Monday, October 13, 2014

Gambler, Saver, or Investor ?

Are you a Gambler, Saver, or Investor?  The answer to that question is important yet a surprising number of people who participate in financial markets do not even know appropriate descriptions for each title.

A Gambler is someone who seeks to “make money” by placing “bets” based on speculation that their “guess” about the future is accurate. A Saver is someone who seeks to accumulate financial assets by spending less than their current income in order to fund future spending. A Saver expects that their financial assets will decline whenever they stop accumulating and begin spending more than their current income in the future. An Investor accumulates financial assets with the expectation that those assets will provide a future and rising income.

One complication is that sometimes Savers engage in gambling and sometimes Investors engage in the process of saving.  But, most people have a “preferred mindset” concerning money that defines them as being primarily a Gambler, Saver or Investor.

The study of Economics is really a social science studying aspects of human behavior.  And as an Economist, I believe that it is important for people to have an understanding of their “preferred mindset” concerning their activity as it relates to financial markets.  This “preferred mindset” will determine their emotional reaction to market fluctuation.

Keep in mind, market participants at any time include Gamblers, Savers and Investors.  Savers may not be directly participating, but since most Savers use bank accounts or insurance company products, they indirectly participate in markets through the activities of these intermediaries.  

When markets are rising, Gamblers are generally happy as most of their bets are winners. In addition, rising markets in a low interest rate environment attracts Savers seeking a higher rate of return.  Prolonged periods of rising market prices tend to generate overconfidence on the part of Gamblers and Savers.  They forget the Fundamental Law of Markets is that market prices fluctuate--UP and DOWN.

When markets decline and Gamblers begin to incur losses, they tend to try to protect their gains by “locking in” and selling.  When markets decline and Savers begin to incur losses, they tend to fear that the “climate has changed” and that the only place for “safety” is with bank deposits or insurance company products.

Investors see market declines from a different perspective.  For the same reason that people prefer good weather over bad weather—sunny days are generally more pleasant than rainy, stormy ones; Investors prefer rising markets.  What makes Investors different is that they understand that downward market fluctuations are “normal and necessary” and really are opportunities that improve the Investor’s chance of meeting their goal of future and rising income.  Investors are always potential buyers and buyers are always looking for a low price. 

Investors know that even when they are “taking income” for example while in retirement that some of their dividends will need to be “reinvested” requiring them to be buyers on almost a continuous basis.

I make no judgments as to the one title or activity being better or more  noble. There are many successful and rich Gamblers. (Although there are probably more Gamblers who lose than win.) And, if you can save enough that your future income requirements will be met, despite inflation; being a Saver provides a certain emotional comfort.  However, few can save enough to meet those future income requirements, inflation considered.

Savers  tend to seek “certainty”.  Yet funding “retirement” with a fixed savings program does not provide the “certainty” they seek.  Retirement comes with many uncertainties:  A) Lifespan; B) Income requirements given uncertain health---medical and long term care expenses; and C) Inflation.

Investors accept the reality and necessity of market fluctuation.  They realize that the present uncertainty of daily “market price” is more than offset by the probability of rising future income from “investing”. By being owners of a highly diversified portfolio of businesses they improve their chances of dealing with the future uncertainties of inflation and unknown living expenses.

It has been said that you can tell whether you are a Gambler, Saver or Investor by their emotional reaction to market fluctuations like we have seen during July-October 2014.  If the market fluctuations during the week of October 6, 2014 caused you to contemplate major liquidation so you can buy back later at a lower price, then you are probably a Gambler. If they made you feel uncomfortable, thinking that perhaps you should sell your investments and just put the money in the bank, then perhaps you are a Saver. If the recent fluctuation caused you to start thinking about what you might buy with cash you have been accumulating, then you are an Investor.

Remember that there is a big difference between those that predict market direction versus those that predict the timing of market direction.  If you think you can predict the timing of market direction, you are a Gambler. On the other hand, History has taught Investors to trust that the market direction for a portfolio of quality diversified portfolio of businesses is generally up over the "long term" of more than five year time horizons.

So, to an Investor, market fluctuations are seen as either a buying opportunity or simply the “cost of doing business”.  Everyone should be a Saver with some of their money, but for many people, being an Investor is the best way to prepare for the future.

If you are a Gambler, all I can say is “Good Luck” since I have no idea what markets are going to do tomorrow, next week, or next month. If you are a Saver, I suggest that you are underestimating the very real uncertainties of Lifespan, Health and Inflation---and suggest that you need much higher savings than you probably have accumulated---or you need to learn how to be an Investor.  As an Investor, I can say that as prices for good quality companies fall, they become increasingly more attractive to buy—hence the probability of you reaching your future income goals actually go up.

One important thing to note.  Increased use of computer software seems to have emboldened Gamblers to make bigger and bigger “bets”. This leads to the potential for an increased level of volatility and makes the market very dangerous for the small time Gambler. (On some days as much as 60% of the market volume is from Gamblers.)  It also makes the market very uncomfortable and perhaps inappropriate for the Saver.  For the Investor with the right patient and disciplined approach, this high volatility potentially creates substantially increased opportunity.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Monday, October 6, 2014

The Mystery of Sustained Low Interest Rates

The terms “HQLA” and “LCR” may be a bit wonky for the typical investor, but given the effects of these terms as they have been recently placed in banking regulations, they are important.

Interest rates are extremely important. They affect the value of almost every financial asset including stocks. It has long been acknowledged that short term interest rates can be influenced, if not controlled by the Federal Reserve and other Central Banks. But, up until recently, it was assumed that Central Banks could not affect longer term interest rates---the assumption was that “market forces” of supply and demand would determine long term interest rates.  

Even Central Banks and many famous economists have been puzzled and frustrated to some extent by the fact that falling interest rates since the 2009 financial crisis have not resulted in more economic expansion and growth.

The economic “law” of supply and demand has not been repealed. Interest rates are low because the price buyers are willing to pay for a given unit of debt obligation is high.  If a “buyer-lender” or “investor” is willing to pay $100 for the promise from a debtor to pay $4.00 per year in interest, the interest rate is 4%.  If however, buyer-lenders bid up the “price” to $400 for the same promise of $4.00 per year in interest, the interest rate is only 1%.  The only way that the price can go from $100 to $400 is for there to be increased demand and/or decreased supply for interest payments. So where is this increasing demand coming from?

For a while, the Federal Reserve itself became a buyer-lender with the introduction of Quantitative Easing. They bought Government Debt with IOU's created "out of thin air". But continued QE was politically unpopular.  So the massive increase in demand created by QE is coming to an end, at least in the US. 

To replace it, a more politically acceptable way to increase demand for the interest payments from the government was devised through implementation of regulations to “insure the financial stability of banks”.  These regulations were recently finalized with minimum standards for LCR or “Liquidity Coverage Ratio”. (Rules approved September 3, requiring 80% compliance by 1/1/2015 and full compliance by 2017.) The Liquidity Coverage Ratio regulations indicate that banks are required to have a certain level of holdings defined as HQLA or “High Quality Liquid Assets”.  The most acceptable form of debt meeting the definition for HQLA?  You guessed it….Government Debt.

A recent Bloomberg article indicates banks have added $180 Billion to their now historically high government debt holdings this year. One estimate indicates that Bank of America alone will have to add $65 Billion to their government debt holdings in the future to become fully compliant with the new regulations. 

Insuring the safety of bank deposits by requiring banks to buy government debt tends to produce low interest rates but it does not encourage any expansion in business activity. Increased savings by the public increases bank deposits and ramps up the requirement for banks to hold even more government debt.

To reverse this trend, given the current regulations, the public will need to borrow more and save less.  Borrowing more is unlikely because again, consistent with well intentioned goal of financial stability, lending standards have been tightened.  Saving less is also unlikely because people are so uncertain about the future.

Lowering interest rates as an economic policy has long been compared to pushing on a string. Economic expansion will require a dramatic change in the global population’s expectations regarding future economic opportunity and prosperity.
So on one hand, the government has been stimulating the economy…but on another hand it has been implementing policies to restrict credit…policies that restrain economic expansion.

Despite the probability that the Fed may raise short term interest rates in 2015, keep in mind that regulations to “insure the financial stability of banks” were put into place not just in the US, but around the world—particularly in Europe.  Interest rates in Europe and Japan are considerably lower than in the US.

Unless we see a substantial increase in “animal spirits” leading to both increased borrowing (hopefully for productive activity) and/or decreased savings, it is very possible that we will have low interest rates for a long time.  (Animal spirits is an economic term referring to people’s willingness to take risks because of an expected future economic boom.)  Of course, in such a low interest rate scenario, without such "animal spirits" we will have many banks where most of the depositor’s money is simply lent to the government.  This is a recipe for economic stagnation.

A far out possibility is that depositors tire of low interest rates and begin seeking alternatives to placing their money with banks subject to the LCR regulations--in other words with "investments" NOT subject to the LCR regs. We have actually seen a bit of this….increased demand and rising prices for dividend paying stocks.

Rising interest rates will only occur because of increased supply of interest payments (more borrowing) from borrowers and/or decreased demand for them (less lending/saving). (This is a bit counter-intuitive as popular opinion seems to assume that interest rates are low because banks are not lending. Interest rates are low because demand for interest payments from the largest borrowers, namely governments, is increasing.) $4 of annual interest would no longer fetch a price of $400. The price would need to fall perhaps back to the historical average of $100. (4% per year interest rate.)  One wonders whether the regulators considered that possibility as one can only imagine the economic effects if the value of HQLA held by banks declined significantly.

Keep in mind, more borrowing might be not because of “animal spirits” and increased productive activity, but rather because of increased borrowing by governments. Given the current situation with Social Security and Medicare, that is a distinct possibility.

So am I making a prediction?  No I am, not. There is a high probability that interest rates will stay low for longer than many expect.  But there is also a possibility that interest rates could rise significantly.  What I am warning about is a high degree of uncertainty regarding interest rates. And, where there is high uncertainty, caution is usually warranted. 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.