On today’s episode of the Agent of Wealth Podcast we talk about what the coronavirus can teach us about a couple of hard to explain financial topics.
In this episode you will learn:
- Why the stock market sometimes goes up even when the news around unemployment, earnings, and the virus is bad.
- How a stock’s performance is based on it’s projected growth and not it’s current numbers.
- The characteristics of stocks that outperform
- The difference between leading and lagging indicators and which one the stock market is.
- Why Albert Einstein once called compounding interest the most powerful force in the world.
| Bautis Financial: (862) 205-5000 | bautisfinancial.com |
I was listening to one of the press conferences from the Coronavirus task force last week where Dr. Fauci, who is the director of the national institute of Allergy and Infectious disease, talked about how coronavirus hospitalizations are a lagging indicator of the impact of the virus.
The point that Dr. Fauci was trying to make was that when we see the statistics on new cases, hospitalizations and deaths from the virus it is the result of actions we took two weeks ago and not today. The actions are things like social distancing and quarantining.
I wanted to segway that into what indicators were and how they are applied to finance and the economy
Leading and Lagging Indicators
So an indicator can be any statistic that is used to predict and understand a trend.
- Leading indicators point toward possible future events
- Lagging indicators may confirm a pattern that is in progress
- Coincident indicators occur in real-time and help clarify things
In the financial and economic space, the stock market is a leading indicator. It points toward the future of what will happen in the economy.
If you need any more evidence that the stock market is a leading indicator look at last week’s performance. The stock market was up 12% which is a good gain for a year, never mind in one week. But the news that came out last week was terrible: There were over 6 million unemployment claims, we crossed 10.000 deaths in the country from the virus.
I’ve had many conversations over the past month about whether we should try pulling money out of stocks into cash only to reinvest when things look better. ie) Trying to time the market. Because the stock market is a leading indicator it’s impossible to time it. By the time that it looks like we have the virus under control and the economy is going to get started up again, the market will already have recovered the drops that it had over the past month.
All of the bad news that we are hearing around unemployment, poor earnings from companies, numbers around the virus are all factored into the prices of the stock market already.
The stock market is not the only indicator that we look at. Some other indicators that we follow are numbers on new jobless claims, new housing starts, or volatility in the bond market.
One that we heard a lot about in 2018 was the inversion of the yield curve which represents a leading indicator that there is going to be a recession. The yield curve is a graphical representation of yields on similar bonds across a variety of maturities. An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. It looks like this indicator was correct in that we are going to have a recession, but it may be a coincidence as the cause of the recession was the spread of the coronavirus which was not something that anyone could have foreseen in 2018.
Projected vs Actuals
This brings us to our next topic which is really similar to indicators and that’s of projected vs actuals numbers.
Have you ever followed a company’s release of quarterly earnings and left scratching your head when something like this happens? A company reports what would seem like great revenue and net income. Maybe their revenue was up 30% and their net income was up 40% over the previous quarter. But right after the numbers came out the stock price nosedives. That’s because while the actual numbers were great the projected numbers were 35% revenue growth and 50% net income.
And the reverse can happen as well. A company can be expected to grow by 20% but then it’s growth comes in at 25% and the stock pops up.
This is why you see some companies that don’t earn any money. They actually lose money each quarter, yet their stock price continues to go up. That’s because the market is not looking at their current earnings. It’s looking at what it thinks the company will earn in the future. Amazon is the classic example of this.
About a month ago, the projections for deaths related to the virus in the US came out. The number was anywhere from 100,000 – 250,000 deaths. Forget about that it’s a wide range for a statistic, but when that number comes out the market factors that into its price. This week in one of the briefings president Trump stated that there are revised death numbers and now we can expect 60,000 deaths and not 100,000-250,000. That number was better than what the market was expecting and therefore that was one of the reasons we saw a bump in the stock market last week.
Another question I receive a lot is what stocks should I buy to take advantage of the current market situation. They’ll bring up a stock like Zoom because everyone is using it now for videoconferencing and it probably has a strong future for the company. The problem is that the strong future is already priced into the stock. Whether the stock outperforms or not in the future will be related on whether it exceeds or falls short of those future projections. It’s not to say that zoom is a good or bad investment. They may continue to have explosive growth. The point that I was trying to make is that it’s not a secret.
While most stock prices are down over the past month and a half, Zoom’s is up 94%
If you are trying to outperform the market you have to focus on stocks that you think will beat their projections. We all know that Apple is going to sell a ton of iphones or netflix is going to get a lot of new subscribers, but are they more than what was projected.
The other projection that the market is implicitly making right now is when the economy is going to open up again. The market has a projection on how long it thinks the economy will be closed for and how much economic damage it thinks will be inflicted. If the economy opens up sooner than that the market will see a pop. If it takes longer than that projection to open up we’ll probably see a drop.
The market is always adjusting to both new information that comes out as well as what it projects to happen. The problem with making investment decisions on new information that comes out is that the market has already priced that information in.
Finally I wanted to move on to one of the most powerful concepts of finance. It’s the power of compounding interest. Warren Buffet has talked a lot about how important compound interest is, but I find myself using too many Warren Buffet quotes. So I’ll use one from Albert Einstein. Einstein famously said that compound interest is the most powerful force in the universe. He said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it
Before we talk about compounding from an investment perspective, let’s discuss how it applies to viruses. We’ve heard about flattening the curve ever since the virus began to spread here in the US.
The curve represents how quick the virus can spread. It starts off slow but then grows exponentially quick. The shape of the curve resembles a hockey stick.
Let’s take a look at the numbers to explore this further. The initial projection was that every person infected with the virus would infect 1.5 to 3.5 people. Let’s use 2. That means that every person impacts 2 additional people.
- Day 0: 1 person infected
- Day 1: 2 additional people are infected
- Day 2: 4 additional people are infected
- Day 3: 8 additional people are infected
- Day 4: 16 additional people are infected
- Day 5: 32 additional people are infected
- Day 6: 64 additional people are infected
- Day 7: 128 additional people are infected
- Day 8: 256 additional people are infected
- Day 9: 512 additional people are infected
- Day 10: 1024 additional people are infected
- Day 11: 2048 additional people are infected
- Day 12: 4096 additional people are infected
- Day 13: 8192 additional people are infected
- Day 14: 16,384 additional people are infected
- Day 15: 32,768 additional people are infected
There’s a famous example similar to this where it gives you the choice of would you rather have a penny that doubles each day for a month or $1 million?
I will spare you the surprise, but if you took the single penny and doubled it every day you would have $5,368,709.12
These two examples highlight the power of the financial concept of compounding.
This compounding spread of the virus also equates to compounding in the investing world.
Compounding can be defined as the interest that an investor earns on his original investment plus all the interest earned on the interest that has accumulated over time. You can contrast that to the concept of simple interest which is the interest earned just on the principal investment.
An example will help explain this a little better.
First we’ll look at an example of simple interest
Let’s say you invest $1,000 in a bond that pays 10% interest.
After year one you would have received $100 in interest.
After year two you would have received another $100 in interest.
After year three you receive another $100.
Let’s say this goes on for 10 years. At the end of 10 years you would have $2,000. The initial $1,000 + 10 years of $100 interest
Now we’ll look at something similar but with compounding interest.
We start off with that same $1,000 investment in a bond that pays 10% interest.
After year one we receive that same $100, however it is reinvested in the bond.
For year two we receive $110 of interest. That’s because we are receiving interest on $1,100.
After year three we receive $121 of interest.
At the end of year 10 we will have a total of $2,593.74
When we compare the two examples you will have 25% more at the end of 10 years if your interest compounds rather than just straight linear interest. The interest rate that you receive and the length of time that your investment compounds magnifies the overall return you will receive.
One of my favorite investment types where you can take advantage of this is by including dividend paying stocks in your portfolio and reinvesting the dividend. Let’s say you purchase 10 shares of Apple stock. Apple then pays a dividend that you reinvest and purchase another share of Apple stock. Now you have 11 shares of Apple. The next time Apple pays a dividend you receive a dividend on 11 shares and maybe you can purchase two more shares of Apple. This continues to go on and over time you can accumulate a substantial portfolio size kicking off a lot of cash flow. I work with a number of people who have done this over time and are using the dividends solely to pay for their retirement expenses.
On episode 20 I talked about using rental real estate to grow your portfolio and cash flow, but rental real estate is the type of linear interest and not compounding. Because if you think about it when you receive rent you can’t reinvest it directly in your existing rental property to compound. But on the episode I do talk about how you can use your net income to purchase additional property which has a similar effect to compounding.
The other part of real estate that does have a compounding aspect to it is your mortgage paydown. If you’ve ever looked at your mortgage amortization schedule, which is the month by month breakdown of your mortgage payment and how much goes to principal and how much goes to interest. You’ll see in the beginning a majority of your monthly payment goes to pay interest. But there is a little bit of the payment that goes to principal and reduces the principal you owe on the loan. The next month the interest that you owe is calculated on that slightly lower principal amount. So the next month a little less goes to interest and a little more to principal. This repeats itself to pretty soon a majority of your payment is paying down the principal and a small amount is going towards interest. One way to accelerate it even further is by paying an extra amount solely to principal.
A pretty cool calculation to figure out compound interest that is easy to do in your head is the rule of 72. The rule says that to find the number of years required to double your money at a given interest rate, you just divide the interest rate into 72. For example, if you want to know how long it will take to double your money at eight percent interest, divide 8 into 72 and get 9 years.
So that wraps it up for this week’s show. I wanted to take a couple of concepts that we’ve been hearing about with the coronavirus and show how they also apply in the finance and investment world.
We’ve been bombarded with questions about the recently CARES Act. My previous two episodes covered the CARES Act and how best to take advantage of the stimulus package. If you have any questions you can schedule a call with me by going to my website bautisfinancial.com. I appreciate you tuning in today and until next time this is Marc Bautis.