You’ve screened your stocks both fundamentally and technically. You been diligent to only select equities in the greatest performing industries. Even subtle decisions like factoring in earnings reports and companies that report same store monthly retail sales cannot guarantee that an equity will appreciate in value. The reality is that there are a litany of factors that cannot be quantified by our computers that can influence the successes and failures of our investments. Market psychology and globalization are two factors many of you have heard me talk about during my seminars and in my book. Certainly, the study of the economy as a whole or macroeconomics is something all investors should be familiar with. I decided to make this the topic of my most recent article because of what transpired this past Wednesday.Here’s what happened:
The Federal Reserve announced a 1/2% rate cut in the Fed Funds Rate to 1% and a 1/2% rate cut in the Discount Rate to 1.25%. The market was strong prior to the announcement because it anticipated this exact decision. So instead of going up even more once confirmed, the market went down; then up; then down again; then down dramatically; and finally back up slightly to finally end the day down 74 points. I was so dizzy from watching these market fluctuations that I thought I was developing an inner ear infection. As I was reaching for a bottle of Amoxicillin, I had the calming thought that this was, in fact, only the third time in October that the blue chips had JUST a double-digit loss.
So what’s up with Fed Funds and Discount Rates and why are they so important that CNBC even had a count-down timer in the lower right portion of the screen leading up to the announcement? It certainly wasn’t important enough for the financial media to explain to the average investor (Joe the Plumber?) what this all means. They don’t speak to us; we’re not the folks with the big bucks. Sometimes I think they should have some guy with a sign exlaining the terminology being thrown around on these shows. This could be analogous to the signers for the hearing impaired. Joe Kernen throws out the term Keynesian economics, Becky Quick cracks up at the reference, and Sid the sign guy shows us the definition….could work.
I should give credit to Jim Cramer who stated to his viewers that evening, “today’s rate cut means individuals and businesses will find it cheaper to borrow money because the federal funds rate is tied to the banks’ prime rate”. But he also tells us to do our homework. In my view, this applies to macroecenomics as well as individual stocks.
Let’s take a Blue Collar look at macroeconomics and give some meaning to what transpired on Wednesday. The U.S. Government has a myriad of tools and policies that it can utilize to manage the economy. They fall under two general categories:
The government’s taxation and spending programs designed to promote economic growth and maintain high levels of employment. Much of this policy is based on the Keynesian economic theory alluded to above. It states that greater government spending is needed during economic downturns and that higher levels of taxation are called for during times of expansion. The former would combat insufficient private demand and head off a path to recession and the latter would hedge against inflation. Currently both presidential candidates are calling for decreased taxes thereby allowing consumers to spend more and stimulate our sagging economy.
These are methods used by our central bank to control the money supply. This will impact interest rates, inflation, and therefore the economy. Here are the key players:
1- The Federal Reserve System (the Fed): The central bank of the U.S. consisting of 12 regional Federal Reserve banks and numerous member banks. All are under the supervision of the Federal Reserve Board which formulates and executes monetary policy. Fed policies have immediate and significant economic impact and therefore are closely watched by investors like ourselves.
2- The Money Supply: Broken down into categories based on the degree of liquidity:
– M1- currency in circulation plus demand deposits(like checking accounts).
– M2- all money in M1 plus time deposits under $100,000 (CDs, savingsetc.).
– M3- all money in M2 plus time deposits over $100,000 and some institutional
The value of money is determied by supply and demand. If supply is too great, the value of money declines thereby driving up prices and interest rates. The Fed has numerous tools to control the money supply. One is Reserve Requirements.
3- Reserve Requirements: The % of customer deposits that commercial banks must maintain in cash as mandated by the Fed. By lowering the reserve requirement, the Fed can increase the amount of money that banks can lend, thereby increasing the amount of money in the economy. Conversely, raising the reserve requirement will shrink the money supply.
4- Federal Funds (Fed funds): Money lent or borrowed overnight between banks in order to meet their reserve requirements. The rate at which these funds are lent is known as the Fed funds rate (Wednesday lowered to 1%). The Fed establishes a “target” Fed funds rate and increases or decreases the money supply to move the actual rate closer to the target. The Fed can also influence the money supply by altering the Discount Rate.
5- Discount Rate: This is the rate at which the Fed itself loans money to banks that are members of the Federal Reserve System. On Wednesday it was dropped to 1.25%. These are the lowest rates available in the economy. Banks then set their own rates at a level above discount. By raising or lowering discount rates, the Fed influences the degree of difficulty for businesses to borrow money. Investors get a look into the Fed’s evaluation of our economy based on it’s decisions regarding discount rate.. The Fed can also control money supply on a daily basis via open market operations.
6- Open Market Operations: This refers to the Fed’s purchases and sales of government securities in order to adjust the money supply. When the Fed buys Treasury securities from banker-dealers, money is injected into the banking system. When the Fed sells them back, money is withdrawn from the banks. If the economy is expanding too rapidly and inflation is becoming an issue, the Fed might raise interest rates. If the economy is in (or heading towards) a recession (hello!) the Fed can lower interest rates in an effort to encourage new borrowing which will lead to renewed growth. That is precisely what we encountered on Wednesday.
Click on the link below to see a chart summarizing the above discussion:
Monitoring the Health of the Stock Market:
Last week I responded to a readers question about what I look for in market conditions before I started selling options again. Here was my response:
A- I am looking for an upturn in the housing and financial sectors as well as a loosening of credit requirements. Once this occurs, there is a strong likelihood that the institutional investors will start re-investing all that cash that is currently on the sidelines. One technical indicator I check is the VIX which is the Volatility Index that tracks the S&P 500. It is a measurement of market risk and is often referred to as the “investor fear gauge”. Values greater than 30 is indicative of investor fear and uncertainty while values under 20 infer calmer, less stressful times in the market. Needless to say, the current chart below is above 30 and approaching the planet Pluto! Use the ticker symbol $VIX to pull up the chart: