Why do they pay these guys so much?

The Fed’s Actions Are Counterproductive: Jim Grant

 

Okay, I don’t know how much this guy gets paid to do his job but I’m sure it’s more than I get paid.  I can tell by his tie.  Anyway, he thinks that the Fed is being counterproductive.  I think he meant ineffective, but counterproductive probably makes a better headline.  Whether the Fed is being ineffective, we have to understand where we would be if the Fed had not taken the actions that it has.

So, let’s think about this for a minute.  First, the Fed has dropped short-term rates to as low as they can go.  The theory is that other rates will follow the short-term rates lower; businesses will borrow to increase investment spending, followed by increasing hiring and decreasing unemployment, which is then followed by increasing consumption spending.  It didn’t really work out that way.  While longer term rates did fall, it wasn’t enough to really entice businesses to invest because they didn’t see an increase in demand coming.  This could be explained, at least in part, by falling home prices which resulted in a large decrease in wealth among consumers.

Lower mortgage rates would normally lead to increased demand for real estate, but the Fed apparently believed that the rates weren’t low enough to drive enough demand for housing to drive housing prices higher, so they decided to take a direct approach and purchase MBSs to push mortgage rates lower.  But, the action is limited again by market factors, which includes the rates on long bonds, which effectively put a floor on how low mortgage rates can fall.  So, the Fed decided to purchase long bonds to drop the yields on those, which would allow mortgage rates to fall a little more.  It certainly seems as if that has happened.  Home prices, at least on average, are rising.

But the problem with mortgage rates is that, if the Fed actually does increase home buying by pushing rates down, the increase in demand for new mortgages will push rates back up, so the effect on real estate prices is probably short-lived.

In the meantime, the Fed’s actions are pushing investment money into higher risk assets because the Fed has effectively crowded investors out of low risk investments.  This is good for the stock market, as well as lousy analysts because when the stock market rallies, it’s easy to look like a genius.  But I digress.

There actually is another reason for the flight to high risk investments - the dividend yields on a lot of stocks, which are higher than bank interest and taxable at a lower rate than bank interest.  And why are dividend yields so high?  Because businesses aren’t investing in capital, like they normally would be because they don’t expect the demand to be there.

So, all that’s happening right now is there is a lot of extra money in the financial markets, and that’s where it will stay until everyone realizes that even stocks aren’t offering a reasonable return.  But what happens then?  The big question is what people will do with their money when every investment is a bad investment.

No surprises

Fed Keeps Stimulus Amid Signs of Weak Economy

"Markets showed relatively little reaction to the GDP report, in part because it reinforced expectations that the Fed will continue to provide stimulus as long as the economy is weak."

And, of course, the Fed did say they would continue to provide stimulus.  Nothing new there.

GDP Shows Surprise Drop for US in Fourth Quarter

"The U.S. economy posted a stunning drop of 0.1 percent in the fourth quarter, defying expectations for slow growth and possibly providing incentive for more Federal Reserve stimulus.

The economy shrank from October through December for the first time since the recession ended, hurt by the biggest cut in defense spending in 40 years, fewer exports and sluggish growth in company stockpiles."

Well, this is a little earlier than I expected, but I wouldn't really call it "stunning."  The way I see it, the good news is where the shrinkage came from, well, except for the exports.  And, as a lot of people are saying, there were a lot of "one-off" items that hurt GDP, sort of like one-time charges on a company's earnings. 

The main question for stocks is whether the Fed stimulus is going to outweigh what is, in my opinion, a likely recession.  One may also wonder how this might affect the federal government's plan to reduce the deficit.

Optimism

Everybody seems to be getting on board with making optimistic predictions for economic growth this year, but I think it's still a little early to be jumping on the bandwagon.  The data that I'm seeing is, well, old data that doesn't reflect the tax increases that went into effect earlier this year.  Still, we do have the Fed pumping more cash into the financial markets, so I don't see much at all to worry about at this point, unless the reports of planned increased hiring come to fruition, in which case, we may see inflation begin to tick up and the Fed put an end to the easy money available in financial markets.

The risk-free rate

I just did a Google search for “risk-free rate.”  It seems there’s this idea that the risk-free rate is some “theoretical” rate. I think there is, in fact, a close enough risk-free rate, which is a rate that is actually attainable risk-free, and that there is also a theoretical risk-free rate (what the rate should be) which may be significantly different than the close enough to risk-free rate. This theoretical rate shouldn’t be used to actually value investments, though, and that’s the risk-free rate I’m interested in here: the rate to use to value investments. A theoretical rate doesn’t allow me to determine the return that I can achieve, or should require, given a level of risk, and if I have cash to invest, I’m not really concerned with what minimum rate I should require on a risk-free asset. I need to begin with what is actually available. The goal is to determine the rate of return an investor should expect among the available investment options. Theoretical rates don’t go very far in the real world.

Let’s look at an example of why I don’t care what the risk-free rate should be. Assume that I have a bill that needs to be paid in 3 months, but I have the cash today. I can do 1 of 3 things:

1. I can pay the bill today.
2. I can hold the cash and pay the bill in 3 months.
3. I can invest the cash at the risk-free rate and then pay the bill in 3 months.

Whether the risk-free rate is as high as it should be, the best alternative is number 3. It doesn’t matter whether I was properly compensated for the time value of my money because in both of the other cases, I won’t be compensated at all.

Offhand, at least for my purposes, I don’t really see much value in knowing what the risk-free rate should be. However, if you’re interested, you can read up on the subject here.

One thing is for sure: the Fed is manipulating the risk-free rate, and it is without a doubt lower than it should be. Knowing that doesn’t do me any good in evaluating investment options though.

Currency

Why America's Top Detergent Is a Black Market Hit
And today, PG announced earnings that beat expectations.  Looks like there are a lot of people stocking up on "currency."

1600?

Amazingly, or perhaps not so much, analysts seem to be edging up their forecasts for the S&P for the year.  So far, the only rationale for this upward revision appears to be because the S&P 500 is up.  It goes something like this: "Well, we broke through the psychologically important 1500 level, so, outside of that pesky fiscal cliff thing in March, it's pretty much clear sailing to 1600."  I'm really expecting something much lower than that, but then, I usually underestimate the irrationality of markets, so we'll see.  I actually think that once we start to see the effect of the tax increases in the economy, we'll see a lot of analysts reversing their optimism.

A little of both

Gary Shilling: Cash Is King, Stocks Are Still Doomed

Say this stuff often enough, and sure enough, you'll be right.  In this case, though, look at the returns you would have missed out on.  Still, I actually think it may be time to start moving more toward cash, because, yes, the crash is coming.  We just can't be sure when. Of course, I wouldn't take this Mr. Shilling's advice on bonds either, because the same holds true with them.  Cash or whiskey.  Whiskey if you expect inflation, and cash if you expect deflation, so maybe a little of both.

Invest in real estate?

What John Paulson Says Is the Best Investment Now

In my opinion, John Paulson is an example of how someone can get lucky, and no matter how badly they do later, the public will remember him as some sort of visionary.  Being a homeowner, I would really like to believe what he says... then again, he made billions short-selling mortgages in 2007, and I'm sure he wasn't busy telling people what a terrible investment mortgages were then.  I am, though, somewhat comfortable with the housing market over the next couple of years.  I'm mostly worried about what's going to happen when the Fed starts raising interest rates or the federal government decides to cut the home ownership tax credits and deductions.  I still see the real estate market as being artificially inflated.  So, the decision to invest in real estate really depends on how much confidence you have in the government and the Fed.  I don't have that much confidence, but I'm also not going to sell... YET.

Put-call parity

Put-call parity describes the relationship that must exist between the prices of puts and calls to eliminate the possibility of arbitrage.  If put-call parity doesn’t hold, then arbitrage will occur until parity is established.

Put-call parity is described by the equation:

P = C + PV(X) – S0 + PV(dividends)

Where:

P = put price

C = call price

PV(X) = present value of the strike price

S0 = current stock price

PV(dividends) = present value of any dividends to be paid on the stock during the life of the option.

For the purposes of this demonstration, I’ll use at the money options on SPY that expire on June 27, 2013.  It isn’t difficult to build a spreadsheet model to facilitate comparing different maturities and different strike prices.

The first difficulty that I see is figuring what the dividends will be.  In December, SPY paid over $1.00, but that was significantly higher than the historical amount, between $0.60 and $0.70.  The reason for this is, apparently, that some companies moved their dividend payments forward due to the fiscal cliff.  I suspect that we’ll see a lower than normal dividend from SPY in March, but it will likely end up about the same after that.  So, I’ll use $0.60 (the low end of the range) for the dividend in March.

One other oddity concerning the dividends is that the ex dates are long before the payment date.  Consequently, the July 31 dividend, which will be paid after the expiration of the option, actually belongs to whoever holds the stock before expiration of the option.  So, if I owned the stock and bought a put to give me downside protection, I would gain the value of that last dividend, and therefore, the July 31 dividend should be included in the calculation.

One other thing to note is that we need to compare the bid price of each to the ask price of the other, because most of us are price takers, meaning we have to buy at the ask and sell at the bid.

Finally, I’ll use the 3- and 6-month T-bill rates as the discount rates.  The 3-month rate is close to the time of the first dividend while the 6-month rate is close to the expiration date.  I suppose an argument could be made that the dividends should be discounted at a higher rate since they are actually not known, but it won’t make much difference.  We won’t count the dividend at the end of January since the ex-dividend date has already passed.

So, currently we have this for our options:

	Bid	Ask
Put	6.37	6.39
Call	5.3	5.34

6 month risk-free rate	0.08%
3 month risk-free rate	0.05%
S0	148
X	148
Div1	0.65
Div2	0.65
Days to div1	102
Days to div2	194
Days to expiration	160

I won’t show the math here; it’s just a matter of plugging the numbers into the equation.  The result is that the put bid price should be 6.55, while the put ask price should be 6.59, a bit higher than the actual prices.  But, it’s only about $0.20, which isn’t enough to offer an arbitrage opportunity when we factor in transaction costs.