Paul Winkler: And back here on The Investor Coaching show. Paul Winkler, along with Ira work, talking about the world of money and investing. Okay. So this is fascinating. “How much of the stock markets rise over the past 11 years is due to QE” was the article that I found that really just blew me away this week in MarketWatch.
What is QE?
And here was the estimate. So QE, what is it? Okay. So the way the federal reserve actually deals with interest rates, one of the things that they try to impact is short-term interest rates. Now long-term interest rates. You’re looking at more of the market is going to be dealing with that because there you have a huge market for buying and selling longer term bonds, but short term bonds, you can impact it just a little bit with the Fed and there’s debate all over the place as to whether the Fed is following or leading in his particular area.
But in essence, what happens is this bank takes in money. You go and make a deposit at your friendly local bank, and they take that money and they keep a reserve requirement. They lend most of it back out. So maybe you put in a hundred thousand, just put numbers to it. And then they take $10,000. They hold, and this is, you know, you’re going to be, you’re coming up on Christmas.
So you take the money that $10,000 stays in, 90 goes back out and goes through the financial system. Maybe 70 of it ends up back in the bank and they keep a reserve requirement of 10% of that. So $7,000 of the $70,000, they lend 63,000 back out. It goes to the financial system. Maybe 50 of it ends back out of the bank and they hold the reserve requirement five. So on average, this happens 78, seven to eight times. And this is where a multiplier effect occurs. We have a multiplier. So your money is used many times over. Well, what happens is some of this money ends up in government bonds.
You know, so some of the money is lent to the government. Some of it’s lent to you to buy your house. Some of it’s lent to you to buy your cars and, you know, whatever, if hopefully you’re not buying cars with borrowed money, but you know, if some people do, they finance their vehicles. So what happens is money gets into government bonds. And that money in government bonds, the government is financing the debt with those fonts and the Fed goes down and you don’t, well, we need to try to reduce interest rates and help out things a little bit here. Let’s do this. Let’s go and take some of our money at the federal reserve and buy those bonds and get rid of that liability and that asset. So to speak for the bank and what we’re going to do, or they’re going to give that money.
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A Little Explanation on How It Works
And then now the banks got all this money now because they’ve got money that used to be tied up in government bonds. Now they got to lend it back out again. And because they have to lend it back out again, we can reduce interest rates. And that helps because we’ve increased the demand for bonds. You push up the price of bonds that drives down the interest rates and voila. You have stimulus in the economic plan with QE. Now how much of the stock markets have gained since the financial crisis? Because remember what we’ve been talking about is that large US stocks have significantly outperformed other areas in the market, even though that would long-term the lower expected returning area of the market.
Well, how much of it’s due to the federal reserves, extraordinary monetary policies, policy actions, according to this, this society general study, a pretty huge chunk was their answer. Pretty huge chunk. In fact, without QA, this is their estimate. The NASDAQ would be closer to $5,000, then $11,000. Wow. Yeah. Wow. The S&P 500 would be closer to $1,800 than $3,300 mind bogglingly, big difference between them.
So they explain that, you know, the quantitative reason the central bank is creating credit out of thin air. And he buys securities from banks and other institutions, as I explained, but skeptics question how much direct impact QE has on buying on prices because bond prices typically move in the opposite direction of yields, arguing that it functions right. Instead more as a signal that policy makers intend to keep market rates low. So it’s stimulating for these particular companies. So why is this important? All of this is really important because we’re looking at more stimulus coming out of Washington, which is more government bond buying, which creates more bonds out there, which the federal reserve just took off the market.
Right? The analysts used their work on QE and the 10-year yield in conjunction with their equity risk premium framework, ESCO equity risk premium refers to the extra yield that investors required to hold securities over treasuries. So in English bonds typically have a much lower interest rate and a lower cost of capital or cost to use your capital than stocks do. Right? But there’s a pretty doggone big, significant equity, right? Risk premium going on, right. There’s a widening in this, in that interest rates are so stinking low right now.
So they found that a variation among different stock indexes with the tech concentrated NASDAQ, eh, feeling the most impact from QA. What did I just say? The tech heavy NASDAQ has gotten the biggest benefit out of this whole QE thing. So this, this thing that investors are doing right now that we see, and we’ve seen, we’ve seen an unbelievable run toward large US growth companies. And we’ve done this analysis over many months where we’ve looked at the amount of money in mutual funds right now, and amount of money in mutual funds, which is what the retail investor is doing.
Wake Up and Smell the Coffee
That in ETFs is mainly in what are really huge companies. So investors are chasing returns like they always do, which could be to their detriment. Exactly. While the S&P 600 small caps were least affected according to the article, which to me is, Whoa, wake up, smell the coffee because it’s brewing, this underlined the tech sector sensitivity to interest rates.
Companies are overall less focused on dividends, but rather more on share buybacks as a note way of neutralizing the impact of restricted share units, small and mid caps on a relative basis, given their higher payout and lower price to book ratios. And I’ve been talking about price to book forever guys are less sensitive to swings and bond deals. So this is absolutely important, what’s the takeaway for you as the investor? If you never listened before this, where I’m saying, you know, guys don’t run away from diversification. As you know, we’ve had this period of time where large US companies have outperformed small caps, and I’ve said this over and over again, it can happen.
We just don’t know when, but it can happen. And that’s why we continue to hold the asset class, even though it has the longest, you know, it’s the lowest long-term expected return, but it’s still why we held it where w why we won’t own it in a diversified portfolio, but it’s a really dangerous thing to go, Oh, this diversification, isn’t something I ought to be doing. All right. Well, let’s just go and throw caution to the wind and let’s just buy these companies or these funds and what people and the people think they’re being rational. When they did this, there was a Nobel prize winning economist. I gave a presentation earlier today where I was speaking and I was talking to this one, a Nobel prize winning economist had made this comment.
We All Have Blind Spots
And I loved his statement that he realizes how easy it is for the public to be fooled and realize that you’re part of the public. It’s a paraphrase. You are very easily fooled. And one of the things that he talked about in his speech was how, not only is it easy to get fooled, but some of the people that are the most easily fooled are the people that tend to be the most intelligent.
We have biases. And one of our biases that we have, you know, which is it’s really hard to overcome. And, you know, it’s an ego-driven bias is really what it gets down to. Richard Fadiman says, the first principle is that you must not fool yourself. And you are the easiest person to fool was his direct quote regarding that. And he says, we have a bias blind spot. He says, whereby most of us are keenly aware. We’re keenly aware of other people’s mental shortcomings.
Yet we’re largely oblivious to our own shortcomings. And we may overestimate our capacities to distinguish dubious from well well-supported. We just, for some reason, we may be, he said, research reveals at best, there’s modest and often negligible correlations between measures of intelligence and critical thinking skills. We think if we’re really good at critical thinking, you know, if we’re really intelligent, we’re going to be great at critical thinking, but it’s a tenuous tie between the two, you know?
So it’s not that you’re stupid that you get pulled off the track. In other words, it has nothing to do with it. It is a blind spot. And the reality is if you’re driving down the road and you’ve got a blind spot, that is something you just can’t see it. And we are often, we don’t know what we don’t know is really what it gets down to.
Ira Work: I did actually. She gave me a good example of that when I was teaching my kids to drive. And actually I even taught my wife to drive. I stood in the blind spot of the car. I just stood there. And I said, turn out, looking, looking, you’re looking at your side view mirror. Can you see me? And she’s like, no, I said, this is why you need to turn your head, not just on the blinker and then move over. Yeah. Because you may see beyond your car and look like nobody’s there, but they’re in your blind spot. Yeah.
Paul Winkler: A lot of times when it comes down to it, you’re talking about turning your head, like, actually making sure that you have safety in the multitude of counselors, and you have to have people around you that know things that maybe you don’t know. And that turning your head gives you information that you didn’t have with just your systems, with a car as is the rear view mirror. So, yeah, that’s a good example. You’re listening to The Investor Coaching Show, Paul Winkler, along with Ira Work.
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