Seeing beyond a huge false dichotomy

This little exchange (see video above) between Professor Jeremy Siegel of Princeton's Wharton School and Barry Ritholtz of Fusion IQ brings out an important misconception that plagues many investors and which, unfortunately, was not directly addressed by any of the participants in the conversation during the discussion.

In the video, host Larry Kudlow asks whether a young person today, having observed the stock market carnage of the last decade, should invest in stocks "for the long run," using the phrase made famous by guest Jeremy Siegel in his Stocks for the Long Run, first published in 1994.

Guest Barry Ritholtz says, "They should buy stocks, but the caveat is they shouldn't just buy them and put them away; they should buy them and engage in risk management; they should use stop-losses --"

"You wanna trade them!" interjects host Larry Kudlow.

"No, no, I don't mean aggressively trading -- I mean you use a trailing stop-loss. You can own any stock in the world, including Enron, and as long as you have a stop-loss fifteen percent below that . . ."

The conversation continues along those lines pretty much for the rest of the segment, with Professor Siegel arguing that attempts to market time lead to increased transaction costs and taxable events, as well as the difficult problem of determining when to come back in if you get stopped out of all your holdings, and Mr. Ritholtz making the point that if you owned companies that were heading towards bankruptcy, you don't need to worry about taxable events, because all you will have are total losses.

Unfortunately, nobody in the segment took a step back and pointed out that the conversation is a huge false dichotomy, and since this is an important point for investors (as well as an argument that plays itself out over and over in cocktail parties, bars, and backyard barbecues across the land), we will try to step back and point it out here in the Taylor Frigon Advisor.

We advise investors to follow a course that neither holds companies forever nor trades them based on market-driven signals. A stop-loss order (in which the investor places a trade order to sell shares of a holding after the price hits a certain trigger below its current price) is a market-driven signal, dependent upon the moves of the market, rather than a business-driven decision based on the underlying business prospects of that company.

This is the distinction that all of the participants of the above discussion overlooked. Instead, we advise investors to follow a different path:

• We advise owning good businesses through multiple economic cycles. Jeremy Siegel and Larry Kudlow were on the right track when they noted that jumping in and out of a company whenever its stock suffers a market-based reversal is a losing proposition in the long run, as we explain in previous posts such as "Ownership of businesses through multiple economic cycles."

• However, it is important to realize that companies themselves have life cycles. As we explained in an important post entitled "Remaining calm without being blind and obstinate" the very term "growth investing" came from the observation in the 1930s by the late Thomas Rowe Price that "corporations have life cycles similar to those of human beings." Investors should seek to own companies during the growth phases of those life cycles, and sell their ownership in those companies when it becomes clear that they are no longer in the growth phase of their business life cycle.

• Market-driven triggers such as the ones that Mr. Ritholtz was discussing in the above video are not the only alternative to buying and holding forever, although from most discussions you hear on this subject you might get that impression. We explain in some detail the sell discipline that we follow and that we recommend investors follow in "The importance of a proper sell discipline."

• Mr. Ritholtz named several companies in his argument that had notorious drops in share price on the way to disappearing altogether. The best way to avoid such drops is not to buy those companies in the first place. We explain the criteria we look for in a classic Taylor Frigon growth company in several previous posts, including "Beautiful Growth Companies," "Beautiful Growth Companies, part II," and "Beautiful Growth Companies, part III."

Finally, we believe that investors should always think of investing as an act of matching capital with innovation. This is the important thought that was not brought out in the exchange of ideas captured in the film above.

It enables those who understand it to see beyond the folly of trying to trade back and forth based on market movements (or based on complex computer algorithms that watch market movements -- as we have explained here and here, no algorithm can predict where the next unexpected innovation will arise, because innovation by definition is unexpected).

It also enables those who understand it to see beyond the "buy and hold" mentality, because they will realize that companies do not typically continue to bring about what Clayton Christensen calls "disruptive innovation" to their industry forever.

We hope that this discussion helps investors to see beyond the widespread confusion on this important subject.

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For later posts dealing with the same subject, see also:

• "Panning for gold during unfriendly business climates" 09/30/2009.

• "Would you sell your successful local restaurant because of a debt hiccup in Dubai?" 11/30/2009.

• "Some lessons from 2009" 12/28/2009.

• "Market-timing and train-timing" 05/25/2010.

• "Another wake-up call" 11/29/2010.

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Air Vulgaria

National Public Radio recently weighed in on the economics of government health care with a metaphor that was so widely panned by listeners the producers ended up trying to apologize for it.

In a piece called "What does 'public plan' mean in health debate," NPR postulated that "President Obama wants all Americans to get to 'Healthyville'" and that private plans are like private airlines, but that since not everyone can afford those planes to Healthyville, "the President wants to create, say, 'Government Air': it's just as sturdy as those other guys, probably a 737, but it might lack a few of the perqs. It might be a little more crowded, and there will probably not be free meals on the public plane, but you will have a seat, and you will get to your destination: Healthyville."

The NPR editor narrating this story, April Fulton, then engaged in a bit of economic analysis, speculating that the current carriers (private planes to Healthyville) will begin to get worried, but "like good capitalists the current carriers must start cutting their prices to attract their customers back. Because demand is high for lower prices, the market will produce lower prices! And then perhaps the cost of healthcare stops skyrocketing into the stratosphere, which was President Obama's hope, all along."

This ham-handed attempt to portray government-run healthcare as a plane to Healthyville that will bring down prices without the loss of anything but a bit of legroom and heated towels for your face (actual examples used in the NPR metaphor) backfired so strongly with listeners that NPR ran a sort of apology two days later which condescendingly explained that "it was not clear to listeners what the piece was attempting to do" and that because the piece was not introduced properly, "it was not clear what the piece was trying to convey" and that therefore "it's easy to see that some listeners might interpret" it the wrong way.

To the contrary, it was quite easy to see what the piece was trying to convey, as even a cursory listen to the actual broadcast will demonstrate. The problem was that the metaphor was terrible and the economic analysis ludicrous.

April Fulton's statement that if "demand is high for lower prices" companies will have to provide lower prices is simply a gross misinterpretation of Economics 101. Prices are a result of the intersection of the supply curve and the demand curve. You cannot dictate that it will be lower without affecting either the supply or the demand (or both). What she is really saying is that she would like to see the government dictate that the price will be lower, and that this will make it happen. What will actually happen, however, is that supply will fall, or that the government will have to restrict demand through forcible rationing.

We'd like to note, however, that the metaphor could be fixed, as demonstrated in the video above, from the classic movie Chitty Chitty Bang Bang (based on a children's story written by Ian Fleming, a former British Naval intelligence officer and World War II commando and the creator of James Bond -- someone who knew a thing or two about countries that sharply restricted economic and human freedom).

In that wonderful little clip, the freedom-loving Englishman who is hijacked by Baron Bombast of Vulgaria is along for the ride involuntarily, and his trip conditions are somewhat less rosy than those depicted by Ms Fulton in her imagined public plane to Healthyville.

Most striking, of course, is the necessity of throwing a few things overboard -- including two passengers! While the NPR story tried to employ economic terms like "demand" and "produce" to support their metaphor, the actual function of supply and demand to bear in mind in this scenario is that whenever something good (in this case, healthcare) is offered for free, the amount that is demanded will be infinite. Because there is not an infinite supply of this good, the most likely response at that point will be the restriction of the demand (in this case, by stopping people from asking for it).

This truth has been well documented in countries that have tried to provide healthcare using government control rather than market controls. The Wall Street Journal recently ran an article detailing the restrictions on access to medical procedures enacted in the United Kingdom, which include refusal to provide biotech drugs that prolong the life of patients with forms of stomach cancer and breast cancer, as well as limitations on biotech drugs which halt macular degeneration. In the case of the macular degeneration treatments, about one in five patients can actually have access to the drug, but only for one eye -- the other eye must be sacrificed for the sake of cost.

If the image of the dictatorial Vulgarians throwing passengers over the side of their airship and into the ocean isn't a good metaphor for the kind of medical treatment documented in that story, we don't know what is.

It is also worth noting that the drugs mentioned in that Wall Street Journal article were developed in the United States, by private biotech company Genentech (recently acquired by Roche*). Treatments like these are rarely -- if ever -- produced in countries dominated by government control of health care, because there are no market incentives to reward the tremendous cost and risk that go into discovering such drugs. This is yet another economic reality ignored in NPR's one-sided story.

In fact, many of the problems with access to and cost of health care in the United States today are the product of extensive government intrusion into the industry, which eliminate choices for providers and potential customers.

The parts of the healthcare system in which such choice takes place demonstrate this truth. For example, the cost of LASIK eye surgery (which is not covered by Medicare and where the government does not control the market) has fallen rapidly, and the availability of this procedure has risen dramatically. Compare this to the example of Magnetic Resonance Imaging, a market in which the government does regulate reimbursement. The cost and availability of MRIs have not budged in ten years.

The entire fiasco with NPR's embarrassing airplane piece is itself a good metaphor for the problems with government intrusion into industries that should be left to free enterprise. NPR is a market participant that is supported by tax revenues, and therefore does not have to worry about quality the way a free enterprise would have to do. The results, unfortunately, are sadly predictable.

* The principals of Taylor Frigon Capital Management do not own securities issued by Roche.

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For later posts on this same subject, see also:

• "The healthcare black hole" 07/16/2009.

• "Blocking out the benefits of free enterprise" 03/02/2011.
  

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Dangerous media distractions

Typical of some of the recent "sky is falling" economic angst roiling the markets lately is this recent opinion piece by New York Times columnist Paul Krugman (pictured above).

Since the disappointing June jobs report issued Thursday, those who were certain we are in a repeat of the Great Depression and those who are certain we need more government stimulus (Krugman fits both categories) have stepped up their alarms that the illusion of recovery is a false one and that we are actually on the brink of economic armageddon.

In Krugman's piece, he begins by saying "OK, Thursday's jobs report settles it," and then goes on to warn of possible "descent into Japanese-style deflation" and the likelihood of "savage budget cuts" in the states. He finishes by warning that without drastic action, we are heading straight to an economic repeat of 1937. Other recent commentators focused on foreclosures and the effect that lower home prices have on consumer spending.

We have addressed many of these concerns in previous posts, pointing out our view that the recession was the result of a technically-induced banking panic and that direct comparisons to the Great Depression such as those Paul Krugman makes in his recent piece are inappropriate (see for example "It's a panic, not a Great Depression," from January 21, 2009).

We have also pointed out the economic data from numerous fronts which indicate that a recovery is indeed underway, including sharp "V-shaped" turns upward in the ISM Manufacturing Index, the Empire State Manufacturing Survey, the Baltic Dry Shipping Index, the Bloomberg US Financial Conditions Index, the Port of Los Angeles' outbound shipping containers records, and other measurements of economic activity, which are depicted in an earlier post entitled "A picture is worth a thousand words." Jobs data is notoriously volatile, and is well-known to be a lagging indicator -- businesses typically begin expansionary activity and then they hire new employees, rather than the other way around.

As for calls for greater "government stimulus" such as the one with which Paul Krugman ends his piece, it is quite possible that the recent struggle in the markets have less to do with fear that the economic recovery is an illusion than with fear that there will be more government intrusion around the corner (including recent talk of a "second stimulus"). We have given reasons previously for our belief that such stimulus plans do nothing to actually stimulate the economy and in fact are actually harmful in that they can unbalance it further.

The important point for investors in this debate is that we believe the myopic focus of much of the media over the past few days on the question "Are we really going to avoid the Great Depression II?" can obscure the tremendous changes on the horizon that are beginning to take shape but that almost nobody is talking about.

We are referring to the paradigmatic shift in bandwidth capabilites that we highlighted in previous posts such as "The Unstoppable Wave," and the tremendous impact that it will have on everything from the way that visual content is delivered for entertainment (a model that has profoundly shaped our culture for over fifty years and which is about to change radically) to the way that people monitor their health, the appliances in their homes, and even inanimate objects such as the socket wrenches and torque wrenches in their garages.

We have also explained that, due to recent increases in unnecessary and counterproductive government intrusion into the business landscape (to say nothing of calls from individuals like Paul Krugman for more such intrusion), investors will have to be unusually discerning in the years ahead when it comes to selecting individual businesses for the investment of capital. Simply "owning the market" may well be inappropriate. We have developed this concept further in posts such as this one and this one.

Having a true perception of what is taking place in the larger picture is critical for successful investing. The media can sometimes be a tremendous distraction towards gaining that kind of vision. One of those times may well be right now.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

For later posts on the same subject, see also:

• "Repeal what remains of the misguided stimulus" 09/01/2009.

• "The Consumer" 10/19/2009.

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "The end of 2009" 12/30/2009.

• "Was the decade lost?" 01/14/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "Another wake-up call" 11/29/2010.

• "Zombie economics" 12/23/2010.

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What Benjamin Franklin can teach us about free enterprise

Benjamin Franklin was one of the Founding Fathers of the United States of America, and a brilliant inventor, author, businessman, and statesman.

Among his many inventions were bifocal lenses for glasses, the lightning rod for houses, and the concept of the public library. He discovered and articulated the principal of "conservation of charge" in electricity, which is foundational to even the most modern technological computing inventions.

He was one of the committee who drafted the Declaration of Independence and one of its signers.

Franklin is depicted on the US $100 bill, and as such is featured in an illuminating joke about economics, brilliantly explained in a recent weekly commentary by noted economist Brian Wesbury.

In the joke, two economists see a $100 bill lying on the ground, and pass it by -- saying to one another, "It can't possibly be a real $100 bill, or else somebody else would have already picked it up!"

As Wesbury insightfully notes, this joke illustrates a blind spot in economic theory: it treats the world "in terms of very impersonal forces that sum the actions of all people" and entirely overlooks the unexpected. In this mistaken way of thinking, there can never be any new inventions or businesses or new value to add to the world -- "if it could be done, someone would already have done it," the typical economic theory seems to say.

We have stated more than once before that this is exactly what is wrong with most economic theories and models -- they have no way of predicting the next unexpected innovation that will change an industry or add to human knowledge and happiness. This is a tremendously important concept for investors -- and entrepreneurs -- to understand.

Benjamin Franklin himself is a wonderful example of this principle, through his numerous innovations and inventions and businesses that added value to his customers -- and through his thoughts and writings on human liberty, which added tremendous value to future generations and ultimately to the world.

Free enterprise allows every individual to add to his own happiness and that of others, by being free to provide as much value as he wants, and thereby make money when others voluntarily pay for it. This is a fundamental human freedom, and we discussed it in our previous post on free enterprise.

We also can't help but note that Franklin was the fifteenth of seventeen children of Josiah Franklin. As such, he is also a wonderful refutation to the zero-sum idea that (in the words of the United Nations Population Fund) there is a "link between population and poverty." As we explained in this previous post on the subject, every person is a potential asset, not a potential liability, because every person is a potential inventor, innovator, or contributor to the good of not only himself but of others.

The next time you look at a $100 bill, or celebrate the Declaration of Independence, take a moment to think about Benjamin Franklin, and the many ways he illustrates the best principles of the concept of free enterprise.

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Free enterprise vs free markets

The Fourth of July is all about political and economic freedom and inalienable individual human rights, and in honor of those themes we'd like to discuss the important distinction between "free markets" and "free enterprise."

Although it may not be a distinction drawn by economists, we like to make a distinction between the terms "free markets" and "free enterprise."

By enterprise, we mean the practice of providing value to others by offering goods and services that they need or want.

Enterprises (or businesses) offer their goods and services in the marketplace, and thus the expression "free markets" is often used as a synonym for free enterprise.

But there is a subset of the word "markets" which refer to the institutions by which capital is matched up with business enterprises -- the exchanges where shares of those businesses are bought and sold, the banks through which those businesses raise capital through loans and other offerings, and all the other mechanisms which surround the process of pairing investment capital with corporate activity. In America, this entire landscape of capital-matching mechanisms is often referred to as "Wall Street."

While we are strong supporters of free markets in the sense that the phrase is used to describe the freedom of businesses to offer their goods and services in the marketplace, we acknowledge that the second sense -- dealing with capital markets -- requires a series of rules and regulations in order to ensure smooth and orderly operation and the ability of all parties to evaluate and compare different capital investment opportunities, much the same way a game of basketball requires rules to enable the game to take place.

These rules involve accounting standards by which companies are evaluated by others, and standards governing all the ways in which transactions are ordered and executed. Government has a proper role in ensuring these boundaries are in place and that they make sense, just as government has a role in ensuring the roads are properly marked with stop signs, center lines, and appropriate speed limits.

We would argue that much of the problem of the past ten years, including the market crashes of 2000-2002 and 2007-2009 as well as the housing bubble and the misallocation of capital that we have highlighted in previous discussions, was a market problem. In large degree, the most recent market panic was related to problems with the accounting regulations (such as FAS 157, which we discussed at length in various posts) and with changes to longstanding short-selling rules. It was also a government problem, with interference in bank lending through the CRA and other legislation, as well as manipulation of interest rates in order to stimulate borrowing and lending.

The reason this distinction is important is that proponents of "free enterprise" and "free markets" (in the sense that the term "free markets" is used as a synonym for "free enterprise") can be caricatured as being against any government role in providing reasonable rules for "markets" in the second sense (the "Wall Street" sense).

While the events of 2008 have caused many to correctly conclude that the rules governing markets were broken (although few of them realize that important rules such as mark-to-market and the uptick rule were altered in 2007, right before the biggest problems began), this should not cause them to lose faith in free enterprise.

By free enterprise, we mean the ability of anyone to start a business without the permission of the government and to compete against other businesses without interference from the government, as long as they do so without practicing actual violence or fraudulent deception. Of course, free enterprise also requires the Rule of Law and the enforcement of contracts, which is a legitimate and necessary role of the government. However, in many other countries an individual cannot start a new business without permission from the government, and the ability to compete against existing businesses is prohibited by a system of cronyism and legal prohibitions on competition.

We don't believe that faith in free enterprise is going away in this country, and that is very important. We would encourage our readers to be advocates for free enterprise within their own circles of influence, and not to let problems with markets derail their own faith in this important component of human freedom.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

For later posts on this same topic, see also:

• "What Rube Goldberg could teach us about economics" 12/08/2009.

• "Free markets, free enterprise, Friedrich Hayek . . ." 07/13/2010.
  

• "The political winds are swirling" 09/15/2010.

• "'There are some things that are just too important to be left to the free market'?" 01/07/2011.

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