Thoughts on Current Market Events: Emerging Markets & Stimulus Wind Down

As sexy as "stimulus" sounds, investors are starting to worry what impact the pulling back of quantitative easing (the Fed's way of stimulating the economy by keeping interest rates low) will have on the markets, both in the U.S. and abroad. Easing up on stimulus should be a good thing, a sign that the economy is doing better, that the unemployment rate is improving, that roses are starting to sprout, and the sun is beginning to shine. But, of course, for every action, there is an equal and opposite reaction (thanks, Mr. Newton), so fears abound.

Pulling back on quantitative easing will likely mean an increase in interest rates here in the U.S. Generally, when Treasury rates rise, other interest rates, including mortgage loans and credit cards, go up, too. Part of the fear here is that the U.S. economy is still fragile. For example, while the unemployment rate has fallen to 6.6%, millions of people have been unemployed for so long that they have stopped looking for work; they are not included in that 6.6%. All told, the labor participation rate is only 63%, according to the Washington Post, the lowest it's been in a generation. Home sales are volatile at best. Consumer spending has been on the rise, but is nowhere near what it was pre-recession. The American middle class is slowly dwindling, which is displayed most simply in the consumer sector, where high-end luxury brands such as Kate Spade and Michael Kors, and low-end retailers like Dollar Tree, are vastly outperforming middle-of-the-roads like Abercrombie & Fitch.   

If interest rates rise too quickly, it could send the U.S. economy into a downward spiral. Credit card interest rates are already high, so consumers could be crippled by higher rates. High gas prices will only compound this effect. High food and health care costs would only make things worse.

Globally, the effect of relieving QE was witnessed recently. When the Fed announced its confidence in the U.S., investors fled emerging markets and ran straight into the arms of U.S. Treasuries. The run-up in the U.S. stock market over the past few years has taken a toll on emerging markets. EM stocks lost 5% in 2013, according to MSCI. EM sovereign debt performed similarly poorly. Leaders abroad have expressed concern about what continued easing will do to their countries' currencies, exports, and inflation levels. 

I like to think of myself as a contrarian investor, as following the crowd rarely leads one to buy low and sell high. That said, I think it's a great time to invest in emerging markets equities while prices are low relative to U.S. stocks. Keep in mind that, as quantitative easing is unwound more and more, EM stocks will likely get more volatile. In the end, I think it will be worth the wait. I'm of the belief that developing countries will not be wiped off the map, that they will continue to grow as time passes. 

I've expressed in previous posts that I don't think the record U.S. stock market levels are sustainable, as they do not reflect the true underlying health (or lack thereof) of the economy. (In fact, the S&P 500 just reached a new high today of 1,853.38.) I expect that they will come down as QE ends. Over time, investments in emerging markets may set off U.S. and other developed markets' losses. 

Guess I shoulda bought a house last week

Dear Readers,
It's been a while since I've written and a lot has gone on in both my life and the markets! On my end, I graduated from business school, packed up my apt in DC, and moved my whole life to New York City. I've gotten settled in well, exploring the city almost every day. I say "almost" because my job search is in full force, and looking for a job can be a full-time one, ironically. But, I'm back to blogging, so here goes!

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So much has happened in the markets over the past month, but much of it has occurred in the past week or so. You probably saw headlines to the effect of, "Markets Flinch as Fed Eyes Easy-Money End," or "Global Sell-off Shows Fed Reach Beyond the U.S."

What happened to cause all of this drama?

At a meeting of the Federal Reserve Board, Chairman Ben Bernanke basically said that he is considering ending quantitative easing (the buying up Treasury bonds by the Fed itself to keep interest rates low so people spend and invest more) later this year or at some point next year, rather than waiting until the unemployment rate was below 6.5%, as he initially promised. This implies that Bernanke feels that the U.S. economy is strengthening at a pace that it won't need to be supported by the government anymore; it's a compliment, really.

Problem is, the market did not interpret it as such.

Investors around the world freaked out, selling stocks and bonds like nobody's business, which shows that investors are not as confident in the strength of the U.S. economy as Mr. Bernanke is. It also shows that investors, businesses, and consumers alike have all gotten very used to record low interest rates. (For example, car sales have jumped exponentially over the past year.)

The trouble is, QE has to end at some point. And with that, interest rates will rise. The big sell-off in bonds last week helped them rise already. The yield on 10-year Treasuries jumped to 2.308%, its highest level since March 2012. The yield on 30-year Treasuries rose to 3.65%, a height not seen since 2011. Even more amazingly, these rates went up faster than they have since August 2009.

So, what does that mean for the average individual, even someone who is not an investor?

Treasury yields are used as a base for many interest rates, from savings accounts to car loans to mortgages. With yields being so fickle last week, mortgage rates have shot up. As of June 27, 2013, the rate on 30-year fixed mortgages were 4.46%, the highest since August 2011. BUT, last week, said rate was just 3.93%.

This is really significant because, of course, the interest rate has a massive effect on the size of a mortgage payment. Think of it this way (courtesy of CBS News):

"A $165,000 30-year loan obtained with last week's 3.93 rate will cost $786 per month. Under the new 4.46 percent rate, that jumps to $832 per month. That's a $46 monthly increase -- or a whopping $16,560 over the life of the loan. ...For a $300,000 30-year loan, the rate increase comes to an extra $92 per month, or $33,120 extra over the life of the loan..."

YOWZA!

Unfortunately, there's not much that individual home (or car or appliance) buyers can do. Never try to time the market, of course. Just wish for the best and refinance as appropriate, although the odds of rates doing down from where they are now are extremely slim, in my opinion.

Can you risk it?

My great aunt had a way with words. Among her best quotes are, "Love is good, but money's better," "Love don't pay the rent," and "Don't marry a man if he don't have a key to something." (Great advice on all fronts.) Once, my sister told her about a guy she'd started dating, and my aunt wanted know if the guy was trustworthy. Instead of asking, "Do you trust him?," she said, "Can you risk him?"

She wasn't all wrong in correlating risk and trust. It's hard to trust the market, since you know it flucurates so much, so it all comes down to how much you stomach.

The first thing to know and remember like your own name is that there is no such thing as a risk-free investment. (Although U.S. Treasuries are called "risk-free" because they are backed by the government, their value is still at risk of being eaten away by inflation. And, it doesn't seem all that possible, but the government could default one day.)

So, if anyone ever offers you an investment opportunity that has "no risk," RUN AWAY because it is a scam.

That said, the amount of flucuation you can stomach is known as your risk tolerance. To help determine your level of tolerance, there are a ton of quizzes you can take. A couple of ones that I found legitimate were from Merrill Lynch and Rutgers University. The one from Merrill focuses solely on investment decisions, while the Rutgers one -- since it is actually a study on risk behavior -- is more broad and user-friendly, in my opinion.

Quizzes like these present you with questions that try to get at how much you are willing to lose for the chance of making gains. It may surprise you how much the magnitude of the potential gain matters versus the magnitude of potential loss. (I won't give it away; I'll let you take the quiz and find out for yourself!)

Some general rules/thoughts regarding risk are:

• If you're younger, you can take more risks. This is because of precious time your portfolio will have to recover from market losses. For example, if you'd invested $100 in the market on January 7, 2000, by December 27, 2002, you would have lost almost $41 dollars. Let's say you decided to hold on to those shares instead of selling them at a loss.* By December 28, 2007, you would have recovered your losses.* Holding for a brief period (that, in this example, was a terrible time for the market overall) would not have served you well, but over a longer period of time, you actually gain.
• Small-cap stocks tend to be riskier than medium- and large-cap stocks. This is because small-cap stocks are from smaller companies that are not as established, but have a lot of growth potential. Take Rocky Mountain Chocolate Factory, which operates in malls, primarily, in 40 states, Canada, Japan, and the UAE. This company is growing in different geographies, but since chocolate is not a commodity, its business can flucuate in hard economic times, so this investment would certainly be riskier than one in Hershey, for example, since the latter has been around for 100 years or so and has a strong global presence.
• Women tend to take fewer risks when investing. Common thought holds that women tend to be more risk averse when it comes to investing. Which could mean that a woman's retirement savings will likely be much lower than her male counterpart's. However, loss aversion can be useful. Women may be more inclined to make more thoughtful investment choices than men and stay out of overly risky investments. Some say that if more women were on the boards of banks, the financial crisis would never have happened.
• Stocks tend to outperform bonds. Historically, stocks have consistently outperformed bonds over time. From 1928 to 2012, the S&P 500 beat out ten-year Treasuries by more than 3 percentage points, which could be the difference between making $871 or $564 off of a $100 investment. It's good to have a diversified portfolio of stocks and bonds that complement each other, but stocks tend to have greater upside potential. Since bonds are debt, the bondholders, like a credit card company, are ultimately more concerned with getting their money back rather than what can be made on top of it. Equityholders, on the other hand, do not have to be paid back, so upside is all they can hope for; in exchange for taking on this risk, they get a higher reward. Get rewarded for holding stocks!

Don't be afraid to take risks, but if you don't have the funds to spare, do not risk them at all. It's much more important to pay down high-cost credit card debt than to start investing. But once you're free from that bondage, fly higher into stocks for [potentially] added financial security.

*Source: Google Finance S&P 500 chart.