"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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Investment Climate, April 2014 -- “WhatsApp?”

We recently published our latest quarterly Investment Climate update for April, 2014, entitled "WhatsApp?"

You can also read previous Investment Climate updates here, and Taylor Frigon whitepapers here.

At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB).

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Fed over-steering, 2008 through 2014

The Federal Reserve Open Market Committee (FOMC) and Fed Chair Janet Yellen recently released two statements which reiterated their "overall commitment to maintain extraordinary support for the recovery for some time to come."  While financial markets rallied on each of these statements, we believe that the Fed has really run out of options in terms of "supporting recoveries" and what's more, we believe that efforts by the Fed to steer the economy almost always end up doing more harm than good.  However, since investors cannot control the Fed and their attempts to steer the economy, they should instead focus on selecting investments that are least threatened by the damage which the Fed's steering is likely to cause.

The first recent statement was released by the FOMC at their regularly-scheduled March 19th meeting (text here) and the second was a speech by Janet Yellen on March 31st (text here).  To understand them, investors should know that the Fed is using two tools to add extraordinary stimulus to the economy, which it has been using since the economic crisis of 2008 and 2009.  Those two tools are:

•  an extraordinarily low fed funds rate which targets the interest rate for the shortest borrowing periods (targeting 0% to 0.25%, the lowest fed funds rate ever, a target which has been in place since late 2008), and . . .
• a policy of buying Treasury and agency debt (agency debt refers primarily to mortgage-backed securities packaged up by government-sponsored "agencies" such as Fannie Mae and Freddie Mac) in order to artificially increase the demand for that debt and thereby artificially depress the interest rates on such debt instruments (if demand for agency debt or Treasury debt falls, then those agencies must raise the rates on that debt in order to sell them, but if demand for them is artificially boosted then those rates can be lower and the debt can still find a buyer -- because the Fed has become a huge buyer).  This second policy is called "quantitative easing" (or "QE") and the chart above shows the debt purchased by the Fed, which becomes an asset on the Fed's balance sheet, with the growth in Fed assets labeled for QE 1, QE 2, and the current QE 3.

In the two statements mentioned above, the FOMC and Janet Yellen basically declared that the Fed will continue both of the above policies until the Fed determines that the "outlook for the labor market has improved substantially" (the statements also use the term "maximum employment").  However, the Fed has been slowing the rate at which they are buying agency debt, and the rate at which they are buying Treasury debt.  They also said that at some point after they wind up their quantitative easing, the Fed will begin to "remove policy accommodation," that is to say "raise the target fed funds rate" again from its current unprecedented low level.  They do not say anything about "unwinding" the Fed's balance sheet -- that is to say, reducing the huge bulge of assets that they have accumulated under QE 1, QE 2, and QE 3 shown in the chart above (now well over $4 trillion of assets, primarily Treasury and agency debt).

While the Fed's statements argue that these policies are designed "to encourage consumers to spend and businesses to invest, to promote a recovery in the housing market, and to put more people to work," and while Janet Yellen's March 31st speech declares that "There is little doubt that without these actions, the recession and slow recovery would have been far worse," we disagree with both of these assertions. We have long argued that the Fed should focus on price stability, and stop trying to "steer the economy" -- see for example "The Fed's oversteering and the wreckage of the past decade" (07/23/2009); "Why do we want the Fed to steer the economy" (09/01/2010); and "Likelihood of Fed over-steering increases" (01/25/2011).  When the Fed tries to steer the economy, history shows that they almost always over-steer and cause a tailspin of some sort.

We also believe that the Fed has probably run out of options for steering the economy, as a direct result of the enormous asset purchases.  Economist Brian Wesbury has pointed it out in an important new commentary entitled "Repudiating Milton Friedman" (dated 03/31/2014). With all those excess reserves, Brian Wesbury explains in his analysis, the Fed can try to raise the fed funds rate all it wants, but that won't stop the banks from deciding to use their excess reserves to make loans and thus to increase the supply of money into the system.  And that, he explains, could lead to the runaway inflation that many pundits have long predicted from these excess reserves, but which has not materialized thus far.  This is because the Fed had previously said those excess reserves would be temporary, and because the artificially low interest-rate environment made lending less attractive.  If the Fed is now signalling that it will someday raise rates without unwinding those excess reserves, then all bets are off and the M2 money supply could finally expand at a very rapid pace.

This is why Brian called his piece "Repudiating Milton Friedman," because Milton Friedman famously said that inflation is always caused by too much money chasing too few goods.  If the scenario described above takes place, Brian notes, the Fed may have to try to stop banks from lending by creating regulations that order them not to loan.  Such regulation would be at odds with trying to influence money supply using the old tools of supply and demand (tools which don't work very well if you leave the banks with such a swollen supply of excess reserves).  

These are serious concerns and all investors should understand the reasoning behind Brian Wesbury's analysis.  He points out that the initial flood of money entering circulation could boost stock prices well above their current levels, but that the ensuing inflation and the severe Fed counter-reaction that it will undoubtedly trigger could create a major negative shock to the economy and the markets.  It will be yet another example of the horrors of Fed over-steering.  

So, what is an investor to do?  The Fed's machinations with the money supply make it certain that over the long term, their dollars will lose purchasing power, and thus it is imperative for investors to own assets that can help counteract that long-term loss of purchasing power. The Fed's machinations also make fixed-income investing extremely hazardous for the foreseeable future, in our opinion -- something we discuss in a previous post entitled "The crisis facing fixed-income investors."  

Ultimately, we believe investors are best served through the ownership of assets, including equity in well-run, growing businesses, and we believe that those equities must be selected very carefully with the above monetary-supply scenarios firmly in mind.

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More, smaller IPOs do not signal a bubble

About a year ago, we published an article expressing our concern that the landscape for companies making it from start-up to IPO had become very unhealthy and had turned into an absolute desert (see "Crossing the chasm to IPO becomes even more difficult," May 17, 2013).  

In that article, we noted that since 1999, and especially since 2008-2009, IPO data has shown a clear trend towards fewer and larger IPOs, making a distinction between the number of IPOs and the amount of dollars raised in those IPOs: the data at that time showed that even when the amounts raised turned back upwards, the number of IPOs remained depressed, indicating that only a few "super-investments" were making it all the way across the difficult chasm from startup to IPO, and that the few who did make it were going public for much larger valuations than were typical in the past (companies like Facebook typified this recent trend).*

We argued that this situation was a negative sign for the economy, for a number of reasons.  First, it indicates that many companies which might have been good enough to go public in the past were languishing in the desert between initial venture backing and IPO, where many would likely perish for lack of funds that in the past could have helped them get their companies off the ground.  When that happens, new and innovative ideas that could make the world better are never realized.  Competition that could bring down prices for consumers or increase quality in that particular industry dies before it makes it out of the nest.  Big incumbents can swoop in and buy up potential competitors for lower prices, either incorporating their potential competitor's innovation, or shelving it indefinitely.  Companies that could contribute to the general standard of living and to the economy might never provide the products, services, or jobs that they might otherwise have provided.

A second negative aspect of the unhealthy IPO desert of the post-2008 era, in our view, is the fact that the trend towards fewer and larger IPOs means that what we might call "ordinary investors" miss out on the opportunity to invest in young, innovative companies before they become behemoths.  If the only companies who make it to the IPO stage are marquee-names like Facebook (which went public at a valuation of over a hundred billion US dollars), then those companies are already huge, mature corporations when they make it to IPO -- and the IPO is by definition the first time that the general public has a crack at investing in those names.

Since we published that article last year, however, the situation has begun to turn around.  An examination of the IPO statistics over at the excellent website of Renaissance Capital now shows clearly that the number of IPOs is growing much faster than the proceeds raised over the past year.  For data through the 26th of March, 2014, their website shows that the volume of proceeds raised in IPOs in the US has grown by 32.2% versus the prior year at this time ("blue chart," below), while the volume of pricings of individual IPOs themselves has grown by an astonishing 83.3% for the same period!  This means that the trend is reversing: more and smaller IPOs are coming to the market.

Right on cue, however, the financial media is now wailing about an "IPO bubble."  Here is a sampling of some recent headlines:

• "Is the IPO market in a bubble?  What to look for . . ."
• "Silicon Valley Hears Echoes of 1999"
• "Are we staring at a tech stock bubble?"

That last article features this quotation: "One of the great indicators of a bubble is when young companies are trying to access the capital markets in great quantities.  We've seen a proliferation of these at an accelerating rate over the past six months."

We would disagree with that broad assertion -- in fact, we would argue that one of the great indicators of a healthy economy is when there are large numbers of young companies making their way "across the chasm" from start-up to IPO.  That is exactly what is supposed to happen in a growing economy!  

It is certainly possible for that process to get out of hand, and most would argue (ourselves included) that the process did get out of hand in the late 1990s, but we believe that it is very difficult to argue that the current environment resembles the 1990s in any way.  In fact, as the above discussion illustrates, the numbers argue that we have been in a very unusual IPO "desert" in recent years, and so arguments that a pickup in IPOs from smaller, younger companies after such a dearth should hardly be taken as a sign of an unhealthy "bubble" situation in the IPO market.

Pictured above is the first page of the initial offering prospectus from another "young company" that was "trying to access the capital markets" -- back in December of 1980.  That company was Apple Computer, and as the prospectus shows, they offered four million six hundred thousand shares of their company in their IPO, at a price of $22 per share, for a total raise (price to the public) of $101.2 million.*   If you take a look at the original prospectus here, you will find a table on page three showing that the company had a little over 54.2 million total shares outstanding at the offering, giving the company a valuation (or market capitalization) of about $1.19 billion at $22 per share.  In other words, the company went public at a much lower valuation than some of the mega-IPOs of recent years.  This meant that even "oridinary investors" could get in on this young company and experience growth in the years to come.  The company was by no means a behemoth by the time it came public.

Another illustrative example is Microsoft, which went public in March of 1986.*  As the first page of their prospectus (shown below) explains, Microsoft offered a total of 2,795,000 shares priced at $21 per share on the day of their IPO, for a total raise of $58.7 million.  If you take a look at their original prospectus here, you will find a table on page four showing that the company had a little over 24.7 million total shares outstanding at the offering, giving the company a valuation (or market capitalization) of about $519 million at the $21 per share.  

Again, we can see that the company went public early enough in its history that "ordinary investors" could purchase shares and participate in years of growth.  When the situation is skewed towards only behemoths like Facebook hitting the IPO market, the only people who can buy shares when the company is valued at $500 million (like Microsoft at their IPO) or even $1 billion (like Apple at their IPO) are the venture capitalists, angel investors, and corporate insiders at the company itself.

Some pundits are apparently happier to see the IPO market restricted to only the enormous mega-successful names, along the lines of Facebook, rather than Apple in its 1980 incarnation or Microsoft in 1986.  We believe that is a mistake, and that the current trend is a healthier sign.  We hope that it continues.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB) or Microsoft (MSFT).  At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Apple (AAPL).

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A walk down memory lane

Yesterday marked the five-year anniversary of the lowest point for the bear market of 2008-2009.  On March 09, 2009, the Dow Jones Industrial Average reached a low of 6,516.90 (today, March 10, 2014, the Dow opened the day at 16,453.10).  The S&P 500 index actually reached its low of 666.79 on March 06, 2009 (today, the S&P opened the day at 1,877.86).

On March 02, 2009, we published a post in this blog entitled "Don't get off the train," in which we wrote: 

As unbelievable as it seems now, there will be a turn in what seems to be a never-ending bear market cycle.  When the markets will turn back up is anybody's guess.  However, when it moves, it can move very rapidly.  [. . .]  This is why we have always emphasized focusing on the business and not the market prices, as we discussed in this previous post, as difficult as it might be in this environment.

One month later, we reflected on that discussion in a post entitled "Don't get off the train, revisited," in which we noted that there were plenty of people who had missed the sudden turnaround in the equity markets which took place in March of 2009 -- and that there were still plenty of people saying the move was just a "sucker's rally" (and we linked to an interview of one well-known investment personality saying that the recent rally was not to be trusted, that the March 9 bottom was not the bottom, and that "we're going to see more bottoms in the next few years").

Since that (incorrect) prediction by that colorful commentator, there has been no shortage of pundits warning that the recovery in the economy and the equity markets was doomed to collapse at any moment, and that investors were in for (as another confident financial personality put it) either a "nasty correction or years of treading water."  You can see on the S&P chart above where the markets were when we commented on that dire prediction -- and you can see where the equity markets have gone since that prediction and the returns that those who listened to those market predictions would have missed, had they taken that (incorrect) prediction to heart and stepped "off the train" based on what the pundits were saying.

During just about every dip in the chart above, there were serious-looking commentators standing by to deliver confident-sounding predictions of another "double-dip" recession, meltdown, or return to the 2009 lows.  Some of the posts we wrote in order to try to inform our readers of what they should really be paying attention to are listed along with an arrow pointing to the point in time at which we published them.  Those include "Double-dip ahead?" "More data says 'no recession.' So why is everyone so uneasy?" "Who is right, Bill Gross or Jeremy Siegel?  Answer: George Gilder"  and "Rip Van Winkle, revisited."

The point of this walk down memory lane is emphatically not to try to establish our ability to predict the market direction better than the talking heads you see on the financial media outlets.  We have always disavowed any ability to "call the market" correctly, year-in and year-out for decades -- and we don't believe anyone else can do that, either.

Instead, we believe that the lesson investors should take from the above record is that they should give up on the "persistent delusion" of trying to time markets, which (as the above chart shows) can be just as dangerous as trying to time trains!  We even wrote a post making that exact point, along with a graphic video that should drive it home quite strongly, entitled "Market-timing and train-timing," in which we said: "trying to time markets is a lot like trying to time trains: if you make a mistake, you can get flattened."

Today, on the fifth anniversary of the turn in the bear market, it should come as no surprise to find plenty of articles noting the occasion and ringing alarm bells that the "party could soon be over." We hope that readers of this blog will quickly recognize that the authors of those articles are reinforcing that "persistent delusion" -- and will waste little time with such "stock market guessing."  

We believe that time invested in finding well-run businesses positioned in front of fertile fields for future growth is a much better use of investors' time than listening to the prognosticators who can always find a host of reasons to back up their often-incorrect predictions (you can see the performance of the TFCM Core Growth Strategy here for an example of how our portfolio of well-run businesses has performed since inception).

We might even add that reading back issues of the Taylor Frigon Advisor might be a better use of their time as well!

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