Lesson Learned in 2008

2008 has been an incredible year for a number of reasons. The main lesson learned during this year has been the importance of financial stewardship. Stewardship of whatever resources that we have been blessed with.

What does stewardship mean? This year when things became rather uncertain in a very quick period, people who were leveraged with significant debt became stressed. Here are some examples of financial stewardship.

1. Spending less than your income on a monthly basis.
2. Only having debt on an asset like a home not on a car. Understanding an asset is something that grows in value.
3. Not having a loan on a liability. Something that shrinks in value is really a liability. If you pay interest on a loan for something that is shrinking in value it is throwing good money after bad.
4. Paying off the credit card balance every month.
5. Living on 80%.
6. Tithing 10%.
7. Saving 10% for the future.
8. Having an emergency fund, cash equal 3 months income.

Have a Merry Christmas!!!

A Stock Valuation Model

Different valuation models exist for a stock. One model is the Constant Growth Dividend Discount Model. This model works for a stock that is constantly growing its dividend. Not sure this applies to very many stocks. Here is the model and let's see what we can learn.

Valuation = Dividend Payout/(Risk Adjusted Interest Rate - Dividend Growth Rate)

We can make the model more applicable for most stocks by substituting Earnings for Dividend Payout and Earnings for Dividend.

What can we learn from this model?

• Valuations increase as the numerator, top, of the equation increases.
• Valuations increase as the denominator, bottom, of the equation decreases. The key is the difference in values between the interest rate and the growth rate.

How do valuations increase?

• As earnings grow because it decreases the denominator at a given interest rate.
• As the interest rate decreases because it decreases the denominator at a given earnings growth rate.

How do valuations decrease?

• As earnings decline because it increases the denominator at a given interest rate.
• As interest rates increase because it increases the denominator at a given earnings growth rate.

Let's look at the stock market at a peak. Typically, the Fed has raised interest rates to slow the economy. As the economy slows the growth rate declines. The higher interest rate and lower growth rate mean that the stock valuation declines perhaps at a rapid rate.

Let's look at the stock market at a peak. Typically, the Fed has reduced interest rates to grow the economy. As the economy grows the growth rate increases. The lower interest rate and higher growth rate mean that the stock valuation grows perhaps at a rapid rate.

Right now the interest rate is very low, below normal, and the growth rate is negative. Valuations change when the growth rate stabilizes and even grows. A math exercise: If the interest rate is 1% and the growth rate is -4% the denominator is 5%. If the growth rate goes to 0% and the interest rate is a value of 1% this means that valuation would 5 times higher.

The bottom line is at a market top or bottom, stock valuations can drop or raise at a faster rate than normal. This means that when the stock market recovers, which it will do eventually, valuations will increase at a rate much faster than normal.

US Stock Market and Inverted Yield Curve

A previous blog stated that an inverted bond yield curve was a good indicator of a recession and when it occurs it means that it is time to switch from stocks to bonds. The below article from Wikipedia explains it.

Inverted Yield Curve

An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.
Partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than the 30-year Treasuries do. An inverted yield curve is sometimes referred to as a "negative yield curve".

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in 2000 just before the U.S. equity markets collapsed. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down.
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To explain further, normally a longer maturity bond has a higher rate due to inflation and to compensate for risk in holding it for a longer period. When the curve changes shape from normal to inverted this is a very bad sign for the stock market and it is time to move to bonds.

2000 US Stock Market Crash

The previous blog showed that for the most recent stock market crash the Fed funds rate was a good indicator. Let's look at the previous crash in 2000. The below table has the date the Fed took action and the resulting rate.

Date/ Fed Funds Rate
February 2, 2000 / 5.75
March 21, 2000 / 6.00
May 16, 2000 / 6.50
January 3, 2001 / 6.00
January 31, 2001 / 5.50
March 20, 2001 / 5.00
April 18, 2001 / 4.50
May 15, 2001 / 4.00
June 27, 2001 / 3.75
August 21, 2001 / 3.50
September 17, 2001 / 3.00
October 2, 2001 / 2.50
November 6, 2001 / 2.00
December 11, 2001 / 1.75
November 6, 2002 / 1.25
June 25, 2003 / 1.00

Note the rate was well above the 3% target rate and the change on May 2000 as an indicator. Also it took 3 years to get to the lowest rate of 1.00% about 3 times longer than the current crisis which indicates that this crisis is unprecedented in speed.

US Stock Market & Fed Funds Rate

The previous blog stated that the Fed funds rate was a good indicator for the US stock market. The below table shows the date that Fed changed the rate and the new rate. Note that the rate was well above the 3% target.

If you remember that the stock market reached a high on October 10, 2007. If money had been moved from stocks to bonds the stock market crash would have been avoided.

Date / Fed Funds Rate

September 18, 2007 / 4.75%
October 31, 2007 / 4.50%
December 11, 2007 / 4.25%
January 22, 2008 / 3.50%
January 30, 2008 / 3.00%
March 18, 2008 / 2.25%
April 30, 2008 / 2.00%
October 8, 2008 / 1.50%

Bottom Line: The stock market and Fed funds rate do not move perfectly together. Acting on the change of the Fed funds rate is very important as it is a very powerful signal.

US Stock Market & Fed Funds Rate

The Federal Reserve controls an interest rate called the Fed Funds Rate. What does it mean for the US Stock Market when the rate goes up or down?

An objective of the Fed is to control the growth rate of the economy, aka the rate of inflation. Typically this inflation rate is about 3% per year. Having inflation significantly above or below this rate is bad for the long term health of the economy. Deflation, something that we are seeing now, is viewed as especially bad for the US stock market.

When the Fed increases this rate it means that economy is growing faster than the 3% target. Conversely, when the Fed decreases this rate it means that the economy is not growing as fast as the 3% target.

The US stock market grows as the economy grows. A direct link exists between the performance of the economy and the stock market. From a macroeconomic perspective, a growing economy would result in growth for the publicly traded companies. This means that as the Fed funds rate is increasing the stock market should do well. Conversely, as the Fed funds rate is decreasing the stock market should do poorly.

The Fed funds rate is essentially an indicator of the direction of the stock market. It is important to watch the Fed funds rate, especially when it gets above the target 3% rate.

In 2000 and 2007 when the Fed funds rate were well above 3% the stock market was doing well. When the Fed lowered the rate, indicating a slowdown in the economy, it would have been wise to have moved most of the money from the stock market and put it in bonds. Also, an inverted bond yield curve condition existed in both time periods.

Did I move my money stocks to bonds in 2000 and 2007? No, I did not and it cost me lots of money. Will I make this same mistake again? Never again, I will not make this mistake a 3rd time.

Why didn't I make the move? Partially, it was due to listening to the experts who have jobs to write articles to make money for publications. Partially, it was due to a bad model that I was taught that showed the stock value increase as the interest rates decrease.

The higher the deviation from the Fed funds rate the larger the move with the rate changes. When the Fed begins to raise this rate, which will occur in the future, this is a very positive indicator for the stock market.

The bottom line: Do not listen the experts and watch for changes in the Fed funds rate. As it is going up be heavier in stocks for your long term investments and as it is going down be heavier in bonds for your long term investments.