Why The Federal Reserve Alters Interest Rates

The United States economy has been on a hot streak.  Overall growth had been present for years and recent corporate tax cuts put gasoline on the economic flames.  Precisely why talk of Federal Reserve interest rate hikes have been littering the news lately.  Today I want to discuss what that actually means for the economy and for you as an individual.

So what does the Fed actually do?

At a very high level the Federal Reserve has been enacted by Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.”  This has come to be known as the “dual mandate.”  Why there is three mandates in the dual mandate I do not know, but I don’t make the rules.

It is important to note that maximum employment is not necessarily 100% employment.  In theory it should be, but in reality you will always have people leaving jobs or in the process of switching jobs for many uncontrollable reasons.  However, since we currently sit at some of the lowest unemployment levels in history I’m not so sure the Fed is as concerned with people being able to find work as they are with the other two things in the dual (triple) mandate.

Right now Jerome Powell and the Federal Reserve are working overtime to figure out how to keep inflation within controllable levels as the economy heats up.  In other words, as more money is accumulated to pay for goods and services they are trying to prevent that $3 Starbucks coffee you shouldn’t be getting every morning from becoming a $4 Starbucks coffee you shouldn’t be getting every morning.

Where interest rates come in

Raising or lowering interest rates is one of the most common tools the Fed uses to keep prices stable.  If they feel the economy is heating up and inflation is rising they may choose to raise interest rates to discourage borrowing, something that goes hand in hand with economic growth, and vice versa.

When the Fed alters rates they are referring to the federal funds rate or the rate at which banking institutions can lend money overnight to other banking institutions.  This may not affect individuals directly, but over the long term interest rates offered by banks change accordingly.  This eventually ripples out into the entire economy with the hope of controlling growth or jump starting the economy when it slows or contracts.

The Federal Reserve’s Federal Open Market Committee(FOMC) meets 8 times a year to discuss rates usually about 7 weeks apart.  This ties into the moderate long term interest rates portion of the dual, but actually triple mandate.  Quite obviously, an extreme change in the rate can have unforeseen effects on the economy so the Fed elects to raise or reduces rate gradually over time.  The Fed can also elect to keep rates unchanged if they believe inflation is where they would like it to be.  Currently the target rate of inflation is 2%.

While robust economic growth is good for everyone as it means more jobs, higher pay, and rising markets it is important that it is contained.  Additionally, it is important to encourage borrowing by lowering rates when times are not so good.  A stable economy that tends to expand over time is best for everyone as it keeps the maximum amount of people employed and will not radically change the price of goods.  The Federal Funds Rate is a tool to keep the economy on the right track.

 

Some more links for you:

Federal Reserve website FAQ section

Federal Reserve of Richmond Essay on the Dual Mandate

Explanation of the Federal Funds Rate

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Reading WSJ is Great. This is Better.

If you’re like anyone that wants to learn more about the markets you probably have a Wall Street Journal subscription.  It is a great resource and something I used to read cover to cover almost every day.  I still read it often, but I tend to skip the bombardment of writers telling me stocks are going up/down on any given day, recently the narrative has been the trade war and tariffs.  Don’t get me wrong these things pose a big threat to the global markets, but in my personal opinion that has not even come close to materializing yet and as someone who looks at the big picture I don’t think one day of stock market noise can be explained by any one thing.

So if you are looking to further deepen your knowledge there are few things you can do, many of which are free or won’t break the bank.  Some of the things we like to do include:

Reading Actual Portfolio Management Research

Find a fund, asset manager, investor, professor, economist or anything of the sort that you like and resonate with.  Read what they have to say and ask yourself if it makes sense.  Then read something completely opposite and see what you think.  I used to think individual stock picking was the only way to invest.  My ideology was that bonds could never give me the returns I needed and other financial products involved heavy amounts of leverage.  Then I read Burton Malkiel’s, “A Random Walk Down Wall Street.”  Now, I like looking at data and Malkiel consistently provided concepts I found easy to understand followed by charts to drive his thoughts home.  I am now more open to a portfolio that is diversified across the world and across asset classes.

Some other ideas include reading AQR Capital’s website.  With $226 billion under management across all their offerings its quite amazing they have a research tab right on the homepage so you can read up on their thoughts and insights.  I am also a big fan of Meb Faber’s blog and weekly podcast.  Aside from running a $1b AUM investment manager he frequently puts out free research and inexpensive books.

Looking At Economic Indicators

The Federal Reserve, Bureau of Labor Statistics, Institute of Supply Management, etc. regularly put out economic indicators that gauge the health of the economy.  A lot of guesswork is taken out when you have data showing how many people are buying houses or how inflated the prices of goods are.

Getting even more creative, public companies are required to disclose their financials every quarter.  The largest companies choose to have earnings conference calls and field questions from some of Wall Street’s top analysts, but these are completely available to the public.  So for free you can hear the executives of top global business talk about what their views are on their businesses and the overall economy.

Some of our favorite indicators include:

  • Real GDP Growth – GDP Growth less inflation
  • Purchasing Managers Index(PMI) – gauges business health by means of a survey to purchasing executives at hundreds of companies which includes new orders, factory orders, employment level, supplier’s delivery times, and inventories
  • Housing Starts – how many people are buying new homes
  • Caterpillar/Boeing Earnings Calls – industrial giants who are sensitive to changes in the global economy

Tinkering With Data Series

There are a number of free or low cost data series out there on the internet.  One of the most popular is the Fama/French database which includes US equity data dating back to the 1920s.   AQR Capital, which I referenced before, has a similar dataset on their website as well.  These two are especially nice because they have different factors you can play around with and see how they have historically performed.

However, even yahoo finance has free data.  Most recently I was playing around with an S&P 500 strategy that tilts into lesser represented sectors of the market and found that yahoo price data was more than sufficient.

And you don’t have to be a programming genius either, you can do a lot with excel and you’d be surprised how one simple plot can lead to many ideas.  One of my favorite websites portfoliovisualizer.com actually allows you to create a portfolio and see how it historically performed.

But if you are a real nerd you can play around with quantopian.com, quandl.com, and quantiacs.com.  These websites have free financial data and essentially built a backtesting engine for you so you just have to code up a strategy and see how it performs.  (Not sure if quandl does the backtesting for you I just heard they have great data)

More than anything it is important to be creative.  The industry notoriously is pretty secretive about their research because an overused strategy is one that does not work.  However, more and more firms are starting to provide research and insights to the general public so make use of what you can.  We are working on starting two new sections of the website. One for money manager’s letters to investors and one with interesting papers, excel spreadsheets, and more. So hopefully we can provide value to you as well.

As always we welcome questions, comments, and thoughts via email at founders@themodernpiggybank.com.  Be sure to subscribe to this website and follow us on twitter @themodernpiggy2.

The Major Indexes Explained

If you turn on CNBC you’ll probably see and hear a bunch of talking heads screaming about how many points the Dow is up on the day or where the S&P 500 is heading.  It can be a lot to take in and even we learn new things about the major indexes from time to time.  So if you are confused about what these things represent you’re in the right place.

The major indexes include the Dow Jones Industrial Average, Standard & Poors 500 (S&P 500), and the NASDAQ Composite.  There are countless more you may have heard of like the Russell 2000, but usually the three listed above are the most talked about and usually can be used to get a quick snapshot of whats happening in the market.

The Dow Jones Industrial Average

^DJI_YahooFinanceChart.pngThe Dow traces its roots back to 1885 and was officially introduced in 1896 when Charles Dow calculated an average of 12 purely industrial stocks.   Surprisingly, it is not the oldest index as it is 12 years younger than the Dow Transportation Average.  It has come a long way since then and now holds 30 stocks with none of the original 12 remaining.  GE has the record for the longest Dow membership, but was recently removed for Walgreens amidst a series of financial blunders.  The companies are selected by a committee of experts with the goal being to select companies that together best represent the US economy as a whole rather than purely industrials for which it was originally intended.

The Dow is the most followed US index.  Whenever it passes a mile stone celebrations are in order and whenever there is a crisis people gauge the severity by how much the Dow has fallen.  Interestingly enough the index is price weighted.  This means that a company that has a greater price per share represents a larger portion of the Dow than a company with a lower price per share.

A table of all the components can be found here.

The Standard & Poor’s 500

^GSPC_YahooFinanceChart.pngStarted in 1957, the S&P 500 is a weighted average of the top 500 stocks in the US by market cap.  Unlike the price weight of the Dow the S&P 500 is cap weighted meaning that companies with a larger market capitalization represent a larger portion of the index.  For example, a price swing in Amazon would have a bigger effect on the index than a price swing in Campbell’s Soup.

This index is just as popular as the Dow and some might argue that it gives a more holistic view of the US economy since it is an average of more stocks.  Since its construction relies solely on market cap it does tilt toward certain sectors of the economy and individual companies.  Currently the S&P 500 tilts toward the technology and financial services sector with about 26% and 15% weighting respectively.  The smallest sector is telecom at just under 2% (I calculated these a few months ago so I apologize if they are not 100% accurate).  To take this a step further about 4% of the index is AAPL while smaller companies can be just fractions of a percent of the index.  Overall, the S&P 500 is a solid way to hold the US market, but its construction can sometimes cause it to lean towards what’s hot.  We are working on an article discussing this in more detail and hope to share it soon.

To see the full list of member companies click here.

The NASDAQ Composite

^IXIC_YahooFinanceChart.pngThe NASDAQ composite is a composite index of all stocks trading on the NASDAQ exchange.  If you haven’t heard of the NASDAQ exchange it’s simply a separate stock exchange from the NYSE set up in the 1970s as the first electronic exchange.  To put this in simple terms every trade on the NYSE gets cleared in New York at the NYSE.  The NASDAQ is different as it allows sellers to automatically connect to buyers in a decentralized manner.  For further details click here for an interesting Investopedia article on how it all works.

Although it is not a tech exclusive index the NASDAQ is notorious for being technology heavy.  The index dropped over 80% in value in the early 2000s dot com bubble.  As of May the index sits at about 46% technology stocks, but otherwise has a good mix of stocks from every sector.  Additionally, it is also market cap weighted like the S&P meaning larger market caps represent a larger portion of the index.  It differs from the S&P 500 in that any company that chooses to list on the NASDAQ exchange is automatically on the index whereas the S&P 500 is the top 500 companies by market cap that are based in the US regardless of exchange.  Over 2600 stocks trade on the NASDAQ and they are all represented in the NASDAQ Composite index although some fund managers might select the top 100 as it makes it easier to package into index funds and the like.

For the full list of companies click here.

The Bottom Line

The major indices do a great job of giving a snapshot of the US markets, but that’s about it.  The construction of these indices show inherent biases towards industries and even individual companies.  Owning the US markets has rewarded investors handsomely over the course of modern history, but it is important to know how indexes and funds are constructed so you can truly understand your investments.

The main takeaway here is to understand what your risks are.  I have no problem with index investing as it is easier for me to justify why a whole market may go up than try to place a value on an individual security.  If we can assess our risks and better understand our portfolios we can start thinking about if we want to hedge that risk out and at the very least we can understand why our portfolio is moving up or down to avoid rash uninformed decisions.

If you are interested in index investing some great funds and ETFs are offered by Vanguard and State Street.  They are extremely passive, have very low fees, and minimal tracking error to the indexes they follow.  As always it is important to read the funds prospectus and understand how it works before investing.

As always we welcome questions, comments, and thoughts at founders@themodernpiggybank.com.  Be sure to subscribe to this website and follow us on twitter @themodernpiggy2.

How To Decide Between A Bank Or A Credit Union

If you are looking to open a new checking or savings account or maybe even secure a small loan you are probably shopping around at all of the banks in your area.  You may not have ever heard of Credit Union’s before or have even give it much thought.  Well today I am going to walk you through the key differences between the two and why I ended up choosing a credit union for my daily banking.

On a very basic level banks and credit unions essentially offer the same services.  You can deposit money into a savings or checking account, open a business account, secure loans, and use ATM’s.  The difference lies in how they operate and how they are run.

Banks Explained

As you probably know banks are for profit institutions. They exist to make money not for their clients but for their themselves and their shareholders.  As a result you may experience things such as higher fees and lower interest rates on savings accounts.  Most commonly people say that going with a larger bank can feel like a very impersonal and sometimes robotic experience.

On the flip side, it’s really nice to have access to ATMs across the country and more branches in more places. And very important to most millennials, most banks are investing heavily in technology to make their online banking and other services more convenient.

Credit Unions Explained

A Credit Union is actually a non-profit institution.  It is technically member owned although there usually are some executives to run the day to day operation.  As a result, lower fees and higher interest rates on savings accounts are used to get customers in the door.  Credit unions usually cater to a smaller more exclusive customer base but there are quite a few that have massive membership numbers.  For example, lots of large corporations have credit unions for their employees and the credit union I use requires your address to be within a certain distance of the nearest branch.  Although, I am sure you will find a credit union to fit your needs.

Aside from the lower fees and higher interest rates on savings accounts credit unions are known for the high quality customer service they provide. Most people who use them say the bankers they interact with really go out of their way to understand your financial needs and help you plan to achieve your goals. This all ties back to the customer owned non-profit status that they hold.

The big downside is the lack of branches and ATMs. Since most Credit Unions serve specific areas or companies they are regionally located and don’t have a national network of branches. However, even though your individual ATM network is usually limited, your credit union may give you access to the CO-OP network which boasts over 30,000 ATMs.

Summary

It really comes down to what you are looking for in a financial institution.  If you are looking for a convenient place to deposit and withdraw money I would say the bank is the superior option, as they are more nationally present and have quick automated processes in place.  If you want to save a little more and the customer service experience is important to you go with the credit union.  These institutions come in all shapes in sizes so my best advice is to shop around.  You might be surprised with what you find.  For example, a small bank might be personable like a credit union with a larger presence and a large credit union might be able to give you lower fees and high interest savings with many of the benefits of banks.

My Experience

I ended up going with my local credit union and here’s why.  Their checking account yields 2% interest on balances up to $10,000 and all I have to do is have at least 1 direct deposit a month and swipe my debit card 12 times a month.  I get direct deposit through work and the 2% interest will pay for my months worth of coffee and then some.  Additionally, they offered me a credit card specifically for those who are new to credit and looking to build up their credit score.  Additionally, my credit union does participate in a CO-OP network and will even give me a refund of up to $20 worth of out of network ATM fees.  It was a perfect setup for my specific situation.

The bottom line is keep an open mind, shop around, and ask questions.  Everyone’s situation is different and could be better suited to a variety of different options. If you need help deciding feel free to reach out to us and we can walk you. Through more detailed differences.

As always you can reach us at founders@themodernpiggybank.com for questions comments and concerns.  Follow us on twitter @modernpiggy2 and please subscribe!

How To Sharpen Your Skills For Free

After I graduated I was looking for a way to keep some of the skills I learned in college sharp and maybe even add some new ones to my tool belt.  There are countless websites out there that will charge you a lot of money for a product you know little about.  For example, one of my clubs in college offered DataCamp for free to dues paying members. DataCamp is a premier resource for learning programming with data science applications in a web environment.  It was a great tool and a great product, but I could not justify paying $30/month for it.

So I tried out a website called edx.com, it is a non profit run by universities offering college level courses many of which are free.  The most popular subjects offered are Computer Science, Language, Data & Statistics, Business & Management, Engineering, and Humanities, but don’t be fooled there are tons more course offerings.  Courses are either self paced or instructor led and provide a sample syllabus outlining lesson plans, software packages, and how much time is recommended to be devoted to the course per week.  In addition, they have professional certificate programs although these are paid features.  I am planning to sign up for the Introduction to Python series to refresh my skills and learn the new features of Python 3.

In addition to edX, there is Coursera where I found a great instructor led course on Wind Turbines that I am looking to complete.  Also, there is lynda.com which has partnered with a lot of universities, such as our alma mater Penn State, and libraries to offer similar free courses.

Whether your looking to learn something completely new or just sharpen your skills there is no harm in taking a free course at one of these sites.  They are great resources for almost all popular subjects and will help immensely in your personal development and the best part is that it won’t cost you a dime.

Buy A House Not A Home

If you are like me, home ownership is probably a long ways away.  However, I recently read a white paper called “The Rate of Return on Everything, 1870-2015” published by the Federal Reserve Bank of San Francisco.  Theres a lot of good facts and data in there and I strongly encourage you to read it (or skim it like a certain Modern Piggy Bank Founder did… looking at you Will).  But if reading 123 pages of economic data and commentary isn’t your cup of tea I’ll spare you the burden and tell you what I found most interesting.

The paper looks at major asset classes over the time period 1870-2015 most notably bills, bonds, equities, and housing and analyzes their return statistics.  Believe it or not housing was on par with equities with average return of 7% a year.  In the post World War II era, equities have taken a marginal lead, but the investor has also needed to take on more volatility and is subject to the ups and downs of the business cycle.  Where as the housing market has been much steadier over time.  Additionally, housing does not correlate heavily to the global markets i.e. a bear market is less likely to have a significant adverse affect on housing prices.

Now home ownership has been seen as a rite of passage in America and a sign that someone is financially well off.  Unfortunately, situations like the 2008 financial crisis show how a house can sometimes not be a wise investment especially your primary residence.  I’m currently looking to apply for my first credit card which I will talk about in a later post, but I find it concerning how the Federal Government insured home loans leading up to 2008 and will loan teenagers with no grasp of the concept of credit hundreds of thousands of dollars to achieve higher education because it’s a “good investment” while private credit institutions want new credit card owners to have $200 spending limits.  Anyways, I digress.

Back on track.  You will always need a dwelling, it will always be an expense.  I will even go on to make a controversial claim that a mortgage on your primary residence is nothing more than an expense.  If you weren’t paying it down every month you would be living in an apartment paying rent.  When you go to upgrade homes you will now have a higher monthly expense with the total offset by the profits on your past home sale.  Furthermore, theres property taxes, utilities, home improvement/maintenance, etc.  Your primary residence will probably not produce a dollar of cash flow.

Enter the rental home market.  Instead of adding to your expense column you can invest your money into a home for tenants.  Sites like airbnb have made this incredibly easy for vacation spots.  Some people even rent guest rooms in their own homes to offset their housing costs.  For me, it makes sense to invest in an asset that tends to increase in value over time, although this is not always the case, while I can put it to work and pay off its expenses and maybe even a little extra.  To take it a step further the white paper previously mentioned suggests that the lower volatility will protect my downside in case things go wrong as opposed to the equity markets which are heavily correlated across the globe.

If you can fit it into your budget and are willing to do the due diligence consider investing in a rental property.  I mean not to discourage you from home ownership because it is something incredibly rewarding that I look forward to one day.  I mean to challenge your thinking so you can minimize your expenses and optimize your savings.

Whether you like what I said or hated it feel free to reach out at founders@themodernpiggybank.com and follow us on twitter @themodernpiggy2.

Trade Like A Quant

Sometimes dubbed the rocket scientists of Wall Street the meaning of quantitative analysts often takes on a broad meaning.  Quant is a fairly broad term honestly, but roughly means someone who takes an extremely mathematical approach to the markets.  While some quants use Einstein level math there are some practical lessons you can take away to use in your own portfolio.

More than anything quantitative analysts apply a rigid rules based approach to the markets.  They have specific buy and sell signals that they adhere to religiously and consistently.  This is where their great returns come from(if their algorithms are correct).  While some get blamed for things like the flash crash where the DOW dropped 9% in minutes it would be wrong to say that it was the strangest thing to ever happen in market history.  A signal for a quant could be something as simple as the 200 day moving average or as complex as analyzing S&P 500 futures contracts volume and expiration and placing an order nanoseconds before the futures expire and pocketing the spread, which is the high frequency trading world.

So how can you apply this? Well a buy and hold strategy sounds great in theory, but its harder to stick to in practice.  Sure its easy to say when the market has not had a down year since 2008, but it would have been really hard to hold onto your portfolio is 2008 when the US equity market shed about 40%.  If you haven’t experienced a massive drawdown like that imagine draining half of your savings.

So if you are someone who can’t weather massive drawdowns, and we don’t blame you if that is the case, consider taking a rules based approach.  It is great to have an investment plan that you can stick to and might even help you sleep better at night.  Here is a simple rule to get you to start thinking about what you might want to do:

Apply a short, medium, and long term moving average to your portfolio.  When conducting your rebalancing, best done once a year for tax benefits, tilt most towards the assets in upward trend above the moving averages, more towards the one that are not trending as strongly above one or two of the moving averages, and least towards those in a downtrend under the moving averages.

Note: This can be considered a trend following approach and is a popular investment style that may or may not suit you.  Over time strategies go in an out of favor so its often wise to pick a strategy that you understand and believe in and stick with it over the long term.

Building wealth takes strong discipline and taking your emotions out of investing by applying rules to a strategy that works can often help mitigate bad decisions.