"We are not measured by the trials we meet -- only by those we overcome."
- - Spencer W. Kimball
March 12, 2013
The Fed and Stocks
by Adam Smith

I was all set to write an article about CEOs when the Dow Jones had to go and hit an all-time high, so I felt compelled to write about the stock market.

During the economic crisis of 2008, the Federal Reserve (Fed) brought interest rates down to try and stabilize the economy. The economy was shrinking, so pushing more money into the banking system made sense. The federal government then spent a trillion dollars to try and stimulate the economy. These were the two strategies that theoretically were going to bring the economy back to prosperity.

They did not work.

Bank’s reserves grew dramatically (up 350%) but lending was subdued. Business waited to see what was going to happen after the slight uptick in economic growth from the stimulus and really did nothing, because the rate of growth became anemic. But the Fed had one new thing they were going to try. They were going to buy long term securities to push down long term interest rates. This is why you are getting daily calls about refinancing your mortgage. Long term rates are at historically low levels which allow lenders to refinance your mortgage at much lower rates than when you purchased your home.

This sounds like a good idea but there is a very ugly side to the low interest rates. Retired individuals that depend on some income from their investments to survive are getting almost none. Bank rates are almost at 0% and interest rates on longer term investments CDs, etc. are not much better. Another policy implemented that hurts the most vulnerable among us.

What does this have to do with the DOW hitting an all-time high?

A return on investments is based on the amount of risk associated with the investment. For example, the interest rate income received from purchasing a Treasury Bill (t-bill) of the U.S. government is very low since the t-bill is considered risk free. The interest rates then increase from there. The rate on bonds issued by very stable profitable companies is a few percentage points higher than the t-bill rate. The rate on debt issued by companies not stable or profitable can have much higher rates than the stable companies.

Stocks are considered more risky than debt from stable companies, so there is an additional premium placed on stocks. The riskier the stock (or company) then the greater the premium placed on the returns for the shares. For example (trying to keep it simple), there are two companies that both state they are going to pay $1/share in a year for a dividend. The stable company’s stock may trade at $10/share giving you a 10% return. It is very likely you are going to get the $1 for your $10 investment. The riskier company would trade at $5/share. If you actually got the $1 you would have a 20% return, of course the likelihood of getting nothing is much higher with the risky company than with the stable company.

So looking at the return rates for the different investments (this is a simple example to explain a concept): t-bill is 3%, stable corporate bond is 3% over t-bill so 6%, and stable company stock 4% over bonds so 10%.

This relation between the investments will generally hold. So when the Fed lowers interest rates there is a mechanical correction that happens in the bond and stock markets. The stock and bond prices increase which drives down the returns from their interest. (For those interested, if the rate of return is x/price of bond or stock, then keeping x constant and raising the price decreases the return.) This keeps the premium in balance between t-bills, bonds, and stocks.

When the Fed decreased short term interest rates a few years ago this correction was quickly impounded in the price of stocks. What is happening now is really different.

By driving down expected long term interest rates, the Fed is causing long term expected returns from stocks to go down which is driving up the price of stocks. This is all part of the Feds plan to “create wealth” in the economy, to make people feel richer and hence spend more money and expand the economy.

That is why the stock markets are so high. It is not due to some great underlying fundamental driving real growth and hundreds of thousands or even millions of people getting employment.

People on Wall Street understand this issue. Warren Buffet recently stated that money managers have their fingers on hair triggers ready to sell when they see that the Fed is going to change policy and increase interest rates. The professionals will be ready for the sell-off of stocks. So who will be the ones hurt most.

Remember the seniors that need to make more money on their investments to survive. Out of necessity they are moving their money from savings to bonds and stocks. They will never know where their money went.

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About Adam Smith

Adam Smith is obviously not the actual name of the author of this column. The real author has worked for two Fortune 500 companies, one privately held company, and a public accounting firm. His undergraduate degree was in accounting, and he earned an MBA for his graduate degree. He also has completed coursework for a PhD. in finance. He continues to be employed by one of the Fortune 500 companies.

The author grew up in the Washington D.C. area but also lived for several years in Arizona. He currently resides with his family on the East Coast.

The author has held various callings in The Church of Jesus Christ of Latter-day Saints.

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