Start Planning on Rising Interest Rates

It always amazes me.  At times when the market is clearly at an extreme individuals will continue to place bets that the market will continue in that direction.  At the top of the .net bubble, investors were still betting that internet stocks would go higher.  When the housing bubble was near its peak people were buying up houses as investment properties, expecting the continue to make double-digit returns each year.  Now we are looking at some of the lowest interest rates in years, yet individuals continue to believe that interest rates will remain low, at times even making bets on lower interest rates.  When you are seeing interest rates on bank accounts at zero, how much lower can you expect to go?

It is true that the Federal Reserve is trying to keep interest rates down to spur economic growth.  The trouble, however, is not that there is not sufficient capital out there to invest.  Banks have their vaults full of money available for lending, but no one wants to take out a loan.  Likewise, companies are sitting on more money than they have in decades, yet none of them have anything they want to invest in.  The Fed has kept short-term (read bank account) interest rates low by flooding the market with liquidity.  They also tried the unusual step of trying to lower long-term rates by buying long-term treasuries.  So far this has met with limited success (read, abject failure) as long-term rates have actually started to rise.  For example, 15-year housing mortgage rates have risen by about 1/2 percent off of their lows.  The trouble is that people see a weakening of the dollar which will lead to inflation.  No one is therefore willing to lock in a 4% rate for 20 years if they expect inflation to be running at 5-10% or higher during that time.

So what do higher rates mean to the investor?  Typically, not good things.  As rates rise bond prices will fall (such that the effective rate of interest rises as well).  Stock prices will also tend to fall as investors expect higher potential returns from stocks to justify the added risk over bond investing.  Higher rates also have a dampening effect on inflation as well, so gold investors will also see their investment shrink.

In general, the best course is to raise cash and invest regularly as rates rise and stocks and bonds fall.  If we ever see the 20% interest rates in bonds that we saw in the 1970′s one could lock in a great interest rate for 20 years or longer.  One cannot sit in cash indefinitely, however, since these things can take quite a while to unwind.  As always, the procedure of saving from earnings and regular investment is the key.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

How Do I Predict Future Stock Prices?

 

 

Ask SmallIvy

 

Dear SmallIvy,

 

How do I predict future stock prices?

 

Regards,

 

C. Hanscom

 

 

 

Dear Mr. Hanscom,

 

First let me say that it is almost impossible to predict short-term prices.  While prices do seem to follow a pattern and there is a whole set of theory involving charting and numerous numerical schemes, the movement of stock prices in the near-term are basically random.  The trouble is that we try to see patterns, even in random events, hence the display of recent rolls at the roulette table.  The chance of another red is always about 48 to 52, but if there have been a streak of 10 reds some will expect the chance to be less.

 

The great investor, Benjamin Graham (a mentor for Warren Buffitt, used a character he called “Mr. Market.”  Mr. Market will sit there and call out prices.  The prices he calls out may have nothing to do with the true value of the stock.  At times his calls may be very high, and yet the next set of calls may be even higher.  Other times he may not be offering nearly enough for a stock, but that does not mean that the next price offered will be more rational.  The investor should simply wait for Mr. Market to offer an acceptable price before buying and selling.

 

The long-term price is a different story.  The ability to predict the long-term price depends upon the ability to predict earnings.  For some companies this is extremely difficult because earnings can change greatly based on world events.  The semiconductor industry is a good example because prices for chips can fall suddenly when a company starts mass producing chips and dumping them on the market.  Earnings can be growing rapidly, but then fall off of a cliff within the year.  Because earnings are unpredictable, predicting price 5, 10, or 20 years out is difficult.

 

Other companies are a different story.  Retail stores, restaurants, technology companies, service industries, and others tend to have fairly predictable earnings.  Because they have a set of customers who tend to buy from them again and again their earnings tend to be more stable.  Add a little knowledge of the rate of current expansion and a reasonable prediction of future earnings results.  The old, established companies that own everything (see Clorox, for example) are extreme examples of this because they have such a wide product array that decreases in one area are usually offset by increases in others.

 

Most stocks therefore have a wide field of analysts who analyze the company.  One of the products that they produce is earning projections for the next quarter and the next few years that can be found on various websites and publications.  Like anything, the near-term predictions are better than the far-term, but a company that has been growing at a steady pace for the last several years can usually be expected to keep the growth rate provided that there is still room to grow.

 

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

The Next Bubble – Bonds

In their recent Wall Street Journal Editorial, Jeremy Siegel and Jeremy Schwartz discuss the new bubble that is looming, corporate bonds:

http://online.wsj.com/article/SB10001424052748704407804575425384002846058.html

Add this to the list of recent bubbles, which includes the small stock/dot-com stock bubble and the more recent housing bubble.  The good news is that this newest bubble may actually be good news for stocks.

The current bond bubble is driven by two factors.  These are the extremely low interest rates set by the Federal reserve and the flight to safety by the general public.

The Federal Reserve drives down interest rates by lowering the rate it charges for banks to borrow money and by buying Treasuries on the open market to add cash to the system.  These actions affect the Fed Funds Rate the Discount Rate, the main tools of the Federal Reserve.  When this happens, bonds tend to go up in price since the higher returns of bonds are seen as more desirable, which lowers their interest rates.  Stocks also tend to go up since the rate of return offered by stocks is more valuable when the interest rate on bonds decreases (investors are willing to take more risk for a better return).  Because the Federal interest rates are near zero, the price of Treasuries has been bid up to the point where there is almost no yield at all (a scant 1%).

The second factor is that because people are so worried about losing money, they figure that 1% is better than a negative return.  Having been burned by stocks and real estate, along with foreign bonds and stocks, investors are looking for a safe haven.  Because one loses money when bond prices decline, however, the small 1% yield could easily be wiped out if interest rates rise.

So what does this mean?  Stay away from the crowd and out of bonds.  Remember that one never wants to follow the crowd, because wherever the crowd is, prices will be high and all of the money available is already invested.  When there is a bubble this rule is especially true. 

Use this current fear of stocks to buy up shares of good companies.  When the bond bubble bursts, as it will if inflation starts to pick up causing interest rates to rise, the money will come flooding back into stocks.  That is just where you want to be when it does. 

Remember that the high rates of returns from stocks are due mainly to a few brief periods where the market climbs rapidly.  If you are on the sidelines when one of these moves occurs, your rate of return will be far less and your retirement much more meager.

Like what you’re reading? Keep the blog going – Refer a friend – http://smallivy.wordpress.com

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Federal Reserve and the Stock Market

There is an old axiom on Wall Street:  “Don’t fight the Fed.” 

The Federal Reserve holds an enormous amount of power over the economy.  While the President is usually blamed for a bad economy and praised for a good one, the fact is that the federal reserve actually has significantly more power over the state of the economy.

The Federal Reserve is made up of a board of bank executives from around the country — the “Governors” — with one individual chosen as the Chairman.  The Chairman is chosen by the President and confirmed by the Congress, but the post is meant to be non-political.  The group meets periodically to discuss the state of the economy and any action that should be taken.  The power of the Federal Reserve over the economy is so acute that the discussions held during the meetings are kept in secret with notes from the meeting only being released several months after they meet. 

Often traders will move the stock market up or down before the Federal Reserve meets based on what they expect the group to decide.  If the group’s decision surprises the market, the stock market will often move up or down several percentage points.  The announcements made by the Federal Reserve are purposely made rather vague since they know the power of their words.

The Federal Reserve controls the economy through two levers, the Discount Rate and the Fed Funds Rate.  The discount rate (http://en.wikipedia.org/wiki/Discount_rate) is the amount that the Federal reserve charges banks that borrow funds from it.  Generally it is frowned upon for banks to borrow from the Federal Reserve directly and they generally get a scolding when they do so.  The exception is during the recent money crisis where borrowing from the discount window was encouraged since other sources of capital had dried up. 

The Federal Funds Rate (http://en.wikipedia.org/wiki/Fed_Funds_Rate) is the rate at which banks loan each other for overnight periods.  The Federal Reserve does not control the Fed Funds rate directly, but instead adds money to the economy or takes it away to affect the rate.  This is done by selling notes, which has the effect of removing money from the economy, or buying notes, which injects money into the economy.  Like anything else, the more money there is in the economy to lend, the lower the price for borrowing (therefore the lower the interest rate).

Because the bank’s costs of capital decrease when the rate at which they can obtain decreases, they also tend to lower the rates they charge.  This trickles up into the economy (except, interestingly, credit card rates), such that most rates tend to fall .  Because the arte savings account provide drops, bonds become more valuable, so their price tends to rise, dropping the amount of interest they provide.  Likewise, because the return of common stocks becomes more valuable, stock prices also tend to rise. 

This is the reason to not “fight the Fed.”  When the Fed is lowering rates, it’s best not to be short, and when the Fed is raising rates, it’s best to prepare for a fall.  Note that in the early ’90′s, the Federal reserve lowered interest rates to bring the economy out of the early 90′s recession.  The stock market took off first, followed by the economy.  President Clinton was credited with the good economy that followed, but it was all touched off by the Federal reserve. 

In the late 90′s, when inflation was starting to pick up and internet stocks were trading at ridiculous prices, Fed Chief Alan Greenspan warned of what he called “irrational exuberance.”  The Fed began raising rates to pick the ensuing bubble.  A few months later, the bubble burst and the early 2000 recession occurred.  President George Bush Junior was blamed for this recession, but the stock market had already started to fall before he took office because of the actions of the Federal reserve.  Finally, just before the latest recession, the Federal Reserve, concerned about housing prices, began to raise rates to dampen the economy.  This caused the housing bubble to burst, leading to the current state.

The action of the Federal reserve typically takes half a year to have an effect.  It takes time for companies to start borrowing and hiring after rates are lowered.  Likewise, when the economy has a good head os steam it takes tome for the wheels to grind to a halt.  Currently, the Federal Reserve set rates at near zero in 2008 and has been waiting for the economy to pick up.  This time, however, worries by banks — perhaps because of the lashing they took last time and the effect of contracts being ignored — have caused a longer delay than normal.  Time will only tell if this situation will right itself, or if we will see a strange situation like the Japanese did during the lost decade.  There rates were at zero, but the economy did not pick up. 

It would not be wise to fight the Fed, however.  These low rates and the amount of money the Fed is pumping into the markets needs to have an effect at some point.  If inflation picks up, however, they may be forced to raise rates even without a recovery.  Let’s hope that isn’t the case.

How Stock Price is Determined– Yield and PE Ratio

An old joke on Wall Street is that a famous investor was asked what he thought stock prices would do in the near term.  His answer was that they would “fluctuate.” 

The truth is, no one can accurately predict what stock prices will do over any given day or week.  In the rare times that one knows the market will rise (such as eternal peace has been declared) or will fall (such as when a major scandal happens), while one may be able to predict the rise or fall, one cannot take advantage of this information.  By the next time stocks trade they will start out at the higher or lower price.  Think about it — if you found out that your house was sitting on a mountain of gold, you wouldn’t still sell your house for 5% more than you paid for it, you would sell it for the value of the gold.  Likewise, the investor who owns the stock you want to buy will sell his stock at a price that factors in the earnings surprise or other news, not at the price before the news was released.

There is a theory that says that stocks (and other assets) are ideally priced at all times, such that any news that has been reported is instantly factored into the price.  For those who know the laws of heat conduction, the equations likewise predict that if you apply a torch to the end of a long steel rod in New Mexico  the increase in temperature will instantly be felt everywhere, even if the other end is in New York.  Of course this is not actually the case, but the heat applied will be felt everywhere it really matter very quickly.  In stocks, while there are sometimes some pricing discrepancies, most of the news that exists is very quickly priced into stocks.   There is no blue light specials.

Note however that the news is filtered through investors perceptions of what it will mean to future earnings.  And why do earnings matter?  Because the more a stock earns, the more the potential dividend the company can pay.  Because companies will be expected to eventually start paying dividends, stocks rise and fall based upon the size of the dividend the company will be able to pay, even if it does not yet pay a dividend.  An investor who owns shares of a company that he paid $1000 for that pays a $100 dividend each year will make a 10% return on his investment from the dividends alone.  If bank accounts are paying 8%, where an investor takes almost no risk, the price of the stock will probably fall until the effective dividend is perhaps 12% since the investor in the stock takes more of a risk than the investor in the bank account. 

Now as I’ve said, investors use news and history to predict not what the dividend yield is, but what it will be in making their decision of what to pay for shares of a stock.  If a copmpany is making earnings of $4.00 per share, once it stops growing and buying new equipment and properties, it can be expected to start paying about a $4.00 per share dividend.  The price will then move up to the point where the yield (defined as the dividend divided by the share price) is considered reasonable.  “Reasonable” is based on various factors, including how safe the dividend is (if a company’s earnings are always changing, such that the dividend may be cut, the stock will be priced less), what dividend other companies at the same level of risk are paying, and what the yields of other investments such as bank accounts and real estate are paying.

Because the potential yield is based on the earnings, and because the price will move up or down based on the potential yield, the ratio of the price divided by the earnings, or “PE ratio,” is a commonly used factor to determine the relative price of a stock.  If the price is high compared with the earnings, such that the PE ratio is high relative to that of other stocks, then investors expect the earnings to grow faster than the market in general, such that the eventual dividend will justify the higher price paid. 

Because the relative risk level, as measured by the predictability of earnings, as well as the potential for earnings growth is relatively equal for companies in the same industry, the PE ratio of competitors will normally be about the same.  For example, Coke and Pepsi will have about the same PE ratio.  In addition, companies in one sector may have different average PE ratios than companies in another sector.  For example, companies that sell computers may have a higher PE ratio than mining companies.  This is because technology companies are growing rapidly at this time, so future earnings can be expected to grow more rapidly for computer companies than for mining companies. 

Also, there may be one company in an industry that has a higher PE ratio than its peers.  This is called “selling at a premium,” and usually indicates that investors expect that company to grow faster than its peers and take market share away.  This is sometimes called “best in breed.”  Companies that hold that position are not a bad investment to make.  An example was Microsoft in its hay day.  The trick though is to know when to get out, since when earnings stop growing faster than the sector norm the price normally falls to cause the PE ratio to fall to the sector average rather than the price holding still as earnings increase.

Like what you’re reading? Keep the blog going – Refer a friend – http://smallivy.wordpress.com

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.