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How Does the Fed “Prop Up” the Stock Market? (Interest Rates and Stock Prices)

A reader writes in, asking:

“I’ve read over and over this year that the Fed is ‘propping up’ the stock market by keeping interest rates low. How does that work?”

Broadly, there are two ways in which low interest rates help to keep stock prices high.

Firstly, to the extent that corporations are borrowers, keeping interest rates low reduces their costs and therefore directly improves their profitability, which of course helps keep their share prices higher. In the case of a struggling corporation, having access to low-cost capital can even make the difference between declaring bankruptcy or not. And of course avoiding bankruptcy proceedings is good for shareholders.

The second effect has to do with the way stocks are priced. (I think it’s actually easier to understand this effect from the perspective of increases in interest rates. So we’ll start with that.)

Stocks are quite a bit riskier than Treasury bonds. So why do you own stocks at all, rather than just buying Treasury bonds with all of your savings? Presumably, you own stocks because you hope to earn additional returns beyond what Treasury bonds earn. That additional return that you hope to earn is known as a risk premium (i.e., additional return to compensate you for the additional risk).

The price of a stock reflects the (market’s consensus as to the) present value of the future cash flows from the stock. And the discount rate used in that present value calculation is usually something along the lines of “whatever we could earn from bonds, plus a risk premium.”

So when interest rates go up, the necessary discount rate goes up. A higher discount rate means a lower present value, which means stock prices go down.

Or you can think of it this way: imagine that TIPS yields suddenly went way up to 3%, rather than the roughly -1% range where they are right now. Maybe you had been estimating that stocks would earn a 4% real return going forward. Before, that was a 5% risk premium. But with TIPS yielding 3%, a 4% real return would only be a 1% risk premium. Maybe you decide that a 1% expected risk premium isn’t high enough to justify the additional risk from owning stocks, so you sell your stocks to buy TIPS.

Collectively, lots of people would be selling stocks to buy bonds in such a scenario. So the price of stocks would fall. When the price falls, the expected return going forward goes up (because a new buyer is paying a lower price for a given amount of dividends/earnings). And the price would continue to fall (i.e., people would keep selling stocks) until the price was low enough that the expected return was high enough to earn whatever the market collectively decided was a sufficient risk premium over bonds.

So that’s what happens when interest rates go up: it has a downward effect on stock prices.

When governments or central banks make efforts to keep interest rates low, the opposite occurs: it exerts an upward pressure on stock prices. That is, low interest rates make the alternatives to stocks not look very appealing — and that helps keep stock prices high.

To be clear though, while low interest rates have an upward effect on stock prices (i.e., they make stock prices higher than they would otherwise be, all else being equal), they do not prevent stock prices from falling. When events occur that worsen the outlook for corporate profitability, stock prices will still fall.

Why is the Market Doing Well Lately?

A reader writes in, asking:

“We’ve basically had a full blown bull market since the bottom in March. VTI has a positive 34% return in just two months. How does that make any sense at all? Unemployment is higher than any time since the Great Depression. The death toll continues to climb, and everybody still says that a vaccine is a year away at least. What gives? It seems like the market has become completely disconnected from reality.”

The first thing to understand is that there’s a big difference between “the stock market” and “the economy.” And this distinction is not a new COVID-19-related phenomenon.

The value of the stock market at any given time is essentially the market’s consensus as to the present value of the expected future earnings of publicly traded companies. That is, the stock market is concerned with the profitability of publicly traded companies. Nothing more or less than that.

So unemployment only affects the stock market to the extent that it affects expectations of profitability. If unemployment goes up by, for example, 10%, that doesn’t mean profits will go down by 10%. The change in expected profits could be greater or smaller than the change in unemployment. Relevant factors there would include:

The second critical point to understand is that that the stock market’s valuation is based on an “expected” (i.e., probability-weighted) value of earnings.

The easiest way to understand this concept is to imagine a company that is undergoing a massive lawsuit. If the suit fails in court, the company would be worth $100 billion. But if the suit succeeds, the company will be bankrupt. Given those facts, what is the company worth right now? That depends on the likelihood of the suit succeeding. If the suit has a 30% probability of success, the company should be worth $70 billion right now (that is, 70% chance that it ends up being worth $100 billion, 30% chance it’s worth zero). If the suit has a 50% probability of success, then the company should be worth $50 billion right now.

As the apparent probability of success of the lawsuit changes, the firm’s value will change.

In the middle of March, extremely catastrophic COVID-19 scenarios (e.g., millions of deaths in the U.S.) were being discussed as real possibilities. We really didn’t know what to expect, and the range of potential outcomes was very wide.

Now, those very worst-case scenarios appear quite a bit less likely. Even if the most likely outcome is approximately the same as it was two months ago (i.e., still not good at all), the probability-weighted outcome can be quite a bit better, because the very worst outcomes have become (apparently) less likely.

But of course that means that the market could still fall again in the near future. If something happens to make the really bad outcomes appear more likely — or if something happens that makes the most likely outcome appear somewhat worse — or if something happens to make the best-case scenario outcomes no longer as good — then the market would probably fall again.

Why It’s Hard to Pick Stocks

A friend (who works in a field as far removed from finance as a field can be) recently asked me why I do not invest in individual stocks. Rather than trying my normal direct explanation, I replied with the following analogy. It’s not perfect, but I think it got the point across. Hopefully you’ll find it entertaining or useful.

Imagine that a friend asks you to go with him to an antique show/fair that’s going to be in town this weekend. It’s a decent-sized one. There’s going to be several thousand items for sale.

You’re not particularly interested in acquiring anything for your own use. But you decide to go along, hoping that you can find a “deal” — something that’s significantly underpriced, which you can sell on eBay for considerably more than you’ve paid for it.

What’s going to affect your likelihood of finding such a deal?

Here are a few factors that I can think of:

  • How early you arrive.
  • How many other shoppers there are.
  • How well informed the other shoppers are.
  • Whether you have any relevant expertise (e.g., if you have an encyclopedic knowledge of rare coins, that could be helpful).

You arrive at the market as soon as it opens, Saturday morning.

But you promptly learn that your friend misread the advertisement. The show opened yesterday. Thousands of shoppers — including many experienced antique bargain hunters — have already been through, picking over all the items.

In fact you learn from another shopper that many of the vendors themselves shopped around at other booths, buying items they thought were underpriced, and then putting them back up for sale at their own booths, at higher prices that they considered more appropriate.

How optimistic are you at this point that you’re likely to find a bargain worth buying?

Not very, probably.

That’s the stock market. Except in the case of the stock market, the market has already been open for many years. There are literally millions of other shoppers. Thousands of professional bargain hunters, shopping every day. And there’s a good chance that you have no particularly relevant expertise.

Dividend Reinvestment FAQs

I thought I’d do something different with today’s article. Below are a few questions — from different readers — about various aspects of reinvesting dividends. None of them required a long enough answer to constitute its own article, but the topics in question are likely to be of interest to other readers.

“I’ve read that from 1960 until now, 82% of the stock market’s overall return is from reinvesting dividends. But I’ve also seen that dividends are usually only 2-3% in a given year, whereas the market’s overall return might be something closer to 8%. I guess what I’m asking is why are dividends so much more important than the increasing price, even though they are a small part of the return?”

It’s not that the dividends are more important than the price appreciation. It’s simply that they are a significant part of the return, and leaving off a significant part of the return dramatically reduces the overall accumulation over an extended period. (This is the same reason that mutual fund expense ratios are super important.)

The longer the period in question, the more pronounced this effect. For example, a $1 initial investment that grows at 8% per year for 75 years will come out to about $321. Reduce the return to 7% instead, and the final result is just $160. In other words, reducing the return by one eighth cut the final value by half. If you instead reduce the return from 8% to 6%, you end up with just $79 — a one-quarter reduction in return reduced the final value by more than three quarters.

That’s why when you read about statistics regarding the importance of dividends over several decades, you see very pronounced effects. Any change to the rate of return will have a magnified impact on the ending value. The effect is smaller if we look at periods that are shorter but still significant over a person’s lifetime (e.g., 20 years).

To reiterate, dividends are important, because they are a significant part of the overall return. But the idea that they are far more important than the price appreciation is simply a misunderstanding of the math involved.

“Why does the price of a mutual fund fall when it pays a dividend?”

In short, the price falls because the fund has less assets, which means it’s less valuable. (The same thing happens with individual stocks, by the way.)

For example, imagine that a fund has a net asset value (NAV) of $25 per share on a given day, made up of $24 worth of various stocks holdings and $1 of cash. Then the fund declares a $1 cash dividend.

Anybody who buys the fund before the ex-dividend date will essentially be getting $24 worth of stocks and $1 of cash. Anybody who buys after the ex-dividend date will be getting just the $24 worth of stocks. Point being: the price should fall by $1 on the ex-dividend date. (Of course in the real world it’s messier than that, because the prices of the various underlying stocks would also be moving around from one day to the next.)

To be clear, the fact that the price falls on the ex-dividend date doesn’t mean that you lose something when your fund declares a dividend. The price falls, but you now have an equivalent amount of cash in your brokerage account. (Or, if you reinvest the dividend, you’re in exactly the same place as before, tax considerations notwithstanding.)

“Should I set my mutual fund to automatically reinvest dividends?”

Maybe.

Having dividends automatically reinvested means that your money begins to earn a return sooner, which is a good thing.

But, if the account in question is a taxable account, it also means that there’s more tracking to be done, because you’ll have a greater number of dates and prices at which you purchased shares. But if you aren’t tracking your cost basis yourself anyway (e.g., you’re using the “average cost” method, and you are relying on your brokerage firm to calculate such for you), then the additional complexity doesn’t much matter. (To be clear though, I would encourage you to keep your own cost basis records, rather than completely relying on another party.)

You should also be aware that automatic reinvesting of dividends could result in a wash sale if you sell the investment in question at what would otherwise be a loss. Generally, this would not be a major reason not to reinvest dividends, as the effect would usually be small. But it’s something to be aware of so that you can report your taxes appropriately.

“How do I calculate the gain or loss on a sale of a mutual fund when I have had dividends and capital gains reinvested? Last year I invested $40,000 in a mutual fund, and it was worth about $40,500 at the end of the year. My dividends and taxable gains for that year, all of which were reinvested, were about $1,700 according to my online statements. Let’s say my fund’s value is $40,500 when I sell it this year. What would be my gain or loss?”

Because you have the account set to reinvest dividends and capital gains, you actually purchased $1,700 worth of shares over the course of last year. So your total basis at the end of the year was $41,700.

So if at the beginning of this year (i.e., before any new money gets invested or distributions get reinvested) you had sold all of the shares for a total of $40,500, then you would have a capital loss of $1,200 (i.e., $40,500 realized on the sale, minus $41,700 cost basis).

If further dividends/capital gains had been reinvested this year before the sale, those would be added to your cost basis as well.

Whether or not you could actually claim this loss would depend on whether or not it’s a wash sale — which it could be, if you own other shares of this same investment (or something else that is “substantially identical”) in another account.

2019 Edition: Social Security Made Simple | Adding a Fund to Improve Diversification

Quick announcement: the 2019 edition of Social Security Made Simple is now available on Amazon. To be clear, there haven’t been any major changes to Social Security since the Bipartisan Budget Act of 2015, so as with last year’s edition, the updates are relatively minor.

For anybody who has not read the book, the outline is as follows:

Part One: Social Security Basics
1. Qualifying for Retirement Benefits
2. How Retirement Benefits Are Calculated
3. Spousal Benefits
4. Widow(er) Benefits
Part Two: Rules for Less Common Situations
5. Social Security for Divorced Spouses
6. Child Benefits
7. Social Security with a Pension
8. The Earnings Test
Part Three: Social Security Planning (When to Claim Benefits)
9. The Claiming Decision for Single People
10. When to Claim for Married Couples
11. The Restricted Application Strategy
12. Age Differences Between Spouses
13. Accounting for Investment Returns
Part Four: Other Related Planning Topics
14. Social Security and Asset Allocation
15. Checking Your Earnings Record
16. How Is Social Security Taxed?
17. Do-Over Options
Conclusion: Six Social Security Rules of Thumb
Appendix A: Widow(er) Benefit Math Details
Appendix B: The File and Suspend Strategy
Appendix C: Restricted Applications with Widow(er) Benefits

You can find the print edition here and the Kindle edition here.


A reader writes in, asking:

“I started a Roth IRA last year, and I currently own the Vanguard Target Retirement 2060 fund. I am planning to add a second fund this year to improve diversification. What would your suggestion be?”

Short answer: I probably wouldn’t add a second fund.

When the entire portfolio is allocated to an all-in-one fund (such as a target date fund or a Vanguard LifeStrategy fund), you don’t have to do any rebalancing, because the fund does it for you automatically. Once you add a second fund to the mix, you will have to rebalance. And once you’ve decided that you don’t mind rebalancing periodically, you might as well just go with a DIY allocation of individual index funds/ETFs anyway, so that you can get the lower expense ratios relative to an all-in-one fund.

Second, adding a new fund would probably not improve diversification in the sense of spreading your money out over a greater number of underlying securities. With a Vanguard Target Retirement fund, you already own four different “total market” funds (U.S. stocks, international stocks, U.S. bonds, and international bonds). For example, adding an allocation to the Vanguard Value Index Fund or the Vanguard Small-Cap Index Fund wouldn’t add any more stocks to the portfolio, because the stocks owned by those funds are already owned by the Vanguard Total Stock Market Index Fund (and therefore owned by your Target Retirement fund).

That said, some people have allocation preferences that are different from “total market” weightings (e.g., they prefer to overweight small-cap stocks relative to their market weighting). And some people have different allocation preferences among the four “total market” components (e.g., they prefer a larger or smaller allocation to international stocks or bonds than what you’d have in your Target Retirement fund).

But target retirement funds are explicitly designed with the goal of being suitable for the “typical” investor. If you can’t articulate something that would make your needs/preferences different from most other people — if you can’t already articulate a particular reason for you to stray from a simple total market allocation such as the one in your Target Retirement fund — then there’s generally no need to do so.

Why Stock Prices Are Still Volatile in an Efficient Market

A reader writes in, asking:

“Last month Facebook’s price fell because the new European privacy law hurt their advertising revenue. I always see the ‘experts’ saying that we shouldn’t invest in individual stocks because an ‘efficient market’ makes it impossible to pick winners and losers. But the idea that every stock is perfectly priced all the time seems wrong on its face. I can tell you right now that if the U.S. passes a similar privacy law, Facebook’s share price will fall again.”

The idea of an efficient stock market isn’t that the stock market can predict the future. Nobody knows what is ultimately going to happen (either with Facebook or with any other company/industry/country).

That is, the market price for a stock doesn’t mean that this is where the price will stay; it’s simply the consensus best estimate, given the information that is currently available.

By way of analogy, imagine that I’m hosting a raffle, in which the winner gets $100. I’m going to sell exactly 100 tickets to the raffle. How much is each ticket worth?

Each ticket is worth $1, because each ticket has a 1% chance of winning $100. (That is, $100 prize x 1% probability of being the winning ticket = $1 value.)

Of course, the reality is that, of the 100 tickets, 99 of them will turn out to be completely worthless, and one lucky ticket will turn out to be worth $100. But we don’t know in advance which ticket will be the lucky one, so until the raffle actually happens, each ticket is worth $1. (In probability/finance jargon, we say that each ticket has an “expected value” of $1.)

The point of the efficient market concept isn’t that an efficient market would successfully predict which raffle ticket will be the winning ticket. Rather, the point is that an efficient market would successfully price each ticket at $1 prior to the raffle.

With regard to Facebook, there’s a possibility that new regulation will come along that impedes the company’s profitability, in which case the stock will be worth significantly less than it’s worth right now. Or, maybe no such event will occur, and the company’s stock price will rise back to what it was before all the hullaballoo.

But because we don’t yet know what’s going to happen, an “in the middle” price is the current consensus price, even though everybody knows it will ultimately turn out to be wrong (i.e., even though everybody knows the value of the company will ultimately turn out to be more or less than the current market value — just like everybody knows that none of the raffle tickets will ultimately be worth $1).

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My new Social Security calculator (beta): Open Social Security