Saturday, January 25, 2014

The Stock Market Disconnect

Most people do not understand the relationship between a company and its stock. When a company first enters the stock market with an IPO (initial program offer) they usually issue a fixed amount of shares. In a simplified model, say a widget company wants to raise money. It has two paths to choose from, a loan or sell stock ownership. Usually the company has already exhausted its credit with the banks. So in an IPO the widget company decides to go public. They want to sell shares, but they also want to retain ownership. So they draw up a charter and issue two million shares. Only one million shares will be sold. The owners get the other million. At this point the widget company enlists a brokerage house to go public.

After the initial IPO sale, a new party enters the mix, called the transfer agent. This is the institution that keeps track of who owns the stock from then on. So if you were to buy 100 shares of IBM today, you are not buying them from IBM, you are now buying them from a broker on the stock market. He is selling shares owned by someone listed as an owner by the transfer agent.

Just because you initiate a sell order for stock does not mean that there is a buyer on the other end. Many brokers are “Market Makers.” They buy and hold until a buyer comes along. So if no one wants to buy Widgets at $10, the market maker will buy at $8 or $9, and you guessed it, sell at $11 the next day.

A lot of stocks pay a dividend and this to a large extent determines the price people are willing to pay for them. Since every stock listed has to put out a 10K financial statement each year (called a red herring for obvious reasons), there is a second way to determine stock value. Divide the number of shares into its stated net worth to arrive at a fair market cash value for the stock. Another way to evaluate the price of a stock, is the price to earnings ratio called P/E. During normal times a P/E ratio from 5 to 10 would be considered average. IBM selling at 179 has a P/E of 11 and pays a 2% dividend; Google selling at 1,121 has a P/E of 32 and pays no dividend. So from examining these two stocks, it isn’t hard to figure out that the buyers and sellers pretty much determine the price they are willing to pay for a stock. During the 1970's a P/E of 4 wasn't uncommon for a car company.

Notice that in the real world, 20 percent ownership of the company stock gives full control, not the 51% common sense suggests is needed. Why? -- because in most company votes, the stock owners split down the middle or don’t vote. This pretty much explains how the 10 percent lunatic fringe element gets to elect our President every 4 years.

There is one other thing to point out, and that is taking possession of your stocks or leaving them with your broker in what is called “street name.” Ordering out a certificate usually costs about $25 and takes about a month to get it. That can be a real hang up if you are a day trader. The other method is to leave it in street name with your broker. He actually holds the stock and your account with him, reflects your holdings. The thing that aggravates me is the fact, if you were to buy 100 shares of Google and keep them in street name, there is nothing to stop your broker from loaning your share to another customer (for a fee) who wants to short Google (sell without owning it). It’s kind of like during the banking crisis when I was shorting Bank of America, somebody else owned it, I borrowed it and shorted it. It’s kind of like supplying the rope for your own hanging. The neat thing about having the certificates, reminds me back to the crash of 1987, everyone was waiting in line to get into the Charles Swab brokerage to sell their street held stocks. There were no lines at many brokerage houses if you showed up with a stock certificate and wanted to negotiate a sale.

What we need to realize about the stock is that it is entirely separate from the company it represents. The transfer agent is as close as you get to the company (unless you attend a shareholder meeting). Good dividends paid by the underlying company and their earnings help support stock prices. The price to earnings ratio gives the buyer some measure of how fairly priced a stock is.

There are stock market experts everywhere today, and as long as the market goes up, who needs to pay for market advice? It’s not like stocks are going to drop in price. It hasn’t always been this way, I can remember a goofy little plaque on my broker’s desk in the early 1980’s of a cartoon character holding a sign saying “DOW 2000.” I can remember asking him, “Do you think it will ever get there,” and we’d both laugh. Back then a company could announce a cure for cancer and the stock would drop 15 points, go figure.

If we were to examine the dynamics of a future market crash, things change somewhat. Instead of rising prices and increased expectations, it is a rush for the exits. Good stocks are sold to raise cash and the dogs are held in the hopes that they will come back. The main thing to realize in a crash, is that the values of the stocks are being re-determined and almost all, invariable will be undervalued by quite a bit. In a panic, there is the creation of “air pockets,” where there are no bids for a stock offered for sale. The market makers have closed up shop because of the volatility. You could conceivable bid a dollar a share for Google and get it if it was offered “at market,” and you were the only bidder.

What one needs to realize about the stock market crash in 1929, is that it was a financial liquidation disaster. It was the investors who held the stocks that were taken out and shot, not the companies themselves. We could be approaching another such event. The stock market reminds me of the Real Estate market of 2006. That million dollar house is still there, but it sells for a lot less now. Our government was able to keep that bubble pumped up with government financing. Will there be another stock market crash? Of course, and the effects will be invisible. Google and IBM will still be there; only the price per slice will be different. Of course after eating steak all of these years, you might gag on the switch to hot dogs.

Effectively, the stock market is the only game in town not under government control. Many different companies produce marvelous products and have stocks you can invest in. Don’t get wrapped up in what they make, and buy the stock for that reason. If they don’t know how to run their business, they could become the next General Motors.

So now you know the difference between the stock, the company it represents and the stock market. The one thing we haven’t discussed is the fact that a person can make just as much money in a market going down as well as one going up. I asked my broker once how come he didn’t recommend shorting stocks and he replied, “Being negative about the market is bad for business.”

The easy way to make a million dollars in the stock market, start out with several million--it works every time.

Thursday, January 16, 2014

The Fed Quantitative Easing and Interest rates

A while back, someone pointed out that if homes were selling like hotcakes when interest rates were 6%, there shouldn’t be any inventory left at 4%. As it is, housing is not as robust as it was in the boom days. Bernanke said that the Federal Reserve would curb their buyback plan of 80 billion a month of Treasury’s and mortgage backed bonds.

Let’s use the back of an envelope and do some computations on the Feds involvement in Real Estate. Figure that they dropped about 40 billion per month buying real estate mortgages. If we calculate the number of homes that could be bought, figure the low end price of 200k and a high end of half a million. So the range of home loans purchased by the Fed is from 200,000 cheap ones to 80,000 expensive ones. The November real estate report calculated that 4.9 million homes were sold in the span of a year nationwide. The wild thing that I haven’t verified is that they claim 7 out of 10 buyers paid cash. If that is true, 1.47 million homes needed financing. Extrapolating the Federal consumption of Real Estate paper, on a yearly basis, we get a range of 1.4 million to a little over a half million homes financed. Take out for a down payment, and it kind of looks like the Fed is the market maker for Real estate loans.

The banks do not want to hold low interest bearing real estate loans and I don’t blame them. It puts them in the position of borrowing from their depositor’s short time and loaning it out long time. The Fed on the other hand, in theory, has no problem holding a low interest rate loan for 30 years. The printed dollars come back to them in monthly payments and in the end; it is a zero sum game.

This whole QE problem which some refer to as QEternity, has robbed the silver foxes of their retirement interest. While at the same time our youth are scratching their heads over the big deal that everyone use to make about compound interest being the 8th wonder of the world. Put money in the bank and save it? Why bother? My credit card pays me 2% interest for spending money and that’s more than the bank pays for saving it. We are living with the “I want it now” generation.

The young are not going to put money in the bank long term, but there is still one game in town going strong –the stock market. People with 401K’s can save on income taxes by putting money away for retirement. Where are these money mangers putting the funds? The stock market.

What needs to be realized is the fact that there has to be a correction of sorts. There is no incentive to save for a “rainy day.” If quantitative easing were to end, where does the money come from to finance the next real estate purchases? I’m not about to give anyone my savings for 30 years at 2% interest.

Many things revolve around interest rates; bonds, real estate prices, pension funds, national debt, bank rates, commodity futures, credit card debt and stock market margin to name a few. What we do know is that interest rates should rise if the Federal Reserve stops its quantitative easing. Risk would reenter the market and interest rates would reflect the perceived risk. The net result, the investor would reallocate their financial resources to take advantage of the markets. Change the rules and the game changes. The real estate recovery would probably hit the skids. A doubling of interest rates would trash the bond market and the interest on the national debt would approach one trillion a year. Commodity futures would cost more with higher interest rates, and the stock market would not be the only game in town anymore. Retirement funds heavily invested in long term bonds and real estate would be toast. Banks would be willing to pay more interest on savings which would be a boon to retirees, and credit card debt could become a lot more expensive. This could lead to a drastic drop in consumer consumption.

There is only one market that the Federal Reserve has not insured—the stock market. So if QEternity continues, we can see Google stock hitting $15,000 a share. Of course you say it could never happen, well, Ben Bernanke’s financial shenanigans remind be of John Law and the Mississippi bubble of 1720 in France (which wasn’t really a bubble); read up on it if you think $15,000 a share is excessive.

What we can realistically state about our present financial government solution to our present dilemma, is that it is not self-sustaining. A long term Federal Reserve bailout is only manipulating the financial structure in ways that affect those about ready to retire or are already retired. Basically Congress has no idea on how all of this Federal Reserve money fits in with their budgets, but it appears to work splendidly.

Presently gas pumps will accept $20 bills but not $50 bills. It takes $62 dollars to fill my tank. Do you get the feeling that the $100 bill is the new “$20” that you use to use? Of course it’s not inflation, let’s blame the Arabs,---and we are not even buying their oil, go figure!

Monday, January 06, 2014

Paying for "Affordable Health Care"

When you hear the words “Affordable Health Care,” no two people are going to be envisioning the same thing. We have health care, but we don’t have health care with unlimited funding. Affordable health care is a political rally point, it means something different to each age group.

Insurance is a method used to cover unforeseen events in our life. A group of people realized that they needed fire, life, car or health insurance, and as a group would figure out the cost that all of the members would bear to help the unfortunate ones. This isn’t something you could purchase after the event occurred. But if the rules were to change, to where you could file for insurance after the fact, it becomes rather obvious, that each and every person in the plan would never draw more than what they put in. The insurance becomes meaningless, it fails to offer the protection desired.

When your health care costs exceed your ability to pay for them, health care is no longer affordable. The purpose of insurance is to avoid being put in this situation. There comes a point in many people’s lives, where the cost of medical treatment is not justified because the high cost of the treatment outweighs its short term benefit (with or without insurance).

What we need to realize is that health care is not really that affordable, it never has been. Once we destroy the insurance aspect of it with a government plan, paying extra doesn’t entitle you to more; it is expected of you to pay more if you earn more. And conversely paying less, is an "entitlement" if you earn less.

I have a solution that is a thousand years old and might not be received well. How about if everyone over the age of 18 has to pay two month’s wages in taxes each year or work for two months for the government? Rome built a very extensive road system using this tax plan. Notice you can’t plead poverty; you show up for work or pay to have someone work for you. This would be quite fair, working people today pay taxes well into May of each year.

Everyone has the right to enjoy living in this country; and if you don’t have the dollars to pay your fair share of taxes, the Federal Government could\would make it possible for you to physically work off your debt. The thing that makes me chuckle, is the fact that the people who can’t afford to pay for health care, have given our government the information necessary to implement a "labor in lieu of taxes," plan. Kind of reminds me of Roosevelt's Social Security plan that laid out the infrastructure for an income tax that was eagerly and immediately leveled at the Hoi Polloi.

Let’s get rid of the free ride, everyone will pull on the rope, so we as a nation can benefit. Of course those that still think that “This is still the greatest nation on earth,” don’t need to pull on the rope--they're probably too busy smoking it. I’m just not sure who we are fooling here, nobody wants to pay more taxes and everyone would like unlimited health care. But would they want to work an additional 2 months for guvernment health care? Prosperity isn't what lies around the corner, Reality is lying in wait.