Happy New Year!




As 2007 comes to a close, many investors prepare to enter 2008 with some trepidation regarding the outlook on the economy.

Economists are widely quoted in the media predicting recession. Today's online Wall Street Journal features a video clip with the Chief Economist of Nomura Securities saying the economic activity in the first half of 2008 will be "flirting with recession" (although he goes on to predict that the second half will return to growth and that "we'll avoid a recession, although it will be a very close call").

Last week's InfoChoice Weekly Banking Bulletin (emailed weekly to subscribers in the banking industry in Australia and parts of Asia) led with a story entitled "Australia should be concerned about US economy" which cited former Morgan Stanley Chief Economist, now Morgan Stanley's Asia Chairman, Stephen Roach asserting that the US is heading into a recession in 2008 (this is not new: Mr. Roach has been predicting recession for some time).

Earlier that same week, economist and former Clinton Treasury Secretary and former President of Harvard University, Larry Summers, gave a speech entitled "Risks of Recession, Prospects for Policy" in which he stated that, "In my view it is almost certain that we are heading for a period of heavily constrained growth, quite likely that the economy will experience a recession as technically defined and distinctly possible that we are headed into a period of the worst economic performance since the stagflation of the late 1970s and the recessions of the early 1980s." Happy New Year, indeed! Not only does he throw around the R-word, but tosses in the 1970s and stagflation for good measure!

A constant barrage of predictions like these have investors in some doubt about welcoming in 2008, and have many scurrying for cover. Yet these predictions keep coming from the same sources that have been predicting the demise of the economy for seven years. They have been dead wrong!

As we have pointed out previously, we believe the current recession drumbeat is yet another false alarm, one reason being that recessions rarely arise when everyone is concerned about a recession but are much more likely when few expect a recession and businesses spend bullishly and mistakenly build up huge inventories. Or even more likely, recessions occur because of bad policy decisions, both monetary (too easy or too tight money) and/or fiscal (tax increases).

Further, as we have also discussed in earlier posts, many in the media and many economists have a demand-side mentality which attributes more weight to the consumer as the driver of the economy. This view has led to consistent underestimation of the strength of the economy for the past seven years. It also ascribes a greater ability of the housing sector to derail the rest of the economy than it has in reality. Almost all of the predictions of recession heard in the news predicate their recession predictions on spillovers from the housing sector.

However, housing only makes up 4.5% of the overall GDP. Even though that sector has been in serious contraction for several quarters, GDP growth has continued to be positive, indicating that the rest of the economy continues to post expansionary numbers in spite of the drag from housing. In fact, the third quarter GDP number (the most recent we have) came in at 4.9% after its final revision. In spite of the assertion of well known bond manager Bill Gross, who stated that we are already in a recession, some supply-side economists predict the current quarter's GDP growth will be above 2%.

The difference in these two views is that demand-side economists believe that housing woes will spill over to the rest of the economy because the consumer is disproportionately impacted by housing market fluctuations, while supply-side economists include the very real problems in the housing sector in their calculations but believe that the production of goods and services (more than 95% of which are not part of the housing sector) continues to grow.

They also point to the strong productivity numbers posted by the current economy. Earlier this month, Q3 productivity was revised upwards from 4.9% productivity growth to 6.3% productivity growth. As we have stated before, our decades of experience have shown that it is the production side (often called the "supply side") rather than the consumption side (or "demand side") that actually drives the economy, and supply-side economists have consistently been more accurate in their assessments of the economic growth than the more numerous demand-side economists (only about 15% of economists are supply-siders).

While the current and upcoming quarters will likely show slower growth than the exceptional third quarter, we believe that prospects for growth continue and that the current recession predictions are overblown.

The prospects for a happy 2008 are not as bleak as the news is making them out to be!

for later blog posts dealing with this same topic, see also:




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It's time for year-end charitable contributions





It's the time of year for posting any contributions to charities and organizations working towards causes you care about. Typically, those donations must be received by the charity by December 31st in order to count towards your tax year for 2007.

However, as Steven Malanga details in this article in the most recent edition of City Journal, many charitable organizations (including, increasingly, religious ones) are actively involved in bashing the capitalist system which enables the creation of the very wealth that they receive from their contributors.

For example, the article quotes the co-president of Interfaith Worker Justice as saying that America must save itself from "its own arrogance, its selfishness and its greed" and as speaking out against those "wallowing in an obscenity of massive unearned wealth." The Executive Director and Founder of the same organization is quoted as saying that America needs "redistribution" to "shift wealth from a few to working families." That same organization (Interfaith Worker Justice) receives funding and financial support from over 100 religious organizations, including the National Council of Churches of the USA (NCC) and, the article notes, some key members of the NCC including the Episcopal Church, the Evangelical Lutheran Church, and the Presbyterian Church USA (PCUSA) "are particularly active."

The article also cites a quotation from Father Robert Sirico, the President of the Acton Institute, which (according to its website) promotes "integrating Judeo-Christian truths with free market principles." He states that if religious leaders targeted by groups such as Interfaith Worker Justice (in this case, seminarians) don't have an economic background, it's easy for them to fall into the fallacy "that our economy is a zero-sum game that demands conflict between business owners and workers."

We've written about the fallacy of the zero-sum mentality on this blog before, such as in this post and this post. It is sad that those who benefit greatly from the wealth creation enabled by a mostly free economy are often tricked by the rhetoric of those with a zero-sum view of the world.

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Holiday Wishes



















This giant sequoia (sequoiadendron giganteum) is the General Grant Tree, in Sequoia and Kings Canyon National Park. Discovered in 1862, it was named the General Grant in 1867.

In 1926, President Calvin Coolidge designated it the Nation's Christmas Tree and each year since park rangers have held a ceremony at the tree on the second Sunday of December.

In 1956, President Dwight Eisenhower designated it a National Shrine and a living memorial to those who have given their lives in wartime in the service of the United States of America.










Seasons Greetings from all of us at Taylor Frigon Capital Management!

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Anatomy of "style drift"









Previously, such as in this post, we have discussed the problem that is common to "mass-managed money" which is the fact that as they grow larger and larger, they are forced to own more and more securities -- and if they invest in equities, they are forced to own shares in larger and larger corporations.

The fact is that most investors in the United States, including ultra-wealthy investors, get their exposure to equities through what we call mass-managed money (money managers who are managing portfolios that exceed $5 billion dollars). In other words, the primary way that these investors connect to the ownership of businesses is through vehicles that are forced, by their sheer size, to own shares in hundreds of businesses, and to own shares in a very specific type of business: LARGE businesses.

This is because mass-managed money is not just a mutual fund phenomenon. Many wealthier investors use managed separate portfolios -- a form of managed money that does not pool the investments of different account-holders into one fund, but keeps them separate. We explain some aspects of separate portfolios in our publication Separate Portfolio Advantages, available here. But although the separate portfolio structure has many advantages over the mutual fund structure, especially for wealthier investors, most of the managers of separate portfolios are huge mutual fund companies who offer separate portfolios that may have more dollars under management than their mutual funds do! Many well-known separate portfolio strategies have upwards of $10 billion under management.

The diagram above is an illustration of what can happen inside a portfolio strategy (whether it is a mutual fund or a separate portfolio strategy) when it grows into the tens of billions of dollars in assets. The diagram shows the famous Fidelity Magellan fund, from mid-1982 through early-2000, and graphs its holdings by the SIZE of the assets. The different colors on the chart represent percentages of the holdings that are in stocks characterized as small-cap value or growth, and large-cap value or growth. This chart can be found on the internet in a Barclays Global Investors research paper entitled "In Pursuit of Performance: the Greatest Return Stories Ever Told" (see page 18 of the document).

Note that in the early years of the fund, before it began to grow to massive proportions, the portfolio was primarily composed of stocks characterized as small-cap growth:


















In this part of the graph, the lightest-colored section (making up more than 50% of the holdings) designates small-cap growth stocks, while the darker blue section above it represents small-cap value stocks, and the gray at the bottom represents large-cap growth stocks. This is the composition of the fund at the left side (earlier years) of the portfolio.

Fifteen years later, however, the right side of the timeline shows a radical change in the composition of the fund:


















Note that by the end of the period under consideration, large-cap stocks (the gray area at the bottom of the diagram) have grown to consume over 80% of the portfolio's stock holdings. Small-cap growth stocks, the lightest of the four colors in the graph at left, used to be the largest portion of the portfolio, but by this slice in time they have been squeezed down to a sliver, and by the end of 1999 they were entirely absent from any meaningful role in the portfolio. By the very end, the lowest color band on the chart (large-cap growth) and the second-lowest band (large-cap value) make up almost the entire portfolio, except for the thin (and shrinking) band at the very top representing the remaining small-cap value stocks. In other words, the record shows a very strong migration of the portfolio from owning stocks in smaller-cap companies to owning almost entirely stocks in large-cap companies. What happened in the intervening years that caused such a transformation in the types of companies that investors held? The fund grew enormously. This X-ray of a "mass-managed" fund emphasizes the points we made in our previous posting (linked at the beginning of this post) about larger funds (or portfolios) being forced into larger stocks. It also reveals the fact that investors may have the same investment vehicle for many years, but that does not mean that they are getting the same portfolio management consistently for all those years: the management team may change their style, or the management team may leave altogether! In short, these diagrams present a picture of "style drift" that is forced upon many investment vehicles as they grow larger and larger. Investors need consistency not just for a couple years but for many decades (the chart covers almost twenty years -- most investors don't think about it, but their need for exposure to equities over their investing lifetime will be usually be even longer than twenty years). Consistency is very difficult to find in today's landscape, which is dominated by mass-managed money and Wall Street salesforces which use mass-managed money as their main investment tool for their clients.

For later posts on this same topic, see also:



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A portfolio manager's perspective on Fed critiques












As we have explained several times in various posts (such as the first one on this blog), our investment philosophy is based upon the long-term health of successful businesses (choosing good companies), rather than upon the shaky foundation of attempting to time market cycles or predict fluctuations of currencies, commodities, or interest rates -- including those controlled by the Fed.

The current market volatility has been widely blamed on recent decisions by the Fed and disagreement by market participants as to what the Fed should actually have done or not done.

Are they right? What should the Fed do? There are excellent economists whose works we have read for years who are at complete disagreement over the proper course of action. In fact, any position you can name right now will generate heated opposition on this subject.

However, although many in the media are pointing (as they have for several years now) to the specter of the 1970s and "stagflation" (a stagnating economy coupled with rising inflation), it is safe to say that whatever actually develops will not be the same thing that the conventional wisdom expects. In fact, an honest comparison of the fundamental economic scenario of the 1970s and the economy that we have today can lead us to conclude that whatever does develop, the 1970s are not it.

We would also argue that, as we have stated in previous posts such as this one from over a month ago, what is really troubling the markets may not have as much to do with the threat of inflation as it does with the threat of taxation. Although not everyone who participates in the market understands the ins and outs of monetary theory and what does and does not cause inflation, everyone understands that when taxes go up you have less money left. Taxes are pretty clear about what they will do to your returns. They give you an exact number of what they will take, unlike inflation which economists can debate all day long.

That said, we do not dismiss inflation's damaging potential by any means, and in a fiat-money system (currency not tied to an objective store of value), inflation is almost always present to some degree. We believe this is yet another argument for ownership of businesses.

All this is why we believe that the best investment philosophy is one that focuses on selecting sound businesses with management teams who are able to navigate through unpredictable fluctuations, whether those are caused by the banking system or by other factors.


For later blog posts dealing with this same subject, see also:


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What is the future of search?




Here is a link to an interesting story by Dean Takahashi of the San Jose Mercury discussing an internet start-up called Mahalo (named for the Hawaiian word meaning "Thank You").

The article reports that "Mahalo is a search engine that is powered by human judgment, known in Web 2.0 circles as 'curation.' Curation uses human expertise to weed out all the stuff that you obviously don't want when you're searching."

The Mahalo site itself states, "With traditional search engines you need to figure out the right search term and find relevant results within an unorganized list that often contains irrelevant results, spam, and some mediocre sites" and "Search results for certain categories such as products, travel, cars, and health, are cluttered with people selling things, making it difficult to find great information on those topics."

Regardless of the actual usefulness or success of this particular Mahalo site and their approach (which they claim is "the world's first human-powered search engine"), the issue should raise important questions if you are thinking like a portfolio manager. What other ways will we "search" (navigate the vast and growing amount of information available on the internet) in the future?

Right now, Google is the acknowledged champion of search. Their share of search is more than twice that of their next competitor (Yahoo!). According to NetRatings, Google share of all search in the US is just over 50%, with Yahoo! second at about 20% and MSN third at less than 15%. Globally, Google represents an even greater percentage of search, at nearly 70%.

However, the search engines mentioned above yield results based on algorithms such as Google's PageRank, which ranks search results based on the web of links to and from different pages. While this method has its strengths, it certainly has disadvantages as well. You may value the input and opinions of certain circles of friends or experts on one subject or another greater than you value the rankings generated by measuring the links on the web.

There are a variety of things that you search for that could be improved with forms of search that include conscious human input, including the input of the various circles of people with whom you associate (your friends from business school for some information, the other parents of children at your kids' school for other information, fans of the Boston Celtics for other information, and so on). Mahalo may well be just the first in a shift in the way that the information on the web is found and navigated. While the existing method will probably continue to have usefulness, in five years it may be just one of many players in the cast of internet facilitators, and a small one at that .

* The principals of Taylor Frigon Capital Management do not own securities issued by Google (GOOG) or Yahoo! (YHOO).


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Deworsification




















In yesterday's post, we discussed some of the drawbacks caused by portfolio size. As "mass-managed money" pools grow larger, they are forced to own more and more portfolio holdings and those holdings typically need to be in larger and larger companies as well.

Some of the largest mutual funds have well over two hundred names -- one fund mentioned as an example had 286. A common question you might have is, "But doesn't that at least give you diversification?"

Diversification is an important concept in investment management. However, the marketing machine of Wall Street has taken an important investment concept and used it, in some cases, to convince people that they need to own more different products, and therby more holdings, than they actually need.

As the graph above illustrates, diversification does reduce the volatility of a portfolio. However, the reduction in volatility is great when you take a one-stock portfolio and make it a two-stock portfolio. There is another large reduction in volatility when you make the two-stock portfolio a three-stock portfolio, but the reduction is slightly less than it was when you went from a one-stock portfolio to a two-stock portfolio. Each additional stock reduces volatility a little less than the last one did. After ten stocks, the reduction in volatility begins to slow dramatically with each additional holding, and after twenty-five stocks the reduction in volatility is very slight, becoming asymptotic after thirty or so holdings. This property of portfolio volatility is well-researched and has been published in many different places for over forty years.

In other words, mass-managed portfolios do not own 286 stocks for diversification purposes. The reason most investors (even wealthy investors) do not know about this principle is probably because there is a vested interest in the investment industry in having people buy numerous products. If people realized that the capital they allocate to the financial markets could be properly invested in a relatively small number of individual stocks and bonds (likely no more than fifty companies), it would seriously threaten the business models of those who make a living selling investors slices of everything under the sun (each slice containing hundreds of individual stocks or bonds, in some cases).

There are many costs associated with owning many more investment vehicles than you need. There are obviously transaction costs and management costs involved, but just as important are the potential opportunity costs. It is true that some businesses are better than others. The more companies you buy, the more chance you have of buying into average or below-average companies. This problem could be called "de-worsification" and it is a serious problem for many investors (although not necessarily a problem at all for Wall Street).

For later blog posts dealing with this same subject, see also:

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The further you are from owning individual companies . . .











The further you are from owning individual companies, the more your investment management tends to be rooted in the performance of markets (or sectors of the market) rather than rooted in the performance of businesses.

In a mutual fund, as we explain on our web site in this recent commentary, you don't actually own the stocks of businesses. The mutual fund owns -- in a giant pool -- those stocks in the businesses, and you own shares in the pool.

One important thing to realize about these pools is that, as they grow very large, they are forced to buy more and more companies in order to find a home for all the dollars in the pool. Look at the list of the top twenty mutual funds by holding, as listed in Wikipedia (but available elsewhere as well).

If you are a money manager with a pool of $94 billion under management, you cannot own just forty or fifty companies. You could not even own just ninety-four companies. You are forced, by sheer size to own hundreds of companies -- not because you particularly want to own hundreds of companies for investment reasons, but because you must find a place to spread all those assets. The top fund on the list above, for example, owned 286 companies in its portfolio when it last disclosed its holdings at the end of the third quarter of 2007.

In fact, you will be forced not only to own a large number of companies, but you will be forced to find relatively large companies (companies with a large market cap) to own. You won't be owning many companies with market caps under a billion dollars, because you will almost buy those companies outright if you put even a small percentage (less than one percent of your assets) into the shares of those companies.

This means that as these pools get larger, these companies own more and more of the same names in the S&P 500 (some may own more than half of the "entire market" if the S&P 500 is taken as a proxy for "the market"). It also means that they own many of the same companies as one another! There are only about 290 companies in the U.S. with market caps of $10 billion dollars or more (these numbers fluctuate slightly every day as stock prices rise and fall). There are only about 23 companies in the U.S. with market caps of $100 billion or more.

As mutual funds own more of the same companies as one another, and as the overall market, they cannot differentiate themselves by owning different businesses. It is hard for them to be able to say, "You invest in Apple, and I will invest in Google, and we'll see who chose a better company after five years." Chances are, they both will own Apple and Google and a whole lot of other large companies as well.

So, investors who build their investment foundation upon mutual funds are resting upon a foundation not of business selection, but of market movement. The mutual fund may move from one sector to another sector during the year (as the manager predicts better or worse performance for this or that sector during the next few months), but this is more a system of predicting markets (or slices of markets) than of analyzing companies (for a discussion of the fact that index funds by definition are built on a foundation of markets rather than companies, see our commentary entitled "The Emperor's New Index Fund").

The growing size of the pools inside individual mutual funds can also lead towards increased portfolio turnover in some (although not all) mutual funds. Because they own a huge number of identical companies as those held by everyone else (not because they want to, but because of the forces described above), they cannot differentiate themselves by owning different companies. Instead, in a very competitive marketplace, they can differentiate themselves by owning the same company but for a different quarter than their competition owned it.

In other words, they realize that they own Apple and their competition owns Apple, but they will differentiate themselves by owning it for a better quarter or two than their competition owned it -- creating higher turnover in some cases, as well as creating a tendency to focus on short-term events rather than on the long-term business outlook for a company over a period of many years.

In short, investors should be aware of the fact that the further they are from owning companies directly, the more likely it is that their investment philosophy tends to be rooted in market-timing activities rather than in lining their fortunes up with the long-term performance of exceptional companies. And, as we explained in this previous posting, most of the big fortunes in this country (over the past twenty years as well as over the past one hundred years) have been made by lining up with successful companies for a period of several years.

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



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Don't isolate your forces




















Deploying your capital has some parallels to deploying forces on the battlefield.

In both cases, for instance, you don't have unlimited resources to accomplish everything you want to do. You can't put troops on every single hill -- you have to weigh the costs and the risks and decide where you are going to deploy your forces. Furthermore, you are making these decisions in a very fluid environment (constantly changing) and you never have perfect certainty. In military operations, you have to make decisions that have real consequences and you have to make those decisions in conditions of some uncertainty.

Similarly, in financial operations you are also making decisions in a fluid environment that changes constantly. You must make decisions that have real costs and consequences. And you must make those decisions in conditions of uncertainty as well (at any given time, some people are bullish and some bearish about the same issues, some people think jobs growth will be X and others feel it will be Y, some think the Fed will do A and others are certain it will do B).

Just like in military operations, you don't have unlimited troops to spread around everywhere that you want to put them. If you sign up for Long-Term Care Insurance, for instance, then you are committing resources (capital) on an ongoing basis, typically for many years, and that capital cannot be used towards buying a piece of real estate or investing in a promising company, for instance.

One very important principle of military operations is that you don't want to isolate your forces -- you want them to be "mutually supporting." In the map above, if you are in command of three platoons or three companies or three battalions, you don't want to send one force way off to the left "just in case" the enemy comes that way and then find that the enemy comes from the right and your unit is too far away to come back and support the unit on the right that is under attack. Far better, given the fluid conditions of uncertainty described above, is to be able to shift your forces to the place they are needed and to keep them in positions that can mutually support one another.

This same principle holds true with your capital. You want your capital to work in a "mutually supportive" manner. You don't want to isolate your resources by sending capital off in one direction "just in case" and then find out that you needed it somewhere completely different. However, most people tend to do just that (largely because the players in the financial world want you to "silo" your assets in their domain -- your financial market assets are usually not well coordinated with your real estate assets, and your insurance instruments are in a completely different "silo" and not integrated with either of the others).

Thinking in these terms about the way you are deploying capital is a good way to approach the financial battlefield. Look for ways in which you are "siloing" or isolating your forces and potentially causing attrition that you could avoid.

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Stick that in your pipe and smoke it


Here is a link to a video presentation of a talk given by Professor Noah Robinson of the Oregon Institute of Science and Medicine at the annual Gilder Telecosm event in October, 2007.

Of course, a fairly large segment of the population does not permit any discussion of this side of the global warming argument to be so much as whispered. Simply uttering such views makes one a target for abuse, ridicule, and personal attack.

The presentation by Dr. Robinson contains evidence about the retreat of glaciers and the increase in CO2 that should be considered by any thoughtful participants in the "global warming" and "climate change" discussion. The data presented cast serious doubt on the connection between human hydrocarbon use (first coal, then coal plus oil, and ultimately coal plus oil plus natural gas) and temperature change and ice melt. Data on glacier retreat show that the retreat began long before significant human hydrocarbon use and that the pace of the retreat has not increased along with the increase in hydrocarbon use.

This issue is one with serious economic consequences, as the calls for international reduction of carbon use grow louder and louder. The same voices denouncing anyone presenting evidence like that shown in this film are often the voices calling for greater government regulation of business through carbon taxation, "cap and trade" regulations, bans on incandescent light bulbs, taxpayer funding for the weatherization of homes, and so on. Over the next several days, you will be hearing about the international gathering in Bali where participants will be discussing these and other government measures.

Influential media outlets such as the New York Times are carrying prominent stories such as those featured on this page, all of which are from the perspective that the connection between human carbon use and climate change is settled science and that "federal regulation of greenhouse gases" is the logical way forward. A prominent story in today's edition of the Times features the title "A Future Without Skis: Alpine resorts are trying to stay ahead of global warming." A New York Times blog entitled "Dot Earth" features an entry today entitled "A Few (Hundred) Things the Next President Can Do to Limit Warming."

National Public Radio, which is primarily funded by taxes, features a similar collection of "Climate Change" stories to those found in the Times. One story from today's Morning Edition features the human-interest angle of a family in Iceland which has been trekking out to the glaciers every year, only to find that they (the glaciers, that is) are shrinking.

"The trip is no longer just about adventure and companionship," says the story's author. "This group has become unintended witnesses to climate change. Leifsdottir says the last 10 years have been much warmer. But global warming isn't good for the world, she says."

Other links on the page take you to "Top Ten Tips for Fighting Global Warming" which urge you to forgo red meat, dry your clothes on a line instead of in a dryer, and "leave the car at home and take public transportation to work," among other suggestions. Calls for "federal regulation of greenhouse gases" mentioned on the Times website are merely calls to make "suggestions" become mandatory for all, and to enforce similarly-minded restrictions on businesses as well.

There are real economic consequences to suggestions like these. Before we return to levels of government regulation of business last seen in the 1970s, we should at least be unafraid to examine compelling evidence showing that such regulation may have no impact on climate change at all. (Even if carbon reduction would be effectual, it does not necessarily follow that governmentally-mandated carbon reduction is the best course of action, but that is a subject for another day).

For more recent posts dealing with this same issue, see also:



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Become aware of IPTV



















Remember what television was like in the 1970s? There were no DVD players, not even VHS players yet -- you watched what was on when it was broadcast. If a movie came to television, it was over a broadcast network (no Netflix). For much of the 1970s, there wasn't even cable television, so you were stuck with a handful of VHF broadcast stations and (if you could dial them in) a few UHF stations where you might find reruns on tiny local stations for some "niche" content.

Television has changed dramatically since those days, but in a few years, the way television is today will seem as archaic as those memories of television back in the 1970s.

The reason is that the capabilities of your computer will be coming to your television, and the two will merge together. This may not seem too revolutionary, but it will be.

The capabilities of computers have been rushing ahead over the past dozen years, while the capabilities of your television have stayed roughly the same over the same time period (with some incremental increases, such as the replacement of VHS with DVDs, or the increase in visual quality ushered in by HD and the increase in size and display quality ushered in by LCD and plasma screens).

Think about some of the things that computers currently allow you to do that televisions do not, such as send content along to your friends and family through an email, or access the same content on any device you want to, from your desktop to your laptop to your handheld device (a Blackberry or an iPhone is really a small computer more than a telephone).

Those features are becoming available through IPTV, or the delivery of video content over networks that use internet protocols rather than the currently dominant methods (primarily cable). This change will be revolutionary not because of greater bandwidth (cable enables the delivery of tremendous bandwidth), but rather because of greater "interact-ability": with internet protocols (as we all know by now because of our use of IP with computers), you can have two-way communication, and you can have communities.

You can see an amazing documentary and email it to your friend. If it is something that would interest all the people from your college sorority, you can share it with all of them (or with any other groups that you join or maintain over computers).

Like other content that lives in the IP network (such as this blog, or your website), you will be able to access all of the video content that you watch on your television on any other device you choose to use, wherever you happen to be. You will be able to control that video with any other device that is on the network (you can use your iPhone as your living room remote, for example, or access your favorite sports team from your laptop while on a business trip).

Like other content that lives on the IP network, you will be able to create your own content. Your parents will be able to watch your HD broadcast of your child's soccer game live (or later on) in their living room in Des Moines (even if you live in Mountain View).

Like other content that lives on the IP network, you will be able to search for it using keywords. But, rather than just being an individualistic effort, your different social networks will also assist you in finding content, much as today (over the IP network) you may receive links to magazine articles or YouTube clips from your friends and family and colleagues.

Some of these capabilities are already available in the first-generation IPTV systems, and the rest and others will probably arrive faster than most people anticipate.

IPTV is going to be a major revolution, and it is just beginning. It is probably something that you should become aware of. It is also one of the heralds of the approach of the next paradigm shift that will be just as important and revolutionary as the paradigm shift created by the arrival of inexpensive computing power and its application to various aspects of life during the period from 1980 to 2000.

For later blog posts dealing with this same subject, see also:
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Don't fear the current recession drumbeat















Recently, the "recession drumbeat" of those warning of the growing risk of a recession has been growing louder and louder.

Yesterday, for example, the stock market rallied strongly on negative comments from Fed Vice Chairman Donald Kohn, which market participants took as signaling a probable rate cut in the upcoming Fed meeting on December 11.

Today's front-page Wall Street Journal article discussing the rally featured a quotation from David Resler (Chief Economist of brokerage firm Nomura Securities International) declaring, "The risks that the weakness in this sector [housing] will pull the overall economy into a recession are rising by the hour." What exactly takes place in the housing sector on an hourly basis to threaten the economy with recession was not specified.

Bearish commentators, noting that the market recently (Monday) passed the official measure of a "correction" (a 10% from a previous high), made pronouncements that the upward moves of the last few days are just "dead cat bounces." Permabear Doug Kass published this article today on The Street.com entitled "This Dead Cat Won't Keep Bouncing."

While the market may indeed retrace upward moves that are predicated on a Fed cut (especially if the Fed deems that a rate cut is not needed), the increasing fear of a recession is overblown.

As we explained in this post, a large percentage of economists and journalists subscribe to the inaccurate "demand side" view of the economy, and this skews their vision and leads to questionable conclusions. Starting with "the consumer" as the fickle engine of the economy (fickle because they view the consumer as forever prone to becoming scared and not spending) the demand-side analyst is always afraid that the consumer will suddenly freeze up and usher in a recession. Current recession predictions generally blame "falling home prices" as the reason the consumer will go into hiding, as if most people buy their Christmas presents using home equity rather than money from their paychecks. The importance the demand side attaches to the "consumer confidence index" is another indicator of why they are always afraid that the moody consumer is always a bad mood away from going into hibernation and bringing on a recession.

However, this worry is misplaced. Healthy economies do not just slip into a recession. Recessions are more often created by misplaced government intrusion than anything else. The current conditions include continuing positive business earnings, lower unemployment percentages than at any time during the entire decade of the 1990s, and generally benign taxation and interest-rate environments. Business growth will always accelerate and decelerate from quarter to quarter, rather than growing at a smooth pace, but the economists we have found reason to trust continue to predict positive economic growth at rates much higher than the general (demand-side biased) consensus.

In fact, there have only been two official recessions, defined as two consecutive quarters of negative GDP growth, in the past twenty years, one beginning in July of 1990 and one beginning in March of 2001.

Similarly, although there have been many market "corrections" in the same twenty-year period (drops of 10% from a previous high), there have been only two actual bear markets (generally defined as a 20% or greater correction), both of which corresponded to the two recessions (there was also a "near-20%" correction in 1998, corresponding to the "Asian Contagion" credit crisis).

These two 20% corrections are depicted in the chart above, which shows the Dow Jones Industrial Average over the past twenty years, with the two bear markets indicated by yellow brackets:

July 1990 - October 1990 (Dow went from 2999.75 to 2365.10 which is a drop of 21.2% and which lasted 87 days).

January 2000 - December 2002 (Dow went from 11,722.98 to 7286.27 which is a drop of 37.8% and which lasted 999 days, the longest since the Great Depression).

While it is important to have cash reserves for market corrections (to prevent your being forced to sell securities at low prices in the event you have a cash need) and it is important to be alert for indicators that threaten an actual recession (such as increased government interference with free trade, increased intrusion into and regulation of law-abiding businesses, increased taxation, or unnecessary over-constriction of the money supply), the current recession fears are largely unfounded demand-side anxiety.

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Would you prefer options linked to your company or to the S&P 500?


In December 2006, this article appeared in the San Francisco Chronicle Magazine typifying the kind of journalism that surrounds the "active versus passive" debate.

The article recounts the education of "hundreds of impetuous young multimillionaires" at Google who were given lectures on the superiority of index investing from Bill Sharpe, Burton Malkiel, and John Bogle prior to the IPO of GOOG in 2004. Entitled "The Best Investment Advice You'll Never Get," the author suggested that any form of active management amounts to "get-even-richer investment schemes" and that the main reason everyone in the country is not investing solely in index funds is that "putting investors into index funds is simply not in the interest of the industry that sells securities."

In fact, as we outline in The Emperor's New Index Fund, there is a steadily-growing portion of "the industry that sells securities" that is doing very well indeed "putting investors into index funds."

The real question that should be asked in that article is how those "hundreds of impetuous young multimillionaires" became multimillionaires in the first place. The answer is the exact same answer that we outline in this post entitled The Classic Growth Stock Investing Philosophy, and the same method that has made most of the big fortunes in this country not only in the 1980s, 1990s, and this decade, but for the past two hundred years: through ownership of shares in a growing company.

Do you think new employees at Google would prefer to receive employee stock options that are tied to actual Google stock, or to the S&P 500? If Google's management truly believes that buying indexes is actually better than owning shares of exceptional companies, then maybe they should incent employees using S&P options rather than Google options.

Trying to own good companies makes sense -- in spite of the fact that most of the press now takes it as an established fact that trying to buy companies that are better than the average is foolhardy or somehow unsavory. Don't be taken in so easily.

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Happy Thanksgiving to all














As we head into Thanksgiving, many of the economic commentaries you hear on the radio or on the financial news media will be focusing on "Black Friday" (so named because retailers supposedly spend the entire year up to Thanksgiving "in the red," and then go "in the black" in a rush of post-Thanksgiving shopping).

Accompanying all this talk of Black Friday every year, and this year in particular, will be plenty of concern over the question of whether "the consumer" will be able to step up to the plate this year and at least get on base, or if he will strike out.

While the shopping appetite of "the consumer" is certainly important -- especially to retailers -- it is a mistake to believe that the consumer drives the economy. Yes, you've been conditioned to believe that the consumer drives the economy, and you've heard it endlessly repeated that 80% of the economy is driven by consumer spending, but it is actually not true that the consumer drives the economy. The consumer is able to spend (consume) because he has a job, and he has that job because of his part in the production side of the economy.

The reason most people believe that the consumer drives the economy is because most of the economists in the world are demand-side economists -- focused on consumption rather than production as the more important side of the supply-and-demand equation. The reason so many economists are demand-siders is not because demand-side economics leads to better conclusions (quite the opposite) but rather because the majority of economists are employed by the government and by academia, where demand-side thinking is entrenched, rather than in the sectors of the economy involved in actual production.

Economist and Professor Emeritus of Economics of Pepperdine University George Reisman outlines the vast philosophical divide between the demand-side approach to economics (which he calls "Consumptionism") and the opposite approach (which he calls "Productionism" but which is often called "supply-side" in the media and popular press) in an invaluable essay entitled "Production versus Consumption."

That essay, originally published in 1964, explains that the productionist sees "the fundamental problem of economic life as how to expand production" and takes for granted the desire to consume, focusing instead on "the ways and means by which production might be increased."

The positive aspects of the productionist approach are too numerous to detail in a blog post, but one very practical benefit is that the productionist approach is right much more often than the consumptionist approach. The last GDP figure was severely underestimated by the demand-side majority, while at least one "supply-side" economist, Brian Wesbury, nailed it within a tenth of a percentage point.

Another positive aspect of productionism (besides the fact that it is right and consumptionism is wrong) is that it sees that the integration of more people and more technology into the overall economy is beneficial and not harmful. Demand-side theory leads to the belief that if more people world-wide are working, they are taking jobs away from others. Thus it leads to a belief that foreigners, or people of other races, or women in the workforce, or people in other regions, or even robots, take away jobs and benefit one group at the expense of another. It is a "zero-sum" mentality -- a "fixed-pie" view of the world.

Production-side theory leads to the conclusion that the more people -- locally and worldwide -- who are able to join the economy, the better. It is not a zero-sum view of the world. As new value is added into the economy that wasn't there before (see this previous post discussing this subject), they will earn money (a place-holder for the value that they produce) and they will spend it, but the way they are enabled to spend is because they were first empowered to produce. In fact, their improved situation actually helps the entire system.

If robots working in Detroit enable more cars to be produced per worker, then there are now more cars per consumer than there were before. If workers in China are able to produce more goods more cheaply than were produced before, then there are now more goods per person available worldwide. More goods per person means that those goods become more affordable than before. If it used to take ten people to make one Corvette, and now it only takes one person to make one Corvette, then it stands to reason that you can now produce more Corvettes per person than you could before, and that more people can potentially acquire a Corvette. The pie has gotten bigger.

Regardless of whether you actually like Corvette cars (it was just a convenient mental example), this process is the story of the past century in the United States, and the reason behind the availability of a vastly greater supply of goods to a vastly greater percentage of society than were available in, say, November of 1907.

Something to be thankful for this year at Thanksgiving.

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Malpass hits nail on head












In his most recent Forbes opinion, Bear Stearns Chief Economist David Malpass hits the nail on the head.

He points to "the uncertainty in U.S. tax rates and the scheduled tax rate increases" as underlying explanations of what ails U.S. markets here in the last months of 2007.

We agree, and point out that we sounded the same note last week in a blog post entitled "What's really troubling the market?"

While the media is full of pundits proclaiming that the "deepening credit problems" are the major issue of the moment, it is naive to think that the market has not been pricing in the current credit problems for many months.

Certainly the problem has been front-page news since the summer, and professional market participants have been making models incorporating the extent of these credit problems and write-downs for some time. It is very possible that there will be some "write-ups" later, when the damage turns out to be less severe than the more pessimistic models anticipated.

Rather, it is more likely that the forward-looking market is now looking ahead to 2008.
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A word about insurance














Late last evening I received terrible news about the medical prognosis of a friend.

I don't talk about life insurance with my friends, but I know a lot about life insurance. Life insurance is not something you really discuss with your friends, even if you are in the habit of discussing the markets or specific investments with them from time to time. You won't read about it on most stock-oriented websites or hear about it on CNBC. But it is an absolutely critical part of your overall family financial perimeter and one we spend plenty of time examining when performing capital management. Just like other parts of the financial picture, there are many different approaches and plenty of strong opinions about which way is best, although people typically pay less attention to the insurance debate and are generally much less well-informed about it than about other areas of capital management.

Most people don't even know the difference between the various forms of permanent insurance (universal life, variable universal life, whole life, and so on) and typically rely entirely on term insurance, which carries much lower premiums and which is also the type of insurance usually provided through their employer.

Insurance needs vary widely from individual to individual and family to family, of course. Term insurance is an important component in your insurance picture and many people should carry some of it during their working years because it provides the largest benefit to the size of the premium. "Buy term and invest the difference" is a common mantra among those who provide investment advice, because they see the accounts where "the difference" is invested as the "main engine." In the statistically improbable event of untimely death during the term of the temporary insurance, the death benefit springs up to replace the main engine that did not get built.

But that is where most people's analysis of insurance ends, and they fail to go any further and see that these strong points of term insurance lead to its weak points and to the reason it should not be the only form of insurance for most families. First, most people will never collect their death benefit, because they are going to live through the term (this makes it by far the most profitable product that insurance companies sell, even though its premiums are much lower than the others). By definition, it does not create a long-term accumulation vehicle the way permanent insurance policies do. The "buy term and invest the difference" argument says it is better to create that accumulation vehicle somewhere else, where it can potentially earn a better rate of return.

The problem with that argument is in the fact that it provides no protection in the event of incapacitation that does not result in death. In the "buy term and invest the difference" scenario, serious incapacitation will likely lead to the loss of any ability to continue "investing the difference" somewhere else. Only one form of insurance, what used to be called "ordinary insurance" or whole life insurance, comes with the ability to buy a disability rider by which the insurance company pays the "invest the difference" premiums in the event that the owner becomes incapable of working. Whole life insurance with a disability waiver of premium rider insures the continuance of the building of cash value as well as the continuance of the insurance.

You can buy a disability waiver of premium rider on a term policy, but that only insures the continuance of insurance, not the continuance of building cash value (term policies do not build cash value), and the relative price of the disability rider on a term policy is much higher. You can also buy a disability waiver of premium rider on some variable life, universal life, and variable universal life policies, but these differ in an important way from those on a whole life policy in that the insurance company only pays the portion of the premium that applies to the insurance. In other words, these enable the continuation of the insurance portion (as does the disability rider on a term policy) but not the continued accumulation of greater cash value.

For this reason alone, regardless of its other beneficial features, whole life insurance deserves serious consideration among those who have children and who are still working towards significant wealth, even if they are the company's fastest rising star on the sales team, or even if they are working at a promising start-up that will probably have an IPO in a few years. Again, it is not a solution that works to the exclusion of term life but rather in conjunction with it, in most cases.

Further, whole life insurance has other features that enable it to work as an important part of the complete financial picture of families with significant wealth. You might be surprised to learn that families with balance sheets of ten million dollars and more often own more insurance than those with less than a million.

At Taylor Frigon Capital Management we don't sell insurance.

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Gambling, Speculation, and Investment















We draw a very important distinction between gambling, speculation, and investment.

Today, many prospective investors do not understand this distinction, largely because the term "investment" is often misapplied to activities which should more properly be identified as speculation, or even as gambling, as we explained in a Taylor Frigon commentary entitled "Gambling, Speculation, and Investment" published earlier this year and available in the commentaries section of our web site.

Another important aspect of this distinction -- beyond the differences outlined in that commentary -- is the fact that both speculation and gambling are forms of a "zero-sum game." New wealth is not actually created in either gambling or speculation: wealth is often redistributed, but new wealth is not created. If four people walk up to a high-stakes poker table, each with one million dollars, only four million dollars will leave that same poker table. At the end of the night, one player may have four million and the other players may have zero, but nobody will walk away with five million. No new wealth is created in a zero-sum game (hence the origin of the term "zero-sum" -- nothing is added; there is zero "summed" or added in the process).

In forms of speculation in the financial markets, this same principle is evident. If you want to place a bet (in the form of futures contracts, for instance) that the dollar is going to go down against the euro, then someone else must be willing to bet that the dollar is going to go up against the euro. If you and I walk up to the exchange with a million dollars each, and you think the dollar is going down against the euro, and I think it is going up, then at the end of the contract (at expiration) you may have two million dollars and I may have zero, but no new wealth is going to leave the exchange: it is a zero-sum game. This is true for speculation on the price of oil and other commodities, as well as for foreign exchange speculation (forex), as well as for bets on volatility (I might bet that an index will stay within a certain range of volatility, and you might bet against me and win if the index moves outside of that range).

Investment, under the proper definition of the term, is the allocation of capital to an enterprise that will actually create new value. In investment, therefore, new wealth can actually arise where it did not previously exist. You can easily see this process from familiar examples of recent years. At one point in the recent past, there was no such thing as an iPod (or iTunes); today, there is an iPod and iTunes. Something of value has been produced that did not exist before. The pie actually gets bigger: it is not a zero-sum game. The same holds true for the creation of cures that did not exist before, or services that made something easier that previously was difficult or impossible to accomplish.

A zero-sum game is a much more unstable foundation for the creation of long-term wealth. It is difficult to win a zero-sum game consistently for decades. Just as in the gambling world of Las Vegas or Monte Carlo, there is a cost to participate in each zero-sum game, so the odds are already stacked against the player and in favor of the house (in the world of financial speculation, there are transaction costs and commissions involved in placing bets using futures contracts or financial derivatives) . Additionally, when involved in gambling and speculation, the game is often constructed such that the effect of a mistake is magnified (think of the phrase "double or nothing," for example).

It our hope that the distinction between gambling, speculation, and investment would become more widely understood, so that individuals are less likely to engage in speculation and gambling when they think that they are actually "investing."

[Of course, there is a place for both speculation and gambling, but it is important to know when that is what you are doing, so that you can make a conscious decision about doing so. Also, it is quite likely that poker is not really gambling under the definition outlined in "Gambling, Speculation, and Investment," but is really a form of speculation. The picture of the 1956 book on poker depicted here is really a picture of monetary inflation over the last fifty-one years, showing the diminishing purchasing power of thirty-five cents].

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Don't hire a journalist to coach your team












Wealth management has become a buzzword among retail financial services firms.

The previous post outlined how wealth management -- which we call wealth allocation planning and capital management -- is a critical concept that encompasses investment management as a subset. If capital management is the science of examining your overall wealth allocation and then ensuring that your wealth is working as capital (wealth employed to create more wealth), then investment management is the day-to-day blocking and tackling required to run the capital that is committed to the financial markets.

For some time now, Wall Street has been preaching the need to divorce wealth management from investment management. If you are an investor who has substantial wealth, you will likely be familiar with the "wealth manager" who de-emphasizes his role in investment management so that he can "focus entirely on wealth management." For almost a generation now, those going to work in the retail financial services firms have been taught not to make the day-to-day buy and sell decisions on securities but to farm that process out to professional investment managers. In other words, the official story is that the wealth manager cannot and should not be an investment manager.

But this thesis is critically flawed, because it leaves the critical decisions of wealth allocation planning and management in the hands of someone who by his own admission does not have the time to stay on the pulse of the themes and trends of the business world and the interaction of corporate capital in the markets. Sure, he keeps up with it, and can even provide entertaining color commentary on what is taking place, but he is not on the field battling in the trenches every day.

In other words, would you want Vince Lombardi running your team or the guy who is up in the booth doing commentary? A reporter may know a lot about the game, but the experience of voicing opinions is vastly different than the experience of making the tough calls day-in and day-out.

Beware of the conventional wisdom that you hear in the world of financial management. The prevailing theory that wealth managers should not dirty their hands with the day-to-day discipline of real money management is a Wall Street truism that deserves closer critical examination.
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Manage your Capital















Investment management is a very important subject. It refers to the process by which you make your buy-and-sell decisions on financial securities over the years.

Important as it is, however, it is only part of the entire picture.

Your financial market investments are only part of your overall capital, and the financial markets are only one of the different places you can invest your capital in order to create greater wealth. Real estate is another form of capital investment. Investments in businesses that are not traded publicly on the exchanges are another. While not actual investments, insurance instruments that you choose to purchase are yet another place you may direct your capital.

Economists define capital as wealth used reduplicatively -- wealth that is employed in order to create more wealth. When you loan money to a bank and receive interest, you are using your wealth in a reduplicative manner.

When the bank gets your money, however, they are likely to be much more efficient in employing that capital to create more wealth. They may loan it out to someone who is buying a house, and receive 6% interest. The money doesn't stay in the house, however -- whoever sells the house puts that money back into the system somewhere, some or all of it may go right back into a bank. Whether it goes right back into the same bank or not is immaterial for this illustration -- if this home seller puts it into a different bank, then a different home seller may put the money he receives into this bank, but for the purposes of the illustration, imagine that the home seller puts all the money right back into the same bank that loaned it to the buyer at 6% interest.

Now the bank turns around and loans it out to someone who is buying a car, this time at 8% interest. Again, the car buyer gives the money to the car seller, and the car seller puts some or all of that money back into the bank. The bank will then lend that money out again, this time perhaps to a credit card user who makes a credit card purchase at an even higher rate of interest, perhaps 10% or 12% or even 18%. In other words, the bank has used the capital it received reduplicatively -- it has used it multiple times in order to make more capital. A corporation will do the same thing, always analyzing where it will get the best return on its capital when it decides where to direct the capital under its control.

Wealthy families and individuals should think this way also, although often they do not. Wealth is different than capital: wealth is defined by economists as goods with value, and it can take the form of money which is simply a place-holder for goods with value (when you produce goods of value in your business, for example, you can trade them for other goods with value but more often you trade them for money, which you can then exchange for other goods with value at a later date).

When wealth is used in order to create more wealth, then it is being used as capital and not simply as wealth. Like a corporation or a bank, a family or an individual should examine the entire balance sheet of all of their wealth.

In the late 1950s and throughout the 1960s, rock climbing techniques were developed in the Yosemite Valley of California for ascending the spectacular big walls and cliffs there. This "Yosemite System" later spread throughout the world and still forms the basis for the system of placing ropes and anchors to protect a climber against a fall (the ropes and anchors are not used
to help ascend the rock -- only to stop a falling climber).

At the basis of the entire system is the anchor -- the connection of the person to the rock (or to a tree), often using nuts wedged into cracks and occasionally using bolts drilled into the rock. The anchor is the foundation of safe climbing -- following the Yosemite System, the belayer at the bottom of the rope is usually held to the rock by a system of three anchors or more. Trusting to fewer than three anchors is risking death in the event of a fall by the lead climber.

Likewise, with your capital, it is important to build more than one anchor as you "climb." Capital directed to the capital markets, in the form of stocks and bonds, for instance, is a critical anchor. However, it is far better to have at least three anchors, for example in the form of real estate and in the form of insurance instruments in addition to financial market assets.

It is possible, with the proper capital management techniques, to use wealth in a reduplicative manner between and among these different anchors -- to use the rents thrown off by a piece of investment real estate in order to pay the premiums on an insurance policy, for example.

This process is properly called "capital management" and it is a larger category than investment management (it includes investment management inside it). Understanding the distinction is important.

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