Obsession

If you are a fan of audiobooks, as I am, then I highly recommend you purchase economist and podcaster Malcolm Gladwell’s new offering, “The Bomber Mafia“. This is a new audiobook that was conceived and designed to be an audiobook, and not just someone reading a print book into a microphone. In the audiobook there are sound effects (such as exploding bombs), music, and recordings from the World War II era that is the subject of the book. Even if you aren’t that interested in the subject – bombing during WW II – you should still buy the book just to listen to the production, if you like audiobooks.

Author Malcolm Gladwell

Obsession

At the outset of “The Bomber Mafia”, Gladwell says he has come to the realization that he likes to write about people who are Obsessives. Obsessive people, Gladwell says, are those who are able to block out all of the external noise and distractions in order to move forward with an idea or a goal that they believe will change the world in some way. While obsessive people may accomplish a great deal, their accomplishments will likely be at the expense of interpersonal relationships. Obsessives typically aren’t great managers of people or even life partners because even the people closest to them can get in the way of their obsessions. People who are obsessive typically aren’t fully healthy, either mentally or in some other way.

Are You Obsessive?

Most people aren’t obsessive, and that is probably a good thing for greater society. Can you imagine what our society would be like if most people were obsessed about something? And what if those obsessions came in conflict with one another? I guess that’s how wars start. So, if you are lacking an obsession, that’s ok. However, you may want to look at the concept of obsession as a way to invest your money.

Entrepreneurs Are Obsessives

I would guess that many, but not all, successful companies are started and run by obsessive entrepreneurs who believe they can change the world and want to convince a pack of employees to engage in the quest to do so. Think about the mega-cap companies that are now the most valuable in the world. Do you agree that Bill Gates of Microsoft, Steve Jobs of Apple, Mark Zuckerberg of Facebook, Elon Musk of Tesla, and Bezos of Amazon are or were obsessives with their visions for their respective companies? Most, if not all, did not let interpersonal issues get in the way of their obsessions. Most were considered to be not very nice guys. However, the world wouldn’t be what it is today without any one of them, and our economy wouldn’t have gotten through the pandemic as well as it did without what they have contributed to our economy.

Look For Obsessives

With respect to your own investing, we have been taught by the Warren Buffetts of the world (another obsessive!) that we need to dig deep into the companies, their markets, and their financials in order to make a fundamental decision as to whether or not to invest in those companies. This is all well and good, but I would also add that you need also to look to see that the leadership of that company is obsessed about its mission. This is probably easier to do with larger companies because these larger companies tend to get more press coverage. However, if you like to dabble in mini-cap stocks or even in private equity or private companies, I would make sure that whoever is leading that company has a reasonable and healthy obsession with whatever that company is trying to accomplish. I would guess that most such entrepreneurs will be obsessed to some level. Now it is up to you, the investor, to determine if their obsession can be realized and monetized, and if that entrepreneur is the one who can lead that company to greatness. After all, there have been a lot of obsessed people who have failed either with their vision or their execution. You need to place your money not just with an obsessive, but with one who is able to bring their vision to fruition and make money for their investors in the process. This is what makes investing, or the allocation of capital, such an interesting endeavor.

IMO

You don’t have to be obsessive yourself in order to invest in people’s obsessions. If you look top-down at corporate management and determine whether their vision of their mission and their ability to execute it is within reason, then a good part of the battle for you as an investor is won. Building a successful company can be ugly at times but an intense focus on that building process is what is needed for that success. Look for those types of people when you invest your money.

Selling Your Home

Perhaps you are reading the news that single family home sales and prices are strong, and that is making you think that now may be a good time for you to sell your home. Maybe your children have finally moved out, or maybe you are concerned that your two-story home may not work for you as you get older. Maybe you are cash-poor and house-rich and want to monetize all you have built over the years and live a more simple life in a smaller home. All of these are good reasons to think about selling your home. The problem is, there are a lot of other issues that you need to consider before making the decision to list your home. Let’s consider some of these issues.

Home For Sale Real Estate Sign and Beautiful New House.

Where Are You Going To Live?

Most people need to sell their current home in order to buy another home. If your case is different, then hat’s off to you. In a seller’s market such as this, selling is the easier part. Buying a new home may be the harder part now, especially if you are looking to live in a desirable market with a paucity of housing supply. Stories abound now of listings receiving multiple offers including offers above asking price. Until you have experienced being outbid on a house you really want, you may not be battle-hardened enough to go the extra mile on a bid so that you win. You may find yourself in a situation wherein you have sold your house but have no place to move to because you weren’t successful in purchasing what you want. Keep in mind, if you are selling a less-expensive house and hoping to move to a more-expensive area or house, you are a net buyer, not a net seller, and so your focus should be on the purchase side rather than the sale side in a hot market such as this. If instead you are downsizing or moving away from the hot market, then your situation may be different. Nevertheless, consider whether the sale of your existing home or the purchase of the new home will be the tougher part of the transaction, and make sure you have the tougher side covered before addressing the easier side. Don’t find yourself having to bridge a gap by having to move in with your parents or your children or into rental housing because all of those add to the cost and to the annoyance factor of the move.

Capital Gains Taxes

If you sell your house for more than you paid for it plus what you have put into it, then you incur a capital gain, which is taxable. Therefore, all of the equity that you pull out of your current house may not be available to you for a down payment on the new house. Fortunately, the IRS does provide relief for this. When you sell your house, you can exclude up to $250,000 of capital gains from being subject to capital gains tax – and up to $500,000 if you are married filing jointly. You need to have lived in your house as your primary residence for at least 2 of the 5 years prior to selling the house to qualify for the capital gains exclusion, and you can still qualify for at least a partial exclusion if you have extenuating circumstances such as death, divorce, military service, or job relocation. For most people in most housing markets, these exclusions are sufficient to cover their capital gains, but in some markets and where people have owned their current house for a long time, they may not be able to exclude all of their capital gains. Consult your tax expert with your specific situation before moving forward under any assumption that you can exclude part or all of your capital gains. Make sure you have a record of money you have put into your house that might have added to its basis and therefore would work to minimize any capital gains taxes.

New Property Taxes

Some states, such as California with Proposition 13, have caps on how much their property taxes can be raised each year. If you live in such a state and your home has appreciated in value during the years you have lived there, your current property taxes may be artificially low. If so, when you buy your new house, your new property tax bill will be based on what you paid for the new house, meaning you could pay a lot more in property taxes on the new house than you did on the prior house. Now, California also has a law that allows some people (Seniors) to purchase a new property within their current County (plus some but not all other Counties) and retain their old tax basis. However, absent such a provision in your state, you may be faced with a much higher property tax bill when you buy a new house.

Other Issues

Do you really want to move into a new house and start again from Square One with respect to your social and community life? Are there so many memories tied up in your existing house that you can’t bear to leave? Does the thought of moving horrify you? It may be too much for some people, but for others, perhaps those seeking to be closer to medical care or to grandchildren or other family members, such change may be desirable. Such non-financial issues are certainly valid issues related to the decision of whether or not to sell your home.

IMO

A lot of people look at these and other issues and decide it isn’t worth it to sell their current home, even in such a hot seller’s market. This is one of the reasons that demand far outstrips supply and that you have multiple offer situations with some listings. Yet, the hot market is tempting, and the market should remain strong as long as the supply/demand equation remains tilted as it currently is and as long as mortgage rates remain relatively low. Talk with tax experts and consider your own situation before making the big decision of whether to sell your house now or not.

Breadth

For most of the past 13 months of stock market rally, I and others have written about our concern that the rally is being propelled by a very few number of stocks, particularly by those mega-cap companies that have benefitted through the economic shutdown caused by the Pandemic. In short, the rally has been strong but not very broad. According to this article in Monday’s Wall Street Journal, that seems to be changing. More and more stocks are participating in the current rally, and that is a good thing if you are looking for a sign that the current rally has legs. (Today’s down action notwithstanding).

200-Day Moving Average

The WSJ article says that the current rally is broad because 95% of all stocks are trading above their 200-Day moving average, a situation that hasn’t happened since 2009, also the first year after a market correction. 200 days is about 40 weeks of trading, and if 95% of stocks are on a 40 week uptrend, then that is indeed evidence of a broad market rally. The 200-Day is considered to be more indicative of a stock’s long-term direction as has more data points than shorter-term indicators such as the 50-Day.

Stay At Home Stocks

This has not been a straight-up rally for the entire breadth of the stock market, and it remains lopsided with the mega-cap stocks carrying the bulk of the load. However, as more people get vaccinated and more aspects of the economy reopen, companies and stocks that had trouble during the worst of the pandemic begin to show life again and investors continue to look for opportunity. Interest rates remain low and therefore returns in the fixed income sector still aren’t there, and so investors continue to invest in stocks rather than bonds. It seems like a situation wherein the mega-caps have led the way and the rest of the stock market universe is now following along.

IMO

I have been very concerned for the past year about the lack of market breadth. We’re not out of the woods yet, but if 95% of stocks are above their 200 Day MA, then that is a good sign that there is true breadth, and that an issue with one of the mega-cap stocks won’t cause the entire house of cards to tumble down.

For Yourselves or For Your Children?

Is one of your financial objectives to leave some inheritance for your children and/or your remaining family? Or are you hoping to spend it all during your own lifetime, enjoy the fruits of your labor and your personal planning, and die with $0 in the bank but owing nothing to anyone? The answer to that may depend on how much money you have to begin with. It is a nice, generous thought to believe that you can leave an estate to your children, but most people don’t have that luxury because they are living paycheck to paycheck and fighting to keep afloat during their own lifetimes. For most people, the legacy they leave to their children is the love that they give them and the money that they spend to feed, raise, and educate them when they are still children. They couldn’t afford to do much else when their children are younger, and they likely won’t be able to afford to provide more for their children upon their death. For most people, Social Security is a very important part of their retirement income, and whatever personal savings they might have they spend themselves, hopefully in some orderly fashion that will leave them still with some money even if they live to a very old age.

Planning to Leave an Inheritance

However, if you are lucky enough to be among the few who already have enough money to live comfortably during retirement and will likely have something left over to leave to their children, you will likely have a different plan both for investing and for your rate of spending your savings during retirement. For instance, if you are not planning to leave an inheritance, something like the 4% Rule should be part of your plan. Withdraw 4% +/- of your net worth every year and hope your money lasts long enough. If you instead are trying to leave something to your kids, then you shouldn’t think about how much of your net worth you can withdraw each year. Instead, you should invest such that you can generate enough current income from your portfolio to live on comfortably during retirement without having to draw on the principal. Easier said than done in this day and age because current income is hard to come by with interest rates as low as they are. It may mean you consider investing in alternative asset classes that pay current income, such as real estate or oil and gas partnerships. You should invest also in traditional income-generating assets such as stocks that pay dividends, preferred stocks, or corporate or mortgage-backed bonds or mortgage REIT’s. All of these pay current interest or dividends but are further out on the risk spectrum than are traditional bonds.

Step-Up In Basis

Another part of the “Inheritance” plan is to own assets for a long time, preferably several years. Hopefully these assets will appreciate in value during that time. If they do, when you pass away, your heirs receive a step-up in basis. This means that your heirs’ tax basis in these assets will be the market value of those assets at the time the heirs became the owners. This is a significant tax advantage to them because they could sell these assets for whatever reason and not incur a capital gains liability. Direct ownership of real estate works well in this regard.

Another Option

Another option to consider is my strategy to own index funds and to write call options against them for current income. Depending on how much you have and are willing to dedicate to this strategy, if you just withdraw the amount of income that you generate from the call option writing (or less), then you may be able to live comfortably during retirement without having to withdraw any of your principal, and therefore you should be able to leave something to your children. This strategy doesn’t work as well if you are trying to leave your heirs with assets at a low basis because of the likelihood that your assets will be called away from you from time to time, necessitating that you re-buy them in order to keep the strategy going. Please contact me with further questions about this option.

IMO

What you want to have done with your assets when you pass away, assuming you have any assets at that time, will dictate how you invest those assets during your lifetime. If you have enough money to live comfortably during retirement and you have a desire to leave something to your heirs, then you should think about investing long-term and about making sure your assets generate current income for your own needs. Otherwise you may die with $0 in the bank even if that wasn’t your intent.

Beware Of Their Agenda

While scrolling through LinkedIn, I saw a recent quote by billionaire Sam Zell to the effect that working in a traditional office will make a comeback because creativity and motivation are not easily fostered by working remotely through Zoom. Of course Sam Zell would say that, I thought. Sam Zell is the head of Equity Office Properties, one of the largest developers and owners of office towers in the US. It’s not news that Sam Zell said he believes offices will make a comeback; it would have been news had he made the opposite statement.

Sam Zell, CEO of Equity Office Propertis

They All Have An Agenda

Sam Zell’s statement is self-serving. More people in offices means more tenants which means higher office rents which means more money in Sam’s pocket. Yet Sam’s statement is consistent with what you see and hear from the talking heads in financial and social media. All of these people are self-promoters with an agenda, which is to put more money into their own pockets. Not that there is anything wrong with that. Every business person is trying to make more money and their statements and actions reflect that motivation.

Think Critically

You can think of all forms of media and sources of information as a forum for conflicting ideas, and it is up to each person to think critically and decide who to believe and who not to believe. The ability to think critically is the key. Just as Sam Zell promotes a return to traditional offices, I’m sure that a statement from the CEO of Zoom (Eric Yuan) would be to the effect that the era of traditional offices is over and that business henceforth will be conducted primarily remotely using platforms such as Zoom. Which statement do you believe? You have to decide for yourself by looking at the data. Same for any situation where you have competing points of view. All of these people are in the game to make more money for themselves, and so are you. Use your best judgement, make your choice, and hope for the best. That is our gift as human beings.

IMO

I am not picking on Sam Zell here. I read his quote and thought there was something universal about it and its context, so I thought I would write about it. My point is to be skeptical about self-promoters; i.e., almost everyone who is quoted in any form of media. Skeptical not in a bad way or that they are bad people, but to understand that they have an agenda to promote which is probably different than your own agenda. Understand this and it will give you perspective on what you need to do to achieve your own goals.

Are Investors Getting Complacent?

As of this morning, the VIX Index, aka the Fear Index, is hovering at around 18, which is the lowest it has been since pre-Covid. The Equity Put/Call Ratio is low, at around 0.74, which is below its 200 Day moving average of about 0.8. The stock market is “melting up”, with the S&P 500 at an all-time record high and the Nasdaq 100 Index up over 1% today and only about 5% off its record high after a sell-off from mid-February into early March. The $1.9 Trillion American Rescue Plan stimulus bill has been signed, and now President Biden has proposed another $2.3 Trillion to be spent on “infrastructure”, although details of the bill suggest otherwise. The rising stock market suggests that investors believe the upsides of all of this government spending will outweigh the downsides and that corporate earnings will rise, and so investors are buying stocks. Do you believe investors are showing their complacency in this view?

Inflation: The Danger

The big risk with all of this government spending is that inflation will rise and that the dollars that people have will be worth less in the future due to this inflation. Higher inflation means higher interest rates, and though the Treasury market has stabilized for the time being, rates will rise if indicators show that the inflation risk is elevated. It was a rise in rates across the yield curve that caused the mini-correction that we had, especially in the Nasdaq 100 Index, during February and early March. Look for another mini-correction in the stock market if rates move up again, even by another 10 basis points. For instance, if the 10 Year US Treasury Yield rises from its current level of about 1.68% to 1.8%, a rate that it hasn’t hit since pre-Covid, look for stocks to sell off again, with high-multiple Nasdaq 100 stocks being the most vulnerable.

Are Investors Really Complacent?

Though the readings on the VIX, Put/Call Ratio, and the record or near-record levels of the big stock indexes might suggest that investors may be complacent and may not be heeding the risks of higher inflation and higher interest rates, I’m not so sure that the readings show complacency. True, the VIX Index is lower than it has been in over a year, but before Covid, the VIX seldom broke above 20 for the prior 4 years. True, the 10 Year Treasury Yield is up, but its yield was north of 2% as recently as July 2019 and for most of the 3 years prior to then as well. Perhaps the low Put/Call ratio and the “melt-up” in stock prices doesn’t reflect complacency as much as it reflects investor optimism that our nation and our economy are finally returning to “normal” after the Covid period.

IMO

I believe the key will be the rate at which inflation will rise. Watch things closely here. If most of the supply chain issues can be addressed and the rise in inflation can be kept in check, then current investor optimism will have been justified. However, if the stimulus spending coincides with an economy that struggles to emerge from supply chain bottlenecks and other international issues, then the bet may have been misplaced. My guess is that inflation will rise to perhaps the mid-2%’s, but that will be manageable and we will make it work. “Be skeptical when others are greedy” is a good thought to keep in mind at this point.

Last Chance to Refinance

Not really – you can refinance at any time if you aren’t looking for the lowest possible mortgage rate. However, mortgage rates are up and there is better chance they will continue to rise than fall over the next year, as all longer-term interest rates are projected to rise. So, if you haven’t yet refinanced and taken advantage of low mortgage rates, now is the time to do it.

Mortgage Bankers Association

According to this article from Calculated Risk, the Mortgage Bankers Association (MBA)’s Weekly Survey from last week shows that average 30 Year Fixed rates have risen 50 basis points since the beginning of this year and now average 3.36%. Not bad, but not as appealing as the sub-3% rates we saw during Q4 2020. As a result, the article goes on, their “refinance index” is down 5% from the prior week’s survey, meaning that fewer applications for refinance are being submitted. This doesn’t mean the housing market is weak. On the contrary, it is significantly stronger and is expected to remain so due to, as the article says, inadequate housing inventory.

Human Nature

If you think about it, it makes sense that refinances will decline as mortgage rates go up. As with any purchase decision – and I consider a mortgage refinance to be a purchase decision because the borrower likely doesn’t need to refinance – if the price is going down, the buyer/borrower will wait to see if the price might go down some more before committing to the transaction. This is called bottom-fishing, and it is also indicative of why deflation is such a bad economic thing: people refrain from economic activity if the price is going down. Then, once rates bottom out or even rise a bit, borrowers will put their chips on the table and commit. They will continue to refinance as rates go up slightly – I am speaking in a macro sense here – until it no longer makes economic sense to refinance. This could take a long time if the borrower hasn’t refinanced in a while, or it could be a short time for serial refinancers.

Pros and Cons of Refinancing

The obvious pro of refinancing is that you have a lower interest rate and a lower monthly payment, especially if you don’t take any “cash out” in the process of your refinance. Another pro is that you might be able to pull some cash out if your home has appreciated significantly since your prior loan and you need a lump sum of money for some reason. Some families finance their children’s college educations through cash-out refinances, which is a very good way to do it because it is better to pay for college by borrowing in the low-3%’s and paying it back over 30 years than it is to borrow at the higher rates of some student loan programs.

The cons of refinancing include the following:

  • You may have to pay points and/or fees for your refinance loan, which means comparing your current mortgage rate to the new proposed mortgage rate is not an apples-to-apples comparison. You have to factor in the cost of these fees and points, which the lender should provide to you when it quotes you the Annual Percentage Rate (APR) of the new loan.
  • One of the reasons your monthly payment goes down is because, with the new mortgage, you now have a new 30 year timetable for paying off your loan. Let’s say you were 10 years into your prior loan: that means you would have your house paid off in 20 years at the current payment. Now, although you are paying less per month with the new loan, you won’t pay off your house for another 30 years. Of course, you can always make extra principal payments that will speed up the payoff process – typically with no penalty payable to the lender. Or you can refinance into a 15 year fixed rate loan, and get the lower rate (and potentially lower payment) and still own your home free and clear in 15 years.
  • If you take cash out as part of a refinance, now you owe more. No problem, you may say, as long as your loan is 80% loan-to-value or lower, meaning that you have at least a 20% equity cushion if you have to sell your house. And, you may be right if you feel like you are in a growing area with a strong housing market. However, don’t take the decision lightly if you are considering a cash-out refinance. It could get you into a financial bind down the road.

IMO

I believe you should act now if you are considering a mortgage refinance if you want a good rate. I believe mortgage rates will rise over the next year, so don’t wait. With the for-sale housing market as strong as it is, there is a better possibility that your house will appraise out at a value that will justify the loan amount that you want, especially if you are looking to take cash out of the transaction.

A Company Is Worth Its Future Earnings

That Gamestop (GME) is in the middle of another Reddit-fueled run is baffling to me. It makes me think that people who are “long” GME believe that GME is worth what someone else will pay for it, and not what the the company will earn in the future. The “Greater Fool” theory, meaning that I will make money as long as some other greater fool pays me more to buy it from me than I paid to buy it, is aptly named. Once all of the greater fools either get skunked or go away to their next victim, those investors who remain will revert to valuing a company based on its projected future earnings. I guess there will will always be greater fools out there who don’t understand this basic Investing 101 concept.

Recap

As many of you are aware, in January 2021 GME went from a boring low-$20’s stock to a $400+ stock over the course of a couple of weeks because of a social media-inspired short squeeze. Well, the short squeeze play died out a bit but not completely, and GME went from about $50 back up to over $250 just this month, and it trades today at about $188. Again, this March run was fueled by a Reddit forum. Do GME’s fundamentals and future earnings justify a $400, or a $250, or a $188 price? They do not. GME announces its earnings later today, and although GME is expected to show a profit for Q4 2020, it lost almost $300 Million for the first 3 quarters of 2020. Though Covid didn’t help, it also wasn’t the cause of GME’s losses, as GME lost nearly $500 Million for the first 3 quarters of 2020. A start-up new high-tech IPO company can have its stock go up while losing hundreds of millions of dollars, but not an established retailer like Gamestop. The point is, based on future earnings, GME’s stock price of $188, or $250, or $400 cannot be justified.

Buffett

I wrote about the discounted cash flow model of business valuation a couple of weeks ago. My point then was that corporate valuations are up because the discount rate, specifically the portion of the discount rate that is termed the “risk-free” rate, is low – in the 1% range or a bit higher. The discounted cash flow, or dcf, model is how legendary investor Warren Buffett values his investments. Buffett views any potential investment purely as a stream of future cash flows. If he understands the nuances of the business and knows and trusts that the managers of that business can do a good job and deliver, then Buffett believes the risks that he will eventually see the projected future cash flows are minimized. When Buffett discounts those future cash flows to the present, if that net present value is more than the price at which the company is trading today, Buffett will look to buy the company’s stock. Fortunately for him, he has enough money that he can buy the entire company, and not just a 100 share piece of it.

IMO

Don’t let Buffett’s store of dry powder for investing cloud your own thinking as to how you should look at an investment. Look to future cash flows. Don’t use the Greater Fool theory and believe someone out there will eventually pay you more than you paid. Use the DCF method for valuing the future prospects of your potential invesstments. And don’t play the GME game.

It Worked For A While, Then It Didn’t

Our doorbell at our home is broken and I am in the process of putting a new doorbell system in place. Easy, you may say, in this age of Bluetooth electronic doorbells with cameras. Well, it turns out it isn’t that easy. I did install a new camera doorbell – a major name brand in the market. It worked for a while, but then it didn’t. The reason it quit working had to do with software: I also subsequently installed a new WiFi router. The doorbell needs to interface with the WiFi in order to connect with the doorbell chime and to send you the pictures of your front door that you can see on the app related to the doorbell. The problem was that the new router’s software and the doorbell’s software wouldn’t speak to one another. Perhaps I should have known this before I spent mega $$ on my router, but who knew? So now I am in the middle of installing a whole new doorbell system, and I am hitting more roadblocks along the way. Funny how what you think should be an easy project turns out to be all-consuming.

Need To Adapt

The point that I am making is that one needs to be able to adapt even if one finds what one thinks is the solution to their problems. This is because stuff happens that could render their solution obsolete. Don’t get too comfortable because the world may change and your solution doesn’t work any more.

Your Personal Finances

There are many ways this lesson applies to your personal finances. In fact, the process of changes and the need to adapt to changes plays out in real time every business day that the markets are open for business. Think about what your plans were a year ago (ok, 13 months ago), before Covid. How have you had to adapt your financial plans and goals since Covid? If you are lucky, you haven’t had to change and adapt very much at all. If that is the case, then your plan back then was solid, and you should keep plugging at it even now as we (hopefully) reach the back end of this awful period. If you have been personally set back by Covid, either through business or job loss or worse, it doesn’t mean your plans were no good. It means that stuff happens and you need to adapt. Maybe you have “retired” a little earlier in your life than you thought you would. If so, you have probably had to adapt and change your personal financial plan and goals a little more than you had hoped to do. Hopefully you have been able to do so without missing many beats.

Your Portfolio

Another issue may be with the composition of your investment portfolio. As markets change, what may have worked before may no longer work for you now. Interest rates change. Industries and sectors move in and out of favor. New technologies may disrupt companies that you may have a stake in. It can be disconcerting to you if you set up what you think is a strong portfolio only to have its foundation shaken by these market changes and disruptions.

The Ask

One thought I have for you is that you don’t have to face the stormy seas of all of these changes by yourself. I ask that you consider getting help from a Certified Financial PlannerĀ® such as yours truly. Though you may feel like you have a handle on your own finances, often, two heads are better than one. Having a trusted financial professional with whom you can discuss and debate plans and ideas may be the perfect ballast that you need to steer your ship. Back to my issue with my doorbell: I didn’t have the right person to help me find the right solution to my broken doorbell. I had good people who knew about doorbells, and other good people who knew about home WiFi systems, but not people who knew enough about both and how they interface with one another. The piecemeal approach didn’t work for me and it cost me. Don’t make the same mistake with your personal finances. If you work with a professional, as you should, make sure the professional has and understands the entire picture, not just a part of it. Only then can they come up with a solution that addresses the entirety of your situation.

Corporate Earnings Discount Rate

The value of a corporation is best determined by estimating future earnings and then discounting those earnings back to the present at some discount rate. The discount rate for that corporation includes the “risk-free” rate, which is typically the US Treasury rate, plus some risk premium that an investor is willing to take on for investing in that corporation in that industry. For instance, a discount rate could be the 10 Year US Treasury plus 800 basis points. This is how Finance 101 students learn to value a company.

Today’s Problem

The problem we are having in today’s market is that the “risk-free” rate is so low. For the past year, since Covid hit and the Federal Reserve dropped interest rates, Treasury rates across the yield curve have been at or below 1%. Only recently have long-term rates (10 years and longer) risen above 1%, and the 10-Year is at about 1.5% right now. With one element of the corporate earnings discount rate so low, either the risk premium will increase and corporate valuations will remain the same, or risk premiums will remain the same and corporate valuations will increase. A lower discount rate means a higher valuation for those future earnings.

The Past Year

We hit the bottom with the Covid shutdown and stock market correction during the 3rd week of March 2020, which is almost 1 year ago. Since then, it has been almost straight up, with the exception of the past couple of weeks. As of today, the Nasdaq 100 Index is up about 88% since the March 2020 low. That tells me that the risk premium that investors place on the earnings of the Nasdaq 100 corporations has not risen; if anything, it has declined. Consequently, the discount rates for their corporate earnings have declined and corporate valuations have risen – by 88% in this case.

Will This Trend Continue?

I mentioned that the past couple of weeks have not been straight up for the stock market, especially the Nasdaq 100 Index. What has crept back in is a fear of inflation. Investors now realize that all of the actions by the Federal Reserve to buy bonds and to loosen the money supply, as well as the fiscal stimulus bills, including the American Rescue Plan Act of 2021 just passed by Congress, could cause higher inflation. Why? Because together they represent significantly more money in the hands of consumers during a period where there are shortages caused by the Covid economic shutdown. More money chasing fewer goods causes higher inflation, and higher inflation causes higher interest rates. The “risk-free” 10-Year US Treasury rate has risen from below 1% couple of months ago to about 1.5% now. This rise in Treasury rates, caused by fears of increased inflation, is causing jitters for investors, particularly for those heavy in the high-flying Nasdaq 100 index companies. If you assume that earnings in these companies will remain strong but now you have to discount them at 50-60 basis points higher than you did 1-2 months ago, that causes a significant change in what you think those companies are worth today. This change in the corporate earnings discount rate, more than changes in the outlook for corporate earnings, explains why we had a 10% +/- correction in the Nasdaq 100 index from mid-February to earlier this week. The Nasdaq 100 has reversed itself during the past couple of days, but further increases in US Treasury rates could send it down once again.

IMO

I hope this explanation shows you that it is not always changes in the forecasted fortunes of companies that causes stock sell-offs. Instead, it can be changes in the assumptions of how investors mathematically derive their valuations, such as in changes in US Treasury Rates and/or changes in risk premiums. So, don’t blame corporate management at first; blame those old bugaboos, inflation and higher interest rates.