The Fed just raised the discount rate–what does it mean?

The discount rate is going up to .75%

After the close of stock market trading yesterday, the Federal Reserve announced that it was going to raise the discount rate from .5% (annual rate) to .75%, effective today.  It will also limit the maturity of “discount window” loans to overnight, effective March 18th.  Previous policy allowed loans of up to 90 days.

What does this mean?

Some background

the Fed Funds rate

Federal banking laws require that each bank keep deposits, called reserves, with the central bank equal to a specified proportion of the loans it makes.  The proportion varies with the kind of loan.

Banks don’t always have the exact amount of money they need to have on deposit with the Fed.  Some have more than they need, some less.  Under normal circumstances they borrow and lend with each other in the market for overnight bank deposits, called the Federal Funds market.

The Fed uses this market as its principal tool for setting money policy.  It announces its desired level for the fed funds rate.  The Fed also trades in this market as necessary to keep the rate at the designated level.  The current fed funds policy, which is to keep that rate under .25%/year, remains unchanged by the rise in the discount rate.

the discount rate

The Fed has another tool for controlling short-term rates, the rate for borrowing funds directly from the Fed rather than from other banks.  This rate, which was a prominent Fed tool a generation ago but is no longer particularly relevant, it called the discount rate. Banks who use this rate are said to be going to the Fed’s “discount window.”

Under normal circumstances, the discount rate is higher than the fed funds rate.  Just before the financial crisis, the discount rate was 1% more.  Banks have no absolute right to borrow from the discount window, but must ask the Fed for permission to do so.  Discount window borrowing normally carries a stigma with it, since it implies that the bank in question has either hugely messed up its planning of reserve deposits, or that other banks are unwilling to lend to it.  Serial discount window borrowers may face Fed disciplinary action.

The situation up until today

With the onset of the financial crisis in 2007, interbank lending, even overnight lending, started to dry up.  At the height of the crisis, no one would buy bank commercial paper.  No one would lend in the fed funds market.  Therefore, banks couldn’t raise money to make loans to customers.  Even worse, banks that were borrowing to have money to meet minimum reserve requirements on outstanding loans were faced with the prospect of having to call in loans to satisfy the reserve rules with the cash they had on hand.

The Fed dealt with this mess by becoming an active lender to any and all member banks at the discount window, by lowering the premium over the fed funds rate, in stages, from 1% to .25% and ultimately extending the maturity of discount window loans from overnight to 90 days.

At the height of the financial crisis discount borrowing was extremely important, reaching well over $100 billion.  Today it has shrunk to less than $15 billion.

Why the changes?

Two reasons:

–the short-term lending market has pretty much returned to normal.  The only reason for a bank to borrow from the discount window today is that the rate is better than a weak bank could get in the open market.  By ending this subsidy, the Fed is sending a message to these institutions to get their houses in order.

–it’s a signal to the financial markets that the Fed intends to act responsibly and return money policy to normal when conditions are right.  Remember, in its announcement, the Fed stressed that for now the Fed Funds rate, the key policy rate, will remain unchanged.  The Fed has already withdrawn a couple of its support programs, but an increase in the discount rate is a much more visible step.  So it has much greater psychological value.

Market reaction

So far, reaction has been muted but slightly negative for stocks and positive for the dollar.  Treasury bonds are up, but that’s because of favorable inflation data announced this morning.

The rise in the discount rate will have no practical effect on world economies.  As a statement, I think it should be read as a mild positive, that the US economy is healthy enough that it no longer needs this support (which wasn’t doing that much any longer, anyway).  I think stock markets should be up on the news.

Looking at Inventory (I): general

Two posts

I’m going to cover this topic in two posts.  This one will be about what inventories are:  the sub-categories of the inventory entry on the balance sheet, and three main ways companies choose to account for inventories.  Tomorrow’s post will cover what kinds of information you can get about a company from comparing the inventory entries from different time periods.

Here goes:

There are three sub-categories of inventory on a company’s balance sheet:

raw materials.  This is pretty straightforward.  Raw materials are inputs to production that the company owns but has not yet begun to process.  They might be a pile of iron ore outside a steel mill or a bunch of windshield wipers stacked in a warehouse next to an auto assembly plant.

This entry records what the company owns, which may be something very different from what’s at the production site.  The idea of “just in time” manufacturing is that the component suppliers have warehouses full of their wares that they deliver on the day they’re needed.

In today’s world, financing cost aren’t the big issue.  Instead, it’s who takes the risk that the stuff in the warehouse falls in price while it’s just sitting there.  The answer is whichever party has less market power, typically the component supplier.

work in process (which a lot of people incorrectly call “work in progress”).  This is stuff that has entered production and is in the process of being turned into finished goods.  The increase in value of the raw materials will be a mix of direct costs involved in making the item, like salaries of assembly workers, and indirect, or period costs, like the cost of renting/leasing the production site, utilities (heating, lighting), and salaries of foremen and the plant manager.

The amount of work in process varies widely from industry to industry.  Assembly of a PC or a cellphone may take a day.  A semiconductor may take several months.  Wine or whiskey may ferment for years.

finished goods.  This one is also straightforward.  It’s the final products a company makes that are waiting in storage for a buyer to pick them up–or in some cases, to materialize in the first place.

How finished goods move from the balance sheet to the income statement Continue reading

Do senior citizens make bad investors?

A soon to be published study of age-related investor behavior

A forthcoming article in the Review of Economics and Statistics by Alok Kumar of the University of Texas at Austin and George Komiotis of the Federal Reserve says older investors are indeed bad.  According to Kumar and Komiotis, a sharp, progressive deterioration of cognitive abilities that begins for most people around the age of 70 overwhelms the positive effects of superior experience.  The result is ever worsening active management performance.There’s a summary of the article, with useful investment tips, in this past weekend’s Wall Street Journal.

The research has actually been around for a while, and was also written up in the New York Times in 2005.

Aging is an issue

I think that aging is a real issue for investors, although not for the reason–age, per se–that the authors cite.

As we age, we become more susceptible to physical and mental diseases that absorb our time and energy, reducing our ability to concentrate on investments.

But also I  think we all underestimate the intense socialization inherent in modern work, especially white collar jobs.  When we retire, it’s like we’re professional athletes who have just broken ties with the team.  No more three hours a day of physical training, no three hours of practice.   No more big games, teammate pressure to perform, no mental training–concentration, visualization.

The intense atmosphere that we’ve become accustomed to and don’t consciously perceive is gone.  Some of us decide we’d prefer going fishing to continuing to train our brains.  And without the social atmosphere and the associated competition, it’s hard to reach the peak performance we achieved easily before.  In what seems the blink of an eye, we’re like the retired athlete who’s no longer a greyhound, but has gained 50 pounds of unsightly flab.

I’ll come back to this later, but first to the study.

How the study worked

The researchers got a discount broker to give them access to data for 62, 387 customers over six years, from 1991-1996.  They looked only at common stocks and common stock trading.

The average account had 4 stocks in it, with a combined value of $35,629.  The median account had 3 stocks in it, worth $13,869.

The study used zip code data to estimate income, education and ethnicity.  Average income, which didn’t vary much across age groups below 60 was $90,782.  Mean wealth was $268,909.  Therefore, the portfolios studied represented about a third of yearly income and 13% of estimated wealth.

About 27% of the accounts were of California residents.  The study looked at both total and ex-California results, which showed no differences.

The conclusions:

–no one beat the S&P 500

–relative performance by age group rose steadily from twenty-somethings to peak with people in their mid 40s.  Performance began a decline that really accelerated after 70.

–High income, better educated clients did better than average.  Low income, less educated and minority group clients did worse.

Where I think the study goes wrong

1.   A quibble. In any endeavor like this, you study the characteristics of a small group that you then argue is representative of the population as a whole.  In this case, the argument is that the traits of clients of the unnamed discount broker are indicative of investors throughout the US.  We already have reason to suspect that this isn’t true here, since California makes up 12% of the US population but 27% of the accounts studied.

2.  The dollar amount of stocks studied is very small.  More important, although the study’s authors argue that the stocks in question don’t represent “play money” or afterthoughts to the account holders, they have no way, other than information from account applications and zip codes, to determine this.

For younger investors, their main source of wealth is most likely their human capital, that is, their professional skills and educational investment in themselves.  Older investors will likely own real estate, pensions, IRAs or 401Ks or stock (or some other ownership interest) in the company where they work.  I don;t think this has ben factored into the wealth estimates.

3.  Financial information in a client’s initial brokerage application can be seriously out of date. Also, the wealth and income data can be seriously understated.  As any financial advisor will tell you, clients can be very reticent about revealing the true extent of their wealth, for fear they will be pressured to shift assets from elsewhere to the broker in question.

4.  I don’t think conventional risk adjustments address the situation of the older investor.  At some point, an investor’s goal changes from trying to accumulate more wealth to trying to preserve the wealth he has.  Beating the S&P 500 goes out the window and preserving income walks in the front door.

In addition, the more cautious attitude an older investor may have will likely be reinforced if he has a financial advisor.  Besides the client’s financial health, the advisor also has to consider the possibility that he may be sued by the client’s heirs if the investments have gone down in value.  Remember, customers of traditional brokers often have discount brokerage accounts as well, where they do trading based on the “full service” broker’s advice.  Why?  …to avoid the high fees the latter charges, and that the client thinks are out of line with the value of the advice received.

In other words, underperformance vs. the market may be a function of increased risk aversion, not cognitive decline.

What I think is important

I usually don’t like newspaper articles about investing, but I thought the Wall Street Journal one was pretty good.

1.  Simplify your investments, so that you are able monitor them in the time you are willing to devote to this.

2.  Have a backup plan for if you become sick or otherwise unable to spend time on investing–in other words, how do you get from where you are now to total indexing.

3.  Have records that allow you, or some one else, to determine things like cost basis.  Be especially careful if you have (as many people do) brokerage accounts you’ve closed but which contain cost data for stocks you’ve transferred elsewhere.  If you hold actual physical stock certificates, make sure that you have a separate list of what you own, in case the certificates become lost or damaged.

Disney–waiting for the upturn; Dec 09 results

First-quarter results–up 15%

DIS reported its December-quarter (first quarter of fiscal 2010) earnings results on February 9th.  Excluding unusual items, earnings per share were $.47 this year vs. $.41 last year.  That’s a gain of 15% over the deep-in-recession performance of 12 months ago.

The investment case for DIS…

…assuming there is one (I own the stock, so I must think there is) rests on three ideas:

1.   ESPN continues to motor along in the US and is successful in expanding into the UK,

2.  the theme parks gradually recover, and

3.  the movie business straightens itself out and starts to make money again.

It would be icing on the cake if the ABC television network/stations stabilized, and/or if–in a reversal of twenty-five years of avoidance–customers started to show up at EuroDisney.  But these operations are small enough that all they really need to do is not get in the way too much.

How did the quarter stack up? Continue reading

Activision–strong 2009, better 2010 in store

The earnings conference call

I listened to a replay of ATVI’s fourth-quarter earnings conference call the other day.  It was an odd event, in my opinion, conveying lots of data but not that much information.  This may in part have been due to the fact that the analysts participating in the call ranged from the very knowledgeable to people who gave no evidence they knew anything about either ATVI or the video game industry.  A fact of life on today’s Wall Street, or an indicator of the declining importance of the video game industry to investors?

High- and low-lights: Continue reading

Kindle economics (III): the Macmillan book dispute

The dispute

The Macmillan publishing house and Amazon had a recent, very public spat about Kindle book pricing.  Amazon had been paying Macmillan about $12.50 per e-book for a $25 list-price new release–the same as it would have paid for a physical book–and then selling it through Kindle for $10.  Macmillan wanted that stopped.

Instead, it wanted AMZN to raise the Kindle price to $13-$15 and use the iPad (and now Kindle, starting in June) agency model to pay it.  That model, also used by publishers in dealing with independent bookstores, calls for the sale revenue to be split 70% for the publisher and 30% to the retailer.  If AMZN didn’t agree, Macmillan apparently threatened to withhold its titles from e-book sale on Amazon for six months after publication, while Apple would be allowed to sell them on day one.

The arguing even went as far as having AMZN cease selling Macmillan books through its website for a short time.  AMZN then issued a surly letter to customers and acceded to Macmillan’s demands.

What’s wrong with this picture? Continue reading