Tag Archives: expectations

Yellen Attempts to Control Expectations

Interest rates rose following the March Federal Open Market Committee (FOMC) meeting in which the Fed eliminated the quantitate thresholds for unemployment and inflation from forward guidance. Without these thresholds, financial markets were left in perplexing uncertainty regarding the timing of interest rate hikes. Particularly, markets speculated as to when rates would rise once the Fed completed tapering its asset purchases. Although the FOMC statement provided an extremely vague time period, Yellen seemed to define the time period to be precisely six months in the post-FOMC press conference.

Unfortunately, financial markets misinterpreted Yellen’s words to be more exact than she intended. Prior to the March FOMC meeting, expectations for a first rate hike were in late 2015 or early 2016. According to the Wall Street Journal, “Some investors had taken Ms. Yellen’s remarks at a news conference after that [FOMC] meeting to mean rate increases might come sooner than they expected”. After the March FOMC meeting, yields on the two-year and five-year treasury adjusted to price in a rate hike around mid-2015 (i.e. about 6 months following the projected conclusion of the Fed’s tapering).

fredgraph2yrTreasuries fredgraph5yrtreasuries

As seen above, the two-year treasury yields had their largest single-day move since 2011 and the five-year treasury yields had their largest single-day move since September 2013 and rose the most since June 2013. The two-year and five-year treasury yields rose to reflect changes in expectations about the future.

In a speech on Monday, Yellen attempted to diminish these expectations to stop yields from moving higher. Yellen offered five reasons why she still sees slack in the economy. First, the number of involuntary part-time workers remains elevated. Second, statistics on job turnover is very low. According to the Wall Street Journal, “[Low job turnover] is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another”. Third, wage growth since the financial crisis has been low by historical standards. Fourth, a significant portion of the unemployed has been out of work for six months ore more. According to the Wall Street Journal, “The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce”. Fifth, the proportion of working-age adults that hold or are seeking jobs (participation rate) has continued declining since the recession and throughout the recovery. Yellen believes these signs of slack in the economy give the Fed room to keep interest rates low.

Yellen also attempted to reshape the perspective on tapering. According to the Wall Street Journal, “She emphasized that the Fed’s recent decisions to reduce the size of its bond-buying program, meant to keep long-term interest rates low to spur growth, shouldn’t be viewed as a withdrawal of support of the economy. Rather, she said the Fed is adding support at a lower pace”. Although some might view the tapering of asset purchases as a withdrawal of stimulus, Yellen prefers the perspective that it is only a decrease in the rate by which stimulus is growing. Furthermore, monthly asset purchases themselves do not stimulate the economy. Instead, the size and duration of the Fed’s balance sheet (i.e. balance sheet monetary policy), which the Fed will maintain even after it stops expanding, will continue to stimulate the economy. As a result, financial markets should not be concerned that the Fed’s tapering is representative of tightening monetary policy.

Despite Yellen’s dovish message, treasury yields have not fallen to their pre-FOMC meeting level. I am not surprised by this because treasury yields were quite low before and are now adequately pricing interest rate risk. Although interest rates might not rise in early 2015, I think rates will start rising by late 2015 and this is reflected in the current level of the two-year and five-year treasury yield.

Safe Investments? – WSJ Reaffirms Common Investing Wisdom

This week both the Wall Street Journal and Forbes magazine featured articles offering investors somewhat sobering, yet unoriginal, wisdom: the buy-and-hold strategy isn’t a “get rich quick” scheme. In his article in the Wall Street Journal, Brett Arends begins by pointing out that a lot of amateur investors don’t understand how large their long-term annual returns are likely to be.

Arends explains that money managers often point to historical data dating back to before the great depression that shows that stocks have produced on average around 10% per year in the long run and that bonds have produced around 5% annually. This is true, you can simply look back to any historical stock chart to see that the prices of the Dow Jones or S&P 500 indices have mostly steadily risen, albeit with more than a fair amount of volatility, since the great depression. He first points out that this ignores the effects of inflation, which eats away at the real value of one’s stock returns. This is important because, after all a 100% return in the stock market wouldn’t matter if the price of all goods and services rise 100% as well. Once one strips off the effects of inflation, investors should more realistically expect stock returns of around 1.5-2% a year plus dividends, which according to Arends’ numbers averages out to around just 3.5% annually. Of course, common knowledge affirms that inflation is always an important factor to consider when looking at one’s investment performance.

He later remarks that although you might expect to make around a 10% annual return on average by buying a general stock index, depending on when you entered the market you might actually face a much higher or much lower return. For instance, if you had invested in a “balanced fund” of 60% stocks and 40% bonds in 1988, you would have made an inflation adjusted return of 218% if you had sold it all just 10 years later. If instead you invested in the same fund in 1971, after 10 years you would have lost 25% over this period if you sold in 1981. This highlights the fact that due to the volatility, or swings in the prices of stocks and bonds, one’s returns depend on when one first entered the market. This is just another piece of common investment knowledge: buy low – sell high, and one’s timing of the market matters (although it might be more due to luck than skill).

In order to confirm these statements, I ran a short MATLAB analysis of the S&P 500 returns from 1947 (post-WWII) to 2013 using data from the website of Robert Shiller (Nobel Winning Economics Professor at Yale). To obtain the real price level of the S&P 500 index, I first converted the S&P500 prices to 2013 dollars using the Consumer Price Index obtained from the Federal Reserve Economic Database (FRED) http://research.stlouisfed.org/fred2/series/CPIAUCSL where,

Screen Shot 2014-03-10 at 2.42.18 PM If you plot the real prices alongside the nominal prices, you get something that looks like this:

S&P 500 Nominal and Real Prices

It’s pretty obvious that inflation eats away at your return. If you invested in 1947 and cashed out in 2013 you would have had only around an 803.8% return over this 66-year period after inflation, rather than the 9633.1% return you’d expect nominally. We can back out the compounded annual percent return by rearranging the equation:

Screen Shot 2014-03-10 at 2.42.30 PM

Using this equation we find that the annual nominal return over this period excluding dividends is ~ 7% and the real annual return is ~3.35% (see my code for calculations). Therefore, holding on to a few shares of stocks isn’t going to make you as rich (as quickly) as you might think.

It’s also easy to see that when you buy matters. If you bought the S&P in 1973 and sold in 1983 you would have lost roughly a third to a half of your money. You would find similar results if you bought in 1999 and sold in 2009, so timing and luck do matter. So blindly investing in an index fund isn’t a fool-proof way to make millions: what else is new? Useful information, but it’s not really uncommon or original, and even undergraduates can figure this stuff out.

John S. Tobey of Forbes makes a similar argument in his article “The Risk Behind Buffett’s Advice.” For many of the same reasons presented by Arend, Tobey tells investors to say “No, thanks” to Buffett’s buy-and-hold advice since not all investors will make money over their (often rather short) respective investment timelines using this strategy. While I think this assertion is a bit excessive, I do agree that investors should conduct the proper due diligence when choosing where to put their money. So I would agree with the additional criteria that Tobey proposes that investors use, including:

  1. Choosing the right index (S&P500, Dow, ETF?)
  2. The use of dividends (reinvested or distributed?)
  3. Investment Fees
  4. Taxes on investment income
  5. Willingness to stick to a plan (avoiding bubbles and investment fads, and not selling your stocks too early or for a loss).

I was initially under the impression that this was common investment knowledge, since Burton Malkiel wrote about these factors in his book “A Random Walk Down Wall Street” way back in 1973. So why are these authors still writing about this? My thought is that many investors and readers who are interested in finance are bombarded with misinformation from many different sources. Financial newspapers show eye-catching headlines describing the next Google, Netflix, or Tesla that will make investors gobs of cash. Stock index tickers show huge annual gains or losses in the S&P 50 or the Dow that obscure the long-run trends and ignore fundamentals. Financial advisors may advertise their phenomenal one or two year track record while obscuring their much smaller long run returns. Overall, it seems as though sorting through the garbage bin of financial advice is a hard task. So although authors like Arends and Tobey aren’t saying anything completely new, it’s important for them to repeat these important lessons so they don’t get lost in the trash.