active manager), and -- while I'm at it -- I get to act as though I'm the only type of financial services firm that actually looks out for my clients' best interests, and that no one can  expect better results than the results that I give my clients, regardless of what criteria they choose for doing the same things that I'm doing.  After all, I have the "academics" on my side!" Some of these "passive" intermediaries make their initial portfolio-assembly or ongoing rebalancing decisions using algorithms or computer models that they have created, but this does not make them any more "passive" than a hedge fund whose managers have created an algorithm to automate buy and sell decisions based on their own goals and timelines and market changes and events.

The comeback from those who are convinced of the inherent superiority of the indexing model to all of this, of course, will be to say that with their lower fees and with the bad track record of most openly-active managers, their portfolio-management, portfolio-assembly, and portfolio-rebalancing criteria are the best for the largest number of clients. We would challenge that assertion, but even if we grant it temporarily, we would say "Fine -- you can say that if you want to, but don't pretend that you're offering something that is quote-unquote 'passive': there is no such animal."

Further, we would argue that the bad track record of "the average mutual fund" (which advocates of index investing are so quick to point out in their marketing material) is primarily due to the fact that most mutual funds tend to invest in "markets" rather than "businesses," which we believe is not the best recipe for success (at least for their investors).  Essentially, the typical mutual fund has become so large that it simply is the market!  We have often said that if this is the real problem with most mutual-fund investment records, the solution is not to run away from selection by business criteria altogether (which "passive" or index investing advocates do almost by definition).  

In the end, it comes down to a question of what investment philosophy you believe is best for selecting investments. There are different beliefs on this subject, just like with anything else, and labels can be helpful in making distinctions between different philosophies. Investors should realize, however, that the "passive" label is misleading -- and it is by no means clear that the philosophy of investing associated with this label is the best way to select companies in which to invest.

We intend to publish a series of future articles exploring this topic further.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB). Had they outsourced their portfolio management to the creators of index lists such as the S&P 500, however, they would have been forced to own it. At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Morgan Stanley (MS).

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Have you heard of this company? BCPC

From time to time, we highlight specific companies which we believe fit the profile of a classic Taylor Frigon growth company. These companies meet the criteria outlined by Thomas Rowe Price, Jr., in his 1973 circular "A Successful Investment Philosophy based on the Growth Stock Theory of Investing," which recommended investors seek out businesses with "capable, dynamic management operating in a fertile field for future growth." Previous posts discussing companies which meet these two broad criteria of good leadership and fertile fields for future business growth have included examinations of QuickLogic (QUIK), Amphenol (APH), and Tractor Supply (TSCO).*

Today, we will briefly examine specialty chemical supplier Balchem (BCPC).* Chemical companies are often extremely cyclical in nature, with both revenues and earnings fluctuating wildly based on the overall economic conditions or on cycles in their specific underlying markets (such as agricultural crop demands). This extreme cyclicality generally means that investors in chemical companies must be able to "get in" and "get out" at the right times (timing the market conditions), because simply owning the stocks of these companies for a long period of years will result in a lot of ups and downs with little actual net long-term growth. Trying to time markets is the very antithesis of the long-term growth strategy articulated by Mr. Price and the version of that strategy followed by Taylor Frigon Capital Management (for previous posts discussing this distinction further, see for example here and here).  

In contrast to many other chemical companies, Balchem has achieved remarkably steady and consistent growth, due to a variety of factors. First, the company's products are put to use in applications which serve some very distinct end-markets, such that their business has a good degree of market diversification. Second, Balchem has unique production capabilities involving products that practically no one else supplies to their markets, as well as involving technologies such as micro-encapsulation which make their chemicals more useful and valuable than they might be without encapsulation. Third, Balchem's products address numerous market applications in areas which could be characterized as "fertile fields for future growth."

Balchem is the largest producer of the chemical choline chloride, a source of the necessary nutrient choline, essential for brain and nervous system health in humans and for physical growth in chickens and pigs, which are raised worldwide as a source of food. Choline is also beneficial to the health and milk production of dairy cows during lactation, but it must be encapsulated in order to pass all the way through the cow's multiple stomachs to the intestine where it can be absorbed into the bloodstream. The sale of choline chloride to agricultural customers makes up the largest portion of Balchem's revenues, at about 46% of the company's trailing twelve-month revenues (split between choline for poultry and for pigs at about 33% of the total trailing twelve-month revenues and encapsulated choline for dairy cows at about 13% of the company's trailing twelve-month revenues).  

The company believes that the use of encapsulated choline for dairy cows is a relatively new application and that there is plenty of room for growth as the benefits of choline for lactating cows becomes more widely understood and adopted.

Balchem also supplies ethylene oxide gas and propylene oxide gas, which are specialty chemicals used to sterilize surgical equipment prior to surgeries (ethylene oxide) and to kill bacteria, mold and insects in nutmeats (primarily almonds) prior to being sold for human consumption (propylene oxide). Of these two gases (propylene oxide and ethylene oxide), Balchem is the sole US supplier of ethylene oxide gas, which is one of three methods which hospitals can select for the sterilization of surgical equipment, competing with sterilization by radiation or by contact with extremely hot steam. Of these, ethylene oxide is the most popular, followed by radiation and finally steam (steam is least convenient because in the other two methods the surgical tools can remain wrapped in their protective plastic tray-wrap, while in steam disinfectant they cannot). Ethylene oxide is increasingly more convenient than radiation because radiation cannot be used on a tray of equipment if there is any plastic component in any of the pieces of equipment -- if so much as a single screw on a pair of surgical scissors on the tray is made of plastic, then radiation cannot be used on that tray. Since plastic is generally less expensive than metal, manufacturers increasingly want to include plastic parts in surgical tools. There are also demographic drivers which generally increase the number of surgeries which are performed, as populations age in the developed world.

Balchem products are also used in the preparation of food for human consumption and as supplements for wellness. Choline is part of the B-family of vitamins and has been shown to contribute to normal liver function, normal metabolism of lipids by the body, and the maintenance of normal levels of homcysteine (an amino acid). It is necessary for the development of the brain and nervous system in infants and may also help prevent Alzheimer's and other dementia diseases. While choline is found naturally in many foods such as green leafy vegetables, adults who do not eat enough of these foods may benefit from choline supplements.

Finally, choline chloride is also used as a clay-swell inhibiting agent in hydraulic fracturing, which has seen rapid growth in the United States for retrieving oil and natural gas from shale deposits (see chart above for the natural gas production from the Marcellus Shale in the northeastern United States since 2000). Approximately 25% of Balchem's trailing twelve-month revenues now come from industrial applications of choline for uses such as hydraulic fracturing. Because choline is non-toxic (in fact, it is actually beneficial to human health), it can be preferable to competing products which could also be used to prevent the swelling of shale clay during mining operations, such as potassium chloride (KCl).

We believe that Balchem exhibits many of the qualities of a classic Taylor Frigon growth company. The company also recently initiated a dividend, which they have subsequently raised successively.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Amphenol (APH), Balchem (BCPC), QuickLogic (QUIK), and Tractor Supply Company (TSCO). 

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Bullish counter-arguments to those declaring the end of growth

What's an investor to do in an environment in which many investment professionals and economists are declaring that strong business growth is a thing of the past, and that the only way companies will be able to grow their bottom lines will be through cost-cutting or acquisitions of other companies because organic top-line growth is pretty much finished?

The power of inflation, even at low levels, to destroy the purchasing power of money requires some exposure to investments which can help mitigate that destruction of purchasing power (see this previous discussion).  Fixed-income yields have of course been extremely low, and over long periods of time it can be demonstrated that fixed income investments lose out to inflation, even in periods when rates have been higher.  Some exposure to the growth potential of businesses is essential for individuals who hope to avoid the slow erosion of their purchasing power over time, let alone for those who hope to grow their wealth and increase their purchasing power over the years.  

But investors in recent years have been bombarded with talk of a new reality in which the pattern of long-term growth can no longer be hoped for in the future.  This new paradigm has been famously dubbed the "New Normal" by many pundits, a phrase and a concept attributed to Bill Gross of Pimco and explained in this "Investment Outlook" that he published in September of 2009.  There, he states:

Well, the surprise is that there's been a significant break in that growth pattern, because of delevering, deglobalization, and reregulation.  All of those three in combination, to us at PIMCO, means that if you are a child of the bull market, it's time to grow up and become a chastened adult; it's time to recognize that things have changed and that they will continue to change for the next -- yes, the next 10 years and maybe even the next 20 years.  We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), saving to the grave.

More recently, Richard Lehmann, an astute analyst of income investment whose opinions we respect, published a newsletter which takes up a similar dour outlook for future growth, but somehow finds a way to deliver some bullish comments at the same time (his analysis can be purchased at his website here).  Entitled "Why I'm Bullish," he argues that the economy is facing a period of low growth, saying: "the major drivers in our economy today are deleveraging, deflation and demographics, the three D's that spell economic malaise for the foreseeable future."  Because of these three factors, he believes, "rapid growth years will not be coming back for another decade or so."  

However, Mr. Lehmann finds some room for optimism, arguing that even if firms cannot hope for much top-line organic growth, they can at least buy some growth through mergers and acquisition, and they can at least grow their bottom lines through the cost-saving technologies and the savings that will come as older workers retire and are replaced by younger workers (who will start with lower wages and probably fewer employee benefits, he seems to imply without directly saying it).

He also argues that another silver lining to this gloomy outlook is the possibility that interest rates won't go up as much as many fear, since low-growth environments should not have much inflation (this is an argument which we believe has some flaws, as we disagree with the "Phillips Curve" connection between economic growth and inflation, and instead side with the monetarists who say that inflation is a product of monetary supply and demand and that inflation can be created in a low-growth economy: witness the "stagflation" of the 1970s).  

So, with all these experienced market observers declaring a "New Normal" for 10 or 20 years, should investors resign themselves to a future in which "rapid growth" is just a fond memory of a long-lost past?  Are we witnessing the "death of growth investing"?  The recent slaughter of the share prices of the market's "growth darlings" seems to put an exclamation point on the arguments of those who, like Bill Gross, have declared the end of such growth.

We would disagree, and -- as long-term growth investors who have been at this in a professional capacity for many years -- we find our own reasons to be bullish in the face of these dire pronouncements:

• First, we disagree with the idea that the end of growth in the economy is a foregone conclusion, or that the days of "childlike wonder" are gone and we all have to become "chastened adults."  We believe that innovation drives economic growth, not demographics, not consumption, not easy money or credit, and certainly not government stimulus.  While we agree that bad government policy and excessive regulation can and do impede innovation and growth, we do not believe human beings will ever stop innovating, and that generations coming up behind the Baby Boom generation will prove to be every bit as innovative as the great innovators of that generation.
• Second, although bad government policy and intrusive regulation are real and present obstacles to growth, investors should remember that these policies and regulations can be changed, and that even just a few positive but simple changes can unleash tremendous growth in an economy.  The recent history of the past several decades is replete with examples of economies in which just a few positive changes sparked outbursts of pent-up innovation and growth, in countries such as China, India, New Zealand, Israel, and many more.  Some of these countries are still far from ideal in terms of regulation or government interference, but even small improvements saw big results: the same can happen in the US where pundits who predict a growthless "New Normal" for 20 years are ignoring the fact that things can change for the better long before 20 years go by.
• Setting aside these first two points, which challenge the long-term "New Normal" or "death of growth" thesis, and granting for the sake of argument that we could face such a gloomy lack of strong growth for an extended period, we still believe that investors should consider the fact that there will always be exceptional companies which can experience tremendous growth, even if the majority of companies are stuck in the kind of non-growth described by Mr. Gross and Mr. Lehmann above.  This was true during the 1970s, and we believe it is still true today, even if we are facing a "New Normal" for the wider economy at large.
• Finally, we would point out that during periods in which such growth is generally harder to come by, those businesses which do manage to distinguish themselves as having rare innovation and top- and bottom-line growth will fetch an even greater premium than they might be able to command in a more positive economic climate.  In fact, we would argue that the very reason that the prices "ran away" on some of the stocks which recently suffered a punishing "momentum correction" was that those companies were showing outsized growth relative to the broader market-at-large (at least in revenues, although some of them have yet to "flip the switch" on earnings profitability, as we discussed in this previous piece).

In summary, we believe there are good reasons to be bullish on true growth-stock investing, even in the face of the declarations of a "New Normal," or the end of "rapid growth years for another decade or so."  We also believe that there are not too many market participants voicing these types of opinions right now, and that the generally gloomy and pessimistic environment we are currently experiencing may be an opportunity for investors who can select companies with exceptional growth potential.

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"Real investing" and the latest "momentum meltdown"

The meltdown of former high-flying "momentum" stocks has accelerated recently, and investors are being treated to a barrage of bearish commentary declaring that the plunge in these stocks is just the leading indicator of the arrival of a long-overdue catastrophe.  

In particular, there is a contingent of commentators whose stated view for the past seven years has been that any supposed "recovery" from the economic crisis of 2007-2009 has been an illusion built upon another massive expansion of credit, engineered by the US Federal Reserve and other central banks around the world, and that the illusion could not go on forever.  Many of these pundits are now pointing to the ongoing "momentum meltdown" as a sure sign that the "credit party is over" and that a severe and prolonged recession must be right around the corner.

An excellent representative website where such contrarian opinion is on full display is David Stockman's Contra Corner, where former Congressman and Reagan administration cabinet member David Stockman publishes articles with his own analysis and articles from his guests, all of which generally share the diagnosis of the economy described above.  In addition to his experience in politics, Mr. Stockman also worked at Wall Street investment bank Salomon Brothers, was one of the original partners of the Blackstone Group, and started his own private equity fund, and so investors should consider his insightful analysis of the current situation very carefully.

In a recent article entitled "It Didn't Snow in San Jose: the Q1 Housing and GDP Rollover is Not Due to Weather," Mr. Stockman argues that "the US economy is freighted down with 'peak debt' and is incapable of the kind of credit-fueled rebound cycle that the Fed has orchestrated in the past," and concludes by saying:

In short, this time it is different.  The debt party is over.  The era of financial retrenchment and living within our means has begun.  It might even be that "selling the dip" is about to become the new normal.  Even this morning's Wall Street Journal could not powder the pig.

Another article on the same website, this one written not by David Stockman but by syndicated writer Wolf Richter and entitled "The Accelerating Momo Reversal: Crashing Like Its 2000 All Over Again," points out that web-radio company Pandora "has plunged 42% in six weeks, taking it back to where it was in September," Twitter is down 44% from its high in late 2013, and network security company Imperva "has crashed 64% from its peak last year."*  He implies that the plunge in the "momentum" names will soon make its way to everything else, saying:

It's different this time, we're ceaselessly told, even on NPR.  For one, the "Tech Bubble," as it's officially called now, is not tied to the larger stock market this time.  So its implosion will be contained.  I remember hearing the same in 1999.

He too concludes that the Fed's easy-money rampage of the past seven years will eventually lead to certain disaster.

Before we discuss a few points where we differ with the arguments made in these two articles and others like them, we would first like to point out that there are many points on which we agree with the general tenor of these arguments and with their frustration at the Fed's and the government's increasing interference with the system of free enterprise, as well as with their assessment that such interference is almost always harmful to the majority of the citizenry and almost always leads to negative consequences of some magnitude.  

We have published many criticisms of the Fed's attempts to "over-steer" the economy (see this previous discussion entitled "Fed over-steering, 2008 through 2014," which contains links to other criticisms we have posted of the Fed's over-steering, beginning in 2008).  

We have stated many times that the Fed should have long ago gotten out of the "emergency" mode which they have maintained since 2008 (see for example this previous post).  

We have labeled the excesses of the welfare state, which are directly connected to the easy-money policy of central banks, "The Question of Our Time" and discussed that subject in numerous previous articles such as this one and this one.  

We have pointed out the serious risks to fixed-income investors created by these welfare-state excesses in posts such as this one and this one. 

And, we have argued that crony capitalism, which is intimately related to all the above problems and which features prominently in the discussions on Mr. Stockman's Contra Corner, is a huge problem that robs the general public in order to deliver profits to a well-connected minority, in previous posts such as this one and this one.

Where we differ with the general tenor of the analysis written by many of those who share our views about all of the above problems, is that these egregious problems have been central features of the US economy since at least 1913 and of most other supposedly "free" economies in the world as well over the same time period.  Aspects of crony capitalism, credit expansion, Fed over-steering, and the rest have always been at work to enrich certain well-connected groups at the expense of the economy at large -- and while these factors have certainly led to unnecessary and painful recessions and financial crises, it would be a serious error to say that all of the innovation and all of the good businesses that have been created by individuals on their own or working together over the years were the illusory products of credit bubbles and cronyism.  We believe that economic growth happens in spite of the often-deleterious actions of government meddlers and central banks, not because of it -- and we would include the recovery that has taken place since 2009 as well.

While we agree that the current public sector "credit bubble" is far more egregious than anything seen in previous decades, we disagree with those who say that this central bank-induced "easy money" is solely responsible for all of the economic growth of the past eight or twelve or fifteen years, and we are really no further today than we were in 1999.  On the contrary, we would argue that even a moment's reflection will show that it would be ridiculous to argue that technology has not changed much since 1999 or even since 2005 or 2006 -- there have been tremendous changes, changes which have added demonstrable value to many consumers (who don't buy technology products because they are forced to but because they want to) but also to many businesses, large and small.

In fact, in the article by David Stockman linked earlier, he mentions corporate profit margins, which he notes are "already way above their historic range," and he argues from this that the current multiple on the S&P is too high.  However, we would argue that one of the real differences between the situation in 1999 and the situation today is that corporations (and businesses of all sizes) have been forced to become much more efficient and much more disciplined on spending, and that technological advances (which have been astonishing since 1999) have contributed to this in a very real and measurable way.  The businesses which have created those technologies have real products and add real value -- it would be a mistake to say that they are all just a "credit-bubble illusion." 

To be fair, Mr. Stockman is not saying that they are, but articles such as the second one linked above, which describe "anything in the social media space where the business model, if there's one at all, is based on collecting and monetizing personal data," implies that the high valuations some of these types of companies have been receiving is the sure sign that we are in a 1999-situation and getting close to the end of the party. Once again, there are points of this argument which we agree with, and we have written about companies whose leadership have made the business decision to put growth ahead of profit quite recently (see this post, for example), but while we agree that some of the valuations in that space are highly debatable, we would disagree that this necessarily signals a "return to 1999," or that this fairly specialized part of the tech market is indicative of every other company investors can choose to own.

In short, we believe that this investment climate calls for the same discernment that investors have had to exercise in previous decades, and that it is very rare to find a period of time in which things were so good that careful consideration on a company-by-company basis was not important, or so bad that there were absolutely no innovative companies which were bringing new value through new solutions which investors could be rewarded for owning.  We have written before that the 1970s was a time of incredibly erroneous monetary policy from the Federal Reserve, as well as extremely intrusive government policy including price controls and all sorts of cronyism, and yet there were opportunities during that period which could lead to tremendous returns, as the late Dick Taylor, who managed money during that decade and during the 1960s, often explained.

We believe that in reality, ownership of stocks in well-run, innovative businesses is really one of the best defenses against misguided government and central-bank policy -- and that such ownership is virtually necessitated by the very same inflationary policies created by the "credit-bubble" activities Mr. Stockman and the other writers are describing.  Stocks have proven to be a much better defense against such policies than even ownership of gold, as we discuss in this previous post. 

These are certainly very unsettling times for many investors, and the "momentum meltdown" of the past several weeks has hit the stock prices of many companies which we own as well, companies which we feel should not be unfairly lumped in with some of the others whose business models (or lack of a business model) are easier to criticize.  We agree that the "emergency" policies that have been in place since 2008 are damaging to the economy at large, and that cronyism and the other problems which Mr. Stockman and the writers in his Contra Corner decry are real problems of which everyone should become more aware.  

Nevertheless, in this situation as in those we have faced in the past (and we managed money through the crash of 1987, the 2000-2002 bear market as well), we believe the only real solution which works for the long-term accumulation of wealth and the protection of purchasing power is a return to what we call "real investing" -- the ownership of well-run businesses which are creating innovation and adding value to their customers.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Pandora (P), Twitter (TWTR), or Imperva (IMPV).

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