Saturday, March 28, 2009

Federal Reserve, Bonds, and Mortgate Rates

This week the Federal Reserve started buying long term treasury bonds in an effort to lower mortgage rates and provide stimulus to the economy by having home owners refinance mortgages and have a lower monthly mortgage payment. The strategy is to create more demand for these bonds and increase the price of these bonds which would lower the interest rate. This strategy did not work and provides a good indicator for an investor. Let me explain this in more detail.

First, mortgage rates are linked to treasury bond rates in the following manner. For example, Wells Fargo offers a 15 year mortgage at a 4.625% interest rate to anyone who qualifies. They buy the amount of 15 year treasury bonds in proportion to the amount of the mortgage at a much lower rate, currently about 3%. Money is made by Wells Fargo on the interest rate spread of 1.625%.

Second, interest rates and bond prices on long term bonds go in the opposite direction. The reason is that a bond is purchased at a lower initial purchase price than the value of the bond and full value is achieved when the bond is held to maturity. For example, a 10 year bond with a value of $1,000 is purchased for about $500 and yields an interest rate of about 7%. If the price of the bond increases to $750 the resulting interest rate is about 3.5%. As the price of the bond goes up and down, and the investor gets the resulting lower or higher interest rate.

Third, from a supply and demand perspective the price of anything goes up as demand goes up or supply goes down. Conversely, the price of anything goes down as demand goes down or supply goes up. As we know from the previous paragraph, as demand for bonds goes up the purchase price goes up resulting in a lower interest rate.

This week the Federal Reserve started buying $300 Billion worth of long term bonds in the open market. Since no additional bonds were issued, the price of the bonds should have gone up lowering the resulting interest rates. What actually happened was exactly the opposite, the price of the bonds dropped resulting in increasing interest rates.

What this means is that more investors are selling their bonds than being bought by the Federal Reserve. When investors start selling long term bonds it is an indicator of future inflation and higher interest rates. As an investor, you do not want to follow the direction of US government, you do not want to own long term bonds.

When interest rates are going up it is positive for investors who purchase short term bonds or stocks. A risk averse investor would purchase CDs or Money Market funds. A risk taking investor would purchase stock. An investor can do better by watching interest rates rather than financial experts on TV.

Sunday, March 22, 2009

Financial March Madness

NCAA Basketball March Madness is underway and going strong. I think the Financial March Madness that occurred this week is even more dramatic.

Here are some of the events:

1) The Congressional Budget Office calculates that the budget deficit will reach $1.85 Trillion this year, yes in 1 year.
2) AIG bonuses were paid worth $165 million, absolutely crazy.
3) The reason AIG executive bonuses get the money is because of a last minute change to the Stimulus Bill drafted by the Treasury Department and agreed to by the Senate Banking Committee, especially Senator Chris Dodd. The House, Senate, and President then approved the bill without properly reading it, since it exceeded 1000 pages in length, even crazier. Quality of legislation is much better than quantity.
4) As any good politician would do in response to public outrage, attempt to place the blame on others. Congress rapidly drafted and passed legislation aimed at AIG, having a tax rate of 90%, without knowing the ramifications of the legislation, even crazier.
5) Former Merrill Lynch executives get $3.5 Billion in bonuses, 20 times greater, without outrage.

It would have been a lot better if our leaders would have written a very short Stimulus Bill giving each citizen $2,600. The AIG bonuses would have been avoided and each of us would have enjoyed spending the money. Instead, newspaper stories exist of how our money is being spent on projects, decided by local politicians, such as on the street outside of Lowes Motor Speedway.

In all of this craziness something WONDERFUL happened, The Federal Reserve agreed to purchase $300 Billion in Long Term Treasury Bonds. This will keep the lid on lower mortgage rates and should reduce rates even further creating a great opportunity to refinance mortgages saving you money. You need to prepare to refinance your mortgage especially if your rate is greater than 5.5%.

These actions taken by the Federal Reserve this week is another positive step in the economic recovery process. This reduces the risk of loss by investing in the US stock market. Next week other positive steps will be taken aimed at the credit crisis and the handling of toxic assets on the balance sheets of financial institutions. This future action makes buying stock in financial institutions much less risky.

If you did not get money directly from the Stimulus Bill, you can get it second handedly by investing in the stock market. As our economy improves, stock prices will improve giving investors capital gains. Bottom Line: NOW is a great time to invest. Contact me if you want help with investing.

Monday, March 16, 2009

Buying Opportunity in Stocks

Topic: Wonderful Buying Opportunity for Longer Term Investors in the US and International Stock Markets

Last week’s newsletter covered the topic of Irrational Pessimism where investors were acting in an irrationally pessimistic manner to some investment options, such as the stock market. The stock market rebounded about 10% during the week and was higher on 4 consecutive days.
Financial experts on the news channels continue to be rather pessimistic. The current topic being debated is the question was last week’s low in the stock market really the bottom? Having these experts being pessimistic creates a wonderful opportunity for longer term investors in the stock market.

The stock market moves with the growth in the US and global economy rather than the opinion of the financial experts. The best indicators are economic data, the price of commodities, especially copper, and interest rates. Economic data indicates that the economy has changed from a severe contraction to approaching neutral. Commodity prices have begun to rise and copper prices having risen appreciably during the last 3 months also suggesting that the economy has improved. Interest rates have also increased during the last 3 months.
In this economic environment what are the most important things to do in order of importance? First, eliminate revolving credit card debt and get rid of this obligation that has an interest rate of about 20%. Second, refinance your home at a lower interest rate, if the rate is over 5.5%, to improve monthly cash flow. Third, payoff any loans on a liability like a car since it is throwing good money after something that is going down in value. Finally, continue to contribute to a retirement plan.

If you have a short term time horizon or are an extremely risk averse investor continue to put money in a money market account or certificate of deposit. A money market at Fidelity is currently yielding about 3%.

A longer term investor should maintain investments in the stock market and continue to make contributions primarily through mutual funds rather than picking an individual stock. An individual stocks carries considerably more risk than a mutual fund.

Things to avoid buying right now: Gold, Long Term Bonds, and Real Estate Investment Trusts. Each of these options will be covered in future blogs.

Wednesday, March 11, 2009

Irrational Pessimism

A new financial term has just arrived, irrational pessimism. About 12 years ago, Alan Greenspan former Federal Reserve Board Chairman, proclaimed that the stock price was too high and called it irrational exuberance. Now that stock prices have returned to levels not seen for 12 years the opposite term has been coined, irrational pessimism.

The meaning of the phrase is that by using a valuation model the current level of stock prices are too low. It could also mean that people are listening to the news media who are getting ratings by publishing only negative financial information. Make no mistake, a lot of negative financial information exists and bad news is good business for the news media. Some better than expected news this week that got little air time included higher retail sales and higher consumer credit usage. Some of the recent economic data suggests that some parts of the economy have begun to improve.

Two issues remain, consumer credit for large ticket items and toxic assets. Currently, the consumer credit fix is the Federal Reserve TALF program that just started this week. This should greatly improve consumer credit in the future. For toxic assets, the much discussed mark to market rule is a major contributor in creating them and this rule needs to change. Next week, this rule is scheduled to be debated in Congress and the hope is that someone gives them good advice and this rule is changed.

Since 1926, the stock market has never corrected more than once in any decade, let alone during the same presidency. The stock market correction for this recession is worse than any other recession. We are unfortunately watching history being made. It is not possible to know when the stock market will reach a bottom, even if people are acting with irrational pessimism. It is important to keep your focus on the important things of life like faith and family during this very turbulent time.

Tuesday, March 3, 2009

New Direction - President Obama

President Obama has been true to his word in keeping his campaign promises. He has got to be the most honest politician in our nation's history. He has put us on the path to social and cultural change surpassing anything in the history of our country. Simultaneously, we are funding numerous initiatives including universal health coverage, alternative energy, expansion of broadband communication, and modernization of the electric grid to name a few.

He is redistributing wealth from Wall Street to Main Street giving tax cuts while raising taxes, it sounds like Robin Hood. We are funding banks, beyond the role of the Federal Reserve, and taking ownership positions in banks without calling it nationalization, very strange. We are projecting a record national deficit of about $1.75 Trillion, more than an entire recent national budget, and in the same breath talk about reducing the national deficit in half to a level that would still be a previous record amount. It sure sounds like we are trying to solve problems using modern math.

What does all of this mean? We are headed down the same path as many European countries. Not all of this change is good or bad. The most important thing to do is to understand it. I will keep you informed as more details are made public and give insight on how to take advantage of the change. From a personal finance perspective, how we handle health insurance coverage and estate taxes will be very important. From a investing perspective, selecting the company that is the leader in each sector and investing in only them will become important.

The world's most famous investor is Warren Buffet who lives in Omaha, Nebraska. His nickname is the Oracle from Omaha. You probably have seen him on TV and read about him. During this economic mess, the stock price of his investment company, Berkshire Hathaway, has lost about 1/2 of its value. If your investment portfolio has lost less than 1/2 of its value from the peak in 2007 until now you are doing better than Warren Buffet.

I am sure that all of you are doing better than the smart and wealthy investors who trusted money to Bernie Madoff. Count your blessings, every economic decline is followed by an economic recovery.