Interest Rates

Market Update – 8/24/2015

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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

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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

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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

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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).