Market Update – Part Two, “The Why” – What’s Causing Market Angst

This is part two of a two-part post on recent market declines. Part one contained what I call “The What”, defining the declines and trying to give some historical perspective. Part two contains “The Why” by trying to summarize, in layman’s terms, what is causing the market angst at the moment and what to do about it.

Trying to understand the stock market is like trying to understand a baby. Everything tends to be perfectly fine until suddenly, it’s not. Even when you can pinpoint the immediate cause of a meltdown, it’s often underlying issues that have been building (tired, hungry, getting sick… in the case of the baby) that are the root cause of the meltdown. There is little to no communication about the why… you just know it’s not good. I’m going to give you my opinion on what has caused the stock market to act like a baby over the past couple of months. Like the baby, the stock market hasn’t told me precisely what’s wrong… I just pay close attention to things that could be root causes so I know what’s going on when a triggering event occurs and causes a meltdown. While we can’t do anything about the meltdown, and we know it’s not abnormal (see Part one of this post), it’s reassuring to know the potential causes. I see six of these, with the last two being the most important:

1) Rising interest rates – the Federal Reserve has been raising the overnight lending rate by 25 basis points per quarter for about two years. It now targets 2-2.25% with markets expecting another quarter-point hike later this month. 2.5% is historically low and the Fed still considers it to be stimulative to growth. However, after nearly a decade of ZIRP (zero interest-rate policy) there is an anchoring effect that must be considered. Suddenly, investors can earn 2% (which is still just barely the rate of inflation) in a savings account or 3-4% in a fairly safe bond fund and it feels like a huge win vs. a decade of zero. On the margin, more may be choosing conservative investments over stocks. Mortgage rates climbing back to near 5% (historically very low) suddenly makes home purchases a lot more expensive when everyone was used to paying 3.5%. We’re seeing home sales decline and price increases halt as a result. Corporations borrowed massive amounts of money at low rates over the past decade and used it to invest in growth, pay dividends, and buy back stock. As those loans become due, where will the money come from to pay it all back? New loans at higher rates? That’s going to hurt the income statement. Secondary equity offerings? Not good for the stock. Then there’s the massive debt that governments, including ours, have taken on. At low rates, that debt is affordable. But as rates rise, the interest payments start to swamp the tax collections (especially after “mandatory spending”). This is how debt spirals to a point where it can’t be paid back. If the Fed stays on its current course to return rates to historically normal levels before the economy can anchor to non-zero levels, it will act as an economic shock and stop growth in its tracks. Last week, Fed chief Jay Powell indicated that the Fed isn’t on a pre-determined course, is close to “neutral”, and will be data dependent. This eased some market concerns, but a Fed policy mistake is still a big market risk.

2) Global trade issues – I think this one is pretty easy to understand. If the US and China are entering a long, drawn-out trade war with tariffs and other impediments to global trade issued on both sides, then there will ultimately be less global trade. Less trade means less growth and less growth means corporations make less money (or grow more slowly) while debt issues are exacerbated. Tariffs as negotiating weapons are ok to the market, especially for long-term gains like protection of intellectual property across borders. Tariffs as the end game will not be ok with the stock market. Every time it looks like there’s a path to easing of tensions, markets rally. Every time tensions increase, markets fall. Lack of communication as to the plan and inconsistent messages cast doubt on ultimate resolution. The stock market is only going to put up with that for so long before pricing in a higher probability of an extended trade war.

3) Strengthening US Dollar – the dollar has been on the rise vs. most other currencies as the US has been doing better economically than most other countries. As the dollar strengthens, US exports seem more expensive to foreign consumers, hurting US demand. US multi-national corporations lose on currency exchange when repatriating foreign profits (weak currency) into US dollars at home (strong currency), thereby hurting profits. Foreign debt issued in US Dollars becomes bigger to the foreign country that owes the money. This weakens the foreign currency further and can spiral into a currency crisis. All of these things are bad for US stocks.

4) European Union Issues – I’ll lump Brexit and the overall fiscal fiasco of the EU into one major issue. If a Brexit deal can’t be reached with the EU and there is a “hard Brexit”, Great Brittan and the European Union essentially stop doing business with each other, resulting in massive job losses and other economic dislocations. The possibility of that happening has ramped up recently as deadlines approach. In the rest of the EU, budget issues continue to challenge the southern countries who need ongoing support from Germany and the wealthier, less debt-riddled countries. The threat of Italy losing its borrowing lifeline, potentially ditching the Euro, and maybe setting off a chain reaction with other countries doing the same is like the Greek issues of a few years ago times 100. It’s becoming more and more apparent that the European Union experiment, in its current form, has failed and it’s now just a matter of stretching out the unraveling for a long enough period so that it can be creatively redesigned or unwound in the least shocking way possible. If Europe can fix itself over the next decade, even if it involves some up-front pain, that would be a massive lift for the global economy. If it can’t and there is a financial shock as a result of unraveling, it certainly won’t be good for stocks.

5) Too much government debt – the world simply has taken on too much debt over time. Governments have promised too much to their people in return for votes (low taxes, high spending). Either defaults are going to happen or inflation is going to spike, thereby making those fixed rate debts seem smaller in future dollars. Either one is going to hurt. The more time that passes with already bloated debts growing faster than the economies they rely on, while interest rates rise, the closer the world gets to a point of no return. We don’t know where that point is, when the debt markets will turn on borrowers that can’t repay, or if / when governments would start the inflationary printing presses to avoid default. This risk moves in slow motion but is probably the biggest one for the long-term.

6) The self-fulfilling prophesy – we’re pretty far from this happening in my opinion, but this is the biggest short-term risk. If the stock market volatility goes on for too long or if the market falls too far, then consumer and business confidence will wane. Our economy is built on confidence. If companies stop hiring, expanding, and investing, and/or consumers stop spending, recession is right around the corner. Similarly, you may have heard about the inverting yield curve lately. Generally, long-term interest rates are higher than short-term rates (positive, upward sloping yield curve if you plot rates on the y-axis and term on the x-axis of a graph). This positive yield curve is an indicator of expected future growth. Lately, short-term rates (specifically the two-year treasury) have been approaching long-term rates (specifically the 10-year treasury). That 2-10 spread is closely watched as an indicator of future growth and it’s dangerously close to inverting. The last several times that happened after a period of normal rates, a recession has been on the horizon. Higher short-term rates than long-term rates are deadly for banks who borrow short (pay on deposits) and lend long (loans and mortgages). If banks can’t make money on that spread (“net interest margin”, their profits dry up and they may wind up with less money to lend or be unwilling to lend. Less lending can impact the ability for businesses and consumers to borrow, potentially leading to recession. This means that an inverted yield curve that predicts recession could actually lead to it… another self-fulfilling prophecy. Keep in mind though that even if recession happens, the typical one is a pause that refreshes, that brings valuations back in line, that scares off the weak hands, that kills the companies that took on too much leverage, that leads to the birth of the next growth cycle. A recession in a world with too much debt though could intensify and accelerate the debt issues described in #5.

Here’s the good news… when there are reasons for concern in the stock market, the eventual elimination of those concerns often leads to new growth. This is frequently called “climbing the wall of worry”. When the worries are all gone and everything is perfect, then perfection is priced into the market and there’s often no more room for prices to increase. No more wall of worry means nothing to climb. So, it’s highly possible that these worries will provide the legs for the next bull market to stand on. I have to admit, when the tax cuts went through, unemployment dropped near 4%, corporate profit margins hit all-time highs, inflation remained low despite low interest rates, I started to worry that there wasn’t much to worry about. Now there’s a real wall of worry to potentially climb.

If you’ve read this far, I know what you’re probably thinking… This is all well and good and thanks for explaining all that but… is this an opportunity to buy cheap, or a last chance opportunity to get out before a big fall? No one ever knows that answer in advance. What we do know for certain is that there are going to be big falls at some points in the future. I tell clients to expect a 50% decline in stocks at some point in life (we had two of them in one decade in the 2000’s). This of course doesn’t mean your portfolio will fall 50% because not all of your money is in stocks. Young clients with decades until retirement and only a small percentage of what they’ll ultimately need to retire have retirement money primarily invested in stocks. But, they actually benefit from a decline in prices because they have much more to contribute to their retirement portfolios (at lower prices if prices fall) than would be lost from a temporary decline in the value of existing assets. On the other extreme, clients who are well into retirement, or those with shorter-term goals where money is needed over the next few years, are not primarily invested in stocks. A portfolio that is 30% stocks / 70% bonds will experience about a 15% loss if the stock market falls 50% (generally less than 15% because bonds tend to do well when stocks fall dramatically). It’s essential to get the mix right, but once you do, it doesn’t matter what happens with stocks over the short-term. You’re either in stocks for the long-term or you’re not primarily in stocks.

We know declines will happen. We just don’t know when they’re going to happen. When you invest, you accept that stocks are going to fall, and create a plan that works despite the stock market’s short-term swings. If a stock market decline scares you off your plan, you’re doing yourself an injustice by allowing that to happen. As I pointed out in Part one of this update, stocks are down at least 5% from recent highs almost half the time. So, should you buy, or should you sell? If your plan calls for adding money to your portfolio to target a future goal and you have free cash flow to do that, then add money (buy). If your plan calls for liquidation to support retirement expenses or to buy that next house, then withdraw money (sell). React to life events, not stock market events. Avoid the temptation to put your emergency fund in stocks during the good times or to pull your retirement money out of stocks in the bad times. In the meantime, we will be using the volatility, where appropriate, to rebalance portfolios back to target (sell what’s up, buy what’s down) and tax-loss harvest (sell securities with unrealized losses and repurchase similar securities to unlock the loss for tax purposes). Volatility fees bad, but without it, stocks would be risk-free. If they were risk-free, they’d be paying 2% like savings accounts. The risk has to be there in order to justify the long-term returns. I will continue to remind you that when the market is smiling, a tantrum is around the corner. When the market is throwing a tantrum, happier times and then more tantrums are ahead. It is the nature of being a parent… er umm… an investor 🙂

What The Fed Rate Hike Means For You

In a widely expected move, the Federal Reserve raised the Fed Funds target rate range from 0-0.25% to 0.25-0.50% earlier today. They forecast a gradual (though not set in stone) increase in that rate by about 1% per year until reaching a terminal rate near 3.5% in 2018. This marks the end of seven years of ZIRP (Zero Interest Rate Policy) and is the first rate hike in nine years. I wanted to take a minute to clarify how this move is likely to impact you. There is a perception that the Federal Reserve controls nearly all rates on all financial products, which is not the case. Below is a non-exhaustive list of what will likely be impacted immediately and over the longer term. As always, if you have questions about something that is or is not covered below, please don’t hesitate to ask.

· Interest Paid By Your Bank On Your Savings – Likely no impact at all in the short-term. The average checking account will still pay approximately 0.00%. The average savings account will still pay approximately 0.05%. Online savings banks, some credit unions, some local banks, etc. will continue to pay in the 0.5-0.9% range. It is very unlikely that the big banks (BoA, Wells, JPMorganChase, etc.) will raise their rates on savings as a result of the Fed hike. Once the Fed Funds rate gets to 0.75%-1.00%, we’re likely to see the big banks begin to pay more in interest and move rates up slightly less than 0.25% with every 0.25% hike by the Fed. While the banks get paid more on their reserves, they won’t really have an incentive to pass that along to the consumer until rates are a bit higher and they start competing over customers. This is akin to when oil prices come down suddenly, but prices at the gasoline pump move down much more slowly over an extended amount of time.

· 15 & 30 Year Fixed Mortgage Rates – Likely little impact in the short-term. Mortgage rates are tied to longer-term rates than the Fed Funds rate (which is an overnight lending rate). Long-Term rates are much more tied to the economy, the supply of and demand for money, competition with long-term rates in other countries, and expected long-term inflation than they are to the short-term rates that are controlled by the Fed. The Fed will move short-term rates up as the economy improves, so in a sense, long-term rates should come along for the ride over time as economic growth leads to higher inflation expectations and higher demand for money. In reality though, increasing short-term rates tends to put a brake on economic growth and given the extreme policies in Europe and Japan that are geared toward keeping long-term rates down in those countries, it’s unlikely that US long-term rates can move up very far very fast.

· Variable Loan Rates (mortgages & other) – Likely to move up in lock-step with the increase in Fed Funds. Most variable rate loans are tied to the PRIME rate (generally 3% above the Fed Funds rate and controlled by banks) or to 1-month, 3-month, or 1-year LIBOR (another short-term lending rate that is very closely tied to the Fed Funds rate plus a premium for credit conditions). The big banks increased their PRIME rate to 3.5% shortly after the Fed’s announcement today. LIBOR has been floating up in expectation of the Fed announcement. As an example, if you have a Home Equity Line Of Credit (HELOC) with a rate that is PRIME + 0.5%, you’ve been paying 3.75% interest on that loan for the past 7 years. As of today, that rate is now 4%. By the end of 2016 it is likely to be 5% and by 2018 it is likely to be 7% if Fed projections are correct. If you have a variable rate primary mortgage that is 1-year LIBOR + 2.75% rounded up to the nearest 1/8th of a percent, that rate was 3.375% a year ago and today it’s 3.875%. It would likely be ~5% by end of 2016 and ~7% by end of 2018 if Fed projections are correct. You can expect a point-for-point increase in the rate of loans tied to PRIME and a close to point-for-point increase in loans tied to LIBOR. LIBOR loans could also see additional increases if credit tightens (like it did in the extreme case in 2008/09 after Lehman Brothers failed and no one trusted lending money to anyone else for a while).

· Economic Growth – There is a school of thought that believes that ZIRP was hurting economic growth and causing dislocations through the financial system. The more traditional economic view is that the lower the Fed Funds rate, the more stimulative it is for growth. I personally believe that low rates are stimulative in that they encourage more borrowing, more lending, more spending, more investing, and less saving (cash sitting around doing nothing). However, the longer rates stay low, the more they push investors into riskier investments in seeking higher yields. This applies both to financial institutions (a SF Credit Union offered a $3M mortgage with no downpayment required last week, for example), and to individual investors putting money in high-yield investments without considering the risk (see this article from Bloomberg about a recent high-yield bond mutual fund that recently told investors they couldn’t sell and get their money back). Eventually, excessive risk-taking leads to a bubble which inevitably leads to a crash. So, in a sense, the Fed’s rate increase and guidance that they will continue to normalize rates helps to avert a growing bubble/crash scenario. Fear subsiding can lead to higher economic growth. Whether that is enough to offset the negative growth impact in reduced lending, borrowing, investing, and spending remains to be seen. A 0.5% Fed Funds rate and $4 Trillion Fed balance sheet are extremely stimulative. But with each increase in rates, and with each reduction in the size of that balance sheet (which will start eventually), they become a bit less stimulative. Economists generally believe that the level of rates and size of the balance sheet are more meaningful than the direction of movement in those rates and the balance sheet. The aggregate psychology of the financial markets seems to put more weight in the direction of movement. I suspect that short-term, the markets will have their way and price in a slowdown in growth, some of which has already started. The Fed’s challenge is that if markets believe higher rates will cause a recession, that belief alone can cause the recession as businesses pull back investment, consumers slow their spending, layoffs start, etc. It remains to be seen whether the Fed can maintain confidence via a very slow trajectory of rate hikes, in which case they’ll be able to normalize rates over time while continuing to let low rates stimulate growth during the rate hike cycle.

· Inflation – Inflation is currently running near zero year over year, mostly due to the impact of the sharp decline in commodity prices. This has run counter to everything in economics textbooks. Central banks all over the world have been printing money to try to stimulate growth and avoid deflation. Even with trillions more dollars, euros, and yen in the system, the aggregate price of goods is not rising. The Fed believes the impact of energy is “transitory” in that lower energy prices tend to feed through the economy short-term and hold inflation down, but over the long-term lower energy prices provide an engine for growth. They believe inflation will get back to their target, which is 2% per year, over the next few years. They say they’re increasing interest rates starting now so that they can do it in a gradual manner rather than waiting until inflation picks up which would cause them to move more aggressively with rate hikes to fend off a hyperinflation scenario (which has caused recessions in the past). Again, it remains to be seen whether they’ll be successful or not.

· US Dollar Relative To Foreign Currencies – The dollar has been on a big run relative to other currencies since mid-2014. Money usually chases higher rates and safety (which rarely go hand-in-hand). In this case, the US looks safer than virtually any other country (some plagued by political instability, others by a banking crisis, others by fiscal issues), and it had the prospects of increasing rates over time while other major parts of the world are decreasing rates and/or printing money to fend off recession. Higher US interest rates are widely expected to continue to increase the dollar’s value relative to other currencies. At some point though (and maybe it’s here), a higher dollar starts to impact US exports substantially, starts to push more work offshore where labor is cheaper, and starts to make foreign investments look cheap in dollar terms while US investments look expensive in foreign currency terms. All of those things can put a dent in US growth and cause interest rates (and therefore the dollar) to come down. There’s no way to know what’s going to happen, but it definitely feels like the dollar is getting very expensive and foreign currencies (particularly those of emerging markets) are getting very cheap. One thing is certain… if you live in the US, are paid in US dollars, and like to travel the globe, it’s a LOT cheaper to do it today than it was a couple of years ago.

Market Update – 8/24/2015

Most of you know by now that when you see a “Market Update” post from me, something ugly is happening in the financial markets. This time, it’s the classic fear of a global growth slowdown, with China at the center of the action. There’s plenty of literature out there pointing to all of China’s problems, so I won’t bore you with a recap. Growth there is slowing, dramatically, and there’s little debate about that. For a long time, emerging market growth was thought to be enough to overcome the stagnation that has happened through much of the developed world. Slowing growth (maybe even a real recession?) in Asia, eastern Europe, the Middle East, and Latin America has left financial markets wondering what can drive global growth. Without it, it’s hard to imagine that corporate profits can continue to grow, hiring will increase, spending will rise, and the virtuous cycle will continue. Oil prices have plunged, partially due to the increase in supply led by the US shale revolution, but lately, I suspect it’s again due to demand slowdown fears led by China. While lower commodity prices are beneficial for consumers, it puts a halt on the growth of one of the sources of job gains in the US and provides even more basis for worrying about global growth. Add in fears of the Fed starting to raise rates soon (which almost certainly isn’t going to happen in September now thanks to the recent stock rout), and we have the makings of a meltdown.

[As I write this at 9:30am, the US stock market just opened and the market itself is not functioning properly. There are stocks and funds that opened down 20%+, were halted, and bounced back sharply. It looks a lot like the flash crash of a few years ago. I’d venture to guess that many of those trades will be cancelled by the end of the day. Many stocks did not open on time. Don’t believe what you’re seeing for quotes until that’s all resolved. I suspect the Dow was never really down the 1000+ points that were indicated shortly after the open.]

I don’t know how bad China will get. I don’t know how much fear will beget fear and cause stocks to fall. I don’t know how long it will take for everything to stabilize. What I do know is that China won’t be wiped off the map and that a billion people have a massive amount of productivity to deliver to the world as skills, technology, and resources move from other parts of the world to China. There is a massive portion of the developing world that is living in or on the edge of poverty. Technology is moving so quickly, making the world smaller and smaller and it seems impossible that the disparity in standard of living between the developing and developed worlds can continue forever. Emerging markets will drive growth eventually… It just make take a while to get through some of the policy mistakes their governments have made and to normalize some of the capital flows that have probably put too much of the developed world’s central bank provided liquidity into emerging markets in search of yield. While the media may try to convince you otherwise on a day like today, the world is not ending.

Take this as a gut check. After years without a major fall, there is a tendency to think that stocks go up in good times, and do nothing in bad times. We’ve forgotten that stocks also go down and they tend to go down much faster than they go up. This causes stress when portfolios have not been set up appropriately for your goals. Ask yourself this question: “If the stock market loses half its value as it did twice in the last 15 years, will I still be able to achieve my goals?” The answer to that question is dependent on what your goals are, how soon you need your money, and how much of your portfolio is in the stock market. If your goal is retirement in 20 years, then you’re going to have most of your money in the stock market and downturns are going to be painful, but you (and your portfolio) won’t even remember that this downturn occurred by the time your retire. If you’re looking to buy a house with most of your money in the next couple of years, then most of your money is in bonds, which actually do fairly well when stocks move lower allowing them to offset some of the stock fall and mute the impact on your portfolio. The real concern for investors should be whether or not you’ve really evaluated your goals and communicated them to your advisor. As long as we’re on the same page, your portfolio is allocated in a way that the stock market falling 10%, 20%, or even more isn’t going to ruin you. That doesn’t mean your portfolio won’t go down… I assure you it will and that’s a necessary risk in order for it to go up in the good times. It means that you should still be able to achieve your goals even if stocks fall sharply over the short term. As I posted on Twitter on Friday, “If it matters to you that stocks fell today / this week, you’re gambling, not investing.” If you feel like you’re gambling and you’re worried, please contact me. It means you’re letting your emotions get the best of you (and I’m happy to talk you off the ledge) or that your portfolio isn’t in line with your goals (which means we really need to talk).

I’ll conclude with something no one wants to hear while the market is falling, but everyone realizes is true eventually. Investing at lower prices actually increases long-term wealth and the probability of achieving your goals. In my most rational moments (which are admittedly hard when the entire world’s stock markets are down 10%+ over two days), I cheer when the market falls and get more nervous when it rises because I know your long-term goals (and mine) have a better chance of success when prices are lower and we can invest more money at those lower prices (see The Value Of Volatility post from 2013). Would you rather your next 401k contribution get invested at last week’s higher prices or this week’s lower prices? Buyers should always want prices to be lower, even if it doesn’t feel good at the time. On days like today, which definitely don’t feel good, please keep that in mind.

PE Ratios, Earnings Yield, Interest Rates, & Valuation

Many of you understand one of the most basic concepts in investments, the P/E ratio. For those who don’t, I’ll give you a brief explanation because you’ll hear “P/E” in almost any discussion on market or company valuation. “P/E” stand for Price-to-Earnings. It’s a ratio of what it costs to own a share of stock in a company, versus the annual earnings of the company that are attributable to that one share. In other words, PE = stock price ÷ annual profit per share. Annual profit is usually referred to as “Earnings Per Share” or “EPS”, so we can simplify a bit and say that PE = stock price ÷ EPS. It’s a measure of how expensive a stock is, relative to the earnings that one share of the company represents. For example, let’s take a look at Apple. The stock is trading at $92 per share. In the year ending Sep 2014, Apple is forecast to earn $6.88 per share (that’s about $41 Billion in profits divided by about 6 Billion shares outstanding). Thus, the PE for Apple is 92/6.88 = 13.37. Is that high or low? How do you determine a fair PE for a company?

To answer that, I like to take the mystery and complication of the stock market out of play and think about a small business, something that you can probably relate to a lot easier. Let’s say you and four friends start a business that earns a steady $50k per year in net profits. When you started the company, you decided you’d each own an equal 20% of the company. In case one of you wanted to sell a part of your share to someone else, you decided you’d each own 200 shares of a 1000 share total (still 20% of the company). If the company earns $50k per year, and there are 1000 shares outstanding, how much does each share of company earn? $50. That is, the EPS for your company is $50. Now, how much is your company worth (how much would someone being willing to pay for one share of your company)? Surely it’s more than $50k ($50 per share) right, because it’s earning $50k per year consistently, so someone who paid only $50 per share for it would get their money back in just a year. You would be highly unlikely to sell a share for such a low price… you’d just keep the share and earn the $50 over the next 12 months from profits instead. On the other hand, the company can’t be worth a billion dollars ($1 million per share), because even though someone paying $1M per share will eventually get their money back by earning $50 per year, 1) it would take several lifetimes, 2) there’s more risk that something happens to the business to reduce its earnings when you need to go farther out in the future to make back your investment, and 3) (most importantly) that $1M can be invested in something else that pays well north of $50 per year so no one would ever pay a million dollars for $50 per year even if it was guaranteed forever. Somewhere in between $50 and $1M per share there is a fair price though. Perhaps the best way to estimate is by using the third rationale above… how much money do I need to invest to earn $50 per year on something with a similar amount of risk? I can put $7700 in a 1-year CD and earn $50 at 0.65% interest. Clearly though, buying future profits of a business is higher risk than a CD so a buyer would want to earn more than the going rate for a CD. There’s also the chance that a buyer may not be able to re-sell the business in a year, so we should look at something that locks up money for a longer time period to compare. How about a 10-year investment-grade (BBB) rated corporate bond? That pays about 5% and has some real risk in it (the company could go bankrupt within 10 years and you wouldn’t get your money back). It would take a $1000 investment in that bond to earn $50 per year. There’s probably still more risk in the small business though because the only way you wouldn’t get your money back in a bond is if the company literally has no money and is forced to liquidate or file bankruptcy. In the small business, even if it just starts to breakeven for a while, there are no profits for the owners, so you may never get your money back. A buyer could argue that she would want a 5% higher return on an investment in your company than he/she could get from the corporate bond. The buyer would be willing to pay $500 per share then, since a 10% annual return on $500 is the $50 per share that your company is generating. $500 per share then might be a fair price for the business. A $500 price for a company earning $50 per year means a PE of 10.

What if your company was growing rapidly and your earnings were expected to increase considerably over the next few years? If $500 (PE of 10) was a fair price for a stable company, surely a buyer would be willing to pay more than $500 (higher than a PE of 10) for a rapidly growing company right? Of course, because he’s not only going to get just $50 per year, he’s going to get $50 this year and more than $50 next year and much more than $50 the year after that. That has to be worth more than the stable company that’s not growing. So now we know that PE’s should be higher for higher growth companies. This should seem pretty intuitive.

There’s another factor that can have a dramatic impact in a fair PE. What happens if interest rates fall and investment grade bonds start to pay 3.33% instead of the original 5%? If investors in a small business like yours still demand a 5% premium to what corporate bonds are paying, they’ll want an 8.33% return from an investment in your company. Since the company is still generating its consistent $50 per share per year, the only way to make that seem like a lower return is to push the value of the company higher. At $600 per share, the $50 in annual profits would be an 8.33% return. The reduction in interest rates pushed the PE (600/50 = 12) higher. So, we can generalize that lower interest rates lead to higher PEs. This may be less intuitive, so I’ll give another way of thinking about it. Instead of looking at the PE ratio, let’s look at its reciprocal. That’s the EPS / stock price. We can call this the “earnings yield”. For our small business above, the earnings yield would be 10% if the stock price was $500 (50/500), it would be 8.33% if the stock price was $600 (50/600) and it would be 5% if the stock price was $1000 (50/1000). If you could get 5% in a savings account or CD, would you ever purchase a company with a 5% earnings yield (remember, steady payments, not expected to grow)? I hope your answer is no, because there’s a lot more risk in the company than there would be in a savings account. So, if bank interest rates were 5%, there’s no way the small business could be worth $1000 per share (5% earnings yield, PE = 20). The price must be < $1000 per share. What if bank interest rates were only 1%? Now you might be willing to take 5% earnings yield in a riskier investment because you’re getting an extra 4% return over what you’d get in the bank. It should seem clearer that lower interest rates in general would make lower earnings yields seem more attractive. If lower rates lead to lower earnings yields, the lower rates must lead to higher PEs, because PE is just the reciprocal of earnings yield.

To summarize, remember that the P/E ratio is the price of a share divided by earnings per share. The reciprocal of the P/E ratio is earnings per share divided by share price and that’s called the “earnings yield”. The stronger the expected growth in earnings, the higher the P/E. The lower the level of overall interest rates, the lower the earnings yield, and the higher the P/E.

Market Update 6/20/13

The Federal Reserve is eventually going to stop firing their Monetary Bazooka (“QE”, as its commonly known). We’ve always known that. Over the last month, culminating in yesterday’s post-FOMC announcement press conference, “eventually” became “soon”. Despite reiterating their promise to keep short-term interest rates near-zero into 2015, their plan to continue to QE program through mid-2014, and their resolve to support the economy through aggressive monetary policy for as long as it needs their support, the Fed has spooked the market by signaling the beginning of the end of monetary stimulus. First, let’s quantify the damage:

There are other factors at work as well including Japan’s unprecedented attempt to stimulate its economy through QE (makes ours look like child’s play) and the currency fluctuations that has caused, China attempting to pop its real estate bubble by extracting stimulus and causing domestic bank liquidity issues, recent protests in Turkey and Brazil, ongoing political instability in Syria, Egypt, and much of the rest of the middle east, inflation in India, Brazil, and some of the other emerging markets, massive unemployment and fiscal issues in southern Europe (Portugal, Italy, Greece, Spain, Cypress) while debating between austerity and trying to stimulate growth. I don’t want to minimize them, but here I want to focus on the Fed, which is really the only change in the past two days. Clearly, from the table above, there hasn’t been anywhere to hide but emerging markets have really taken the biggest beating as expected since they are typically the most volatile asset class.

In addition, mortgage rates have started to rise, following treasury rates. 30-year fixed rates have moved from 3.3% in May to an average of 3.93% last week according to Freddie Mac’s weekly survey, and likely well over 4% this week. Continued increases in mortgage rates will hurt the housing market which has been in full recovery mode for last 18-months and is the prime reason behind the economy’s strengthening.

So, should you be worried? I would be worried if any of the following are true:

1) If my financial plan was built on an expectation that I’d be able to borrow at absurdly low rates forever. I’ve been building 4.5% rates in for the near term and 6-7% rates for 2015 and beyond into all client plans. Higher rates are unfortunate, especially if you’re hoping to buy a home soon, but rates are still within the tolerances of your plan. It’s important to note also that if rates move much higher over the short-term, prices will most likely come down as buyers simply won’t be able to afford the higher monthly payment that comes along with higher rates on the same amount borrowed. In hot markets like the SF bay area, higher rates, if matched by an expected increase in supply thanks to higher prices, could stop the housing recovery in its tracks.

2) If my financial plan was built on an expectation that my investment portfolio would only go up, day-after-day, with no volatility forever. If you believe that’s possible, you haven’t been listening to anything I’ve said or written in the past. No portfolio (except maybe Bernie Madoff’s) will do that and your financial plan certain doesn’t have that expectation built in if I helped to create it. We’ve seen stocks relentlessly increasing since March 2009 and have to expect pullbacks / corrections from time to time. It’s the price you pay as an investor for the reward of higher long-term gains. As a general rule of thumb, you have to be prepared to lose 50% of the portion of your portfolio that’s in the stock market in any downturn. If you’re 50% stock / 50% bond, that means a 25% loss can be expected at some point (it’s happened twice in the last 13 years). As I’ve said before, if you’re uncomfortable with the potential for loss, then you must be more conservative and must accept lower long-term return expectations. There’s no way around this point.

3) If I was invested only in stocks and long-term bonds for my short-term goals and I needed every dollar I had invested for those goals. I coach all clients to invest conservatively for short-term goals, in some cases extremely conservatively, and to maintain cash for ultra short-term goals where you need every dollar you have. I’m not using long-term bonds in any client portfolios, favoring shorter-durations which will fare better in a slowly rising rate environment.

4) If I was investing for long-term goals primarily in stocks, but couldn’t get past short-term results, even though they don’t matter over the long-term. This one is psychological, but is key. Unless you think you have a crystal ball that can predict the short-term future of the markets, you just have to accept the short-term in favor of higher expected long-term returns. Hopefully you’re all on board. If you’re not, investing may not be for you.

5) If I hadn’t communicated my goals and plans with my financial advisor, or if I didn’t have a financial plan at all. Here’s there’s room for worry if things have changed in your life, you’re a PWA-client, and you haven’t communicated those changes or kept up with your annual reviews, or if you’ve never completed or kept up with a financial plan to begin with. To quote Yogi Berra as I’ve done in past posts, “If you don’t know where you’re going, you might wind up someplace else”. A similar result can be expected if you haven’t told your financial advisor where you’d like to go!

On the flip side, instead of worrying, remember that a falling market creates opportunity as long as you continue to add to your portfolio. You’ll be much better off with some dips along the way to your goal than you would in a straight line where the market only goes up, counter-intuitive as that might seem.

With all of the above said, perhaps some of you are still worried that rates are going to soar, the market is going to plunge into an abyss, and we’re headed for the Great Depression v2.0. After all, the real danger in unstable markets is the circular feedback loop that they have on the economy and that the economy has on the market. If asset prices irrationally fall, consumer and corporate confidence tends to fall too, which can slow the economy and cause asset prices to fall. Normally, this kind of feedback loop has the potential to cause a catastrophic downward spiral where fear begets fear and markets crash. If the Fed was stepping away and saying, “we’ve done all we can”, I’d worry about that too. In this case though, the Fed hasn’t stepped away from the market. They haven’t taken the training wheels off the bike, given the child a push, and turned their back. They’ve told that precious child that they’re going to take the training wheels off when she’s mature enough and steady enough and they’re monitoring that regularly. When they do, they’ll be there running along with the bike keeping it steady until it has picked up enough speed that she can balance and pedal without falling. And, if by some chance she falls off that bike even with all the support, they may put the training wheels back on again, repair the damage, and try again later. Yep, there may be crying, there may be a sleepless night or two, there may be a scraped knee, but she’ll make it. There may be short-term dislocations in the market as selling causes margin calls which leads to more selling temporarily, but the economy and the markets will make it as well.

To summarize, don’t worry unless you don’t have a plan or you haven’t communicated your goals to your financial advisor. Market volatility is both normal, and even helpful over the long-term. Finally, realize that the Fed hasn’t spent 6 years trying to get the economy back in working order only to walk away and let it crash now.

What’s In A Score

A few people have asked recently about how credit scores are determined, what is a good credit score, what score it required for the best rate on a mortgage, etc.  The following is an article I wrote for the PWA Newsletter back in 2008, updated for the interest rate world we live in today.

Okay, so you’ve checked your credit report, made sure there are no errors and are satisfied with the result.  Now what?  Now you have to understand what your credit report is used for and how your credit score is determined.  When you apply for a credit card or a loan, the prospective lender gathers your information and attempts to determine your credit risk.  They do that by analyzing the personal data you send them, by examining your credit report, and by reviewing your credit score, AKA your FICO score.  This process ultimately decides whether you get the loan or not and the terms for which you’ll qualify.  As shown below, your credit score can have a dramatic impact on the interest rate you’re offered and will therefore impact your payments and total interest over the course of the loan.

 

Rate by Score

Based on $300k 30-year mortgage and LTV of 60-80%. As published by MyFico.com

Your FICO score is determined by a complex system that was created by the Fair Issac Company (hence the name FICO).  To our knowledge, the actual formula has never been released, but the general algorithm has, and that’s really all you need to know to improve your score.  It is based on:

  • Payment History (35%) – do you pay your bills on-time, have you ever filed bankruptcy, are you currently or have you ever been in default.
  • Amounts Owed (30%) – what portion of your available credit are you using, how big are the balances (esp. on revolving debt), how many accounts (and of what type) are active and/or have balances.
  • Length of Credit History / New Credit (25%) – time since your oldest account was opened, age of all active accounts, number of recent applications for accounts and new accounts, time since last application and new account
  • Types of Credit Used (10%) – prior and current use of different types of credit (mortgage, installment, revolving, etc.)

There are many standards of what constitutes a “good” FICO score.  Some say higher than 720, others say higher than 750, and still others say higher than 780.  Because each lender will use the information in their own way, all we really know is that the higher your score is, the better off you’ll be. The median score is around 720 and the 90th percentile score is just over 800 according to estimates published by myFico.com and bankrate.com.  To estimate your FICO score, you can use the free calculator at: http://www.bankrate.com/brm/fico/calc.asp or register for a free site like www.creditkarma.com which tracks an estimate of your score over time.  To see the real thing, when you obtain your free annual credit report from one of the reporting agencies, purchase your score from them for a nominal fee (<$10).