THIS IS MY 180TH BLOG ON UNDERSTANDING MONEY
TOOLS
December, 2019
What precipitated me to write this blog? I was having coffee recently with a
good friend from Nebraska and he asked my thoughts about what was happening in
the financial markets. Love
it. To my surprise he had no idea
on basic financial understandings although he had money in mutual funds. He is
smart, can adapt, but finances are out of his realm as a large farmer. Typical
of today’s thinking, “as long as the market keeps going up, who cares?”
We got into basic logics of finance and economics. (Economics is merely finances of a
governing body, let’s say a county, state or country.) I lost him, and he told me so. Therefore, the old expression from the
movie Cool Hand Luke immediately came to mind, “What we’ve got here is a
failure to communicate”! I blame
myself. So, with that said let’s
redefine some finance basics.
First, we have had great distractions since Mr. Trump took
office so that our attention has been driven away from the extreme and dire
financial situation our country and the world is really in. Thinking back, our media attention went
to the “wall” between Mexico and the US and our immigration problem on the
southern border. Mexico was going to pay for the wall! Who believed that one? Then, came the threat of weaponry and
missiles with North Korea.
Following that was China and our import/export imbalance and tariffs. (And by the way, the imbalance is
greater today than ever.) Lastly
and currently, we have the Presidential impeachment process going on. I think very few people can bring you
current on any of these issues.
They fade away, little being accomplished.
Now, what has been overlooked and most important in my eyes
is the “real” state of economic stability. We will look at the stock markets first. Everything “should” evolve from
finance, meaning profits and losses.
These ratios, norms, stats, baselines, etc. come over long periods of
time. You can deviate a short time
from the normal accountability, but then correct to the norm.
What have we here?
Our most conservative index is the DOW Industrials of 30 precious
stocks. The Dow/Jones was started
in May, 1896. The S&P has 500
stocks and started in 1957, and so forth.
Therefore, we have a good history on standards and baselines to run off
of. In a free market we should
return to the norms. Insurance companies, our government pensions, banks and other
entities use these stats, or paradigms to figure out future expected returns.
Let’s return to my coffee buddy. I explained that over the last 124 years the Dow Industrial
average has had a P/E with a mean of 15 to 1. I showed him that as of the last week in November it stood
at 29 to 1. This brought questions
into conversation; these being how did it get so high and what should the norm
be? Answer to part one is 1) the
intervention by the US Government, 2) everyone jumping into the market as they
may feel left out and 3) companies borrowing at very low rates of interest and
buying their own stock back, thus raising the price of their stock and the
markets. Simple! These points above have falsely raised
the stock markets compounding growth at 10-15% over the past 10 years when our
GDP and corporate growth has been about 3%. It can’t hold forever.
Returning to coffee buddy, he asked how to figure a
realistic stock or market price.
Let’s assume an index, like the Dow average, is priced at 28,000 and has
a historical P/E like the Dow of 15 to 1.
(That would be an expected return on investment of earnings of 6.5%,
dividing 15 into 100.) It’s okay if you couldn’t understand that last figure! 28,000 is where the Dow is today. Also, today it has a P/E of 29 to
1. How are we going to calculate
an approximation of where a realistic market price should be? Take the 28,000 and multiply by 15/29,
thus 28,000 times 15 = 420,000, then 420,000 divided by 29 = 14,482. That is where the Dow should be
rationally priced.
In the above example, I know that the Dow should be at
15:1. Look it up! Let’s say I go to the market at any
given time during the day and it shows me the Dow “at” 15:1. (15/15 = 1) Then, the Dow should be at
28,000, but that is not the case. If you should be so lucky as to see a stock or market way under-priced, add
money slowly as the stock or market could go lower. Seek value, just like buying investment art or a fine
collector car. Who will buy you
out of the stock or market? If the
Dow’s value slid to about 10:1 P/E, you’d also probably be making about 4 to 5%
on dividends unless Board of Directors lowered their company’s dividends. When it comes bonds, look at value and
risk. Also, “ladder” maturity
dates of these bonds.
What kind of financial numbers are we talking about to raise
the stock markets so high? Since
September 22nd the government has placed about $1.3 trillion into
our largest banks and stock markets to “stabilize and calm the markets”. This has been done, “off balance
sheet”, with the approval of the President and the Treasury Department. If you go to Google and put in US Debt
Clock, you will find the debt at $23.1trillion not reflecting the figures I
mention. Regarding large companies
buying their stock, according to the latest figures corporate debt now stands
at $10 trillion, higher than any time in history.
Now, for some thought without answers. We all saw what happened with debt in
the real estate industry and banking in 2008-2010. What if the stock markets fall and companies cannot pay the
interest on bonds? What if the US
Government cannot pay interest on bonds?
What happens if banks have to “mark to market” the value of their stock
holdings and loans outstanding? This should be adjusted periodically.
The government says our economy is solid. I see, only if we keep borrowing and
lending to people and companies who/which should not be borrowing more
money. False impressions of a good
economy. The old expression of
“give an economist an end result you want, and he will find the numbers to
prove it true!” Doesn’t take a
genius to realize something is amiss!
I hope this gives you a good understanding of some financial
basics.
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