Market Interpretation: June 2013

    Over the past six months the market has been rising and I have read a lot of article on why people think this is happening. Some analyst think this is an over reaction to good news and that the market is going to take a big hit soon as a corrective measure. As a note, today the market is down about 0.80%. This view of how the market is over valued is completely wrong for many reason.

    Analyst are looking at market GDP as an indicator of the stock market which is very flawed. This flaw is due to the Keynesian thought process which is wrong in more ways than I would like to talk about in this post. The reason the market took a hit today is because the market didn't add as many jobs in the private sector as the analyst predicted (http://www.latimes.com/business/money/la-fi-mo-adp-jobs-economy-20130605,0,2964130.story). This argument of unemployment is why some analyst have been predicting that markets have over reacted to good news and that the markets will correct downward. The problem is these analyst haven't been looking at corporations at a micro level and then figuring out how this effects the market and the economy.

    The real reason that the market has had an upward trend is due to increased productivity. Increased productivity leads to an increase in GDP and many other measures but it is important to note that productivity is far more important than GDP. Since the credit crisis many people were laid off meaning that unemployment has gone up. These companies first took a hit since people didn't have money to spend. As the market started to recover and many Americans started to increase spending regardless of employment due to the stimulus and social programs. These companies started to streamline their processes and got more efficient since they had fewer employees and an increase in output. Basically these companies have learned to run their business with less employees which has led to an increase in productivity. Productivity meaning that the ratio of employees to units produced as decreased.

    This increase in productivity has led to the need for less employees which means unemployment rates will remain high. The unemployment rates will change once the demand for goods and services grows enough to employee these people or until companies get lazy again and become more inefficient. The bottom line is that companies are reducing costs in comparison with revenue which is leading to higher returns on their stock. Since many companies are experiencing this trend it is making the market or at least the indexes such as the S&P 500 increase as a whole. The market will fluctuate over time but the long-run (the next 1-2 years) will have good returns unless more manipulation on behalf of the government we currently have forces companies to make inefficient decisions.

    As a side note many people are predicting another market crisis in the next 5 to 10 years which I would agree with as long as the government and Keynesian ideas continue to dominate. This upcoming crash will be due to poor policy and over regulation which has been the causes of most if not all of our financial crisis.

The Psychology Behind Student Debt

            Student debt is a growing concern among Americans as we have now pasted a trillion dollars nation-wide. Student debt isn’t always needed and higher education is not always worth the cost but I will cover higher education issues in another post. The issue at hand is how to make smart decisions on how to repay the loans. The one decision that I would like to cover is investing.

            I have heard from many people including financial planners who recommend making investments as a way to save for one’s retirement. I agree that retirement is an important goal to look towards but there is a psychological pitfall by investing while having student debt. Many people feel that investing now will make you millions of dollars and that is far more than your student loans. This is wrong.

            Students should be looking at the returns not the total “expected" amount. A Federal Stafford loan has an interest rate of 6.8% and a Federal Graduate Plus loan has a rate of 7.9%. There are also Federal Perkin loans which have a 5% interest rate and private loans which can have lower rates as long as you have good credit. Private loans offer little or no repayment options. Most students will have a rate between 6.8% - 7.9%. Now it is crucial to understand that debt (loans) are the same as an inverse investment since you will have cash outflows instead of expected cash inflows. For comparison, a 10 year bond (the same maturity as a Federal student loan) today is yielding 2.14% (risk-free rate). The average stock return is about 8% over the long-run.

            Now you can clearly see that borrowing money at any of the rates above and receiving returns at the risk-free rate yields a negative return (2.14 – 6.8 = -4.66%). Now there is the option of investing in stocks with the assumption that you will get 8%. The 8% however is risky and the additional 5.86% is compensation for taking the risk. The 8% return is an assumption that an individual holds the market portfolio over a very long period. Holding a well-diversified market portfolio is also costly in many ways which reduces the 8% return.

            A student is best off reducing their monthly expenses by paying off the debt as soon as possible. If a student has excess money it should go towards paying down the highest interest rate loan or by paying down the smallest loan and using the snow ball approach that Dave Ramsey recommends. By investing in risk-free assets you are reducing your wealth and by investing in risky assets you are exposing yourself to financial hardships and uncertain returns.

            The psychological pitfall is to assume that retirement is your end goal and offers a higher return than the cost of your college debt. The end goal for everyone should be to maximize wealth which needs to be done with the consideration of risk and return. Paying off your student loans first and then making investments once the debt is gone is the best way to maximize wealth with low risk. If you end up landing a job after college and the company matches up to a certain amount for a retirement account you should in this case make an investment since the risk/return is far better than the cost of the debt. I would however not invest any more than what they will match. The take home lesson here is to consider your debt interest rates against your investment interest rates and make sure that you maximize your returns as best as possible.

Greed 1.0

Introduction to the Greed Series

     I am going to be exploring the concept of greed by writing a series of blogs and getting feedback from those of you reading as well as from the people around me. Through my recent readings of finance, economics, and the news I have begun to question whether greed is good or bad. Since I am pursuing Financial Engineering and have read many news articles about how bad and greedy Financial Engineers are, I have started to question the society we live in. So please feel free to read the first paper below and give your feedback.

This photo is courtesy of InvestingCaffeine.com

Greed - 1.0

     The word greed has a negative connotation. First we must define greed so that we can discuss the concept of greed. According to Merriam-Webster online dictionary, greed is “a selfish and excessive desire for more of something (as money) than is needed.” That definition is basic and easy to understand at first but the question then becomes what is needed? Is needed food and shelter? Or is it more than that? Is love needed? The question of needs can become controversial and we will therefore assume that it is food and shelter so that we can continue on our exploration of greed. Greed dates back to the biblical times and is condoned by Christians and many other religions as a sin. The question I would like to explore is why is greed bad? Can we all be greedy and be happy? Or is greed bad for a society?