2010: the year in review

The year is rapidly drawing to a close, and what a year it was. Many important issues came into the spotlight in 2010 -- too many in fact to cover in a short post, so we've selected three to discuss which we believe include some of the more important lessons investors can carry with them from 2010 into the years ahead.
  • The world is waking up to the folly of endless taxpayer-funded pension systems. We called this "The question of our time" and it dominated headlines from Greece to California this year. After World War II, many governments instituted pension payments for retirees that were funded by the taxes levied on those still working. At the time, life expectancies were much shorter (men often worked past 62 and the average life expectancy was only 65), and as the Baby Boom of children born after the war grew up and entered the workforce, these pension ideas seemed to work. In some places, the benefits became more and more generous and the retirement ages at which retirees could draw them became younger and younger. This year was the year in which many around the world woke up to the fact that this system is unsustainable. See also "Greece and California."
  • The "Unstoppable Wave" rolled on with a vengeance. The other half of the solution to foolish government entitlement programs is economic growth. While some pundits looked at the budget crisis in European countries such as Greece and in US states such as California and argued for an "austerity" solution of higher taxes and fewer entitlements, the real answer is higher economic growth rates and fewer entitlements. We've argued that the best recipe for economic growth is for government to ensure that it does not discourage innovation. We've also pointed out that the "Unstoppable Wave" paradigm shift taking place is so powerful that even ordinary-grade government ineptitude will be unable to derail it. The year 2010 provided all kinds of examples of the kind of transformative innovations that exponential increases in bandwidth can have on various industries, from the explosion of online retail shopping after Thanksgiving to the proliferation of smartphones and tablets, particularly their application to businesses but also even combat operations. Some of the best investment performance during the year came from businesses involved in this paradigm. See also "On the verge of something important" and "Another wake-up call."
  • The "experts" who wrote off the economic recovery were as wrong as those who wrote off the San Francisco Giants. Conventional wisdom going into 2010, and during much of the year, was that the rebound after the crater of March 2009 was just a big head-fake, and that the economy would probably slide back into "years of treading water" or even replay the worst that had gone before with a "double dip." It was fashionable in the media to say we were still in a recession, long after the recession had officially ended. In July, the UK's Telegraph published a story entitled "With the US trapped in a depression, this is really starting to feel like 1932" and opened with a quotation from Robert Reich declaring that "The economy is still in the gravitational pull of the Great Recession. All the booster rockets for getting us beyond it are failing," despite the fact that the economy (as measured by Gross Domestic Product) had been showing steady expansion since June 2009. Since then, the economy has continued to expand, embarrassing the critics who had written off America's ability to grow. Incidentally, we've argued that it would have grown even more without the harmful and wasteful government "stimulus" plans. We pointed out the similarities between those who confidently wrote off the economy and those who confidently wrote off the World Champion San Francisco Giants, and cautioned investors to beware of the conventional wisdom they hear on the financial television shows, even if it is coming from the mouths of impressive-looking economists with PhD's. In fact, we think that the Giants victory might well be one of the most important things for investors to remember from 2010, and recommend that our readers (even those who aren't Giants fans) revisit this post on the subject!
And on that happy note, we'd like to wish all our readers a very Happy New Year and a prosperous 2011!
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Google and Groupon

P Morgan Brown has a noteworthy article discussing Groupon's decision to spurn Google's $6 billion buyout offer and raise more cash themselves to expand.*

Beyond the specifics of the Groupon story itself, the article provides plenty of food for thought on important subjects such as acquisitions, the importance of management teams, different management styles, paradigm shifts and the interchange between the "engineer viewpoint" and the "salesforce perspective."

We believe these are important topics for investors to consider, and would recommend readers also look at few of our past posts on related subjects, including "The koi pond analogy of investing" and "Capable, dynamic management operating in a fertile field for future growth."

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

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Seasons Greetings and Warm Wishes

Seasons Greetings and Warm Holiday Wishes from all of us here at Taylor Frigon Capital Management!

The photo above shows this year's wreath-laying ceremony at the General Grant sequoia in the Sequoia and King's Canyon National Park.
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Zombie economics

The New York Times recently published an op-ed by columnist Paul Krugman entitled "When Zombies Win," in which the author laments that the extension of lower tax rates are a puzzling example of the triumph of "free-market fundamentalists" (as an aside, we prefer the term "free enterprise") whom, he declares, "have been wrong about everything."

He goes on to say that such ideas (like the idea that lower tax-rates encourage growth) are "zombie economics" which he defines as "doctrines the crisis should have killed but didn't."

As evidence, he offers this startling sentence: "How, after the experiences of the Clinton and Bush administrations -- the first raised taxes and presided over spectacular job growth; the second cut taxes and presided over anemic growth even before the crisis -- did we end up with bipartisan agreement on even more tax cuts?"

While Mr. Krugman's own biases are so obvious to anyone who is familiar with his writing that such statements will probably come as no surprise, we believe it is worth pointing out that in this sentence he is completely and utterly wrong on his economic history.

It's true that the (also somewhat biased) Nobel prize committee awarded Paul Krugman a Nobel prize in economics, but he seems to have missed the fact that it was only after Bill Clinton and the first GOP-controlled Congress in forty years enacted spending restraint in 1996 enroute to a capital gains tax rate cut in 1997 that economic growth took off in the latter half of the 1990s! See the chart below, showing quarterly GDP growth as a percentage, and note the presence of GDP growth above 6% (in chained 2005 US dollars). Note that the roaring GDP growth rates began after the 1996-1997 changes (first red arrow on the left side of the X-axis).

And, while we have several issues with some of the economic moves of the Bush administration, it is also true that US GDP went from around $11 trillion to over $13 trillion (in chained 2005 dollars) under the lower tax rates that George W. Bush enacted in his first term (see GDP chart in this previous post). Note also in the chart above that GDP growth of 6.9% was seen in Bush's term in 3Q2003, in conjunction with the enactment of his tax rate cuts (second red arrow on the right side of the X-axis). Growth rates of 3.0%, 3.5%, and 4.1% in 2004 and 2005, and of 5.4% in the first quarter of 2006 (which can also be seen in the chart above), can hardly be described as "anemic."

If we wanted to, we could also go back and look at growth after the JFK tax cuts (which he proposed in 1962 and which were enacted in 1964, after his death), when GDP grew at quarterly rates of 10.2% (1Q1965), then another 5.5% (2Q1965), then another 8.4% (3Q1965), then another 10.0% (4Q1965) and another 10.2% on top of all of that (1Q1966)!

Is Mr. Krugman ignorant of these simple facts of economic history, or is he trying so hard to prove that "free markets" are a failure that he can't let such trivial details get in the way of his larger argument?

We propose that it is Mr. Krugman's view of freedom as a failure that is the dead idea that should have been laid to rest long ago. Perhaps the issue was not settled yet in 1968, when the seminal zombie movie Night of the Living Dead was released, and the United States and the Soviet Union were involved in a space race to prove which economic system -- one based on free enterprise or one based on central government control -- was more viable, but four decades later it is inexcusable for an economist of Krugman's stature to pretend otherwise. We all know how the race to the moon turned out, as we wrote on the anniversary of Apollo 11 last year.

The question "Do lower tax rates and other economic policies that enhance the freedom of individuals to start businesses and employ their talents as they themselves see fit promote growth or not?" has been decisively settled by history as well -- we invite readers to view previous posts on that subject such as "Why can't we all just get along (on economic policy)?", "Growth is the answer: the primacy of human creativity," and "'Reducing taxes is the best way open to us to increase revenues."

Even better, we would recommend readers listen to another Nobel laureate economist, and one who had a much better grasp of history: Milton Friedman. For starters, we have linked to some of Milt Friedman's discussions on these important subjects in previous posts such as "A failure of government, not of private enterprise," and "The healthcare black hole."

Another excellent resource is the extensive interview of the late Professor Friedman from 1999 which was recently published on Youtube here.

It is amazing that the events of the twentieth century did not settle this issue once and for all, but as long as publications such as the New York Times continue to give a platform for the dissemination of arguments against free enterprise, the intellectual fight against zombie economics must continue.
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Andy Kessler: "Spectrum Scarcity? Hardly."

Andy Kessler has an excellent article on his website entitled "Spectrum Scarcity? Hardly." We've referenced his writings previously, such as in this post. In this article, as well as in a subsequent interview on Tech Crunch, he is discussing the concept of "net neutrality" -- or, more precisely, the role of government in regulating commercial practices on the internet.

We recommend listening to Mr. Kessler's views in conjunction with our previous posts on the subject, including this one.

We also recommend Bret Swanson's commentary on the recent developments at the FCC regarding this issue, which he published in RealClearMarkets here. Along with George Gilder, Bret Swanson is the author of "Unleashing the 'Exaflood,'" an important article we have referenced before and which we discussed here.

It is clear to Mr. Kessler (and to us) that the bandwidth paradigm shift currently underway is the most important economic development impacting businesses and future innovation today and for the coming decade. We also agree wholeheartedly with his arguments that government must not stifle competition and innovation in this critical field (and with his argument that incumbents typically lobby hard for legislators to preserve the status quo at the expense of potential newcomers).

However, we are also encouraged that recent developments, while not perfect, appear to reduce the chances for some of the most onerous initiatives proposed by those in favor of increased government regulation. We'll take that as a mild positive, while continuing to agree with Mr. Kessler that more competition for the delivery of bandwidth would be even better.

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Noteworthy article: "iPhone added $2 billion to trade deficit with China"

We've called our readers' attention before to Carpe Diem, the excellent blog by Dr. Mark J. Perry, professor of economics and finance at the School of Management in the Flint campus of the University of Michigan (see for instance here and here).

Professor Perry recently posted a noteworthy analysis entitled "iPhone added $2 billion to trade deficit w/China." In it, he demonstrates that the entire retail sales price of an Apple iPhone is considered a Chinese export to the US for the calculation of the trade statistics cited by the government and by economists, even though only 1% of that retail price goes to the cost of the assembly in China (the rest goes to various chipmakers and other component suppliers, including the company that designs, engineers, and markets the phone -- Apple).*

The information presented in Professor Perry's post is a powerful argument against protectionism (for more on the problems with protectionism, see here and here).

It also should be a powerful wake-up call to those who have fallen for the alarmist rhetoric that the US is in danger of losing its economic sovereignty to China, or is in danger of having China suddenly refuse to buy any more US Treasurys.

We would advise all investors to read Professor Perry's complete post, and to remember it the next time they hear a politician or an economist bewailing the "trade deficit."

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL).

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Lawlessness in California

Classical scholar, university professor, and author Victor Davis Hanson has a new article entitled "Two Californias" chronicalling some of his on-the-ground observations from the great Central Valley of California, one of the most productive agricultural regions in the world. He reports some dismaying developments, but ones which are not surprising to those who have grown up in the state and spent a lot of time in the Valley over the years.

His observations during his travels by bicycle in and around the small agricultural towns north and south of Frenso carry a common theme of growing lawlessness stemming from the state's total abdication of its responsibility to enforce existing laws, including but not limited to immigration laws.

As a matter of economic principle, we are 100% in favor of immigration and believe that every human being should be seen as a potential contributor to the overall value of society. This position is in contrast to those who hold a zero-sum (or "demand side") view of the world, which sees others as potential threats who are competing for shares of a "fixed pie" of wealth.

People who hold such a view typically believe that foreigners, or people of other races, or women in the workforce, or people working in other countries, or even robots and machines employed on assembly lines are taking away jobs at the expense of others. On the contrary, we believe that more productivity (whether from robots and machines or from the participation in the economy of groups and regions that did not contribute previously) is good for everybody, and makes the "pie" bigger.

This is exactly what has happened in the history of California, as immigrant groups from all over the world have contributed to create one of the most vibrant economies in America (or anywhere else).

What is most disturbing about the article from Professor Hanson is the element of lawlessness that is introduced as a result of government abdication of its most basic responsibility to enforce the laws written by the representatives of the citizens. Without the rule of law, innovation and economic growth cannot take place. Individuals cannot contribute to the economy because private property is not respected or protected and in the resulting unpredictable (and dangerous) environment, it does not make sense to build and add to a business.

As we wrote towards the end of our post entitled "The Consumer" in October of 2009:

"Unlike the desire to consume, the desire to produce can be completely squashed by foolish policy. For instance, if you lived in a country where the police did not stop looters from breaking into your store and taking all your goods, you would soon learn not to build a fixed store with inventories of goods and services. This is why in most countries without the rule of law, small-scale stands in open-air markets and bazaars are the norm, rather than larger permanent shops which can take advantage of economies of scale. Generally speaking, in those countries, scarcity is the norm, and sufficient quantities of goods and services to meet the basic needs of all those who desire them are not produced."

This is the environment that California's failure of leadership is creating in some parts of the state, and matches that described by Professor Hanson in his personal travels through the Central Valley. The problem is related to California's incredible increase in entitlement spending (which really accelerated exponentially during the 1990s) to levels similar to some of the worst offenders in Europe, which we discussed in posts such as "Greece and California" and which Chapman University Fellow Joel Kotkin described with great insight in "The Golden State's War on Itself" earlier this year.

These are extremely important economic principles of which every citizen should be aware, but which many do not understand or choose to ignore. For those of us who live in the great state of California and who yearn to see it continue its long history of innovation and growth, we can only hope that this plight will be recognized and corrected.

Please share this information with your friends and family.

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Noteworthy article: "How the bond market vigilantes work"

Here is an excellent article from economist Scott Grannis entitled "How the bond market vigilantes work." We recommend all investors interested in understanding the current situation with the bond market and QE2 read it carefully.

We have been concerned about the inevitable snap upward in bond yields (and corresponding drop in bond prices) for some time, and have sounded cautionary notes about the recent flood of investment dollars into bonds, in posts such as this one and this one.

The chart above shows that there has been quite a bull market in bonds for the past year (yield line trending downward) but that may have ended quite decisively in the past couple of weeks.

Scott Grannis explains exactly what is going on, and why yields will likely continue to trend higher in the months ahead.

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Noteworthy article: "Netflix everywhere"

Here is a noteworthy article from Wired magazine entitled "Netflix Everywhere: Sorry Cable, You're History," written by Daniel Roth.*

We recommend it for several reasons. First, it is an excellent illustration of a "paradigm shift." We have discussed the importance of this concept in numerous places, such as here and here.

Second, it relates to the "Unstoppable Wave" paradigm that we believe all investors should understand. Recent posts on this topic can be found here and here.

Further, it illustrates the point we made back in February 2008 in this post, in which we pointed out a New York Times article whose author declared: "downloadable movies require high-speed Internet connections - and only about half of American households have them. That number won't change much for years."

We used that article back then as an example of failing to appreciate how rapidly things can change -- in other words, failing to appreciate the power of a paradigm shift, even one that was well under way in 2008. This is a very important lesson for investors.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Netflix (NFLX).
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Noteworthy article: "The Democracy Recession"

Here is a noteworthy article from today's Wall Street Journal opinion page, entitled "The Democracy Recession."*

We believe that investors should read it in conjunction with our previous posts, "The Four Pillars" and "Does a rising tide really lift all boats?"

We would also point out the distinction between "democracy" and true economic freedom, discussed in this post from July of this year.

These trends are important for investors to keep an eye on.

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* Readers who are not subscribers to the Wall Street Journal can read that article by going to this search result page and clicking the top search result, which goes to that story.
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Noteworthy article: "The puzzling assault on for-profit colleges"

Here's a noteworthy article discussing entitled "The Puzzling Assault on For-profit Colleges,"* and it is one with which we agree. The article discusses the latest government ideas for increasing regulation of the for-profit higher education industry.

We believe that investors should read it in conjunction with our previous posts, "Intellectual affluence" and "Bubble alert!"

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* Readers who are not subscribers to the Wall Street Journal can read that article by going to this search result page and clicking the top search result, which goes to that story.
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Have you heard of this company? EZCH

We've spent some time discussing what we believe is the biggest transformation affecting both the business landscape and our day-to-day lives: the enormous increase in the amount of data that can be sent rapidly and inexpensively from place to place. We would advise readers to go back and visit our recent post "Another wake-up call" and look at the graph depicted in the image on that post, and watch the video linked in that post discussing that graph, if they have not already done so.

We would also recommend going back to a post to which we often refer, "The Unstoppable Wave," in which we link to a 1996 article by George Gilder. In that article, George explains his very compelling definition of a "paradigm shift," and foresees the paradigm shift taking place right now, saying: "To grasp the new era, you must imagine that bandwidth will be free and watts scarce."

The rapid increase in bandwidth (the amount of data per second that can be sent through the network) and the rapid decrease in the cost of bandwidth that George describes and that we have been living through in recent years has led to transformative changes in our lives and in many industries, and these changes will only accelerate.

Video is now easy to upload and download for free. People can watch premiere sporting events online, some free and some for a small fee, typically less expensively than through cable TV or satellite. Some readers may remember the days when sending or downloading a file of a few megabytes would tie up their data connection on their computer for hours!

EZchip Semiconductor is an innovative fabless semiconductor company which designs processors used in the equipment that moves the increasing volumes of data flowing across the networks. These network processors are built into switches, routers, and other networking equipment designed by companies such as Juniper Networks, Alcatel-Lucent, Ciena and others.** See the EZchip diagram above, which shows where in the network such equipment resides.

EZchip's network processors incorporate functions that previously required several different chips (such as processing engines, classification engines, and traffic managers). By incorporating the functions that formerly required several chips into one chip, network equipment designers can save both space and energy use in their products, which are extremely important considerations. Equally critical is the fact that EZchip's processors provide higher bandwidth throughput capacity than chips offered by other merchants or chips designed by the network equipment companies themselves.

EZchip is headquartered in Israel, where a tremendous amount of innovation is taking place right now, and many of the executives and engineers at the company are graduates of the prestigious Technion Israel Institute of Technology.

Amazing as it may seem, many in the investment world are unaware of the importance of the paradigm shift described above, and of the specific value-add that EZchip network processors bring to the companies which make the equipment that must handle the rapidly swelling tide of data being sent over the web. We believe that some on Wall Street are just now beginning to notice this company and taking positions in the stock.

We believe that EZchip meets the definition of a Taylor Frigon growth company that we've described in numerous previous posts (see some of the criteria discussed in this post, and some of the examples provided in previous posts such as this one or this one). We would advise investors to analyze EZchip for themselves, and to understand how it and companies like it fit into the larger paradigm underway.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by EZchip Semiconductor (EZCH).

** At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Juniper Networks (JNPR), Alcatel-Lucent (ALU), or Ciena (CIEN).
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The "wealthiest" tax rates matter to everyone

The debate over extending the current tax rates is raging, and we believe that the most important economic consideration is being left out of the argument by both sides in this debate.

Currently, the argument is being framed something like this: one side proposes the extension of the current lower rates for "the middle class," but letting the lower rates expire "for the wealthiest Americans" (this group considers those earning over $250,000 in income per year wealthy), while the other side is arguing that the lower rates should be extended for everyone.

Those who believe lower rates should be extended for everyone generally put forward the argument that many small businesses could see their taxes raised, and that "we can't raise taxes on small business in a fragile economy". This simply ignores the fact that while the economy is not growing as fast as one would hope, the economy is expanding and has been since roughly June 2009.

There are several problems with this argument. First, it assumes that raising tax rates is fine, as long as we are not in a fragile economy or a downturn! We would argue that low tax rates are critical for growth and innovation at all times (see here and here for previous posts on that subject).

The bigger problem is the inability to explain why raising marginal tax rates on the highest income levels hurts everyone. Even if small businesses were somehow excluded from the increase in rates for those earning more than $250,000 per year, the impact of the tax hike on upper income brackets would be crippling to growth and innovation. This is true because, as Art Laffer points out in an article we've linked to previously, "one should expect a greater supply-side response with a change in the highest tax rate than with any other rate."

In other words, if the rates were raised for all dollars earned above $250,000 and someone earned $250,001 in a particular year, the higher rates would only be applied to that extra one dollar (the lower rates would be applied on all the dollars earned up to $250,000). On the face of it, this fact makes it seem like an increase in the rate charged on that final one dollar is not such a big deal -- but on the contrary, it proves the point Art Laffer is making above. If the government is going to take a bigger percentage of that final one dollar, but not as large a percentage of the previous two hundred fifty thousand dollars, then people are less likely to work harder for that last dollar.

The choice to try to make more or not is intensified at the highest bracket. When the marginal tax rate on the highest bracket goes up, people who are in the position of making that one extra dollar dramatically scale back their decisions to do so -- it is perfectly logical cause-and-effect.

While this might not seem like such a big deal when those people are described as "millionaires and billionaires" popping thousand-dollar bottles of champagne every night with their dinner, it is a fact that innovative businesses that create new jobs are overwhelmingly financed by those who are making this very decision on whether to pursue those marginal extra dollars or not.

As we wrote in this post almost three years ago:

"If you are a venture capitalist and you know that if you risk $2 million in a start-up business which may pay back $12 million in a few years, but which may also go to zero if that start-up fails (as many start-ups do), you might be willing to risk that $2 million if you get to keep 85% of the gain (even though there is a risk that there will be a total loss). But if the government tells you that they will tax the gain at 50% (instead of 15%) you may calculate that it is no longer worth risking the total loss of $2 million for the possibility of making only $4 million (after taxes) instead of $8.5 million. In that case, you may not fund the entrepreneur at all, and a business will not form that (under a less onerous tax rate) might have blossomed and added great value (and many jobs) to the world.

"Changes in tax rates cause immediate changes in the decisions of those who are allocating large amounts of capital for the formation of new businesses and the expansion of existing businesses. In fact, even the prospect of taxes rising within two or three years will have a big impact on the allocation of capital right now -- in the example above, that venture capitalist may very well have to wait at least two years before any tangible results come from his investment, so he is making his calculation based on his assessment of the future tax rates that will hit his potential capital gains. The prospect of higher tax rates in the future will have a big impact on the very important allocations of large amounts of capital today. These large allocations of capital, the productionist or supply-sider argues, are the engines which actually drive the economy."

If those who finance innovative businesses decide not to pursue that "extra dollar" (or extra few million dollars), then new drugs and cures will not be funded (take a look at the recent movie Extraordinary Measures for insights into how new medical advances are financed), advances in consumer technology will not be what they could have been, and in general the economy and quality of people's lives will be retarded.

This is the argument that is being overlooked by both sides. One side is saying that "millionaires and billionaires" don't need a tax rate cut at all, while the other side is arguing that the rate cuts should be extended to everyone, because of small business or the fragility of the economy. While small business is important, it is not the main reason that marginal rates in the highest bracket are critical to everyone.

Sadly, very few people in the US understand this argument, as evidenced by this recent Gallup poll, which shows that, while 40% want the tax rate cuts extended to all, the percentage zooms to 83% when the tax rate hikes are withheld from "the wealthiest Americans," with some of the additional 43% setting that "wealthy" limit at $250,000 and some setting the bar higher, such as for those earning over a million dollars.

It's not really their fault -- nobody on either side ever cares to explain this to the American people. Nobody ever takes the time to explain how critical financing is to things that make a real difference in people's lives, and how critical the highest marginal tax rate is to those big-dollar financing decisions. Please pass this post on to your friends and family as a way to shed some light on this critical subject.

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Another wake-up call

The world is mostly consumed with worry over European sovereign debt as we head into the end of November. We've discussed this subject several times in the past, in posts such as "The question of our time," (06/06/2010), "Not fragile" (07/28/2010), and the recent "European debt issues and the primacy of growth" (11/08/2010).

We've said all along that this "crisis" is actually a good thing (or at least, that it has a silver lining), if it causes people to realize that the endless growth of public-sector (government) jobs and entitlements must be brought to heel, and that the real solution to the problem is to foster private-sector growth and innovation. As George Gilder -- one of the greatest thinkers in the United States for the past four decades -- explains in an article linked in this post, the simple formula for encouraging private-sector growth and innovation is simply lower taxes and sound monetary policy.

There are encouraging signs both in Europe and in the United States that people are starting to get this message.

While they work that out, we would recommend investors focus on the exciting opportunities for growth taking place right before our eyes. In the video above, former Morgan Stanley analyst Mary Meeker* gives a rapid-fire presentation from the recent Web 2.0 summit in the San Francisco Bay Area that highlights the phenomenon we have called "The Unstoppable Wave" and presents incontrovertible evidence that it is definitely taking place.

We would recommend that all investors watch this video and think very carefully about the implications of the trends she is discussing. While the speaker is framing the ten topics she discusses as "questions that internet company executives should be asking themselves" right now, we would argue that they are questions that every investor should also be asking themselves as they commit capital to one company or another (whether in the form of buying bonds issued by a company -- or a country -- or in the form of buying stock).

The speaker touches briefly on Clayton Christensen and his insights into what he calls "disruptive innovation." This is an extremely important concept for investors and one we discussed in some detail in "Clayton Christensen, disruptive technology, and your portfolio recovery plan" (02/04/2009), and we recommend revisiting that post and following some of its links before watching the video above.

This video discusses a huge ongoing phenomenon that illustrates what Dick Taylor and Thomas Rowe Price were talking about when they recommended that investors seek "fertile fields for future growth" (often characterized by what are called "paradigm shifts" today). We believe that many investors -- including many professional investors on Wall Street -- are still not completely tuned in to the size of this ongoing paradigm shift. Investors who heeded our posts on this subject from late 2008 and early 2009 could have taken advantage of some excellent investment opportunities related to this tectonic shift. If not, this can serve as another wake-up call.

While the rest of the investment world focuses on sovereign debt alarm bells (alarm bells that are generally providing a healthy wake-up call to the dangers of creeping public-sector expansion), we recommend investors pay attention to the trends highlighted in this recent video, and ensure they are preparing for them in their own businesses and in their investment portfolios.

* At the time of publication, the principals of Taylor Frigon Capital Management owned preferred stock issued by Morgan Stanley (MS).

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Happy Thanksgiving 2010

This is our fourth Thanksgiving for the Taylor Frigon Advisor, and in keeping with the tradition of our previous posts on this holiday, we find it fitting to reflect on the countless blessings of a free enterprise economy (follow these links to previous Thanksgiving posts from 2007, 2008, and 2009). Such reflection is invited by the very nature of the American holiday of Thanksgiving, which stretches back to the feast celebrated in 1621 to give thanks for their first successful harvest by the pilgrims of Plymouth Bay Colony, joined by the Wampanoag Indians led by Massasoit, who sent his braves into the woods to bring back deer for the occasion.

In 1789, President George Washington recommended Thursday the 26th of November of that year to be a day in which all the people of the United States would come together to give thanks to "the beneficent author of all the good that was, that is, or that will be" for the Constitution "now lately instituted, for the civil and religious liberty with which we are blessed, and the means we have of acquiring and diffusing useful knowledge, and in general for all the great and various favors which he has been pleased to confer upon us."

In 1863, President Abraham Lincoln established Thanksgiving as a national holiday, reminding the citizens that: "Needful diversions of wealth and of strength from the fields of peaceful industry to the national defense have not arrested the plough, the shuttle, or the ship; the axe has enlarged the borders of our settlements; and the mines, as well of iron and coal as of precious metals, have yielded even more abundantly than heretofore."

The incredible sweep of economic growth and prosperity which stretches from 1621 to 1789 to 1863 and on through the twentieth century and today staggers the imagination. The first Thanksgiving was a response from settlers who had every reason to be concerned of starvation from one harvest to the next, while today the United States is so bountiful that it regularly sends hundreds of thousands of metric tons of food into the oppressive and belligerent Communist country of North Korea, which is so bankrupt that it can neither feed its own citizens adequately nor purchase food for them with goods that it produces.

The contrast is an important one. Many today continue to subscribe to the zero-sum fallacy that in a free economy characterized by open competition between producers of goods and services, any gain by one party must come at the expense of someone else. However, as Friedrich Hayek explained in 1968, this free competition "is not a zero-sum game, but one through which, by playing it according to the rules, the pool to be shared is enlarged" (cited in G.R. Steele, Keynes and Hayek: the money economy, page 43). Truly, no one can deny that the pool of opportunity and prosperity in this country has been exponentially enlarged in the years between George Washington's Proclamation of General Thanksgiving in November, 1789 and today.

This result has not been the same in other countries over the same period of time, especially those where the zero-sum theories of Communism (which teaches that wealth always comes at the expense of others) have held sway for long periods of years, or those in which oppressive kleptocracies still prevail (which also operate under a zero-sum approach to economics).

As we noted last year at this time, we believe the cornucopia traditionally associated with Thanksgiving is the perfect opposite to the "fixed pie" of zero-sum thinking. Unlike the view that there is only so much wealth to go around, and that some get it at the expense of others, the cornucopia or "horn of plenty" is a symbol of constant increase, like the expanding pool of which Hayek wrote in 1968. As we gather for Thanksgiving this year, we can reflect again that this is not just a mythical concept!

We wish all of our readers a safe and happy Thanksgiving in 2010.

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Have you heard of this company? NAT

In the past, we have highlighted examples of classic Taylor Frigon growth companies: well-run businesses positioned in front of fertile fields for future growth.

Today, we're posting a November 8 interview with the CEO of a company we own in our Income Strategy, which seeks income-producing securities, some of which may be debt-based (such as bonds) but some of which are ownership-based (preferred stock and common stock in dividend-paying companies).

As we've recently explained, it is very important for income-seeking investors to have a clear understanding of the issuer of their income securities, whether they are buying the company's bonds or the company's stock. They should seek to determine whether the company is well-managed, and whether it is taking steps to grow and ensure its survival against competitive threats.

Nordic American Tanker Shipping, featured in the above interview, has a somewhat atypical operating model compared to many companies investors may be familiar with, in that they pay out substantially all of their net operating cash flow in the form of dividends to their shareholders.*

The company runs a strong balance sheet with little to no debt, and can therefore take advantage of periods in which the prices on tanker ships soften by adding to their fleet more easily than many of their competitors. The company's operating cash flows, of course, are dependent upon the shipping rates they can charge for moving bulk oil across the ocean, rates which fluctuate based on a variety of global economic and political factors.

In the interview above, CEO (and founder of the company) Herbjørn Hansson explains some of the important aspects of his company's business model in exemplary fashion. The interview is also noteworthy for a quotation that all investors should write down and hold onto.

At two minutes and fifty seconds into the video clip, Mr. Hansson says: "As I've said in other contexts, America is a stronger nation than Americans think."

We absolutely agree with Mr. Hansson's statement. We have made the same point ourselves, for example in this recent post, which shows that the US economy has grown almost 30% over a period that many are calling a "lost decade," or this post in which we provided counter-arguments against the constant drumbeat of negative economic predictions and those calling for a new plunge as steep as the one that took place in 2008-2009.

In many respects, the negativity we wrote about in those earlier posts is still going on today, although business earnings in the most recent quarter largely exceeded most analysts' expectations. The bigger picture is that this failure to realize the strength of the American economy leads to all kinds of errors, including the fear of other countries (such as China) and the bashing of their attempts to grow.

Instead of bashing China and other emerging economies, the US should simply remove the self-imposed obstacles to our own economic growth (including excessive corporate tax rates, penalties on the repatriation of capital earned overseas, inflationary monetary policy that drives up commodity prices and weakens the US dollar, and regulations which make it more expensive to hire new employees).

We recommend paying attention to the video above, both to understand some aspects of the environment in which Nordic American Tanker operates, and to hear CEO Herbjørn Hansson argue that America is a stronger nation than Americans think. Underestimating the resilience of the American free-enterprise system is a major error, and one that many commentators of all political persuasions often commit. We hope that it is an error that readers of this blog will avoid.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Nordic American Tanker (NAT).

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"Greened" Into Economic Oblivion

In this Wall Street Journal article, our good friend and venture capital partner George Gilder has eloquently framed the salient issues surrounding "green" investing. George highlights the unintended consequences that are already being felt due to the almost cult-like obsession that many in the political, business and now venture capital community have adopted with respect to investment in ventures tied to the environmental agenda. It is the latter group that concerns George the most and we share that concern.

At a time when growth is slow and job creation is at a standstill, the malinvestment taking place in this quest for "feel good" business ventures is, frankly, frightening. Pursuit of investment in businesses that generally wouldn't exist without the "helping hand" of government subsidy starve real innovators and entrepreneurs -- the would-be creators of new products in biotech, nanotechnology and many other scientific fields -- of the capital they require to bring their creations and innovations to market, thereby creating jobs that are truly "sustainable".

We believe George Gilder's article deserves the widest possible distribution. Please read it and pass it on to your friends and family.

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A growth-based perspective on income investing


We've been accused of having a one-track mind when it comes to our message to investors (invest capital in well-run companies positioned in front of fertile fields for future growth). While we take that as a compliment, we decided that, just in case some readers might be a little tired of reading about the importance of growth (if it is possible to get tired of that subject), we decided today to change the subject and talk about income-producing securities instead.

At Taylor Frigon Capital Management, we recognize the need for some investors to own income-producing securities. Because of the danger posed by inflation, we believe that growth in most cases needs to be the foundation of an investor's portfolio, with income playing an auxiliary role "on top" of the foundation of innovative, growing companies (see here and here).

In the Income Strategy that we manage for investors, however, we don't exclusively own fixed-income instruments such as bonds: instead, we seek a variety of income sources, including floating-rate debt instruments, preferred stock, and common shares in companies that pay royalties or dividends.

The important thing for investors to remember is that, in order for the dividends or interest payments of a company to be secure, that company has to have the ability to stay in business. For common stock that pays a dividend, the best way for that company to be able to raise the dividend is for that company to have fields for growth! In other words, we may be sounding like a broken record again when we urge income investors to consider growth as an important criteria when evaluating a potential income investment.

Friday's announcement by Intel Corporation that they will be raising their dividend by 15% to 18 cents per share per quarter (or 72 cents per share per year) is a perfect case in point.*

While we own shares of Intel Corporation for our Income Strategy, one of the reasons we are comfortable owning it is the company's continued ability to add value and grow. In announcing the approval of the increased dividend, Intel CEO Paul Otellini said, "Intel remains on track to have our best year ever and we continue to generate strong cash flows. Our ongoing operational performance and confidence in our business going forward provide the ability to return more cash to shareholders."

We agree with Mr. Otellini in seeing the connection between future growth and dividend yield, and urge our readers to consider this important aspect of investing for income as well.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Intel (INTC).
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European debt issues and the primacy of growth

We'd like to elaborate a little further on the question of US Treasury bond yields, which we touched on in our previous post about those who fear nobody will want to lend to America since "we don't make anything here anymore." The comparison is often made between the US and countries such as Argentina or Greece, with the admonishment that America will soon face a similar debt crisis.

Today, the news is focusing on the debt situation in Europe, where countries such as Ireland and Portugal are seeing their borrowing costs go up in response to fears about their economic strength. The sovereign debt of these countries (the parallel to US Treasury debt here) must carry higher interest rates in order to attract investors that are fearful about their ability to make good on their obligations. Their ability to pay the interest on their bonds is directly related to their tax income, which is in turn, of course, dependent upon the strength of their economy, the profitability of their businesses, and their levels of employment.

We recently wrote a series of blog posts about this subject relative to the debt problems in Greece, where an economy that doesn't produce very much is expected to support a massive number of government employees and retirees, who receive ongoing salaries at retirement of up to 80% of their "pensionable salary" for the rest of their lives, and who retire at an average age of 58. When it became clear that Greece could not possibly continue to support these lush pension plans forever, the more industrial and productive nation of Germany was called in to support Greece's debt payments to Greece's lenders, and Greek politicians began enacting "austerity" packages to slow down the runaway government benefits train (see "Greece and California" and "The Question of Our Time").

This situation is admirably laid out by Jan Randolph, the head of the Sovereign Risk Department at IHS Global Insight, in an interview on Bloomberg Television this morning (see above).* He says:

"If you take the perspective of German taxpayers and the German government, they're always called in at the last moment, at the height of the crisis, to come in and save the situation, and the way they do that is to provide the German government's balance sheet, and the taxpayer, to effectively guarantee, to ease the situation as far as investors are concerned; they've done that with the big backstop package now in place for Greece, Spain and Portugal, but they resent it -- they don't like being used like this. The Germans say this is, you know, we can't have a situation where investors are playing 'moral hazard' with German taxpayers, and if we do have, in future, a sovereign debt crisis, then investors have to understand those risks at the point of making the investment, rather than expecting the sovereign to come in and bail them out."

This is exactly the situation that many fear may take place in the United States in the not-too-distant future, substituting China for Germany as the lender that becomes fed up with lending money to a nation that "doesn't make anything" anymore.

The difference, however, is that the United States of America remains an extremely vibrant and productive economy, in spite of the protestations of the doomsayers. How much more productive we would be without government stimulus packages and excessive regulation and corporate tax rates is hard to say (probably many times more productive), but the fact remains that innovation and growth are still part of the DNA of our nation and there are plenty of young entrepreneurs trying to start companies right now (and coming here from other parts of the world to try to start companies as well).

And America's economic output is not merely "phony services" as some critics maintain: the nation's industrial manufacturing output is still at levels of magnitude above anything achieved in previous decades. Take a look at this graph of the most recent industrial manufacturing output as measured by the St. Louis Fed:

As the graph shows, America produces far more "stuff" than any time in its past history, even though there was a sharp dropoff during the recent recession. That steep drop has since rebounded sharply, as seen by the "V-shape" uptick at the end of the graph.

Because America is so productive, comparisons to Greece, Argentina, Portugal, or Ireland are really not valid.

However, just as the German taxpayers Mr. Randolph describes in the quotation above are resentful of having to bail out the lush pensions of the less-productive nations in Europe, American taxpayers (the producers) are resentful of having to bail out the lush giveaways of states such as California and Illinois, and of auto industry companies in Detroit. This is the resentment that makes some people quick to agree with the doom-and-gloom scenarios painted by those who argue that America's economy is falling off of a cliff, and that we won't be able to get it back because "China won't give us any more money."

Such talk has an air of wisdom and economic sanity, but it really misses the most important aspect of capitalism: growth. It grossly underestimates American capitalism and its power for growth. Yes, that growth can be retarded by foolish policy from Washington and foolish monetary policy from the Fed, but as we have said in the past, America has always had to "get by in spite" of such foolishness. Today is no different.

We believe strongly in the primacy of growth and human creativity, as we wrote here. The real solution for countries in Europe -- as well as for US states such as California -- is to foster growth, primarily through lower corporate and marginal income tax rates. That would spur even more growth and innovation in America. In the meantime, however, investors should realize that wild comparisons between the US and Argentina (or even Zimbabwe) are completely overblown.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by IHS (IHS).

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

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Glenn Beck is an economic butterbar

There's an old saying in the US Army that "there is nothing more dangerous than a second lieutenant and a map." The gist of this rather unkind sentiment is that a second lieutenant (the most inexperienced officer rank) has a lot of authority, as well as a lot of training, but does not yet have the experience to have the big picture. Everyone who has ever been a second lieutenant has heard that saying, and its effect is to make them more humble and more open to learning so that they do get the big picture as quickly as possible, as most of them rapidly do.

While we respect Glenn Beck's formidable ability to communicate and educate, it occurs to us that when it comes to economic matters, he is a bit like the second lieutenant described above. He knows just enough to be dangerous, and he has a position of great influence, but he does not have the big picture, and the theorists that he is listening to are leading him astray. He has absorbed a kind of "Cliff's Notes" of solid Austrian capitalist economic theory, but not the entire system, and it is leading him to make frightening economic pronouncements that have the power to scare a lot of people.

Yesterday on his November 3 show, Glenn Beck argued that the reason jobs have not been coming back is that "we don't make anything here anymore" and therefore we have to borrow money from "our bank," the Chinese. However, they aren't going to want to give us anymore money, because they don't have any confidence in our ability to make anything, and that everyone will lose 20% of their money -- if the Fed's untested plan even works, which it probably won't.

He suggests that this may all be part of a conspiracy to bring the dollar down, in order to impose a single global currency, much like the euro in the European Union.

It all sounds very logical, and scary, and Beck trots out enough "Cliff's Notes" economic theory (accompanied by talented cartoon illustrations on his chalkboard) to scare the average viewer into complete paralysis.

However, like the proverbial "second lieutenant with a map," it is trying to provide direction, but it is heading the wrong way.

Readers of our blog will know that we are no fans of the oversteering Fed and the devaluation of the US dollar (see for example here and here and here). Neither are we fans of excessive government spending, and have written about that previously as well.

However, Beck's arguments -- that the dollar is really just an IOU that is becoming worthless since "we don't make stuff here anymore" and that the Chinese are "our banker" who give us money and may decide to stop doing so -- do not follow from the above two observations, and they echo almost exactly the Cliff's Notes economic theory touted by Peter Schiff, who was telling all his clients to bet against the dollar and invest in foreign securities in 2008 (which was exactly the wrong thing to do at that time, as it turns out). In fact, we wouldn't be surprised to see Peter Schiff appear as a guest on Mr. Beck's show, or learn that the two have had conversations about economic theory**.

We provided a link to a video with some of Mr. Schiff's comments, such as his arguments that America was on the way to becoming a "banana republic" because we've thrown away our industrial base and have become "just a phony service-sector economy," and some counter-arguments to those incendiary remarks, in a post back in December 2008 (the chart in that post shows that we are manufacturing more here in the US than ever before!).

America is still an innovative, growing economy that produces an absolutely staggering array of goods and services. How can Beck and Schiff say with a straight face that America doesn't make anything anymore? Does Microsoft still make software? Does Apple make iPhones? Did a little company in Pennsylvania invent and manufacture the drill bit that broke through to rescue the Chilean miners a few weeks ago? It's true that iPhones may be assembled in other parts of the world, but their design and software come from Silicon Valley.*

The actual fact is that China and other countries hold US bonds not out of some sense of paternalistic good-will towards the US, as we explained in a post from May of this year, but rather because America remains a vibrant, growing, innovative economy -- far more vibrant and growing than almost anywhere else in the world. When a world crisis strikes, the demand for American bonds and American dollars goes up, not down, which proves this point.

Also, while we do not believe the Fed needs to implement QE2, and have said all along that the Fed should stop the easing already (but that Bernanke's Phillips Curve fascination keeps him afraid of deflation instead of inflation), the experienced, insightful and freedom-loving economist Scott Grannis explains here why Beck's explosive description of the latest Fed move is not exactly in line with what is really going on.

We believe investors should be very careful when someone is preaching a doom-and-gloom scenario filled with quasi-economic theory. The Fed has been practicing an inflationary policy for decades, to one degree or another, and investors do need to be aware of that. But, as we have argued recently, we believe that growth and innovation are the best way to combat this decades-long policy.

Glenn Beck should stop underestimating the resilient capitalist system we have here in the United States and the growth and innovation that it allows (growth and innovation that was even present during the dark hyperinflationary days of the 1970s). He obviously has absorbed some decent economic theory, but like a brand-new lieutenant, he has not yet accumulated the experience to go in the right direction when it comes to making economic pronouncements.

Investors who are driven to panic by these sorts of dire predictions from people they see on TV should understand these matters.

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

** For those readers who do not believe they sound alike, we provide below a partial transcript of Glenn Beck's remarks from the November 3 show, and suggest they compare them to the arguments of Mr. Schiff such as those voiced in this December 2008 interview which was linked in our December 2008 blog post referenced above:

Well, when you devalue the dollar so much that people say, “I don’t think it’s going to be worth anything anymore; I don’t think it’s going to be any good.” When you devalue the dollar or when you just keep spending money, and then you start to print it, well today the Fed announced – now this is the Fed – they’re going to buy government debt – they’re going to buy Treasurys themselves – that’s $600 billion to buy government debt. Let me show you something: when the Fed says they wanna buy it [holds up a dollar] – this is an IOU -- that says – this is a Federal Reserve Note – that’s what it says, right at the top, Federal Reserve Note, this is the Fed, promising you that they will give you a dollar – of gold (it used to be gold or silver, not anymore) – they’re gonna buy now, the Fed, $600 billion dollars, this is what they call quantitative easing. I know what you’re thinking: “I’m sure my neighbors don’t know what ‘quantitative easing’ is.” Here it is – simple definition: the government buys stuff to stimulate the economy. OK. You’re now thinking: “Well that’s not new for this administration.” You’d be right. But there is a difference here. Quantitative easing – this kind – where we are buying our own debt and printing the dollars to be able to buy that debt, is really kind of the last bag of antibiotics.

[. . .]

That’s the last line of defense. That is the “big-dog” antibiotics. Once those antibiotics don’t work on you: [falsetto voice] “bye-bye.” Well after stimulus packages – that’s like, I don’t know, amoxicillin or z-pak – then bailouts (ooh, that’s a little stronger) – then more stimulus package, more bailouts, reducing bank interest rates to zero or close to zero . . . we’re out! We got nothing left. Here comes the nurse with a bag of really strong antibiotics . . . What does it tell you? That Obama’s Keynesian philosophy of “spend our way out” has not worked. It won’t work. We need to re-set ourself. This is the “Hail Mary.” This is the final spending attempt. This is the last line of defense, or, as I have called it now and warned you that it was coming, I’ve been telling you that it would be the “Weimar Republic” moment. It is largely untested and unconventional – I mean, sure, Zimbabwe tried it. It’s a huge gamble. It is probably the biggest bet in history, and the biggest bet in the history of the planet, but all the chips . . . are yours.

And here’s how it works. Right now we’re having a problem . . . with jobs. One of the reasons we don’t have jobs is: we don’t make anything here anymore. WE don’t make ANYTHING. Why don’t we? Pensions is one reason. You can’t make stuff in America because it costs too much.

[. . .][vignette about unions sending money to Congress to get them to borrow money][. . .]

Don’t worry, we’re gonna borrow the money. Bonds. Bonds. Remember, what is this? This is an IOU – remember that! An IOU. Don’t worry, we’re gonna borrow it, so we can buy stuff. We borrow it – where do we get it? This is us, going for a mortgage. Who’s our bank? The Chinese. Well, here’s the problem. At some point, the Chinese say: “Yeah . . . you know, I don’t think so, guys. This is junk bond status. I don’t think you’re gonna pay us back, because you guys are spineless, and you’re in bed over here, and the whole system is corrupt. I don’t think your country is ever going to be able to make ANYTHING ANYMORE. So I don’t think we’re gonna buy your bonds.”

Well, that’s what they’re afraid that is coming, they’re afraid this is gonna happen. We have to pay – we have to raise interest rates – we have to raise the yield on bonds, say, we’re gonna pay you 10%, 15%, 20% in profits -- just take a bet on us, will ya? It’s like a credit card, when you’re a bad client they just jack your interest rates? They’re afraid that’s coming – and it is coming! China won’t give us any more money.

So, what do we do? Instead of being reasonable and having this guy go back and saying, “you know what? No! We can't do any of that” --

Instead, they’re going to bypass the Chinese, and they’re going here. These are the bankers. Now, I thought we hated Wall Street people, and banks, they – they’re evil. Right? No, no, no! This is actually the Fed. What is the Fed? Don’t worry. Just a collection of big bankers, you know, the Goldman Sachs people -- we don’t really know for sure, because we’re not allowed to look – oh, that sounds honest!

So you go to the bankers, and the bankers say, “Don’t worry! We’re gonna go to the Treasury, and print more money. We’ll just print more money, and we’ll take this money off the printing press and buy your bonds, so you can help out the unions.” That’s fantastic. You know where that leaves us? EXTRA BROKE! It leaves us with nothing in the end.

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

[Editor's note -- after this post was published, Mr. Beck quoted Mr. Schiff by name in the episode that aired later that day (November 04, 2010), confirming the thesis put forward above].

For later posts on this same topic, see also:

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