billroper | A Brief Primer on the Markets

Well, the Dow Jones has just dropped 10% across the last two days following the election. I heard the financial reporter on WBBM-AM this morning saying that it was because people thought that Obama would not be in office soon enough to implement his economic plan. Now, that's fascinating logic. I could equally easily say that it's because the markets recognize that Obama will soon be in office to implement his economic plan which has included things like raising the capital gains tax rate in the interest of fairness, regardless of its impact on government revenues. (That may or may not be part of his economic plan now, as these things are subject to change.)

But that would be equally specious reasoning. In the short run, it's not necessarily easy to figure out why the market is doing a particular thing, only that it is doing it and that it reflects some belief that the value of the shares traded is either higher or lower than it was before. And you need to recognize that there is a buyer and a seller in each of these transactions, so for everyone who is deciding to sell a share at a given price, there's someone else who is willing to buy it.

I used to work with a fellow named Gregg Jarrell, who had been the chief economist at the SEC. He was, in a masterpiece of timing, scheduled to give a speech the day after Black Monday back in 1987 when the stock market shed about 22% of its value in one day.

Gregg stepped to the podium and said two words: "Efficient markets."

He brought down the house.

See, here's the thing you need to remember. The markets set prices efficiently in the long run. From day to day, they're as subject to irrational behavior as, well, any one of us are as individuals. They're also subject to short run manipulation. You may have missed the story the other day where Volkswagen was briefly the largest company in the world by market capitalization. It turns out that a lot of people had shorted the stock figuring "It's an automaker. They're going down." They then got squeezed by a run up in the underlying stock and lost their shirts, because they had to be able to get shares in order to get the heck out of their short positions.

It turns out that Porsche managed to get control of enough of VW's shares that there were twice as many shares shorted as were actually available in the market. Oops. Poor short sellers.

It's not enough to be right. You've got to have enough cash to ride out those periods in the market when everyone else is convinced that you're wrong.

Take, for another example, oil prices. I frequently said that I thought that oil was unsustainably high and that I thought the natural price was somewhere around $70 a barrel. Now, admittedly we've had some really lousy economic news that's helped drive the price down, but look at where we're hanging right now. $60.77 a barrel. Down from $147 a barrel. Boy, I could have made a fortune.

If I'd only known when I was going to be right. We were never really that short on oil, but we were certainly getting squeezed. We're not that long on oil right now either, but the squeeze is done. For now.

Sure, I could have made a bet in the commodities market that oil was going down at any time. But could I make a bet that was timed correctly? Not without getting lucky.

Trying to time the market is a good way to lose money. If you sell stocks when the market is going down, you might miss the bottom of the market, which would be good. You also might miss the recovery. This is why, should you have a stack of money to invest (Right now? Have a stack of money? What'd you do, win the lottery?), the best thing to do is to invest some of it now, and some of it six months from now, and some more of it a year from now, and so on. You might miss some gains going up, but you're also unlikely to put all of it in at the top of the market, which would suck a whole lot.

In the long run, the best place to put money is into equities. This assumes that you're investing for the long run, because -- in the short run! -- you can lose a lot of money. But if you have the time to wait it out, you'll on average be better off by buying stocks than by keeping your money in the bank.

This is why investment planners tell you to reduce the amount of equities in your retirement accounts as you approach retirement age. If you're going to need the money soon, equities are not a safe place to be. You want the money in something more stable.

The risk of an investment is related (in at least one dimension) to how much the return on that investment tends to fluctuate in the short run. If you're willing to absorb more risk, you can get a higher long run return.

You just have to be sure that you can survive until the long run arrives. Because, to quote Keynes, "In the long run, we are all dead."

So if you have the chance to do so, keep putting money away in your retirement plan. And if you've got a good bit of time until you retire, put it in equities.

That's what I'm still doing. And it's what I've done with Katie and Julie's college funds.

That's my money going where my mouth is.

Flat | Top-Level Comments Only

From:

stevemb.livejournal.com

"I heard the financial reporter on WBBM-AM this morning saying that it was because people thought that Obama would not be in office soon enough to implement his economic plan."

A financial reporter who doesn't understand that markets don't suddenly react to long-anticipated events is like a sports reporter who doesn't remember how many strikes it takes to put a batter out. Sheesh.

From:

wyld-dandelyon.livejournal.com

I must admit that people DO react to long-anticipated events.

Now, the mysterious formula whereby the financial analysts say this or that specific reaction to a general event caused the specific actions to a portion or all of the market-- often these analyses are as mysterious to me as how the news people manage to correctly call (almost every time) the elections they do "project", even in cases where less than 1% of the votes have been tallied.

Not that I couldn't understand, but they don't report enough of the actual data for me to know if there really is a factual basis for an educated analysis leading to a conclusion, enough for a reasonable educated guess by someone very familiar with that type of data, or whether what they're saying is just their highly-paid seat-of-the-pants opinion.

From:

jdonat.livejournal.com

My 401k has lost a bunch in the last quarter.. I'm not retiring soon, so it's just a blip.
Until you need it, it really doesn't matter that much. I'm increasing my percentage into my 401k and Fujitsu is also increasing their match. Rare, in these times.

As far as the capital gains tax goes -from 15% to 20 isn't bad... and I don't know about you, but I don't 'have' any capital gains right now. ;)

From:

drsulak.livejournal.com

The market is guessing cap gains will not be increased in 2009. Not that it will matter a whole lot :-)

From:

billroper

See below. I argue that it actually does matter.

From:

billroper

Well, yes, but it's the question of future capital gains that you have to look at. If you're invested in a 401(k) or IRA, that's immaterial, because those investments are going to be taxed as ordinary income when you make withdrawals at retirement. But for anything outside the IRA, it makes a difference.

Let's assume that the pre-tax return on the market is 8% (to pick a number out of the air). If the capital gains tax rate is 15%, then your net after-tax return is 6.8%. At a 20% rate, your after-tax return drops to 6.4%. That's enough of a difference that some marginal investments become less profitable. Companies have more difficulty raising equity capital (because the net rate of return on equity is lower), so the marginal projects don't get done. So you don't hire people to do those jobs on the marginal projects, which means the government collects neither income nor payroll taxes from the unemployed workers.

The question you have to ask yourself -- in an economic sense! -- is whether the country as a whole is better off by collecting a higher capital gains tax rate (which may or may not lead to higher net collections just on capital gains) or whether a lower capital gains tax rate encourages job creation enough to make it a net positive.

Or not. This sort of dynamic analysis is difficult, at best. And unfortunately, the impact of tax changes is analyzed by Congress using static scoring which assumes that there are no changes in behavior when rates change. We know that's not true.

And we also know that you can use dynamic analysis to overstate or understate the impact of a change in tax rates. But I submit it's more likely to be accurate than static analysis.

From:

jdonat.livejournal.com

So what you're (and most other folks who look at stuff like this) are saying is that it's a tossup whether raising the capital gains taxes back to pre 2000 levels is worth it at all. Makes sense. Just havent had a chance to look at it this way. And, if the economy keeps tanking, it becomes a nice thought exercise until stuff starts turning around. Given what I've been seeing, this argument about capital gains may be academic until 2010, or later, for most of us.
Makes me very happy that my job is fixing computers and not trying to make a living out of this.

From:

drsulak.livejournal.com

I suspect if you didn't know there was an election, you would be unable to tell anything about the election or who got elected. For a reporter to claim it's because someone was elected is dopey. The market is going to vacillate until folks are convinced a majority of the economic surprises are over.

And yes, keep investing for long term. The market is low now. That being said, nothing prevents it from going lower in the short or medium term. Or staying essentially flat for a couple years.

Me, I'm keeping my 401K contributions steady...

From:

singingpatient.livejournal.com

no one can time the market. dollar-cost averaging. simple, boring, it works.

From:

billroper

Yup.

From:

mia-mcdavid.livejournal.com

I realized with a start somewhere around the second week of the market collapse that our house must be highly unusual since we had neither discussed nor even considered selling our stocks. We're both ex-bankers.....

From:

orangemike.livejournal.com

Then you're not stupid enough to be mutual fund managers.

From:

grey-lady.livejournal.com

To be fair to *some* of the mutual fund managers, they've been forced into selling by people panicking and pulling their money out of mutual funds. And they've had to sell at a loss to be able to supply the cash.

From:

orangemike.livejournal.com

They should have been in cash sufficiently to allow for redemptions.

From:

billroper

I'm sure that they were in cash enough to allow for a normal level of redemptions. But keeping too much money in cash changes the fundamental nature of your mutual fund, because the asset mix (and your ability to manage it to move out of assets that perform poorly into better-performing assets, depending on the kind of fund you're in) is what investors are paying you to do as the mutual fund manager.

When you get an abnormal level of redemptions, you're going to end up selling stocks. That's how it works.

From:

orangemike.livejournal.com

I'm one of those surly contrarians who would have been in an ultra-short ETF, so that I could cash in THAT position to pay for redemptions. There are times when cash is the least foolish position.

From:

billroper

I'm not sure that would have helped, depending on whether I've correctly interpreted "ETF" in your post.

I do know that one of the contributing factors in the market meltdown was when the Lehman Brothers bankruptcy caused one of the companies that bought its commercial paper for the money market fund that it runs to "break the buck". The assets of a money market fund should never be less than $1.00. When they are, bad financial juju happens. And remember, money market funds are supposed to be "as good as cash" in terms of liquidity.

I have some money in one of the same company's government bond money market funds and I still can't get at it. This is a bit annoying, as I'd actually like to be buying equities with it right now...

From:

wick-deer.livejournal.com

I think that, when all the dust settles, one of the lessons from the market meltdown will be that the system as a whole had way too much leverage. People had gotten so wound up with "sophisticated" transactions, that they forgot the basics like assessing risk and being adequately capitalized for the risks that were being taken.

From:

madfilkentist

Commentators can always explain something after the fact. Give them an event which is totally contrary to what actually happened, and they'll come up with a logical explanation of why it had to happen.

From:

singingpatient.livejournal.com

it's been amusing watching analysts trying to explain the wild swings of late. some days, there are just no reasons for big drops- or big gains. In a time of extreme volatility, it's like trying to explain the every move of someone who's bipolar.

From:

patoadam

I'm concerned about the possibility of a long, L-shaped recovery. I went to cash in my IRA and 401(k) in July and August, 2007. See Sequoia Capital's opinion.

For those who haven't sold yet, is it too late? I don't know.

From:

weirdsister.livejournal.com

There has been talk amongst liberals in Congress about nationalizing 401ks. Have you heard anything about this, and what is your opinion?

From:

billroper

I did hear that. In my opinion, that would be insane. (Although I believe it would only apply to new contributions to your 401(k) plan. The existing balances wouldn't be touched. It's Argentina that appears to be nationalizing its workers' private retirement plans.)

As I recall (and some details may be inaccurate), you would make a mandatory contribution of 5% of your pay into an account held in your name. The government would contribute a certain amount of matching funds and would guarantee a 3% return in excess of inflation. On the face of it, that should sound good to people who are currently shellshocked by the decline in their retirement funds.

What it actually means, though, is that the government will take the money which would otherwise go into real assets (stocks and bonds), spend it now, and have to find a way to pay the promised benefits in the future when people retire.

Curiously enough, we already have a similar plan. It's called Social Security. And it appears to be heading toward a demographic disaster, because -- despite the fact that there is a "Trust Fund" -- the money has long since been spent by the government.

So this simply appears to me to be a bad way of increasing payroll taxes. I really doubt anyone would be stupid enough to enact such legislation, let alone sign it. I suspect that people -- once they understood the plan -- would have a fit.

But it is possible to underestimate the stupidity of Congress at any given moment. :)

From:

loriruadh.livejournal.com

Bill, I used to work for Social Security, and every dollar borrowed from the Trust Fund by any Federal Agency has been paid back. Those agencies were (and are) required to begin paying the money back the same way any business must repay a loan, and there is a strict repayment schedule. Nor can they borrow more money until the first is repaid.

What most people don't understand is that they don't have an account that's like a bank account, what you're banking is "quarters of coverage." You need forty quarters (ten years) paying into OASDI to retire.

What has kept things going is that for most of the history of Social Security we have had more people paying into it than receiving benefits. With the boomer generation retiring (and failing to meet the replacement level of previous generations*), the pendulum swings the other way because we will have more beneficiaries than workers.

But there is a simple solution that WILL keep Social Security solvent -- raising the "cap" on wages earned. The cut-off is around a $100k IIRC. What this means is if you make $100K or less a year, your OASDI or FICA tax will not increase. But if you make more than $100K it's going to go up if the cap is raised or done away with.

It was once assumed that the more affluent retirees would not file for Social Security -- bad assumption, did you know that Senator John McCain, with all his wealth, Federal salary, and military pension also collects Social Security Retirement Benefits? So, if everyone is filing for benefits, they should be paying their fair share while they're working.

*Boomers aren't reproducing at the rate their parents did.

From:

billroper

I understand that there are U.S. Government Treasury securities that are labeled as the "Social Security Trust Fund". What no one has been able to explain to me is how the existence of those securities changes how we will actually get a dollar to pay benefits when they are due.

Let's assume for a moment that the Federal budget was completely balanced, save for the fact that they owe me a Social Security check (at some hypothetical date when I'm retired and drawing Social Security). The money to pay for that check has to come from somewhere.

No problem! The government will liquidate part of the Trust Fund to pay the benefit. Except that doesn't actually generate a dollar to pay me with (assuming that they don't just go print a dollar which would have numerous bad effects), it simply makes an accounting adjustment on the Federal government's books. The actual dollar has to come from somewhere.

To generate a dollar to pay me with, the government has three choices:

Cut spending by a dollar

Raise taxes by a dollar

Issue a dollar of new debt

Ok, now run this thought experiment again, except assume that there's nothing in the government that's labeled "Trust Fund". To generate a dollar to pay me with, the government has the same three choices.

As far as raising the cap on wages, my understanding was that the reason that the cap existed is that benefits are also capped; thus, the amount of tax that you pay relates to the amount of benefits that you're allowed to receive. While we could remove that cap, it starts to convert Social Security from an earned-benefit program to something else. Historically, we've thought would be undesirable.

That could be subject to change.

From:

gundo.livejournal.com

One other thing that would help is if Social Security actually became a safety net...so that if you *are* an affluent retiree, you don't get it. Period. Doesn't matter if you pay in or not.

From:

billroper

I have long believed that if I had enough money so that I felt I was living comfortably in retirement, that the government would make sure that I wasn't getting a Social Security payment. I don't necessarily believe that's right, but that's how I'm planning my finances.

I know that many people who support the existing Social Security system believe that cutting off benefits to more affluent retirees will reduce the willingness of taxpayers to support the system, as they'll -- with some justification! -- believe that they will be next to be cut off when there's a budget problem.

From:

gundo.livejournal.com

We already have gradated taxes based on income...why not have gradated benefits based on income as well? That way those who actually *need* Social Security can have it.

I have a problem when people I know who are multi-millionaires brag about how they are now using the government for health insurance, and are using their SS checks for expensive dinners when there are people who really *need* that money.

From:

billroper

Well, we already do have one form of graduated Social Security benefit -- if you make more than a certain amount, then you pay tax on half of your benefit (the theory being that was your employer's contribution).

But, as I said, if the objective is to convert Social Security from a retirement plan to a welfare plan, then your approach makes sense. I'm not sure how much support there will be for it.

From:

gundo.livejournal.com

I think it already *is* a welfare plan to a large extent...being honest about it would be the best thing for the program as a whole.

From:

rmeidaking.livejournal.com

Right now, the vast majority of investors are just standing pat, and so there's quite a bit of volatility, but not much volume. People selling right now are either trying to lock in a "loss" position for the year, or they desperately need the money.

As Warren Buffet keeps pointing out, this is a good time to buy the quality stocks. The trick is in figuring out which ones *are* the quality stocks... Shearson Lehmann Bros. would have been recommended a year ago, after all.

From:

daddy-guido.livejournal.com

I once got advice from a guy who made huge money in investing.

He indicated that while you always look at the financials of a company to make sure they aren't being mismanaged, that the best criteria for buying stocks are:
1. Buy shares in companies whose products you use, like and respect.
2. buy shares in companies whose product or service is something you know a lot about.

I would add that diversified companies like GE are often good bets because they don't rely on a particular sector of the market to be successful.

From:

daddy-guido.livejournal.com

This brings to mind an interesting conversation I had a while ago. I was looking at a "play" account that i have - a sepIRA with a few thousand bucks in it. I use it to play crazy hunches, such that if I lose the whole fund, it doesn't really affect my life, because it's not worth pulling the money out with penalties and all, and it lets me do crazy market shit on a small scale.

Anyway, I tend to buy stocks that meet 2 criteria - 1. undervalued (IMHO) and 2. pay dividends like clockwork.

When looking at the numbers on the screen, and of course there was this huge line declining to the right. A co-worker wandered by and said "wow, you lost a lot of money"
"no, i haven't" i said. "but the line, and the numbers in red, etc" sputtered the co-worker.

"but I haven't lost anything IN REALITY" I said.
I then explained that although the market price on the shares I own are lower than when i bought them, i had no plans to sell them today, or anytime in the near future. This is because although the stock price is lower, the dividends being paid are roughly the same for most of the stocks. I then pointed out that by using the funds generated by the dividens, i could buy MORE shares of the stocks at these depressed levels, thus generating MORE dividends, and that eventually, left long enough, the shares would generate enough dividend income to pay for themselves.

Thus eventually, free shares of stock that continue to provide income, all in an account that doesn't tax me until/unless i sell the shares and withdraw the cash. Which cannot happen for at least 25 years. In point of fact, some of these shares are currently paying dividends generating as much as a 50% return at their current price, which means shares bought TODAY, assuming continuing dividends at the same rate, WILL PAY FOR THEMSELVES IN TWO FREAKIN YEARS.

The co-worker walked away muttering about crazy financial schemes. But for those of us who have a lot of time before retirement, and trhe means to do any kind of investing in tax deferred accounts.... this may someday look like the Golden Years in retrospect.

From: (Anonymous)

Perhaps it's time to give Social Security myths a rest, since the myth-makers are leaving office shortly. The notion that Social Security is headed for a "demographic meltdown" ignores the fact that the 1981 changes were put in place precisely because of Baby Boom demographics. What has happened since is that the gains from increased productivity have been distributed very unevenly through the economy. The median wage, after inflation, has stagnated.

There is no practical reason Social Security cannot be returned to long-term balance. Four years ago, the actuaries at SSA were busy vetting a number of plans from Congressmen and Senators. Several would work with roughly equal amounts of pain. One would have been to double the income cap on paying into the Trust Fund, skip the cost of living increase one year, then skip the annual increase again once in the next five years. The shortage seems to be in political will.

How the Trust Fund works is not mysterious. Saying its investment in Treasury bills "has long since been spent" is just stating the obvious. The entire national debt has long since been spent. So has the bond revenue for every highway and school building in sight. That does not make the holders of T-bills or municipal bonds think their investments are imaginary.

The notion that the money won't be repaid to SSA for disbursement assumes the United States will renege on its debt. Should that happen, there would be worse things to worry about.

The mechanism for investment of the Trust Fund is simple. SSA invests in Treasury securities that are almost the same as T-bills. The chief difference is that the securities held by the Trust Fund are never traded on the open market. Given the national debt is a certain size, the Treasury can either auction off T-bills, and pay interest to the market, or sell the special securities to the Trust Fund, and pay about the same amount of interest.

If Roper and the people born on the same date are paying in $1 million to Social Security, the Trust Fund buys that much more in Treasury securities this month, and the Treasury sells that much less in T-bills on the open market. Conversely, when Roper and those who share his birthday are due $1 million in benefits this month, the Trust Fund cashes in that amount of securities, and the Treasury sells that much more on the open market. The size of the national debt and the size of payments for debt service stay the same.

Someone could take the extreme position that all money these days is imaginary. Ron Paul and the gold bugs have gotten a lot of mileage out of that. Really, though, what is money but a shared, consensual hallucination? Should we not be putting our efforts into maintaining the illusion?

From:

billroper

And yet, Mr. Anonymous, you fail to answer the question that I posed elsewhere in this post. Or maybe you do. Reading your next to the last paragraph, it appears that the government finds itself in the same position whether the Trust Fund exists or not.

Which is what I said.

From: (Anonymous)

Bill, let's say that this morning you bought a 90-day T-bill for $997.20. When it matures next February 5, you decide to take the $1,000.00 and run. Where does the Treasury get that thousand dollars to pay you? The expected answer would be: about $997 from selling another T-bill to a different buyer, and about $3 from tax revenue. Of course, since the budget is running a deficit this year, the Treasury might have to sell $998 in 1.001 T-bills, and only get $2 from taxes. If, by some miracle, the current Federal budget deficit turns into a surprise surplus, the Treasury might only have to sell .999 T-bills to pay you, and get $4 from taxes. When the Trust Fund starts drawing down, the same choices will be available.

Looking at it another way, the Treasury can sell a variety of instruments to a variety of buyers. One buyer is another government account with a current surplus. When that surplus is drawn down, by cashing in Treasury securities, the Treasury will need to shift the mix of buyers of its debt, or pay down the debt, or both. Absent changes to Social Security, this is what will happen over roughly thirty years starting six years from now. Clear enough?

From:

billroper

I understand exactly.

What this means is that the position of the Treasury after making the payment is exactly the same as if there were no accounting entry on the Federal books labeled "Trust Fund".

Clear enough?