8/15/2013 6:30 PM ET|
Fed tapering: What investors need to know
When the Federal Reserve winds down its monetary easing and interest rates normalize, it will change absolutely everything in the markets.
In October 2007, just before the crash, the stock market put on one last surge to new highs. Even though it was clear there were icebergs all around -- and indeed several ships were already taking on water and listing heavily -- the participants in the market decided to party One Last Time.
My excellent friend Peter Bennett, a money manager in London who has called most of the big market moves over the past 15 years, sent a missive to his clients with a powerful one-word headline: "Farce."
Well, here we are again. I am not so bold as to predict what is going to happen over the next few months, but the situation on Wall Street brings that word to mind yet again.
In the past two months bonds have slumped, long-term interest rates have surged, and yet the Dow Jones Industrial Average ($INDU) and the Standard & Poor's 500 Index ($INX) have been hitting new highs.
I don't offer crystal-ball gazing, hocus-pocus or any other associated magic or marketing shtick. I can only offer some basic math, basic common sense (I hope) and the perspective of someone who's first discipline was neither management nor science but history.
In a nutshell: Federal Reserve "tapering" -- the winding down of "quantitative easing," and the normalization of interest rates -- changes absolutely everything in the markets.
The bond markets already know this. The stock market doesn't. Investors need to understand the math. Most of them don't, and Wall Street isn't going to tell them.
So let's do the numbers, shall we?
As recently as May, as a result of the policies of the Federal Reserve, the basic interest rate which underpins financial markets -- the interest rate on the 10-year Treasury note -- was as low as 1.6%. Today it's already risen to 2.7%. Furthermore, history says the interest rate has typically fluctuated around 2% above inflation. Over time, that's what people who've been willing to own 10-year Treasury bonds have expected as an average return on their money. As the bond market currently predicts inflation of about 2.5% over the next decade, we can estimate that when the Fed stops rigging interest rates and they go completely back to normal, the rate on the 10-year would probably be around 4.5%.
Now let's look at what that means for stocks.
When you buy shares in the stock market, you are purchasing the right to a stream of dividends stretching out into the far distant future (forever, at least in theory). You're buying the right to all those lovely dividends from ExxonMobil (XOM) and General Electric (GE) and Wal-Mart (WMT) and Coca-Cola (KO) and Procter & Gamble (PG) and so on. Although you won't claim those dividends forever, because you aren't immortal, you can claim them for as long as you like. And when you no longer want any more you can sell the stock, with its claim on all the subsequent dividends, to someone else. And so on.
Imagine a share of stock that will pay you $100 in dividends every year for the next, say, 100 years. How much is that worth in today's money? How much would you pay for that stock? To know the value, you have to apply a relevant "discount rate" -- in layman's terms, and with some oversimplification, you have to know what interest rate you could get on the money if you didn't buy the stock.
In May, you knew you could earn 1.6% a year, at least for the next 10 years, if you left your money in 10-year Treasury notes. Applying a 1.6% discount rate to our stream of $100 dividends produces a value of $4,972. In other words, that's how much that theoretical stock would be worth, in today's money, if we use a discount rate of 1.6%.
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I thought it said "tampering" and not "tapering".
Then I remembered we don't live in a free society. Tampering is not news.
"AND WHEN THE WALL STREET CROWD STARTS THROWING A HISSY FIT AND TANKS THE DOW 5000 POINTS THE FED WILL STEP IN"
Bet not. How many investors will rely on the age-old routine of buying on the dip from today's significant losses? Anybody know who sold? It wasn't Wall Street, it was 401K and retirement investors. The fewer the players as QE tapers, the bigger the losses. A 5,000 point loss isn't going to halted by the SEC or bailed by the Fed because both are seeking to keep the Dollar viable. The markets are fully dysfunctional to the economy and the Dollar right now. I suspect the aftermath of today's losses is a mild positive but next week will be much like this one.
how about the 4 trillion the feds have written in the last 4 years. where are the jobs where is anything except the rich got richer taxes up to pay for the Q1 2 3 if this guy writes a story put in all the facts not what looks good. gas and food up wages down where in he== did we the american people gain from any of this oh yes are 401k is back even to where it was 4 years ago . so the 120 thousand i lost back then. i now have back how much would that 120 been worth today if i had been able to get it out and say put into GE stock what would it be worth today but my money was in a 401k and could not sell . people forget that when it was falling if you had a 401k you could only move 5000 a day we had a limit. independent investors could sell as much as they wanted the 401k is how the government is going to turn us into a socialist country they have control of your money next the constitution god guns health care its all happing just read the writing on the wall
The Devil in the Detail will be just how normalized, interest rates will be. That will be the near term Canary in the Coal Mine. Ultiimately, how the World figures out how to deal with 500-700 in Scam Derivatives across the Globe will be a far bigger factor in where we move from here. If Companies finally figure out that paying more folks a living wage will create a far more stable economy, that will be another huge factor moving forward. You Reap what you Sow.
This article is simplistic and confuses stocks with bonds. You cannot apply simple interest rate formulas to predict what a stock is worth, regardless of whether or not it pays dividends. The objective of any legitimate business is to make money, more of it every year. It does that by growing it's business, improving its ROI, and returning value to shareholders in terms of both growth and income. Therefore, a large portion of a stock's current price reflects future expectations.
Dividends are the frosting on the cake; using this article's formula, Apple would be worth $200 or so.
Personally, I feel we are on the cusp of a major growth phase in our economy that may last decades. The only thing holding back the trillions of $ in retained corporate earnings is uncertainty over the direction of policy from the dimwits in Washington.
Since the financial crisis started, our national debt has increased by $6T and FED reserve has added over $3T to its balance sheet by printing the money and handing it out with asset purchases. The stock market has increased in valuation by roughly $6T-$7T, what happened to the other $2T-$3T government and FED handed out? Did we gave that away to foreign countries as profit by consuming imported good and services? You do the math and figure out how we are going to pay the debt or what should be the real value of equity and assets, rather than what stock market represents? We are captured in a hot air balloon, FED is supplying $85 B per month fuel to keep it airborne, it would not sustain flight, once the fuel is cut off!
For God's sakes man. Did I miss something. Did I just come out of a coma and Fox News bought MSNBC. Don't tell your IPOD surfing Obama/Biden voting public the truth. They can't handle the truth. Next thing you know you will tell them how the FDIC works. Every Government pensioner 401K toting retireree wannabe thinks they are insured for $250,000.00. And they have been since the great depression. Because only a few banks and savings and loans have have got caught with their hand in the cookie jar. But when this market collapses and they all fail??????? It will be too late to read the 600 page FDIC legislation fiasco (i.e. Obamacare). Oh God! I hope I didn't frighten anyone. Come to Tejas boys we'll put you to work. Only thing is you will really have to work. No free I phones healthcare and food stamps here. You will make money the old fashion way. You'll earn It. YehAAAAAAaaaaaaaaaaa!
dividends stretching out into the far distant future
You could not make a more fallacious statement. Dividends are only paid out when the company is doing WELL, and there's no guarantee you'll have solid performance in just a few years, never mind a 'far distant future'. Companies cut dividends all the time. Had you invested in dividend paying GM up to 2008 and reinvested the dividends, guess how much money you'd have now. $0. That's right. The old GM shares went away, leaving the investors with zip and the NEW GM share after reorg are what people are trading now.
Yes, a dividend paying share is a less risky investment, in general, than one that doesn't. You STILL have to stay on top of things, like anything else.
Remember folks, the return ON your principle isn't as important as the return OF your principle.
Agree with the author, the Fed's artificial propping up of the market by buying 85B of bonds each month will cause the stock market to go down dramatically by 30-50% when QE quits.
as always, over the long run, the market will adjust to the new economy without the Fed money.
I would recommend holding long like Buffett.
Your investment will gain appreciation over the long run of the next few years.
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