MONEY Greece

What the Turmoil in Greece Means for Your Money

The head of radical leftist Syriza party Alexis Tsipras waves to supporters after winning the elections in Athens January 25, 2015. Tsipras promised on Sunday that five years of austerity, "humiliation and suffering" imposed by international creditors were over after his Syriza party swept to victory in a snap election on Sunday.
The head of radical leftist Syriza party, Alexis Tsipras. Marko Djurica—Reuters

Expect lower stock prices.

Faced with an apocalyptic unemployment rate of 28%, voters in Greece have drawn the line on austerity measures that have mired the country in a crisis rivaling that of the Great Depression. In the worst case, the move could lead to Greece’s exit from the European monetary union. In the best case, it will produce much-needed debt relief for the country’s ailing economy. But either way, it’s prudent to assume the turmoil will roil equity markets both here and abroad.

The issue came to a head earlier this week when Greece’s “radical left” Syriza party won a plurality of votes in the latest election. Led by 40-year-old Alexis Tsipras, Syriza campaigned on a platform to ease the “humiliation and suffering” caused by austerity. This includes debt relief and rolling back steep spending cuts enacted by Greece’s former government in exchange for financing from the International Monetary Union and other members of the European Union.

To say Greece has paid dearly for these cuts would be an understatement. The consensus among mainstream economists is that austerity during a time of crisis exacerbates the underlying issues. We saw this in Germany after World War I when France and Great Britain demanded it pay colossal war reparations. We saw it throughout Latin America following the IMF’s structural adjustments of the 1980s and 1990s. And we’re seeing it now in Greece and Spain, where unemployment has reached levels not seen in the developed world since the Great Depression.

The problem for Greece is that Germany and other fiscally conservative European countries aren’t sympathetic to its predicament. They see Greece’s travails as its just deserts. They see a fiscally irresponsible country that exploited its membership in the continent’s monetary union in order to borrow cheaply and spend extravagantly. And they see an electorate that isn’t willing to accept the consequences of its government’s actions.

To a certain extent, Greece’s critics are right. Over the last decade, its debt has ballooned. In 2004, the country’s debt-to-GDP ratio was 97%. Today, it is 175%. This is the heaviest debt load of any European country relative to output.

It accordingly follows that the European Union stands once again at the precipice of fracturing. If the Syriza party sticks to its demands and Greece’s neighbors won’t agree to relief, then one of the few options left on the table will be for Greece to exit the monetary union and abandon the euro. Doing so would free the country to pursue its own fiscal and monetary policies. It would also almost inevitably trigger a period of sharp inflation in a reinstituted drachma.

This isn’t to say global investors should be petrified at the prospect of even the most extreme scenario — that of Greece abandoning the euro. In essence, the euro is nothing more than a currency peg that fossilized the exchange rates between the continent’s currencies in 2001. By going off it, Greece would essentially be following in the footsteps of the Swiss National Bank, which recently unpegged the Swiss franc from the euro after a drop in the latter’s value made maintaining the peg prohibitively expensive.

A more complicated question revolves around the fate of Greece’s sovereign debt. Seceding from the monetary union won’t eliminate its obligations to creditors. It likely also won’t change the fact that the country’s debt is denominated in euros. Thus, if Greece were to exit the euro and experience rapid inflation, the burden of its interest payments would get worse, not better. This would make the prospect of default increasingly attractive if not necessary in order to reignite economic growth.

But investors have shouldered sovereign debt repeatedly since the birth of international bond markets. Just last year, Standard & Poor’s declared that Argentina had defaulted after missing a $539 million payment on $13 billion in restructured bonds — restructured, that is, following the nation’s 2002 default. Yet stocks ended the year up by 11.5%. The same thing happened when Russia defaulted in 1998. Despite triggering the failure of Long Term Capital Management, a highly leveraged hedge fund that was ultimately rescued by a consortium of Wall Street banks, stocks soared by 26.7% that year.

Given all this, the biggest impact on investors, particularly in the United States, is likely to make its way through the currency markets. When fear envelopes the globe, investors flee to safety. And in the currency markets, safety is synonymous with the U.S. dollar. Over the last year, for instance, speculation about quantitative easing by the European Central Bank, coupled with the scourge of low oil prices on energy-dependent economies such as Russia and Mexico, has increased the strength of the dollar. This will only grow more pronounced if the U.S. Federal Reserve raises short-term interest rates later this year.

The net result is that American companies with significant international operations will struggle to grow their top and bottom lines. This is because a strong dollar makes American goods more expensive relative to competitors elsewhere. Consumer products giant Procter & Gamble PROCTER & GAMBLE COMPANY PG -1.6108% serves as a case in point. In the final three months of last year, P&G’s sales suffered a negative five percentage point impact from foreign exchange. As Chairman and CEO A.G. Lafley noted in Tuesday’s earnings release:

The October [to] December 2014 quarter was a challenging one with unprecedented currency devaluations. Virtually every currency in the world devalued versus the U.S. dollar, with the Russian Ruble leading the way. While we continue to make steady progress on the strategic transformation of the company — which focuses P&G on about a dozen core categories and 70 to 80 brands, on leading brand growth, on accelerating meaningful product innovation and increasing productivity savings — the considerable business portfolio, product innovation, and productivity progress was not enough to overcome foreign exchange.

With this in mind, it seems best to assume revenue and earnings at American companies will take a hit while Europe works toward a solution to Greece’s problems. In addition, as we’ve already started to see, the hit to earnings will be reflected in lower stock prices. There’s no way around this. But keep in mind that we’ve been through countless crises like this is in the past, and the stock market continues to reward long-term investors for their patience and perseverance.

MONEY Oil

Why Oil Prices May Not Recover Anytime Soon

A worker waits to connect a drill bit on Endeavor Energy Resources LP's Big Dog Drilling Rig 22 in the Permian basin outside of Midland, Texas, U.S., on Friday, Dec. 12, 2014.
Brittany Sowacke—Bloomberg via Getty Images

Things could get worse for the oil industry before they get better.

Oil prices have collapsed in stunning fashion in the past few months. The spot price of Brent crude reached $115 a barrel in June, and was above $100 a barrel as recently as September. Since then, it has plummeted to less than $50 a barrel.

Brent Crude Oil Spot Price Chart

There is a sharp split among energy experts about the future direction of oil prices. Saudi Prince Alwaleed bin Talal recently stated that oil prices could keep falling for quite a while and opined that $100 a barrel oil will never come back. Earlier this month, investment bank Goldman Sachs weighed in by slashing its short-term oil price target from $80 a barrel all the way to $42 a barrel.

But there are still plenty of optimists like billionaire T. Boone Pickens, who has vocally argued that oil will bounce back to $100 a barrel within 12 months-18 months. Pickens thinks that Saudi Arabia will eventually give in and cut production. However, this may be wishful thinking. Supply and demand fundamentals point to more lean times ahead for oil producers.

Oil supply is comfortably ahead of demand

The International Energy Agency assesses the state of the global oil market each month. Lately, it has been sounding the alarm about the continuing supply demand imbalance.

The IEA currently projects that supply will outstrip demand by more than 1 million barrels per day, or bpd, this quarter, and by nearly 1.5 million bpd in Q2 before falling in line with demand in the second half of the year, when oil demand is seasonally stronger.

That said, these projections are built on the assumption that OPEC production will total 30 million bpd: its official quota. However, OPEC production was 480,000 bpd above the quota in December. At that rate, the supply-and-demand gap could reach nearly 2 million bpd in Q2.

Theoretically, this gap between supply and demand could be closed either through reduced supply or increased demand. However, at the moment economic growth is slowing across much of the world. For oil demand to grow significantly, global GDP growth will have to speed up.

It would take several years for the process of lower energy prices helping economic growth and thereby stimulating higher oil demand to play out. Thus, supply cuts will be necessary if oil prices are to rebound in the next two years-three years.

Will OPEC cut production?

There are two potential ways that global oil production can be reduced. One possibility is that OPEC will cut production to prop up oil prices. The other possibility is that supply will fall into line with demand through market forces, with lower oil prices driving reductions in drilling activity in high-cost areas, leading to lower production.

OPEC is a wild card. A few individuals effectively control OPEC’s production activity, particularly because Saudi Arabia has historically borne the brunt of OPEC production cuts. Right now, the powers that be favor letting market forces work.

There’s always a chance that they will reconsider in the future. However, the strategic argument for Saudi Arabia maintaining its production level is fairly compelling. In fact, Saudi Arabia has already tried the opposite approach.

In the 1980s, as a surge in oil prices drove a similar uptick in non-OPEC drilling and a decline in oil consumption, Saudi Arabia tried to prop up oil prices. The results were disastrous. Saudi Arabia cut its production from more than 10 million bpd in 1980 to less than 2.5 million bpd by 1985 and still couldn’t keep prices up.

Other countries in OPEC could try to chip in with their own production cuts to take the burden off Saudi Arabia. However, the other members of OPEC have historically been unreliable when it comes to following production quotas. It’s unlikely that they would be more successful today.

The problem is that these countries face a “prisoner’s dilemma” situation. Collectively, it might be in their interest to cut production. But each individual country is better off cheating on the agreement in order to sell more oil at the prevailing price, no matter what the other countries do. With no good enforcement mechanisms, these agreements regularly break down.

Market forces: moving slowly

The other way that supply can be brought back into balance with demand is through market forces. Indeed, at least some shale oil production has a breakeven price of $70 a barrel-$80 a barrel or more.

This might make it seem that balance will be reasserted within a short time. However, there’s an important difference between accounting profit and cash earnings. Oil projects take time to execute, involving a significant amount of up-front capital spending. Only a portion of the total cost of a project is incurred at the time that a well is producing oil.

Capital spending that has already been incurred is a “sunk cost.” The cost of producing crude at a particular well might be $60 a barrel, but if the company spent half that money upfront, it might as well spend the other $30 a barrel to recover the oil if it can sell it for $45 a barrel-$50 a barrel.

Thus, investment in new projects drops off quickly when oil prices fall, but there is a significant lag before production starts to fall. Indeed, many drillers are desperate for cash flow and want to squeeze every ounce of oil out of their existing fields. Rail operator CSX recently confirmed that it expects crude-by-rail shipments from North Dakota to remain steady or even rise in 2015.

Indeed, during the week ending Jan. 9, U.S. oil production hit a new multi-decade high of 9.19 million bpd. By contrast, last June — when the price of crude was more than twice as high — U.S. oil production was less than 8.5 million bpd.

One final collapse?

In the long run — barring an unexpected intervention by OPEC — oil prices will stabilize around the marginal long-run cost of production (including the cost of capital spending). This level is almost certainly higher than the current price, but well below the $100 a barrel level that’s been common since 2011.

However, things could get worse for the oil industry before they get better. U.S. inventories of oil and refined products have been rising by about 10 million barrels a week recently. The global supply demand balance isn’t expected to improve until Q3, and it could worsen again in the first half of 2016 due to the typical seasonal drop in demand.

As a result, global oil storage capacity could become tight. Last month, the IEA found that U.S. petroleum storage capacity was only 60% full, but commercial crude oil inventory was at 75% of storage capacity.

This percentage could rise quickly when refiners begin to cut output in Q2 for the seasonal switch to summer gasoline blends. Traders have even begun booking supertankers as floating oil storage facilities, aiming to buy crude on the cheap today and sell it at a higher price this summer or next year.

If oil storage capacity becomes scarce later this year, oil prices will have to fall even further so that some existing oil fields become cash flow negative. That’s the only way to ensure an immediate drop in production (as opposed to a reduction in investment, which gradually impacts production).

Any such drop in oil prices will be a short-term phenomenon. At today’s prices, oil investment will not be sufficient to keep output up in 2016. Thus, T. Boone Pickens is probably right that oil prices will recover in the next 12 months-18 months, even if his prediction of $100 oil is too aggressive. But with oil storage capacity becoming scarcer by the day, it’s still too early to call a bottom for oil.

MONEY Jobs

Why Is Employment Picking Up? Thank Government

public construction workers
Reza Estakhrian—Getty Images

After hurting the employment picture for so long, local, state and federal governments are finally adding to payrolls.

The U.S. economy continued its winning streak by adding 252,000 jobs in December, the 11th consecutive month employers hired more than 200,000 workers. The unemployment rate fell to 5.6%, a post-recession low, as various sectors (from business services to health care to construction) added to payrolls.

Boosting hiring isn’t exactly new when it comes to private businesses, which have been bolstering their staffing for every month for almost five years.

What’s different about the recent pickup in employment is the positive effect of governments (state, local and federal). While jobs aren’t being added at rapid pace, they have grown steadily over the past year, and are no longer subtracting from the labor market like they were not too long ago.

Government employment increased by 12,000 in December, compared to a reduction of 2,000 employees in the last month of 2013. Compared to a year ago, state and local governments throughout the country have added a combined 108,000 jobs.

As recently as last January the government shed 22,000 positions. Sustained, incremental growth beats much of the sector’s post-recession record, which saw employment drop off thanks to lower tax revenue and austerity measures.

Government payrolls increased by about 0.5% over the last year — which doesn’t look terribly good compared to the private sector’s 2.1% gain. But when you look at the recent gains against the 0.05% decrease in the twelve months before January 2014, you start to appreciate the recent uptick.

Gov't jobs

What’s going on?

Well, state and local government finances have stabilized and marginally improved over the past couple of years, giving statehouses and municipalities a chance to improve its fiscal situation.

Take this note from a recent National Association of State Budget Officers report which says, “In contrast to the period immediately following the Great Recession, consistent year-over-year growth has helped states steadily increase spending, reduce taxes and fees, close budget gaps and minimize mid-year budget cuts.”

The nation’s economy grew at an annualized 5% rate in the third quarter, after jumping 4.6% in the three months before. The trade deficit fell in November to an 11-month low, thanks in part to lower energy costs, which will help fourth quarter growth.

NASBO expects states’s revenues to increase by 3.1% in the next fiscal year, compared to an estimated 1.3% gain in 2014, with much of that spending dedicated to education and Medicaid.

With a more solid financial position, governments across the country are able to spend more on basic items, like construction. Public construction, for instance, increased by 3.2% last November compared to the same time last year, according to the Census Bureau.

Overall government spending has stopped following dramatically and actually picked up in the third quarter on a year-over-year basis.

Expenditure

Of course, government employment still has a ways to go before returning to normal. In the five years after the dot-com inspired recession, public sector employment gained by 4.5%. (It’s fallen by 2.8% since the recession ended in June 2009.) And while state budgets have normalized, Governors aren’t exactly flush with cash.

Says NASBO: “More and more states are moving beyond recession induced declines, but spending growth is below average in fiscal 2015, as it has been throughout the economic recovery.”

Not to mention hourly earnings fell by five cents, to $24.57, a decline of 0.2%.

Still, some employment growth is better than none at all.

Updated with earnings data.

MONEY investing strategy

5 Mental Habits That Make Investors Rich

141106_INV_DreamInvestor
PeopleImages.com—Getty Images

Don't take yourself so seriously.

If I could build a dream investor from scratch, his name would be Paul.

Paul is an optimistic a-political sociopathic history buff with lots of hobbies who takes others’ opinions more seriously than his own.

Let me tell you why he is going to kick your butt at investing.

The sociopath

Psychologist Essi Vidling once interviewed a serial killer. Vidling showed the killer pictures of different facial expressions, and asked him to describe what the people were feeling. The murderer got most right, except pictures of people making fearful faces. “I don’t know what that expression is called, but it’s what people look like right before I stab them,” he said.

Paul couldn’t harm a fly. But a key trait of sociopaths is the ability to remain calm when others are terrified, so much that they don’t even understand why other people get scared. It’s also a necessity to becoming a good investor. In her book Confessions of a Sociopath, M.E Thomas writes:

The thing with sociopaths is that we are largely unaffected by fear … I am also blessed with a complete lack of sentiment … My lack of empathy means I don’t get caught up in other people’s panic.

Paul is like this, too. He doesn’t understand why people investing for 10 years get fearful when stocks have a bad 10 days. Recessions don’t bother him. Pullbacks entertain him. He thought the flash crash was kind of funny. He doesn’t care when his companies miss earnings by a penny. He’s immune to that stuff, which is a big advantage over most investors.

The a-political investor

Paul has political beliefs — who doesn’t?

But he knows that millions of equally smart people have opposite beliefs they are just as sure in. Since markets reflect the combined beliefs of millions of people, Paul knows that there is no reason to expect markets to converge on his personal beliefs, even if he is dead sure it is the truth. So he never lets his politics guide his investment decisions.

Paul knows that political moralizing is one of the most dangerous poisons your brain can come across, causing countless smart people to make dumb decisions. Even when he is bothered by political events, Paul repeats to himself in the mirror: “The market doesn’t care what I think. The market doesn’t care what I think.”

The history buff

Paul loves history. He loves it for a specific reason: It teaches him that anything is possible at any time, no matter how farfetched it sounds. “One damned thing after another,” a historian once described his field.

Paul knows that some people read history for clues on what might happen next, but history’s biggest lesson is that nobody has any idea, ever.

When people say oil prices can only go up, or have to fall, Paul knows history isn’t on their side — either could occur. He knows that when people say China owns the next century, or that America’s best days are behind it, history says either could be wrong.

History makes Paul humble, and prevents him from taking forecasts too seriously.

The hobbyist

Paul likes golf. He enjoys cooking. He reads on the beach. He has a day job that takes up most of his time.

Paul loves investing, but he doesn’t have time to worry about whether Apple is going to miss earnings, or if fourth-quarter GDP will come in lower than expected. He’s too busy for that stuff.

And he likes it that way. He knows investing is mostly a waiting game, and he has plenty of hobbies to keep him busy while he waits. His ignorance of trivial stuff has saved him thousands of dollars and countless time.

The open-minded thinker

Paul knows he’s just one of seven billion people in the world, and that his own life experiences are a tiny fraction of what’s to be learned out there.

He knows that everyone wants to think they are right, and that people will jump through hoops to defend their beliefs. He also knows this is dangerous, because it prevents people from learning. Paul knows that everyone has at least one firm, diehard belief that is totally wrong, and this scares him.

Paul is insanely curious about what other people think. He’s more interested in what other people think than he is in sharing his own views. He doesn’t take everyone seriously — he knows the world is full of idiots — but he knows the only way he can improve is if he questions what he knows and opens his mind to what others think.

The realistic optimist

Paul knows there’s a lot of bad stuff in this world. Crime. War. Hunger. Poverty. Injustice. Disease. Politicians.

All of these things bother Paul. But only to a point. Because he knows that despite the wrongs of the world, more people wake up every morning wanting to do good than try to do harm. And he knows that despite a constant barrage of problems, the good group will eventually win out in the long run. That’s why things tend to get better for almost everyone.

Paul doesn’t get caught up in doom loops, refusing to invest today because he’s worried about future budget deficits, or future inflation, or how his grandkids will pay for Social Security. Optimists get heckled as oblivious goofs from time to time, but Paul knows the odds are overwhelmingly in their favor of the long haul.

I’m trying to be more like Paul.

Related:

Check back every Tuesday and Friday for Morgan Housel’s columns.

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MONEY The Economy

The Stock Market Loses a Big Crutch as the Fed Ends ‘Quantitative Easing’

The Fed has concluded its asset-purchasing program thanks to an improving labor market. Here's what QE3 has meant to investors and the economy.

After spending trillions of dollars on bond purchases since the end of the Great Recession — to keep interest rates low to boost spending, lending, and investments — the Federal Reserve ended its stimulus program known as quantitative easing.

The central bank’s decision to stop buying billions of dollars of Treasury and mortgage-related bonds each month comes as the U.S. economy has shown signs of recent improvement.

U.S. gross domestic product grew an impressive 4.6% last quarter. And while growth dropped at the start of this year, thanks to an unusually bad winter, the economy expanded at annual pace of 4.5% and 3.5% in the second half of 2013.

Meanwhile, employers have added an average of 227,000 jobs this year and the unemployment rate rests at a post-recession low of 5.9%. It was at 7.8% in September 2012, when this round of quantitative easing, known as QE3, began.

What this means for interest rates
Even with QE over, the Fed is unlikely to start raising short-term interest rates until next year, at the earliest.

In part due to the strengthening dollar and weakening foreign economies, inflation has failed to pick up despite the Fed’s unprecedented easy monetary policy.

And there remains a decent bit of slack in the labor market. For instance, there are still a large number of Americans who’ve been unemployed for 27 weeks or longer (almost 3 million), and the labor-force participation rate has continued its decade long decline. Even the participation rate of those between 25 to 54 is lower than it was pre-recession.

What this means for investors
For investors, this marks the end of a wild ride that saw equity prices rise, bond yields remain muted, and hand wringing over inflation expectations that never materialized.

S&P 500:
Equities enjoyed an impressive run up after then-Fed Chair Ben Bernanke announced the start of a third round of bond buying in September 2012. Of course the last two times the Fed ended quantitative easing, equities faced sell-offs. From the Wall Street Journal:

The S&P 500 rose 35% during QE1 (Dec. 2008 through March 2010), gained 10% during QE2 (Nov. 2010 through June 2011) and has gained about 30% during QE3 (from Sept. 2012 through this month), according to S&P Dow Jones Indices.

Three months after QE1 ended, the S&P 500 fell 12%. And three months after QE2 concluded, the S&P 500 was down 14%.

 

Stocks

10-year Treasury yields:

As has been the case for much of the post-recession recovery, U.S. borrowing costs have remained low thanks to a lack of strong consumer demand — and the Fed’s bond buying. Many investors paid dearly for betting incorrectly on Treasuries, including the Bill Gross who recently left his perch at Pimco for Janus.

Bonds

10-year breakeven inflation rate:

A sign that inflation failed to take hold despite unconventionally accommodative monetary policy is the so-called 10-year breakeven rate, which measures the difference between the yield on 10-year Treasuries and Treasury Inflation Protected Securities, or TIPS. The higher the gap, the higher the market’s expectation for inflation. As you can see, no such expectation really materialized.

BreakEven

Inflation:

Despite concern that the Fed’s policy would lead to run-away inflation, we remain mired in a low-inflation environment.

fredgraph

Unemployment Rate:

The falling unemployment rate has been a real a bright spot for the economy. If you look at a broader measure of employment, one which takes into account those who’ve just given up looking for a job and part-time workers who want to work full-time, unemployment is elevated, but declining.

unemployment rate

Compared to the economic plight of other developed economies, the U.S. looks to be in reasonable shape. That in part is thanks to bold monetary policy at a time of stagnant growth.

Indeed, many economists now argue that the European Central Bank, faced with an economy that’s teetering on another recession, ought to take a page from the Fed’s playbook and try its own brand of quantitative easing.

MONEY Markets

The Dow Moved Triple Digits Today. Here’s What You Should Do.

Arrow cut out of piece of paper
Gregor Schuster—Getty Images

Nothing. You should do absolutely nothing. Here's why.

[Update: The DOW went up 216 points on Oct. 23.]

The Dow Jones Industrial Average has long been held up as the stock market index to follow. Now that the Dow Jones is at such a high level, even moves that are small on a percentage basis allow for attention-grabbing headlines like “Dow Jones Today Skyrockets Over 200 points!” or “Dow Jones Plummets 150 points!”

While these headlines lure in readers, they do nothing to make us better investors. Read on to see why the best investors ignore the daily movements of the DJIA.

Dow Jones today

Do you remember when the Dow jumped 220 points after tensions with Ukraine moderated? How about the 200-point drop after Chinese industrial production slowed, or the 180-point jump following the release of minutes from the secret early-March meeting of the Federal Reserve?

I doubt it.

And don’t get me started on early October. The Dow Jones Industrial average dropped 272 points on a Tuesday — its biggest drop of the year to that point. The next day, the Dow jumped 274 points — the Dow’s biggest gain of the year. Then, on Thursday, the Dow fell 334 points.

114e89f4f5bf149c3b8e810b60149638

The headlines would have you think the world is ending or that you won’t be able to retire because of these market dips. The stock market is one of the few places where, whenever things go on sale, no one wants to buy.

However, these moves only amounted to a 2% drop from the end of the previous week. To put that in an even bigger-picture perspective, the Dow is basically flat year to date.

ee887b6cfb37ef2b441b0ef774201d41

What you should do now?

Nothing. You don’t have to do anything. If your investment strategy changes based on one day’s market movements, you’re doing it wrong. Your focus should be to stick to your plan, constantly educate yourself, and invest for the long term. And if you don’t have a clear strategy, this is your wake-up call.

Research has shown that process is one of the biggest determinants of success in the market over the long term. While your process can yield good or bad results in the short term, those with a proven process do better than the average investor over the long term.

For total beginners, I would first suggest learning about how the market works and how you can do at least as well as the market through index investing. I highly recommend The Little Book of Common Sense Investing by John Bogle as a great place to start.

If you understand the basics of the market as well as index investing, check out The Motley Fool’s 13 Steps to Investing Foolishly, which will teach you the process The Motley Fool has used to consistently beat the markets over the long term.

Everyone can learn from this

For every investor, focusing too much on daily market movements is a mistake. Things happen for no discernible reason. Rather than wasting time wondering why the market is up or down by a percent or two, we should focus on business fundamentals and continue to search for quality stocks trading at bargain prices.

We also must keep calm and not make rash decisions based on short-term market moves. Research has shown that it is far better to focus on minimizing mistakes, rather than overreaching for greatness. As economist Eric Falkenstein wrote: “In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”

And as Warren Buffett’s longtime business partner Charlie Munger said: “We try to profit more from always remembering the obvious than grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

My Dow Jones Industrial Average prediction for today

The Dow Jones Industrial Average will continue to fluctuate. That’s a given, and we have no control over it. What you can control is your reactions to those fluctuations — and the best reaction is usually no reaction.

Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog where he writes about investing, happiness, life, and success in life. He has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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MONEY Markets

Four Reasons Not to Worry About the Stock Market

Waterfall
Roine Magnusson—Getty Images

Take a deep breath and consider some historical context.

The funniest thing about markets is that all past crashes are viewed as an opportunity, but all current and future crashes are viewed as a risk.

For months, investors have been saying a pullback is inevitable, healthy, and should be welcomed. Now, it’s here, with the S&P 500 down about 10% from last month’s highs.

Enter the maniacs.

“Carnage.”

“Slaughter.”

“Chaos.”

Those are words I read in finance blogs this morning.

By my count, this is the 90th 10% correction the market has experienced since 1928. That’s about once every 11 months, on average. It’s been three years since the last 10% correction, but you would think something so normal wouldn’t be so shocking.

But losing money hurts more than it should, and more than you think it will. In his book Where Are the Customers’ Yachts?, Fred Schwed wrote:

There are certain things that cannot be adequately explained to a virgin either by words or pictures. Not can any description I might offer here ever approximate what it feels like to lose a chunk of money that you used to own.

That’s fair. One lesson I learned after 2008 is that it’s much easier to say you’ll be greedy when others are fearful than it is to actually do it.

Regardless, this is a critical time to pay attention as an investor. One of my favorite quotes is Napoleon’s definition of a military genius: “The man who can do the average thing when all those around him are going crazy.” It’s the same in investing. You don’t have to be a genius to do well in investing. You just have to not go crazy when everyone else is, like they are now.

Here are a few things to keep in mind to help you along.

Unless you’re impatient, innumerate, or an idiot, lower prices are your friend

You’re supposed to like market plunges because you can buy good companies at lower prices. Before long, those prices rise and you’ll be rewarded.

But you’ve heard that a thousand times.

There’s a more compelling reason to like market plunges even if stocks never recover.

The psuedoanonymous blogger Jesse Livermore asked a smart question this year: Would you rather stocks soared 200%, or fell 66% and stayed there forever? Literally, never recovering.

If you’re a long-term investor, the second option is actually more lucrative.

That’s because so much of the market’s long-term returns come from reinvesting dividends. When share prices fall, dividend yields rise, and the compounding effect of reinvesting dividends becomes more powerful. After 30 years, the plunge-and-no-recovery scenario beats out boom-and-normal-growth market by a quarter of a percentage point per year.

On that note, the S&P 500’s dividend yield rose from 1.71% in September to 1.82% this week. Whohoo!

Plunges are why stocks return more than other assets

Imagine if stocks weren’t volatile. Imagine they went up 8% a year, every year, with no volatility. Nice and stable.

What would happen in this world?

Nobody would own bonds or cash, which return about zero percent. Why would you if you could earn a steady, stable 8% return in stocks?

In this world, stock prices would surge until they offered a return closer to bonds and cash. If stocks really had no volatility, prices would rise until they yielded the same amount as FDIC-insured savings accounts.

But then — priced for perfection with no room for error — the first whiff of real-world realities like disappointing earnings, rising interest rates, recessions, terrorism, ebola, and political theater sends them plunging.

So, if stocks never crashed, prices would rise so high that a new crash was pretty much guaranteed. That’s why the whole history of the stock market is boom to bust, rinse, repeat. Volatility is the price you have to be willing to pay to earn higher returns than other assets.

They’re not indicative of the crowd

It’s easy to watch the market fall 500 points and think, “Wow, everyone is panicking. Everyone is selling. They know something I don’t.”

That’s not true at all.

Market prices reflect the last trade made. It shows the views of marginal buyers and marginal sellers — whoever was willing to buy at highest price and sell at the lowest price. The most recent price can represent one share traded, or 100,000 shares traded. Whatever it is, it doesn’t reflect the views of the vast majority of shareholders, who just sit there doing nothing.

Consider: The S&P fell almost 20% in the summer of 2011. That’s a big fall. But at Vanguard — one of the largest money managers, with more than $3 trillion — 98% of investors didn’t make a single change to their portfolios. “Ninety-eight percent took the long-term view,” wrote Vanguard’s Steve Utkus. “Those trading are a very small subset of investors.”

A lot of what moves day-to-day prices are computers playing pat-a-cake with themselves. You shouldn’t read into it for meaning.

They don’t tell you anything about the economy

It’s easy to look at plunging markets and think it’s foretelling something bad in the economy, like a recession.

But that’s not always the case.

As my friend Ben Carlson showed yesterday, there have been 13 corrections of 10% or more since World War II that were not followed by a recession. Stocks fell 35% in 1987 with no subsequent recession.

There is a huge disconnect between stocks and the economy. The correlation between GDP growth and subsequent five-year market returns is -0.06 — as in no correlation whatsoever, basically.

Vanguard once showed that rainfall — yes, rainfall — is a better predictor of future market returns than trend GDP growth, earnings growth, interest rates, or analyst forecasts. They all tell you effectively nothing about what stocks might do next.

So, breathe. Go to the beach. Hang out with your friends. Stop checking your portfolio. Life will go on.

For more on this topic:

Check back every Tuesday and Friday for Morgan Housel’s columns. Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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MONEY The Economy

Why the Fed Should Stop Talking About Raising Interest Rates

Some central bankers have called for raising rates sooner rather than later. Recent economic data — and the huge stock market sell-off — should dampen those calls.

There have been two presidential inaugurations and six Super Bowl champions since interest rates were effectively lowered to 0%. Recently, some Federal Reserve officials have said they expect to raise rates by the middle of next year thanks to a decently expanding economy and stronger job growth.

Some central bankers, though, think the middle of 2015 is too late and have been pushing to increase borrowing costs sooner. Esther George, President of the Kansas City Fed, said as much in a speech earlier this month, and two members of the Federal Open Market Committee voted bristled against easy monetary policy in their most recent meeting.

But with developed economies around the world showing dismal growth and less-than-stellar economic metrics here at home — punctuated by a rapidly declining stock prices (the stock market is, after all, a reflection of the market’s forecast for the economy six to nine months down the road) — it might be time for these inflation hawks to quiet down.

“Until we see wages expanding faster than the rate of inflation, and significantly so, we won’t see much in the way of inflation pressure,” says Mike Schenk, Vice President of Economics & Statistics for the Credit Union National Association. “Why raise rates if you don’t have inflation?”

Inflation Hawks

Dallas Fed President Richard Fisher voted against the most recent monetary action policy, according to minutes of the meeting, due to, among other factors, the “continued strength of the real economy” and “the improved outlook for labor utilization.”

Earlier this month, Philadelphia Fed President Charles Plosser said that he’s “not too concerned” about inflation growth below the Fed’s 2% target and joined Fisher in voting against the Fed policy because he disagreed with the guidance that said rates will stay at zero for “a considerable time after” the Fed ends its unconventional bond-buying program later this month.

George, meanwhile in a speech earlier this month, said Fed officials should begin talking seriously about raising rates since “starting this process sooner rather than later is important. If we continue to wait — if we continue to wait to see full employment, to see inflation running beyond the 2% target — then we risk having to move faster and steeper with interest rates in a way that is destabilizing to the economy in the long term,” according to the Wall Street Journal.

Jobs

The jobs environment has been improving in recent months. The economy added almost 250,000 jobs in September and the unemployment number fell to a post-recession low of 5.9%. But the unemployment number doesn’t tell the whole story.

If you look at another metric that takes into account workers who only recently gave up looking for a job and part-time employees who want to work 40 hours a week, the situation is much worse. Before the recession, this broader unemployment rate sat at around 8%. It’s now at almost 12%. There are still about three million workers who’ve been unemployed for longer than 27 weeks, up from around 1.3 million at the end of 2007.

Inflation

Right now, and for some time, there has been very little inflation. Prices grew 1.7% over the past year in August, per the Bureau of Labor Statistics’s Consumer Price Index. Even the Fed’s preferred inflation tracker, the PCE deflator, showed prices gain 1.5% compared to 12 months ago.

Wage growth is likewise stalled. Taking into account wages and benefits, workers have only seen a 1.8% raise. It’s just difficult to have inflation in a low interest rate environment without wage growth.

St. Louis Fed President James Bullard recently said that the Fed should consider postponing the end of its bond-buying program. “Inflation expectations are declining in the U.S.,” he said in an interview yesterday with Bloomberg News. “That’s an important consideration for a central bank. And for that reason I think that a logical policy response at this juncture may be to delay the end of the QE.”

Europe

European economic woes aren’t helping. Germany, Europe’s largest economy, recently cut it’s growth forecast, now only expects to grow by 1.2% in 2014 and 2015. Sweden and Spain saw prices actually decline in August, and now there’s fear that the euro zone will endure a so-called triple-dip recession. The relative prowess of the American economy compared to Europe’s has strengthened the U.S. dollar, thus making our exports less competitive.

Look, the U.S. economy isn’t about to go off a cliff. Not only did we see growth of 4.6% last quarter, but employers are adding jobs at a decent clip and the number of workers filing first-time jobless claims fell to the lowest level since 2000, per the Labor Department.

But with low inflation and European struggles to achieve anything close to robust growth, raising interest rates anytime soon doesn’t appear likely.

MONEY Jobs

Why Low Job and Wage Growth is Worse Than Rising Inflation

Hot air balloons floating higher and higher
Jon Larson—Getty Images

As the economy picks up steam, and employers add more workers, investors say that inflation is their biggest impediment to saving. Here’s why they’re wrong.

As the economy added another 248,000 jobs in September, pushing the unemployment rate to a post-recession low of 5.9%, investors are feeling more confident.

In fact, investors are more optimistic than they’ve been since the recession, per a recent Wells Fargo/Gallup survey which measured the mood of those with more than $10,000 in investable assets. Of course the so-called Investor and Retirement Optimism Index is still only at around half the levels of the 12-year average before the 2008 recession. Investors may be more sanguine than three months ago, but that doesn’t mean they think the economy is going gangbusters.

Nevertheless, there was one particularly interesting data point in the survey: “Half of investors (51%) think the pressure on American families’ ability to save is due to rising prices caused by inflation.” Meanwhile only 37% said the pressure was inflicted by stagnant wage growth.

Which is strange.

What inflation?

If you look at the Federal Reserve’s preferred measure of core inflation (which strips out volatile energy and food prices), prices have risen around or below the Fed’s stated 2%-target since the recession.

The Consumer Price Index, a gauge of inflation released by the Labor Department, actually fell on a monthly basis in August for the first time in more than a year, and only grew at an annual rate of 1.7% since this time last year.

Proclamations of rising inflation ever since the Federal Reserve started buying bonds and lowering interest rates in response to the recession have yet to materialize. And those advanced economies that did raise interest rates a few years ago (like Sweden), have come close to deflation.

Meanwhile wages aren’t growing at all. Average hourly earnings in August rose 2.1% versus the same period last year, and the growth rate has been stuck at around 2% since the recovery. The same is true for the employment cost index, which measures fringe benefits in addition to salaries. Ten years ago the index increased by 3.8%.

REALERw
St. Louis Federal Reserve

 

While the unemployment rate has fallen considerably this year, other gauges of jobs are still troubling. Long-term unemployment has tumbled since its post-recession peak in 2010, but there are still almost 3 million people who’ve been unemployed for 27 weeks or longer. If you include workers who’ve recently stopped looking for a job and those working part-time when they’d rather be full time, the unemployment rate is 12%, more than four percentage points above the pre-recession level.

The Fed has implemented an easy monetary policy in order to attack this problem. “The Fed is keeping interest rates low as long as they can and maintaining very loose policy in support of jobs,” says USAA Investments’s chief investment officer Bernie Williams. “They will only tighten up with great reluctance.”

Pick your poison: stronger wages or rising inflation?

In a battle between pushing wages higher and the risk of inflation, the Fed is willing to err on the side of rising wages, says Williams.

BMO senior investment strategist Brent Schutte agrees. “As a society, you decide what is good. Economics is a choice between two things. We’ve clearly decided that higher inflation and rising wages is a good thing.”

Despite years of effort, though, the Fed hasn’t been able to bring back rising wages.

If you’re still unconvinced that a lack of salary increase and slack in the labor market should be more of a concern to your finances than the threat of inflation, check out new research by former Bank of England member David Blanchflower.

Along with three other co-writers, Blanchflower recently published a study titled, “The Happiness Trade-Off between Unemployment and Inflation.”

The researchers found that unemployment actually has a more pernicious effect on happiness than inflation. “Our estimates with European data imply that a 1 percentage point increase in the unemployment rate lowers well-being by more than five times as much as a 1 percentage point increase in the inflation rate.”

In an interview with the Wall Street Journal, Blanchflower said, “Unemployment hurts more than inflation does.”

As the economy gently improves, and people start going back to work, the hope is that wages will start to rise. Inflation might then rise above the Fed’s 2% target, and Yellen and Co. may raise rates in effort to cool off the economy. But we’re not there yet. And investors, for the sake of their wallets and psychology, would do well to remember that.

MONEY The Economy

China is Slowing. What If Its Housing Bubble Bursts?

Even if the real estate market in the world's second-biggest economy were to collapse, the repercussions may not be bad as you think.

While global investors covet China’s growth — as evidenced by the buzz surrounding Alibaba’s IPO — the Chinese economy is actually slowing down.

In 2013, the world’s second largest economy grew at an annual rate of 7.7%. By 2015, according to a recent report by the Organization for Economic Co-Operation and Development, that will drop to 7.3%. Meanwhile, the U.S. economy’s growth rate is projected to increase by almost one percentage point.

What’s going on? Well, China’s industrial production gains in August slowed to their lowest level since 2008 and retail sales growth declined by a few percentage points year-over-year.

Perhaps most important, the nation’s newly built home prices only grew by 2.5% in July, after surging by 10% at the beginning of the year.

The notion of a housing crisis in an economy more than three times the size of France brings back flashbacks of 2008 and probably a few chills down every investor’s spine.

“A property price crash in the world’s second largest economy would have global implications,” says Wells Fargo Securities economist Jay Bryson.

But those global implications wouldn’t be as worrisome as the U.S. housing collapse six years ago, per Bryson. Here’s why.

The Worst Case

To play out this thought experiment you have to assume that at some point in the near future China’s home prices will experience a decline on the order of what the U.S. experienced over the past decade. (Bryson played out this scenario in a recent report.)

Currently, residential investment makes up a pretty decent portion of the Chinese economy – about 10% of nominal GDP. To put that in context, that ratio was closer to 6% for the U.S. in 2006.

So housing is a big deal in China. If they experienced a value decline like we did, Bryson estimates that would lop off about one percentage point of growth. But the pain wouldn’t stop there.

A collapse in housing prices would result in fewer construction jobs – estimated at around 60 million people in urban China. Jobless workers would spend less, which means that those goods and services the now-unemployed construction workers would normally purchase would not get bought.

If out-of-work construction workers reduce their spending on food and entertainment, the businesses that produce that food and entertainment will make less money and then some of their workers may face unemployment too. Since my spending is your income, lower spending means people have less money in their paychecks, and the nation’s GDP suffers.

Moreover, if housing goes in the tank, banks will see losses, which means they’ll tighten credit, resulting in fewer loans for people to start businesses.

Let’s not forget the actual homeowners. If home prices fall, homeowners’ equity declines as well. (See: Sell, Short). And when people’s chief asset is suddenly worth a lot less, they’re not going to spend as much on other, discretionary items. “Although the lack of data makes it impossible to quantify the wealth effect in China, researchers have found that there is a statistically significant direct relationship in the United States between changes in wealth and changes in consumer spending,” per Bryson’s report.

Lower demand from China means that countries which sell goods to China (think Chile and Australia) will sell less stuff. As corporate profits are squeezed, a global bear market may result.

“Although China may not be as important to global economic growth as the United States, the global economy clearly would not be immune to a major property market downturn in China,” says Bryson.

The Not-So-Bad Case

Freaked out? Breathe deep and take solace in the fact that despite this potentially harrowing dénouement, the world probably wouldn’t endure another global financial crisis. And that’s thanks to responsible Chinese borrowers.

Chinese households usually have to put a lot more money down – 30% on their first home, up to 60% for an individual’s second – than Americans. So if prices were to decline substantially, Chinese homeowners would be in a much better position than Americans back in 2007 to deal with the crisis. For example, household debt-to-disposable income has grown substantially in China since 2007, but it’s still about one-third the size of U.S. households back in 2007.

The world will also feel less of a pinch. When mortgages started going bad in the U.S., foreign financial institutions lost close to $750 billion of the more than $2 trillion in write-downs resulting from the crash. That was because foreign banks owned a lot of U.S. mortgage-backed securities. Not so here. “Chinese mortgages are generally held by Chinese financial institutions in the form of whole mortgages.” So if prices were to drop, Chinese banks would suffer while U.S. one’s most likely wouldn’t.

Lastly, the Chinese government wouldn’t sit on its hands while its economy came crashing down. Beijing’s debt-to-GDP ratio is around 15%, so it has a lot of room to recapitalize its banks if needed.

So what’s an investor to do?

“I don’t lose sleep at night worrying about China, nor should other people,” says Bryson. “But they may want to keep an eye on it.”

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