We recently published our latest quarterly Investment Climate update for April, 2014, entitled "WhatsApp?"
At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB).
Investment Climate, April 2014 -- “WhatsApp?”
We recently published our latest quarterly Investment Climate update for April, 2014, entitled "WhatsApp?"
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.
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.
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).
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!
Post-Newtonian economics
In spite of the fact that recent US economic data has shown new home sales increasing strongly (latest report showed a 9.6% increase in January new single-family homes), strong numbers on business investment in equipment (growing at a 10.5% annualized rate according to today's US GDP revision data), and strong corporate profits (recently making a new all-time high), investors and the general public at large continue to demonstrate angst over the economic outlook and to express concern that somehow any recovery since the 2008-2009 crisis has been entirely engineered by the Fed and could collapse again at any moment.
As an example, after Fed Chair Janet Yellen addressed a Senate panel yesterday (article here) and said that it is difficult to determine whether recent "softness" in economic data was related to exceptionally cold weather over the past few months or whether it could indicate that growth was slipping for another reason, many observers took it as evidence that the Fed might soon consider putting a temporary hold on the "tapering" of quantitative easing -- and financial markets rallied at the prospect!
We have said many times in the past that we do not believe that good investing is based upon an ability to predict the next move in the economy, and we have also said that we have never held ourselves out as being able to predict the next move in the economy, either (see for example here). We also do not have much confidence in anyone else's ability to do so.
However, we can say for certain that we do not believe that the economic recovery that has taken place since the 2008-2009 recession -- as weak as that recovery has been, for a variety of reasons -- has been due to the easy-money policies of the Fed or its quantitative easing. Neither do we think the economy will suddenly collapse again if the Fed keeps on tapering, or even if the Fed raises interest rates. In fact, we would argue that the Fed's extreme policies have actually been part of the reason that the recovery has been less robust than it should have been.
This is because we believe that economies are actually driven by something very different than what most people mistakenly believe drives economic growth. We do not believe that economies tend to fall apart without government care or central bank micro-management. We do not believe that various forms of "stimulus" are necessary to prod and poke people into spending money or starting businesses or trying to improve their own situation -- or even trying to improve the situation for other people around them. In fact, we believe that these things tend to happen by themselves, as men and women use their talents and creativity to come up with new ideas and to experiment with solutions to problems. It is government tinkering that tends to be the problem, not the solution, although a big economy composed of enough men and women trying to solve problems can resist an awful lot of government tinkering without breaking down (as evidenced by the economic growth over the past five years).
In light of this view, we would like to introduce into the discussion some extremely important statements made by George Gilder in a recent talk (video here), in which he expounded upon the revolutionary economic views he published in his new book, Knowledge and Power. In that talk, he explains that the economics of Adam Smith -- as positive as Adam Smith's contribution has been to economic thought -- were really a reflection of Newtonian physics, and the view of the human being as a kind of atom in a world of other atoms, responding to the incentives and pressures and scarcities and resources that he or she encountered (see the portion of the video between 3:00 and 4:00).
This view, Gilder explains, in many ways reduces men and women (in the eyes of economic theorists) to the equivalent of a chicken in a "Skinner box," reacting to this or that stimulus. Such a view invites governments to try to create the perfect set of conditions, adding or withdrawing stimulus here or there, trying to prod the poor homo economicus this way or that, in order to steer the economy into growth. George admits that even supply-side economics (of which he has been a champion in the past) falls into this fallacious view of mankind (see the portion of the video between 4:00 and 5:00).
Instead, George offers a radical new view of economic theory -- one that may perhaps be called "post-Newtonian economics"! He argues that an economic system is "a knowledge system, not an incentive system." In a knowledge system, knowledge is gained by performing a series of falsifiable experiments, in order to gain information and ultimately form conclusions. This, George argues, is what entrepreneurs do at all levels (from the largest businesses to the smallest): they try different solutions to see what works. It is the entrepreneur or innovator who comes up with a new solution, who introduces the key element of surprise into the world, who actually creates economic growth.
This is a very different model than the "incentives-driven" view of economic growth. We have touched on this important insight of George's previously here as well. If he is correct, and we believe that he is, then that means that investors should spend a lot less time worrying about the level of Fed stimulus, and a lot more time analyzing which companies are creating "successful experiments," so to speak. Which companies are offering some new solution, a solution which may have been a surprise when they first brought it out, and which solutions are gaining traction as people or businesses like that solution and find value in that solution.
Businesses which we believe are doing that can be found all over the economy, even in the economic conditions we are facing today. They may be creating new solutions in surgery, by using robots; they may be creating new solutions in transportation, by matching up carriers with shippers in more efficient ways; they may be creating new solutions in data networking, by using software to do tasks that previously required dedicated hardware; they may be creating new solutions in ways that we haven't even noticed yet, but which you have noticed in your own business activities or daily life!
We believe George Gilder's new, post-Newtonian way of looking at economic and entrepreneurial activity is truly world-changing. And we believe that adopting that mindset can be very beneficial for investors and economy-watchers alike.
However, we can say for certain that we do not believe that the economic recovery that has taken place since the 2008-2009 recession -- as weak as that recovery has been, for a variety of reasons -- has been due to the easy-money policies of the Fed or its quantitative easing. Neither do we think the economy will suddenly collapse again if the Fed keeps on tapering, or even if the Fed raises interest rates. In fact, we would argue that the Fed's extreme policies have actually been part of the reason that the recovery has been less robust than it should have been.
This is because we believe that economies are actually driven by something very different than what most people mistakenly believe drives economic growth. We do not believe that economies tend to fall apart without government care or central bank micro-management. We do not believe that various forms of "stimulus" are necessary to prod and poke people into spending money or starting businesses or trying to improve their own situation -- or even trying to improve the situation for other people around them. In fact, we believe that these things tend to happen by themselves, as men and women use their talents and creativity to come up with new ideas and to experiment with solutions to problems. It is government tinkering that tends to be the problem, not the solution, although a big economy composed of enough men and women trying to solve problems can resist an awful lot of government tinkering without breaking down (as evidenced by the economic growth over the past five years).
In light of this view, we would like to introduce into the discussion some extremely important statements made by George Gilder in a recent talk (video here), in which he expounded upon the revolutionary economic views he published in his new book, Knowledge and Power. In that talk, he explains that the economics of Adam Smith -- as positive as Adam Smith's contribution has been to economic thought -- were really a reflection of Newtonian physics, and the view of the human being as a kind of atom in a world of other atoms, responding to the incentives and pressures and scarcities and resources that he or she encountered (see the portion of the video between 3:00 and 4:00).
This view, Gilder explains, in many ways reduces men and women (in the eyes of economic theorists) to the equivalent of a chicken in a "Skinner box," reacting to this or that stimulus. Such a view invites governments to try to create the perfect set of conditions, adding or withdrawing stimulus here or there, trying to prod the poor homo economicus this way or that, in order to steer the economy into growth. George admits that even supply-side economics (of which he has been a champion in the past) falls into this fallacious view of mankind (see the portion of the video between 4:00 and 5:00).
Instead, George offers a radical new view of economic theory -- one that may perhaps be called "post-Newtonian economics"! He argues that an economic system is "a knowledge system, not an incentive system." In a knowledge system, knowledge is gained by performing a series of falsifiable experiments, in order to gain information and ultimately form conclusions. This, George argues, is what entrepreneurs do at all levels (from the largest businesses to the smallest): they try different solutions to see what works. It is the entrepreneur or innovator who comes up with a new solution, who introduces the key element of surprise into the world, who actually creates economic growth.
This is a very different model than the "incentives-driven" view of economic growth. We have touched on this important insight of George's previously here as well. If he is correct, and we believe that he is, then that means that investors should spend a lot less time worrying about the level of Fed stimulus, and a lot more time analyzing which companies are creating "successful experiments," so to speak. Which companies are offering some new solution, a solution which may have been a surprise when they first brought it out, and which solutions are gaining traction as people or businesses like that solution and find value in that solution.
Businesses which we believe are doing that can be found all over the economy, even in the economic conditions we are facing today. They may be creating new solutions in surgery, by using robots; they may be creating new solutions in transportation, by matching up carriers with shippers in more efficient ways; they may be creating new solutions in data networking, by using software to do tasks that previously required dedicated hardware; they may be creating new solutions in ways that we haven't even noticed yet, but which you have noticed in your own business activities or daily life!
We believe George Gilder's new, post-Newtonian way of looking at economic and entrepreneurial activity is truly world-changing. And we believe that adopting that mindset can be very beneficial for investors and economy-watchers alike.
