Dude, Where's my Great Depression?

Today, the Bureau of Economic Analysis in the Commerce Department released their first estimate (advanced estimate) of the Gross Domestic Product for the 2nd Quarter 2008, at 1.9%. This number was lower than the consensus estimate, which had predicted 2.3% growth for the quarter.

The media talking points for the GDP release were that the number was "disappointing," "worrying," or "surprisingly weak," and pointed to the final revision to the 4th Quarter 2007, which was revised downwards to -0.2%, indicating that the economy did contract during the last quarter of last year (during which the Fed was hastily cutting rates and businesses had reason to put off borrowing until rates went even lower, since it was clear the Fed was going to keep right on lowering rates to assuage the financial sector).

However, as economist Brian Wesbury notes today in his discussion of the GDP data, the BEA's current assessment of the first and second quarters of 2008 show economic expansion at an annual rate of 4.8%. In other words, not only have we not seen another quarter of contraction (which would fit the accepted definition of a recession) but we have seen growth at nearly 5% annualized since that quarter of contraction.

Mr. Wesbury also notes that this advance 2nd Quarter estimate includes the BEA's assumption of massive inventory decline during the quarter, and that further study will probably lead to a significant upward revision in the GDP number by the BEA.

Even without those likely upward revisions, the expansion of nearly 2% in the 2nd Quarter is nowhere near the economic catastrophe that the conventional wisdom has been confidently proclaiming is the worst since the Great Depression, backed by endlessly recycled quotations to that effect in the financial media. In fact, the overall economy is continuing to expand in spite of the housing market aftershocks of the Fed-induced malinvestment in real estate during the period 2003-2006, and the hangover in the financial sector created by massive underwriting of related securities.

We have noted recently that earnings season so far has been generally healthy and beating expectations. A week after that note was published, 348 of the 500 companies in the S&P 500 have reported earnings -- nearly 70% of the companies -- and so far 66% of them have beaten analyst expectations, with 11% meeting expectations and 22% falling short of expectations.

As Mr. Wesbury said in his piece of the GDP figures, "These are nowhere close to recessionary numbers," and we would second that regarding many of the earnings results we have seen so far.

The media will continue to flog the "worst recession since the Great Depression" story for a few more months, but we believe the data showing the real situation is out there for those who know where to look.

For later posts dealing with this same topic, see also:
Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.
Continue Reading

The bond market rules the world . . .

When it comes to earning money through investment, there are really only three broad categories of instrument: those that are based on ownership of an asset (such as stock in a business, or investments that are tied to ownership in real estate), those that are based on lending money to an institution in return for interest payments on the loan (such as bonds issued by corporations and government entities, as well as the interest payments issued by banks in return for the use of your deposits, and a whole host of other debt-based instruments), and those that are based on wealth redistribution (such as lottery tickets, in which a large number of people put in a small amount of money and a few people get a large payout -- other forms of wealth redistribution include taxes, gambling, and to some extent insurance -- these are "zero-sum" schemes since someone gains and someone loses and nothing new is created).

It should be clear to readers of this blog that we believe the foundation of a long-term strategy of wealth preservation and wealth creation should be built upon ownership, and primarily upon the ownership of shares in well-run businesses operating in fertile fields of growth. We also advocate the ownership of real estate as part of the overall capital management strategy for most investors.

However, as we have alluded to before, there are also many situations in which investors should add an income strategy to this main foundation, and strategies requiring steady cash-flow streams often use the second category of debt-based instruments (or "fixed-income" instruments) in order to provide the properties of permanence and definition that are not found in ownership-based investments to the same degree.

In light of the role played by debt-based instruments, it is worthwhile to take a closer look at some of the issues we see from the perspective of long-time professional portfolio managers. A common expression on Wall Street is that "the bond market rules the world," both because of its vast size (about $10.3 trillion larger than the stock market at the end of 2007) and because of the impact that interest rates have on stock prices due to the discount rate that is applied to discount future earnings in order to give a present value on the future cash flows a company is expected to produce.

While the common stereotype of bond investments is that they are "boring" and "safe," the reality is that debt-based instruments are fundamentally composed of an IOU from a borrower, and because of that fact they behave in distress very differently from ownership-based investments such as stocks. The nature of an IOU is very black-and-white: you are receiving payments from the borrower, or (in the event of a failure of the borrower) you are not. In other words, when things go wrong in the world of an IOU, it often takes the form of a sudden transition from "you're getting your payments and everything looks fine" to "you aren't getting your payments, and getting your principal back is now questionable as well."

Note that most of the financial crises of the past thirty years have centered around failures in one part of the bond world or another: the Latin America debt crisis of 1982, the "Asian contagion" of 1997, even the implosion of Long-Term Capital Management's government-bond arbitrage scheme in 1998.

This is not to suggest that debt-based instruments are inherently problematic or that investors should avoid them, but rather to point out the sudden nature of default when it does occur. Statistically, default rates are very low among most categories of bonds that make up the overall bond market, and can be reasonably predicted through proper securities analysis -- most of the problems occur when massive amounts of leverage are added to the equation. It should also be pointed out that leveraged strategies involving fixed-income instruments are far more common and far more extensive than leveraged stock investment strategies. Today's mortgage and credit crisis underscores this, as default rates on the debt in question is at 3% or less, but the leverage involved is enormous, since the amount that can be borrowed against bond positions dwarfs the amount that can be borrowed against stock positions.

Because of the characteristics of debt-based investments described above, we believe that it is very important to diversify sources of income payments inside of a proper income strategy. In addition to owning bonds from different issuers, we also analyze cash-flow sources other than bonds. Again, analysis of the credit quality of the issuer (in other words, the borrower) is very important.

The above two points apply especially to investors who are getting interest payments from banks right now.

First, the credit quality of the bank (its balance sheet) is something investors have tended to ignore since the creation of the FDIC in 1933 (another unfortunate example of implicit or explicit government backing leading to a diminished perception of risk, as we described in an earlier post). It should be clear by now that this is an important consideration.

Second, the diversification of sources of interest is as important with interest you get on cash reserves as it is with any other debt-based income. In other words, these interest payments shouldn't be coming from one big bank CD issued by a single bank. Money market funds, while not insured by FDIC, are by nature pools of literally hundreds of debt-based instruments, giving them much greater diversification of income, which we believe is an important aspect of income strategies.

Along these same lines, it is important to note that the credit history of an insurance company is also a very important consideration for insurance policies with a cash value component (most forms of permanent insurance) and for policies that participate in insurance company dividends. We have touched on important reasons why these policies can work together along with financial market assets and real estate in previous posts such as this one.

Finally, the reality of inflation is critical with the debt-based category of investment instruments. Unlike ownership-based instruments, the debt-based instrument pays back whatever its contract says it will pay back, and nothing more. As long as the borrower doesn't default, it will pay that income stream and return principle at maturity, but as inflation causes the dollars it pays back to purchase less and less, it is effectively paying back a smaller and smaller amount over the years (graphically illustrated here and here).

For all these reasons, it is clear that ownership-based investment should form the foundation of an investor's long-term strategy, and why we say that income strategies can be built on top of that foundation, rather than ever being the foundation itself. The distinction between ownership-based, debt-based, and wealth-redistribution based instruments is important, and investors should understand the very different characteristics of each category.

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

For later posts on the same subject, see also:

Continue Reading

Beautiful Growth Companies, part II

Back in April, we published a post entitled "Beautiful Growth Companies," in which we highlighted some of the quantitative indicators of the kind of well-run growing companies that our discipline builds upon as the foundation of a long-term wealth management plan.

While noting that "no mathematical formula alone can be relied upon to aid in identifying growth companies," in the words of T. Rowe Price, we noted that the "statistical guidelines" he set out included:

1. A return on invested capital of 10% or better, and continued increase in capital from retained earnings.

2. Above average profit margin for the industry in question, and a favorable trend of improving the profit margins.


3. Compound annual earnings growth of better than 7%.

We revisit these statistics, and the company we used back in April to illustrate them, both to emphasize what we said earlier this week about earnings of certain companies continuing to grow strongly in spite of the gloomy outlook being broadcast about the state of the economy, as well as to illustrate an important point about the ownership of certain types of companies in the face of inflationary pressures caused by the Federal Reserve.

Yesterday after the market closed, medical waste disposal company Stericycle* (which we highlighted in the April 28 post) reported earnings growth of approximately 23% from the year-ago quarter and beat the consensus analyst forecast by two cents per share in the process.

In terms of the three criteria listed above, Stericyle's ROIC increased to 11.7% from around 11%, they were able to maintain a profit margin of 25.7% in spite of diesel cost increases of 57% from the year-ago quarter (a margin decrease of just 0.2%), and the company has a long-term EPS growth rate of 17% (including ten consecutive quarters of double-digit organic earnings growth).

Not only is this company a stellar example of the kind of companies that our investment process seeks to identify and own for clients, but also illustrates a very important point we have made previously about growing companies as a historically-proven store of value in the face of the threat to purchasing power posed by inflation.

Jeremy Siegel argued in an article we linked to previously that stocks can protect against inflation because "the earnings of a firm will rise as the price of its output rises with inflation" and he presented graphs showing the superiority of the historical returns of stocks even against traditional inflation hedges such as gold or commodities.

Stericycle's ability to retain its margins even in the face of the fuel inflation noted above is specific recent evidence of this principle. Note that not every company has the same ability to pass along energy costs, but certain factors in Stericylce's business model, including the indispensable nature of the services that they provide to hospitals, doctors, and dentists, make their company an ideal example of this concept.

Recent earnings news continue to validate the concepts we have written about previously, and to bear out the principles that we have relied on for decades and that have been passed down from previous generations of money managers.

* The principals of Taylor Frigon Capital Management own shares of Stericyle (SRCL).

For later posts dealing with the same topic, see also:
Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.
Continue Reading

Earnings season so far: beating analyst expectations

As of the end of the day on Wednesday, July 23rd, one hundred eighty-six of the five hundred companies which make up the S&P 500 have reported earnings (37.2% of the total companies in the S&P 500).

Of that number, 71% have beaten analyst expectations, 9% have reported earnings that were in-line with analyst expectations, and 20% missed analyst expectations.

You may recall that we have argued against the desire of many in the media to seize on quotations such as "the biggest economic shock since the Great Depression" (which was repeated on many news channels in April of this year) and "worse than any recession we've had since World War II" (which was widely repeated by the news media earlier this month, always noting that this gloomy remark came from a "billionaire investor").

Well, earnings season so far has not cooperated with this irresponsible storyline. Companies are stubbornly growing their earnings at a greater rate than the conventional wisdom has predicted, as evidenced by the fully 71% who have so far beaten forecasts.

Some of these earnings beats are coming from fairly significant companies. For instance, Intel Corporation* reported quarter-over-quarter earnings growth of 25% -- not bad for a company in the middle of a period that has been called worse than the 1970s and the worst since the Depression. Their earnings beat consensus forecasts by three cents a share.

(The next day, two independent research companies both concluded from their analysis that PC shipments grew either 15% or 16% during the quarter, beating estimates as well. An analyst from one of the companies, who had predicted slower growth, said "We're waiting for sales to slow down.")

Yesterday, Intuitive Surgical announced earnings grew 66% year-over-year in the quarter, despite analyst predictions that the slowing economy would have hospitals tightening their belts and unwilling or unable to purchase the robotic surgical systems that are creating a paradigm shift in some types of surgery**. While the consensus had predicted earnings of $1.18 per share, Intuitive earned $1.28 per share, beating by a dime.

The naysayers will argue that beating earnings expectations isn't an absolute measure: maybe those expectations were excessively low, but that doesn't mean that companies are doing well by beating excessively lowered analyst estimates. However, that counter-argument is exactly what we are saying: the conventional wisdom has been calling for a disaster, and the reality is turning out to show that the conventional wisdom has greatly exaggerated the reports of the economy's demise. Further, the average absolute return for the S&P companies reported so far was nearly 10% as of Monday evening, according to this report from Zack's Investment Research.

We have argued that investors should pay attention to the concept of "situational awareness" in order to avoid having a mental picture that is either too rosy to match the actual situation, or too gloomy to match the actual situation. In that article back in April, we said "today, there is a widespread perception that the economy is on the brink of a cliff" but that the overall situation was actually one of opportunity, even though few investors were currently looking to future opportunities.

While many continue to declare that they are "waiting for sales to slow down," we believe that events in the coming months will continue to surprise many on the upside.

Nevertheless, we emphasize that our core strategy is based on the selective, long-term ownership of well-run growing companies through many market cycles, rather than on any scheme of calling and timing market cycles..

* The principals of Taylor Frigon Capital Management do not own shares of Intel (INTC).

** The principals of Taylor Frigon Capital Management own shares of Intuitive Surgical (ISRG).

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

Don't fear the current recession drumbeat, Revisited

Back in November, we wrote a post entitled "Don't fear the current recession drumbeat," in which we argued that the chorus of predictions that the consumer would drive the economy into a recession because he could no longer borrow as much against home equity was misguided.

Since then, we have seen oil rise to record highs, and the major stock market indexes experience a harsh bear market, dropping over 22% between the October 9th high (for the S&P 500) and Tuesday's closing price from this week (July 15th).

Given these results, were our denunciations of those arguing for a consumer-led recession misguided? Should we retract those statements and admit a major flaw to our reasoning?

Well, no. The economy has not, in fact, experienced a recession. Although growing more slowly, it is still expanding, and this week total industrial output in June was announced to have grown by 0.5%, against expectations of 0.1%. We would also add that if the Fed were to raise rates, and stem the dollar's decline, we would actually see a reacceleration of growth. Businesses put off decisions on longer term strategic investment if they suspect rates will go lower and/or the purchasing power of their dollar may be undermined by inflation.

Unfortunately, what has happened is that the Federal Reserve began drastically cutting interest rates last fall, as depicted in the revealing graph above, which comes from this insightful opinion piece in yesterday's Wall Street Journal.

That graph shows clearly that the doubling in the price of oil, from a little above $70 a barrel last fall to recent prices above $140, correspond exactly to the emergency loosening in monetary policy by the Fed. This is exactly what we have argued previously, for example in this post from June 4. Furthermore, although the Fed (in particular Chairman Ben Bernanke) has given lip service to the inflation/dollar-decline problem, mere lip service has only served to exacerbate the problem we describe.

In spite of what you hear from many commentators on the financial media shows, the supply and demand characteristics of oil did not change dramatically in the past few months: what changed was the Federal Reserve, which has been too loose for years but exacerbated the problem further starting in the fall with their attempt to steer the economy out of the financial mess created by the CDO boom that they helped to create.

This most recent Fed over-reaction is at the heart of the oil spike, as well as the inflation pressures we are now experiencing (the inflation pressures were started by their earlier too-loose position, and the recent loosening will cause that inflation to spike further in the months ahead). We have explained previously that the Fed's attempts to steer the economy, rather than provide a stable currency for businesses and citizens, are causing inflationary problems that impact everyone.

At this juncture, we continue to argue that ownership of good businesses should form the foundation of wealth planning. Charts contained in links at the end of this post demonstrate that even in an inflationary environment, stocks in companies that add value to the economy (and can therefore raise their prices to keep up with inflation) are the best store of value for longer periods. The lower prices resulting from a bear market provide opportunities to add to investments for those able to do so, as we have also stated previously.

We would also add that, on top of the main foundation of ownership in good businesses, if you own securities producing income streams (such as interest-bearing instruments), it is important to diversify those income streams. Don't get all your income from CDs issued by a single bank, in other words. On top of the main foundation of equity in good businesses, we advise ownership of a diversified income strategy for those whose situation calls for it, and even ownership in the stock of non-public start-up companies when appropriate.

In spite of appearances, the economy itself is not going off a cliff. It is important to have a clear understanding of the causes of the current environment, in order to make the correct decisions in the conditions we are currently experiencing.

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

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

The Wages of Socializing

Our perspective on the current Fannie Mae and Freddie Mac debacle is a portfolio manager's perspective: do not commit capital to companies whose business is deeply entwined with the government*.

It is hard enough to predict the business performance of a company even when it isn't subject to the whims of elected officials.

Beyond that simple dictum, Fannie and Freddie have raised several red flags over the past several years which would be enough to disqualify them from inclusion in a portfolio of well-run businesses.

For starters, both companies were found in 2004 to have manipulated their earnings (as reported by their oversight agency, OFHEO, the Office of Federal Housing Enterprise Oversight). Their management team and boards of directors are often packed with political appointees rather than savvy businessmen and women who have spent their careers gaining experience in fields related to the business of mortgages and securitization. Further, until 2003 these companies didn't even publish regular SEC filings the way every other publicly-traded company was required to do.

Any one of the above problems would be enough to disqualify them from being considered "well-run businesses positioned in front of fertile fields of growth" (a formula we have discussed in several previous blog posts, such as this one).

But, many investors do own securities issued by Fannie and Freddie, such as their public stock, their mortgage-backed debt securities, or their own debt (often called "agency bonds" or "agencies"). One reason their stock was attractive to many investors is the fact that, as "government-sponsored enterprises," they could borrow at lower rates than other private corporations in order to buy mortgages for their own portfolio or to sell to other investors. They used this ability to borrow cheap in order to leverage themselves above 30 to 1 (some analysis suggests as high as 60 to 1).

With all that leverage, they built huge portfolios for themselves: $727 billion for Fannie and $712 billion for Freddie as of 2008 (see this excellent opinion piece from economist Larry Kudlow published yesterday). These portfolios have been extremely lucrative for their employees and their shareholders. Although any private company or individual who leverages himself to such an extent in order to try to make money risks bankruptcy if the investments go awry, Fannie and Freddie have always operated with an "implicit" understanding that the government would stand behind them in a crisis, which is exactly what happened on Sunday afternoon when Treasury Secretary Paulson made that backing explicit.

While we might wisely choose not to invest in entities with so many red flags, as U.S. taxpayers it turns out that we don't have a choice. Thus, as portfolio managers, we must also be concerned about the impact these entities can have on the entire financial system and the economy.

All taxpayers are liable for sharing the losses of Fannie and Freddie, even if they didn't have the opportunity to share in their gains. This is what is called "privatizing the gains and socializing the losses," and it is a situation that the opinion staff of the Wall Street Journal has been vociferously warning against since 2002, in a series of articles available from this Journal page (wittiest title: "Speaking Truth to Fannie" from March 12, 2003).

To the extent that the Fed holds off on raising interest rates in order to ease pressure on these two troubled behemoths, the damage to the purchasing power of everyone's dollar due to inflation hits everyone. The giant capital infusions to Fannie and Freddie offered in Sunday's Treasury announcement would also have an inflationary effect and further rob citizens of the purchasing power in their currency.

The situation with Fannie and Freddie shows the wages of socializing: because the government stood behind them (with your money), Fannie and Freddie took risks that they never could have taken if they had been regular private companies without the safety net of taxpayer dollars, and borrowed money at a price they never could have gotten without that same safety net.

Some defenders of this socialization of Fannie and Freddie say that it is necessary in order to help more people buy homes than would otherwise be able to do so. However, economist Wayne Passmore of the Board of Governors of the Federal Reserve argues otherwise, according to research he did of the actual numbers involved, in this report published in December of 2003. Similarly, we argued in our latest quarterly commentary that these attempts at "social engineering," such as the Community Reinvestment Act, only serve to create inefficiencies, and ultimately hurt those they were intended to help.

In the 2003 report, Dr. Passmore states: "The GSEs' implicit subsidy does not appear to have substantially increased homeownership or homebuilding because the estimated effect of the GSEs on mortgage rates is small." He goes on to say, "My calculation also suggests that roughly 42 percent to 81 percent of the GSEs' market value is due to their implicit government subsidy."

This same pattern is common whenever government interference removes penalties for irresponsible behavior: greater risks will be taken in pursuit of profits, and the intended benefits from the government intervention will turn out to be minor or nonexistent. In the end, the taxpayers will have to pay the wages of socializing, whether they saw the red flags and warning signs, or not.

* The principals of Taylor Frigon Capital Management do not own shares in Fannie Mae (FNM) or Freddie Mac (FRE).

For later posts on the same subject, see also:
Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.
Continue Reading

The dark side of "making hay while the sun shines"

This will be a revealing week on Wall Street, with earnings reports due out from some of the big brokerage firms and major money-center banks.

As we have said previously, even the CEOs and CFOs of the biggest investment banks don't seem to be able to gain a clear picture of their own balance sheets right now. The reason, as we explained in that post, is that their "manufacturing" department (the underwriters who were eagerly creating CDOs and other instruments in order to rake in investment banking fees while the Fed-induced mortgage boom lasted) cranked out so much product that they couldn't sell it all. This excess product, we said, ended up stuffed in "the warehouse" of their own inventory, "so much so that management inspections keep turning up more of it squirreled away in dark corners and underneath old shelves in the back, and a lot of it has been discovered to be rotten."

At every earnings report, we get a new look at the balance sheet of these companies, as closely as their leadership is able to determine. Over the past six months, it has become clear that they cannot determine their balance sheet picture at all clearly, because they keep announcing emergency capital raises right after declaring confidently that they are done with raising capital for the year.

But why were these investment banks cranking out so much of this product when their own salesforce was saying that they couldn't possibly sell it all? The reason is that they were "making hay while the sun shines" and raking in banking fees, and that those in charge of the departments that were doing it were getting paid big bonuses in cash compensation. The damage to the shareholders (and to the many employees in other departments whose compensation was tied to the stock price) would only happen later, after they had already made their money.

This situation is akin to the way some hedge funds operate, finding a certain market situation that they can exploit for great advantage while it lasts. For instance, if a hedge fund decides we are in a certain long-term trend, such as a declining dollar, they can make money by betting against the dollar. They won't just bet their own money against the dollar -- they will load up on as much leverage as they can get to bet against the dollar, and as long as the dollar continues to decline they will make huge returns.

A common-sense question to ask would be, "What happens, Mr. Hedge Fund, when the dollar finally turns around, and you are leveraged to the hilt and short the dollar?" The answer will be, "I will go out of business, plain and simple, but I will have made a huge amount of fees and bonuses from my investors in the meantime. And, judging from the current direction of the dollar, the good times for betting against it won't run out tomorrow -- I still have a lot of time to make hay while the sun shines." Eventually, the investors in that fund will be left holding the bag, but those running the fund will have made a fortune before the inevitable end comes.

This is exactly what has happened in some of the biggest investment banks in the land, because their management decided that they wanted to behave more like hedge funds. They incented those who were creating tremendous profits for the firm by underwriting asset-backed securities and other synthetic instruments such as CDOs, and now that the inevitable end has arrived, it is the common shareholders who are left holding the bag, analogous to the investors in the hedge fund described above.

These firms should go back to doing the kind of business they are supposed to do: if the investment banks would get back to making money by taking companies public and by doing merger and acquisition deals, and the commercial banks would get back to making money by underwriting responsible loans instead of trying to juice their returns with irresponsible loans, they would have a perfectly operable business model that would allow them to make profits.

At the bottom of this whole situation is the Federal Reserve, which created the conditions for the explosion in lending activity in the first place, by holding rates too low from 2003 to the present. It is astounding to hear the calls for an expanded role for the Fed as a solution to this problem!

We would add as a footnote that, although many are saying that the "current crisis" makes it impossible for the Fed to raise rates, it would help many of the banks if the Fed would raise rates, since the revenues of commercial banks are directly tied to the difference between what the bank pays depositers for funds and the bank earns from borrowers on loans. It is very difficult for banks to lower the rates they pay on deposits any further from the low level they are at right now. Higher interest rates would help these banks earn better returns from the "spread."

The conclusions to the current financial mess should be clear: if the investment banks would stick to their proper business (rather than trying to be hedge funds), and the commercial banks would stick to their proper business (rather than trying to be FHABA or HUD), and the Fed would stick to its proper business (providing a stable currency, rather than trying to steer the economy), then "making hay while the sun shines" would not end up as "settin' the woods on fire."

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

Just Say "No" to Net Neutrality

Yesterday, Chairman of the Federal Communications Commission Kevin Martin came down hard on the side of "network neutrality" by recommending punishment against Comcast Corporation*.

According to the Associated Press (see the report here), Mr. Martin said "The commission has adopted a set of principles that protects consumers access to the Internet. We found that Comcast's actions in this instance violated our principles."

At issue was a formal complaint brought to the FCC by net neutrality activists ("consumer-rights groups") Free Press and Public Knowledge. Their complaint alleged that "a network operator, Comcast, is engaging in substantial network neutrality violations" and that "a moment of truth has come."

Network neutrality, or net neutrality, is the idea that networks established by private companies (and built with private capital) must recognize "the consumer's right to use any equipment, content, application or service on a non-discriminatory basis without interference from the network provider" according to the definition on the Save the Internet website run by the aforementioned Free Press.

While all this sounds good and pro-freedom, what it really amounts to is the very un-American idea of the government jumping on private corporations and telling them what they have to do with their own property. It means that networks built with private capital and owned by shareholders must be run in accordance with the dictates of a group of federal bureaucrats, regardless of whether the shareholder-elected leadership of that company feels it is the best way to run their business, and regardless of whether shareholders lose money because of it. It means, in the words of the aforementioned Public Knowledge, that "the network operator must bear the burden of demonstrating that any interference with traffic is necessary to support a lawful goal."

In fact, as the AP story indicates, the elected members of Congress have (so far) been unable to pass net neutrality bills into law, although sympathetic members of both the House and Senate have sponsored such legislation. But now, FCC Chairman Martin and just two other unelected members of the commission will be enough to punish Comcast and set a precedent for further complaints against carriers.

At the heart of all this is the same issue that forced AT&T (often called "Ma Bell") into breakup at the hands of the Department of Justice in 1984. The same sort of complaints were leveled in that case, alleging that AT&T had a "monopoly" because they only allowed certain types of telephones to be connected to their networks (phones that their subsidiary Western Electric manufactured, for instance). The current argument over net neutrality is no different than the argument that AT&T should be forced by the heavy hand of government to open the network which they designed, paid for, and built to any and all service providers**.

In fact, today's news gets to the heart of all anti-trust issues. There should be no laws against a so-called "monopoly," because monopolies which get lazy or provide poorer service than competitors can offer typically get killed because they fail to recognize where the next disruption (or paradigm shift) will come from. Long-distance telecommunication has been a classic example of that. Oh, and by the way . . . AT&T is basically back together again! What a waste of twenty years of lack of innovation in telecom!

Net neutrality may sound like a worthy cause against "monopolistic" tendencies in big network providers, but the fact is that these providers do not operate in a monopoly at all. There are no government restrictions on companies forming to compete against various network providers. Comcast is a network provider that uses cable, and they are in fact the largest such cable provider. But customers who dislike their service for whatever reason are perfectly free to go find a different network provider -- and that provider doesn't need to be through a cable company. Customers today can choose network providers who are phone companies, cable companies, satellite dish companies . . . the field is currently wide open, and cable companies are fighting hard for business survival. They have absolutely no incentive to drive customers away.

Maybe that is why Comcast and BitTorrent recently reached a deal on managing the very type of network traffic that the "consumer-rights groups" were ostensibly upset about when they brought their formal complaint to the FCC, as described in this Wall Street Journal opinion from April of this year.

As the Journal points out, the free market provides incentives for companies to work out issues like this one (and if a company does not, they can expect to lose customers to a competitor).

But government intrusion such as the smackdown of Comcast by Kevin Martin and the FCC will ultimately hurt consumers, because it will virtually guarantee less innovation and (in the end) less access and freedom than would otherwise develop. Supposed "consumer-rights advocates" like the net neutrality crowd should consider that eventuality.

Because this issue is central to the technological advances that are important to driving our entire economy, and to increasing productivity in industries as wide-ranging as medicine, national defense, and global logistics, foolish moves prompted by innocent-sounding ideas like "network neutrality" can have serious consequences.

* The principals of Taylor Frigon Capital Management do not own shares of Comcast (CMCS).

** Some net neutrality advocates might argue that, while AT&T built their network themselves, the government did in fact provide the funding and talent that started the internet back in the days of the ARPAnet (conceived by the Department of Defense agency ARPA and built using a government contract and thus taxpayer dollars in 1969). However, the fact that the internet started in its earliest form inside a government agency does not mean that every company that accesses the internet today must allow government agencies to dictate their business model. Net-neutrality advocate Google would certainly never agree to such a line of reasoning. Comcast built their network using their own revenue and the capital provided by their shareholders to buy the servers and the switches and the trucks and the cables and to hire all the employees that enable that network to operate. They did not receive taxpayer dollars to build the network that they open up to their paying customers, and the government should not be telling them what to do with that network. If customers don't like it, as noted above, they have the option of renting access from the networks built by competitors instead. The principals of Taylor Frigon Capital Management do not own shares of Google (GOOG).

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

for later posts on this same subject, see also:

Continue Reading

The Investment Climate: July, 2008

We recently published "The Investment Climate: July, 2008" in the commentaries section of the Taylor Frigon Capital Management website.

We have written before (such as this post, from March of this year) that much of the turbulence in the financial sector stems from accounting issues, including mark-to-market regulation. We have also noted that, because of their accounting problems, "even the CEOs and CFOs of those firms [major Wall Street investment banks] do not have a clear picture of the conditions of their own balance sheets," as we discussed in this post from June.

Nevertheless, as we have also pointed out in recent posts, there are areas of opportunity for investors who are able to look past the current problems and take appropriate action.

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

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

Big changes coming, part II

Several months ago, we wrote a post called "Video games and the future of computing," in which we noted that the general computing experience (including the internet) is still two-dimensional, whereas video games have been three-dimensional for many years. We linked to an article by Peter Huber, which begins: "For a preview of the computer that's headed your way, sneak into your teenager's bedroom."

Today, Tech Crunch's Erik Schonfeld discusses one Silicon Valley company (Menlo Park start-up Vivaty) trying to create a "3-D web browser" capability. Later in the day, Google announced the public debut of its own virtual world, called Lively*.

We have stated in several previous posts (including this one from February, this one from May, and this one from June) that the growing ability to transfer massive amounts of data -- including video -- almost instantly is going to bring about enormous changes in the internet. Already, YouTube videos account for a significant percentage of data transferred over the internet, and Google's Larry Page stated in a recent earnings call that ten hours of new video are uploaded to YouTube every minute*.

But the vigorous growth of "video to internet" is only a current indicator of the significant changes that this growing capability to transfer data will bring about in the next several years. In the realm of video, it will also take the form of video to the television (as we discussed in a November post entitled "Become aware of IPTV"), and ultimately will enable "video to video," which is already a reality at a cost that some large corporations can afford, but which will later become cost-effective for average users as well. You can get a brief taste of what this may look like -- as well as the effect it has on people -- in this whimsical video of "The Telectroscope" which the Wall Street Journal's Andy Grove highlighted in June:

This transformation will involve not only actual video (captured from actual real-world scenes) but also the ability to create more and more realistic computer-generated video images. The graphic quality of images in computer games (and those of aspiring 3-D web browser company Vivaty, as well as those in "virtual worlds" available today) are still obviously artificial. However, as some of the computer images shown above -- generated by AMD's ATI and discussed in this on-line video -- demonstrate, the ability to make graphics in an ordinary computer that approach "photorealism" is rapidly approaching*.

Even beyond the tremendous expansion of video capabilities which have the potential to transform the internet (and our lives) in numerous ways in years ahead, the ability to rapidly transfer very large amounts of data enables other important capabilities, such as network storage and parallel processing. These have been discussed for many years, but the increasing ability to move more and more data will enable them to be applied in wider and more pervasive ways than previously possible.

With their focus on the current market turbulence, and the events of the past several months (all of which, we have argued previously, are connected to the Fed's response to the bear market of 2000-2002 and the misallocation of capital encouraged by artificially low interest rates), few investors are currently aware of the significant opportunities presented by some of the changes discussed above.

We would argue that this is a very good time to start to look into them.

* The principals of Taylor Frigon Capital Management do not own shares in Google (GOOG) or AMD (AMD).

For later posts on this same topic, see also:

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

Liberty and Property

On July 4th we celebrate the Declaration of Independence, signed on July 4, 1776. Its second paragraph contains the famous words, "We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty, and the pursuit of Happiness. -- That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed."

The concept that governments derive their powers from the consent of the governed, and that individuals have unalienable rights to life, liberty and the pursuit of happiness is fundamental to the prosperity and progress that America has enjoyed in the ensuing two centuries.

Critical to that prosperity and progress has been the protection of property from seizure by criminal elements and by the government itself -- a protection firmly established in the Constitution's Bill of Rights and sadly lacking in many other nations to this day, to their severe economic detriment.

In light of this central importance of the protection of property, a brief discussion of the relationship between inflation and liberty is perhaps appropriate.

Since money is a store of value, the erosion of the value of money has long been recognized as an assault on individual property. Thomas Paine, in his 1786 publication Dissertations on Government, the Affairs of the Bank, and Paper Money averred that:

"The only proper use for paper, in the room of money, is to write promissory notes and obligations of payment in specie upon. [. . .] But if he is worth nothing, the paper note is worth nothing. The value, therefore, of such a note, is not in the note itself, for that is but paper and promise, but in the man who is obliged to redeem it with gold and silver. But when an assembly undertakes to issue paper as money, the whole system of safety and certainty is overturned, and property is set afloat."

Economist Ludwig von Mises in 1912 wrote that: "It is impossible to grasp the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights" (Theory of Money and Credit, 455).

Even John Maynard Keynes in his early years echoed these sentiments, saying in 1919: "There is no subtler, no surer means of overturning the basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose" (Economic Consequences of the Peace, 220-221).

Thus, the issue of sound money is an issue of property rights. Since the passage of the Federal Reserve Act of 1913 and the institution of a fiat currency in the United States, there has been a steady and significant erosion in purchasing power of money, graphically illustrated in the increasing amount of money required to send one ounce of first class mail in the stamps above.

In 1938, it would have cost 3 cents.
By 1958, the cost had risen to 4 cents.
By 1968, the cost had risen to 6 cents.
By 1978, the cost had risen to 15 cents.
By 1988, the cost had risen to 25 cents.
By 1998, the cost had risen to 32 cents.
In 2008, the cost is currently 42 cents.

This erosion of value represents to citizens the certainty of the erosion of their actual wealth over time, and requires them to find alternatives that will not lose their value relative to inflation. We have argued before that the surest way to do that since 1913 has been by connecting some portion of your wealth to the growth of successful business enterprises through the ownership of stock in those businesses (see here for that post, which also includes a link to academic research which demonstrates convincingly that stocks have succeeded in this effort to a far greater degree than investments in commodities such as gold, or investment in bonds and other interest-bearing instruments).

In this sense, Tom Paine was prescient when he stated in the same 1786 essay quoted above that "One of the evils of paper money is that it turns the whole country into stock jobbers." Whether investment in stocks is evil is a subject for another day. But it is important to emphasize that "stocks" are real shares of ownership in a business, and ultimately their worth is determined by the success of the business behind them. This is the very opposite of the problem that Paine saw with paper as money -- paper that was not backed up with anything other than a fiat (the Latin word for "let it be" or "let it be so"). Because we have had a system of fiat money (the same thing Paine meant when he talked about "paper money") for nearly a hundred years, we believe ownership in businesses is an absolute necessity for the preservation of the wealth.

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

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

The bears are out

The major stock market averages managed to post mild gains today after bouncing back from significant lows during the day.

By closing up for the day, the markets again avoided a close that would be officially 20% lower than their closing highs, which were set on October 9, 2007 for the DJIA and the S&P 500. On that day, the Dow closed at 14,164.53 and the S&P closed at 1,565.15.

During today's trading, the Dow reached a low of 11,185.71 at 12:44 p.m. Eastern -- down 21.03% from its high in October. By closing at 11,382.26 the drop from October's closing high is 19.64%.

Similarly, the S&P reached a low at 12:27 p.m. of 1,260.93 which represents a drop of 19.43% from its October closing high. By closing at 1,565.15% the S&P is currently down 17.9% from its October closing high.

With the stock markets treading along the boundaries of official "Bear Market Territory" (generally defined as a correction of 20% or more from a high), the bears are out in force in the financial media.

Bloomberg ran a story today highlighting the gloomy outlook of Eli Broad, founder of Kaufman & Broad (later KB Home) and SunAmerica, who declared that "This is worse than any recession we've had since World War II." Not only that, but the 75-year-old billionaire declared that "This is the worst period of my adult lifetime," which means that he must think the economy is in worse shape than it was at any time during the 1970s -- an astonishing comparison.

Yesterday, CNBC invited Peter Schiff to broadcast his bearish view that "this whole bubble economy that we have is now deflating" and that the only solution he sees involves the prescription that "we're going to have to live through a severe recession." Mr. Schiff was also featured in an interview over the weekend in Barron's.

In spite of the current market volatility, and in spite of comments like the quotations from Mr. Broad and Mr. Schiff cited above, the simple fact is that America is not in a recession right now and is not likely to enter a recession during 2008.

Even with the drag on the economy caused by the housing industry over the past two years, the GDP continues to expand. Gross Domestic Product is now over $14.2 trillion -- up from less than $10 trillion in the year 2000, and from $1 trillion to $2.6 trillion during the decade of the 1970s. Moreover, the growth rate of the GDP during the second half will probably be twice that of the first half of the year, due to the stimulus provided by the Fed since last fall. This non-recession will decidedly not be the worst since World War II.

In fact, we have stated before (here and here) that this market is likely to be volatile, and will have trouble finding its footing before the fall time-frame and the runup to the presidential elections.

In the meantime, we would advise investors to take a cue from the previous bear market and be willing to add and then add again during corrections, if your cash-flow situation makes that possible. As we noted back in January, it is very difficult to predict the real bottom in any significant market correction, and the market will often probe for a bottom several times before it is done, often separated by weeks or even months.

Adding to equity holdings during severe corrections takes genuine intestinal fortitude, and (as you can see from the quotations above) even wealthy investors often fail to do it when the bears are out and prowling.

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

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

Continue Reading