Beware the Fed


There is an old axiom on Wall Street:  “Don’t fight the Fed.”

The Federal Reserve holds an enormous amount of power over the economy.  While the President is usually blamed for a bad economy and praised for a good one, the fact is that the federal reserve actually has significantly more power over the state of the economy.

Despite the name, the Federal Reserve is not an institution of the Federal Government.  The Federal Reserve is made up of a board of bank executives from around the country — the “Governors” — with one individual chosen as the Chairman.  The Chairman is chosen by the President and confirmed by the Congress, but the post is meant to be non-political.  The group meets periodically to discuss the state of the economy and any action that should be taken.  The power of the Federal Reserve over the economy is so acute that the discussions held during the meetings are kept in secret with notes from the meeting only being released several months after they meet.

Often traders will move the stock market up or down before the Federal Reserve meets based on what they expect the group to decide.  If the group’s decision surprises the market, the stock market will often move up or down several percentage points.  The announcements made by the Federal Reserve are purposely made rather vague since they know the power of their words.


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The Federal Reserve controls the economy through two levers, the Discount Rate and the Fed Funds Rate.  The discount rate (http://en.wikipedia.org/wiki/Discount_rate) is the amount that the Federal Reserve charges banks that borrow funds from it.  Generally, it is frowned upon for banks to borrow from the Federal Reserve directly and they generally get a scolding when they do so.  The exception is during the recent money crisis where borrowing from the discount window was encouraged since other sources of capital had dried up.

The Federal Funds Rate (http://en.wikipedia.org/wiki/Fed_Funds_Rate) is the rate at which banks loan each other for overnight periods.  The Federal Reserve does not control the Fed Funds rate directly, but instead adds money to the economy or takes it away to affect the rate.  This is done by selling notes, which has the effect of removing money from the economy, or buying notes, which injects money into the economy.  Like anything else, the more money there is in the economy to lend, the lower the price for borrowing (therefore the lower the interest rate).

Because the bank’s costs of capital decrease when the rate at which they can obtain decreases, they also tend to lower the rates they charge.  This trickles up into the economy (except, interestingly, credit card rates), such that most rates tend to fall.  Because the rate savings accounts provide drops, bonds become more valuable, so their price tends to rise, dropping the amount of interest they provide.  Likewise, because the return of common stocks becomes more valuable, stock prices also tend to rise.

This is the reason to not “fight the Fed.”  When the Fed is lowering rates, it’s best not to be short, and when the Fed is raising rates, it’s best to prepare for a fall.  Note that in the early ’90’s, the Federal Reserve lowered interest rates to bring the economy out of the early 90’s recession.  The stock market took off first, followed by the economy.  President Clinton was credited with the good economy that followed, but it was all touched off by the Federal Reserve.

In the late 90’s, when inflation was starting to pick up and internet stocks were trading at ridiculous prices, Fed Chief Alan Greenspan warned of what he called “irrational exuberance.”  The Fed began raising rates to pick the ensuing bubble.  A few months later, the bubble burst and the early 2000 recession occurred.  President George Bush Junior was blamed for this recession, but the stock market had already started to fall before he took office because of the actions of the Federal Reserve.  Finally, just before the latest recession, the Federal Reserve, concerned about housing prices, began to raise rates to dampen the economy.  This caused the housing bubble to burst, leading to the current state.

The action of the Federal reserve typically takes half a year to have an effect.  It takes time for companies to start borrowing and hiring after rates are lowered.  Likewise, when the economy has a good head of steam it takes time for the wheels to grind to a halt.  The Federal Reserve set rates at near zero in 2008 and had been waiting for the economy to pick up.  It appears that there has finally started to be some growth, and the Feds are starting to slowly raise rates because they fear inflation picking up.  As they do so, it is likely to slow the economy and may cause stocks and bonds to fall, at least temporarily.

It would not be wise to fight the Fed.  If you have money invested that you need within a couple of years, it might be wise to take opportunities to sell.  If you are invested long-term, however, it would probably be better to just stay put.  You don’t know if the effects will be immediate or if there will be a great run-up through this New Years’ season as there often is.  If President Trump is able to get a tax cut through, that will also add fuel to the fire and you might miss out on a great advance in stock prices before the Fed’s effect is finally felt.  The effects of the Fed are temporary and matter little if you’re investing for 20 years.  Missing a big move up in stocks because you’re sitting on the sidelines will.

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Dealing with Market Crashes


Let’s face it – the market has been doing great lately.  We’ve seen virtually everything go up during the last ten months or so, ever since the election.  Talk of tax cuts should add further fuel to the fire, since less money being diverted out of the economy means more money for investment and spending.

But eventually, this party will come to an end.  Indeed, many economists and pundits have been talking about the frothy nature of the market and saying that maybe it is time to move towards the exits.  I would say that this is good advice for some, but not for everybody.  It is good advice if you need the money within a year or two, or maybe even a few years, but it is not good advice if you don’t need the money for twenty years.

You see, markets that have plenty of people trading, which the stock markets do, will instantly price in all news, expectations, and insights.  If people knew that the markets were about to decline, they would be selling now, which means that prices would be going lower already.  The fact that there are plenty of people willing to come forward and buy shares at current prices says that people have seen all of the news out there and decided that current prices are reasonable.  Sure, bad news may come out tomorrow and cause stock prices to fall, but the market might continue to climb for another year or two.   If you’re sitting there on the sidelines with a pile of cash, you’ll be losing money to inflation, missing out on dividends, and perhaps missing out on a 20-40% gain in share prices before the fall happens.

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So why should people who need the money in a few years sell?  The reason is that when big drops do occur, it typically requires 2-5 years for the markets to recover back to where they were before the drop.  The average amount of time required, looking at all periods since 1926, is 3.3 years.  That means if a big drop happened today, it might take 3, four, or even 5 years before share prices returned to where they were before the crash.  In really bad times, like the Great Depression, it might take 10-15 years.  If you really need the money within 5-10 years, and the consequences of not having all of the money would be dire, sell.  If you could get by with half and you have 5-10 years, it might make sense to hold on.

If you really need the money within 5-10 years, and the consequences of not having all of the money would be dire, sell.  If you could get by with half and you have 5-10 years, it might make sense to hold on.  If you need the money next year, your chances are about 60/40 that your account will be higher by then.

So what should you do if the market crashes and you don’t need the money for a long time?

1.  Don’t panic.  As the Hitchhiker’s Guide to the galaxy says, don’t panic.  Panicky people do stupid things, like selling in the middle of a decline.  The best thing you can do during a market decline is to just relax and stick to your investment plan.

2.  Do nothing.  A market crash is a bit like skidding on the ice.  The best thing you can do is to take your feet off the peddles and let yourself coast to a stop.  I usually just stop following stocks for a while, maybe checking account balances about once a month or two, and maybe looking for some stocks on which to take a loss as a tax deduction if it is around the end of the year.  Otherwise, I just wait for a recovery.

3. Buy more.  Instead of looking at a market crash as a bad thing, when you’re many years out from needing the money, it can actually be a great thing to see prices decline.  Typically stocks go down well below their fair value when everybody’s selling, so a market crash is a great opportunity to load up on cheap shares.  Some of the best returns you’ll ever see come the year or two after a major market decline.  If you can raise some money to allow you to scoop up some shares, basically everything will be on sale.  Realize, however, that there may be a few downturns before the market finally straightens out and head up again, so don’t be discouraged if your shares decline after you make your first purchase or two.  You’ll probably not buy at the bottom.

New to investing? Want to learn how to use investing to supercharge your road to financial freedom?  Get the book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Finding a Good Financial Advisor


I am not a financial advisor, as I say in my disclaimer – just an experienced investor willing to share from my experience.  I also think that a lot of people can invest without a financial advisor – it just really isn’t that hard if your read a little, particularly if you use mutual funds.  There is other advice, however, such as tax planning, insurance, and estate planning for which a financial advisor would be invaluable.  Also if you are really not comfortable with investing and would like some experienced help, a financial advisor would certainly not be a bad thing.

In finding a financial advisor, particularly to find one to help you invest in stocks, here are the things for which I would look:

1) In general, find one who charges a fee per service, rather than a percentage of assets or some other system.  There would be a fee for each consultation, perhaps a fee when he does things like help set up or manage the portfolio.

2) Find an advisor who recommends trading infrequently.  Good investing does not involve jumping deftly in and out of the market.  It involves creating a plan of regular investing and sticking to it.

3) Find advisors that advise using normal stocks, ETFs, and no-load funds.  Some advisors make a commission from fund companies to sell products with big sales loads that typically are loaded with fees.  There is little reason to buy funds with sales charges and loads – there are too many good ones that come for free.

4) Find an advisor who is willing to teach you, rather than just do things for you.  A good financial advisor will want to teach you to be a good investor.

5) The investing style should be age-appropriate.  If you are young, he should recommend mostly stocks (although if you are very risk-adverse, he may recommend a higher bond mix).  If you are nearing retirement, he should be recommending more bonds and fixed-income assets like high-yielding stocks (for example, utilities).

6) If you are looking to invest in individual stocks, find one who has experience investing in individual stocks.  In picking stocks, he should be looking at things like earnings growth, financial stability of the company, return on equity, and so on.


To learn about how you can use investing to build wealth, check out my first book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

 

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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